Residual Income

Definition
Residual income is a measure used as part of divisional performance management
for investment centres. An investment center’s residual income (RI) is the profit
earned that exceeds an amount “charged” for funds committed to the center. The
“charged” amount is equal to a specified target rate of return multiplied by the asset
bae and is comparable to an imputed rate of interest on the divisional assets used.
The rate can be changed to compensate for market rate fluctuations or for risk. The
RI computation is:
Residual Income = Operating Income – (Percent cost of capital x Average Operating
assets)
Residual income yields a dollar figure rather than a percentage. Expansion (or
additional investments in assets) should occur in an investment center if positive RI
(dollars of return) is expected on the dollars of additional investment.
Notice that operating income and average operating assets used here to calculate RI
are the same measures used in the ROI calculation. The one new item, percent cost
of capital, is the company’s percentage cost to obtain investment funds (often called
capital). For example, a company that raises funds by issuing bonds would use the
interest rate associated with the bonds in establishing its percent cost of capital.
Additionally, residual income serves as a way to track the flow of your earnings. It is
also a method of determining a company’s stock value. You calculate a company’s
stock value by adding their book value and the current residual income value.
Residual income measures the profit left behind after you subtract opportunity costs.
Advantages
 Economic profit: residual income is related to the concept of economic profit
that accounts not only for explicit (out-of-pocket) costs but also opportunity
costs. Economic profit is revenues (from outputs) minus the cost of inputs and
opportunity costs. Because residual income accounts for the cost of
investment (i.e., the opportunity cost of using invested capital), it is
conceptually related to economic profit.
 Project (investment) selection: residual income provides one advantage
over return on investment (ROI) - a comparable performance measure - in
that it provides incentives to pursue profitable projects regardless of the
business unit’s past performance. As long as residual income is positive, a
business unit (manager) will likely agree to implement the project. When using
ROI measure, managers will likely select profitable projects with a return
above the unit’s past ROI performance and ignore profitable projects with a
return below the unit’s past ROI performance (in order to maintain or increase
unit’s ROI).
 Adjusting cost of capital for risk: organizations can use different
requirements for minimal rate of return for different business units.
Organizations can use a higher required rate of return for riskier business
units and a lower required rate of return for less risky business units.
Disadvantages
 Business unit size: residual income is usually a bad measure for comparing
business units of a different size. Larger business units usually can generate
greater profits, given their amount of assets, and hence will likely have larger
residual income. Thus, when comparing business units of a different size,
residual income could make larger units look to perform better than smaller
units even though that might not be true.
 Myopia (short-term outlook): by using accounting numbers for short-term
performance evaluation (e.g., quarterly or annual profit and investment
measures), organizations may create a short-term outlook or myopia for
managers. As the result, managers may make decisions that are not optimal
in the long run (e.g., not investing in much needed equipment; not training
employees).
 Number choice (subjectivity): similar to many other performance measures
that use accounting numbers, organizations can use different proxies for profit
and investment. Also, when calculating residual income, organizations can
use different proxies for minimum rate of return. As such, it is possible to
come up with different residual income measures for the same business unit
in the same time period. While residual income is to some extent an objective
measure of performance (i.e., we can agree on how the numbers are
calculated), it still adds a subjective element to performance evaluation
through the choice of accounting or other financial numbers.

Types of Residual Income

Equity Valuation
In equity valuation, residual income represents an economic earnings stream and
valuation method for estimating the intrinsic value of a company's common stock.
The residual income valuation model values a company as the sum of book value
and the present value of expected future residual income. Residual income attempts
to measure economic profit, which is the profit remaining after the deduction
of opportunity costs for all sources of capital.

Residual income is calculated as net income less a charge for the cost of capital.
The charge is known as the equity charge and is calculated as the value of equity
capital multiplied by the cost of equity or the required rate of return on equity. Given
the opportunity cost of equity, a company can have positive net income but negative
residual income.

Corporate Finance
Managerial accounting defines residual income in a corporate setting as the amount
of leftover operating profit after paying all costs of capital used to generate the
revenues. It is also considered the company's net operating income or the amount of
profit that exceeds its required rate of return. Residual income is typically used to
assess the performance of a capital investment, team, department, or business unit.

The calculation of residual income is as follows: Residual income = operating income

- (minimum required return x operating assets).
Personal Finance
In personal finance, residual income is known as disposable income. The residual
income calculation occurs monthly after paying all monthly debts. As a result,
residual income often becomes an essential component of securing a loan.

A lending institution assesses the amount of residual income remaining after paying
other debts each month. The greater the amount of residual income, the more likely
the lender is to approve the loan. Adequate levels of residual income establish that
the borrower can sufficiently cover the monthly loan payment.

Reference
Residual Income (Available at Residual Income (RI) (kaplan.co.uk).)
Residual Income (Available at
https://www.investopedia.com/terms/r/residualincome.asp)
Raiborn, C. and Kinney M. (2013). Cost Accounting 2 nd Edition. Cengage Learning.
pp 560-561

Business Unit Profitability Analysis

Definition
 Business unit analysis is an activity where a company reviews each unit in order to
assess its effectiveness and efficiency. The review may take place under the
unit’s manager and an organizational manager, which ensures objectivity in the
review process. Business unit analysis often looks at the services each unit provides,
the delivery method for the services, and information necessary to complete the
process.
Business unit profitability analysis can help us determine how profitable a given
business unit is. In the analysis, we will evaluate sales and expenses for that unit.
Expenses include equipment, floor space, salaries, etc. There are a couple of
approaches to business unit profitability analysis, but the underlying principle is the
same:

 What is our income for the business unit?

 What are the expenses?

Types of Business Unit Profitability Approach

Full Cost Approach
The full cost approach looks at ALL expenses related to the business unit and
assumes they impact that business unit. For example, the building space used to
make both staplers and binders still benefits the stapler production: according to the
full cost approach, these expenses count against the stapler business unit also.
Other full cost expenses could include managers' or directors' salaries, taxes, rent,
utilities, and marketing.

Contribution Approach
Much like product profitability analysis, the contribution approach narrows the
focus to only look at sales and expenses related directly to the stapler product line.
Profit margin is then sales minus direct expenses.
The benefit to this approach is that it cuts out those other expenses, such as floor
space for production.
Advantages of Business Unit Profitability Analysis
Business unit profitability analysis can help decide whether a particular product line
or business unit continues to contribute to the organization. Like product profitability
analysis, forecasting and run scenarios for the business unit are possible to conduct.
With the data, determining if there is an increase in production that would benefit or
hurt the unit. These decisions are made based on the data that has been collected.

Reference
Business Unit Profitability Analysis: Definition & Examples (Available at
https://study.com/academy/lesson/business-unit-profitability-analysis-definition-examples.html )

What is Business Unit Analysis (Available at https://www.infobloom.com/what-is-business-

unit-analysis.htm )A

Assessment Questionnaire
Residual Income
1. An investment is multiplied to required rate of return, to calculate
a. congruent cost of investment
b. transfer cost of investment
c. operating cost of investment
d. imputed cost of investment
2. If the required rate of return is 13%, operating income is P375,000 and the
total investment is P265,000, then residual income would be
a. 30,500
b. 20,500
c. 25,500
d. 32,500
3. The costs that are not incorporated in accounting records, but are recognized
in different situations are classified as
a. congruent costs
b. imputed costs
 c. operating costs
d. transfer costs
4. The rupee amount for required return of investment is subtracted from income
to calculate
a. net income
b. after tax income
c. residual income
d. operating income
5. A responsibility center in which manager is responsible only for sales is a(n)
a. cost center
b. revenue center
c. profit center
d. investment center
6. Residual income is sometimes used to overcome the tendency of ROI to
discourage investments that are profitable for the company, but that lower the
division’s ROI
a. neither true nor false
b. true
c. false
d. maybe
7. Unlike ROI, residual income does not encourage a short-run orientation
a. neither true nor false
b. true
c. false
d. maybe
8. Residual income is the difference between operating income and the product
of the hurdle rate and the company’s average operating assets.
a. neither true nor false
b. true
c. false
d. maybe
9. Statement I. In calculating residual income, the minimum rate of return is set
by top management and is the same as the hurdle rate used for return on
investment.
Statement II. The use of residual income encourages managers to accept any
project that earns above the minimum rate.
a. only statement II is correct
b. both statements are not false
c. both statements are not true
d. only statement I is correct
10. Statement I. The direct comparison of the performance of two different
investment centers is difficult using residual income because residual income
is an absolute measure.
Statement II. Economic value added is just a specific way of calculating
residual income.
a. only statement II is correct
 b. both statements are not false
c. both statements are not true
d. only statement I is correct
11. Residual income is calculated as
a. operating income – (ROI x average operating assets
b. operating income / (ROI x average operating assets)
c. operating income / (minimum rate of return x average operating assets)
d. operating income – (minimum rate of return x average operating assets)
12. The performance measure that uses after-tax operating income and the
actual cost of capital employed is
a. return on investment (ROI)
b. residual income
c. economic value added (EVA)
d. margin
13. Which of the following is an absolute dollar measure rather than a
percentage?
a. average operating assets
b. residual income
c. economic value added (EVA)
d. all of these
14. In calculating residual income, the variable set by top management is called
a. average operating assets
b. operating income
c. hurdle rate
d. actual operating assets
15. It refers to earnings before non-operating revenue, expenses, interest, and
taxes
a. EBIT
b. revenue
c. operating income
d. profit

Business Unit Profitability Analysis

1. It is a measure of the profit earned on sales which denotes the profit part of
the total revenue earned, after deducting cost of sales.
Gross Profit Margin
2. It is a measure of a company’s efficiency in managing its assets.
Activity Ratios
3. It is measured by profit margin of which net income is divided by sales.
Profitability
4. It is the final ratio that validates the overall performance of a company.
Net Profit Margin
5. An indicator of how profitable a company is relative to its total assets and
gives idea as to how efficient management is at using its assets to generate
earnings.
 Return on Assets
6. It is a ratio used to measure a company’s pricing strategy and operating
efficiency

7. It is an approach use to narrows the focus to only look at sales and expenses

related directly to a product line.
Contribution approach
8. It is an approach that looks at all expenses related to the business unit and
assumes they impact that business unit.
Full cost approach
9. In this analysis, the company evaluate sales and expenses for that unit to
determine how profitable a given business unit is.
Business unit profitability analysis 
10. It measures at the amount of profit that a customer generates.
Customer profitability analysis
11. It helps standardize companies’ results, allowing for greater comparability
across time and industries.
Financial ratios
12. It describes the amount of income necessary to maintain and grow a
business.
Earning sufficiency
13. It describes the income amounts that an entity can reproduce in the future –
“bottom line earnings”
Earnings sustainability
14. It is concerned with ranking products to decide which to emphasize.
Relative profitability
15. It is the process of linking a company’s overall profit back to the profit of a
specific product.
Product profitability analysis