Residual income, often referred to as residual return, is the net income that a subsidiary or division of an organization generates after being charged a percentage return for the book value of the net assets or resources under its control. This approach ensures that the subsidiary or division maximizes its profits after accounting for the use of assets.
Types/Categories of Residual Income
- Corporate Residual Income: Used to assess the performance of subsidiaries or divisions within a large corporation.
- Investment Residual Income: Evaluated in the context of investment portfolios to determine the profitability after accounting for the cost of capital.
- Personal Residual Income: In personal finance, it refers to the income remaining after all personal debts and obligations are paid.
Key Events in the Development of Residual Income
- Adoption in the 1980s: Many large corporations began adopting residual income as a performance measure during the late 1980s and early 1990s.
- Integration with EVA: The evolution of Economic Value Added (EVA), developed by Stern Stewart & Co., closely aligned with the principles of residual income, leading to its wider acceptance.
Detailed Explanation and Calculation
Residual income is calculated using the following formula:
$$ \text{Residual Income} = \text{Net Operating Profit After Taxes (NOPAT)} - \text{(Capital Charge)} $$
Where:
- NOPAT: Net operating profit after taxes.
- Capital Charge: The cost of capital times the book value of net assets.
Example Calculation
Consider a company with two divisions, Division X and Division Y, each contemplating a £1,000,000 investment:
|
Division X (£) |
Division Y (£) |
| Proposed Investment |
1,000,000 |
1,000,000 |
| Profit before Interest and Tax |
200,000 |
100,000 |
| Cost of Capital |
15% |
15% |
Calculation:
$$ \text{Cost of Capital Charge (15% of £1,000,000)} = £150,000 $$
|
Division X (£) |
Division Y (£) |
| Profit before Interest and Tax |
200,000 |
100,000 |
| Cost of Capital Charge |
150,000 |
150,000 |
| Residual Income |
50,000 |
(50,000) |
Importance
- Performance Measurement: Residual income provides a more accurate measure of performance by considering the cost of capital.
- Decision Making: Helps managers make informed decisions about investments and project viability.
- Risk Adjustment: Different cost of capital percentages can be applied to account for varying levels of risk across divisions.
FAQs
How does residual income differ from EVA?
Residual income and EVA are conceptually similar, both measuring financial performance after accounting for the cost of capital. EVA typically includes more detailed adjustments to NOPAT and capital.
Why might managers prefer ROCE over residual income?
ROCE is simpler to calculate and understand, making it easier to communicate and implement across the organization.