MANAGEMENT AND SERVICES

RESPO NSIBILITY
ACCO UNTING,
SEGMENT, EVALUATIO N
& TRNSFER PRICING

RESIDUAL
INCOME
DISCUSSION &
PROBLEMS
ALDEA, ATUEL, ESQUINAS,
PAGCALIWANGAN, OMANGA
CONCEPTS FORMULA SAMPLE
PROBLEM

Residual
Income profit of a division less an imputed charge for
Residual income is defines as the operating

operating capital used by division.

It is also used in identifying the limitations
encountered in ROI (return on investment) for it
uses amount as a basis of evaluating the
acceptance of a prospective investment or in
evaluating the performance of an investment
Minimum project.

Income
Sometimes labeled as imputed income, implied
income, implicit income or desired income. The
investment base used in computing the
minimum income is to the amount agreed upon
by the corporate headquarter management.

RESIDUAL INCOME & MINIMUM

INCOME
 CONCEPTS FORMULA SAMPLE
PROBLEM

IMPUTED
INTEREST
RATE
Imputed Interest Rate is based on the prevailing
market rate from which the business generates
profit without accepting a high business risk. It is
ordinarily the pre-tax cost of capital and in
principle, should reflect the degree of risk of the
reporting responsibility center.

RESIDUAL INCOME & MINIMUM

INCOME
Concepts Formula Sample Problem

S E G M E N T I N C O M E P X X *

L E S S : M I N I M U N I N C O M E   ( X X ) * *

R E S I D U A L I N C O M E   X X

* ( E B I T - E A R N I N G S B E F O R E I N T E R E S T A N D T A X )

* * ( I N V E S T M E N T X I M P L I E D R A T E )
 SAMPLE
CONCEPTS FORMILA
PROBLEM

Assume that for Marvin Gross

Company, a division's current

controllable contribution margin

(before capital charge) is $250,000

and the relevant investment is

$1,000,000. The ROI then, is 25%.

Suppose top management wants

division management to accept

incremental investments as long as the

return greater than 15%. 

Solution

Division controllable profit (before imputed capital)    $250,000

Less: imputed capital charge (15% x $1,000,000             150,000
Division residual income                                                 $100,000

SAMPLE EASY PROBLEM

FURTHER
DISCUSSION...
 Assume that the company’s cost of capital (or
minimum required rate of return) is 10%.
The following table reveals calculations of the
residual income for each segment.

                                                                             Electrical                               Galvinizing
Segment Operating Income             P7, 282, 000                        P9, 556, 000
Less: Assumed  Cost of Capital
            (Minimum Income)
             P79, 424, 000 x 10%               ( P7, 942, 400)
             P45, 042, 000 x 10%                                                                   ( P4, 504, 200)

Residual Income                                      (P660, 400)                           P5, 051, 800

 Continuation...

IN THE EXAMPLE, IT IS QUITE APPARENT

THAT GALVANIZING IS PRODUCING A
BETTER RATE OF RETURN ON THE
INVESTED ASSETS  
 ( FEWER ASSETS PRODUCED MORE
INCOME).

This information sheds a

completely different light on the
relative performance of each unit.
Remember that the two units are
not far apart in overall
profitability.

However, once the cost of capital

is placed on the evaluative scale, it
appears that the galvanizing unit
is doing far better than the
electrical unit. Residual income can
be a powerful tool for identifying
and ranking the performance of
business units.
 DESPITE ITS BENEFITS, ONE
MUST BE VERY CAREFUL IN
UTILIZING RESIDUAL INCOME

FIRST, THERE IS THE

USUAL ISSUE OF SHORT
RUN VS. LONG RUN
CONSIDERATIONS.

SECOND,MANAGERS NEED
TO BE SAVVY TO THE
IMPACT OF ACCOUNTING
RULES.  

THIRD,
 ALTERNATIVE
RATE WILL
CHANGE THE
MEASURE OF
RESIDUAL
INCOME.
THE END