Residual income

Residual income is a key concept in both corporate and personal finance, representing the earnings that remain after all costs, including the cost of capital, have been accounted for. It is a valuable metric within the broader category of financial planning and performance measurement, used to assess the true profitability and value creation of an entity. Unlike traditional accounting profits, residual income explicitly considers the required rate of return on the capital invested, making it a more comprehensive measure of economic performance. The concept applies to businesses evaluating divisional performance and individuals managing their personal finances to achieve financial independence.

History and Origin

The concept of residual income, often interchangeably used with "economic profit," has roots in classical economics, tracing back to economists like Alfred Marshall in the late 19th century. Its application as a management accounting tool for evaluating business segments gained traction as early as the 1920s, notably by companies like General Motors.¹⁶ However, the concept gained significant modern prominence and wider adoption in corporate finance with the popularization of Economic Value Added (EVA) in the 1990s by the consulting firm Stern Stewart & Co.¹⁵ EVA is a specific, adjusted form of residual income designed to measure a company's true economic profit by making various adjustments to conventional accounting figures. The firm's work helped highlight that traditional financial statements often did not fully capture the cost of all capital, particularly equity, leading to a potentially misleading view of profitability.¹⁴

Key Takeaways

• Residual income measures profit beyond the minimum acceptable rate of return on invested capital.
• It is used in corporate finance to evaluate the economic performance of business units or projects.
• In personal finance, it refers to discretionary income remaining after all essential expenses and debt payments.
• Calculating residual income helps promote goal congruence in organizations by aligning managerial decisions with shareholder wealth maximization.
• Unlike traditional accounting net income, residual income explicitly deducts a charge for the cost of equity capital.

Formula and Calculation

In corporate finance, the formula for residual income (RI) is typically expressed as:

Alternatively, if focusing on equity holders:

Where:

• Operating Income (or Net Income): The profit generated by a business unit or the company before specific deductions.¹³
• Capital Invested (or Equity Capital): The total capital employed in the business or the equity portion. This can refer to the assets of an investment center.
• Required Rate of Return (or Cost of Equity): The minimum acceptable rate of return that investors or the company expect from the capital employed. This is often the cost of capital, which accounts for the opportunity cost of funds.

For instance, if a division has an operating income of $1,000,000 and uses $5,000,000 in capital with a required rate of return of 12%, the residual income would be $1,000,000 – ($5,000,000 * 0.12) = $1,000,000 – $600,000 = $400,000.

Interpreting the Residual income

A positive residual income indicates that the business unit or project is generating profits in excess of the required rate of return on the capital employed, thus creating economic value. Conversely, a negative residual income suggests that the entity is not earning enough to cover its cost of capital, implying a destruction of value, even if it reports a positive accounting profit.

Th¹²e primary purpose of interpreting residual income, especially in decentralized organizations, is to encourage goal congruence. Managers of investment centers are incentivized to undertake projects that add to the company's overall wealth, rather than merely improving their division's return on investment (ROI) at the expense of overall corporate value. This measure provides a clearer picture of whether a division is truly adding to shareholder wealth.

##¹¹ Hypothetical Example

Consider "Tech Innovations," a division of a larger technology company. For the most recent fiscal year, Tech Innovations reported an operating income of $2,500,000. The division has $15,000,000 in average working capital and long-term assets employed. The parent company's cost of capital for its divisions is 10%.

To calculate Tech Innovations' residual income:

Required Charge = Capital Employed × Cost of Capital
Required Charge = $15,000,000 × 0.10 = $1,500,000

Residual Income = Operating Income – Required Charge
Residual Income = $2,500,000 – $1,500,000 = $1,000,000

In this example, Tech Innovations generated $1,000,000 in residual income. This positive figure indicates that the division not only covered all its operating expenses and the cost of its employed capital but also generated an additional $1,000,000 in economic value for the parent company. This makes it a successful division from an economic perspective.

Practical Applications

Residual income finds broad application across different financial domains:

• Corporate Performance Measurement: Companies use residual income to evaluate the financial performance of individual departments, divisions, or projects. It helps management assess whether a business unit is generating returns above its cost of capital, thereby contributing to overall firm value. This ince¹⁰ntivizes managers to accept all projects that yield a return greater than the company's cost of capital, even if it lowers their division's ROI. The Association of Chartered Certified Accountants (ACCA) highlights residual income as a key tool for measuring divisional performance.
• Val⁹uation Models: In investment analysis, residual income models are used to estimate the intrinsic value of a company's stock. This approach values a company based on its book value plus the present value of its expected future residual income. This meth⁸od can be particularly useful for valuing companies that do not pay dividends or have unpredictable cash flows.
• Executive Compensation: Residual income can be integrated into executive compensation plans to align managers' incentives with the long-term goal of increasing shareholder wealth. Tying bonuses to residual income encourages managers to make decisions that truly create economic value.
• Personal Finance: In a personal context, residual income refers to the money an individual has remaining after all monthly debt obligations are paid. This meas⁷ure is often used by lenders to assess a borrower's capacity to take on new loans, ensuring they have sufficient funds left over to manage new payments and maintain a reasonable standard of living. It is distinct from disposable income, which is income after taxes but before necessary expenses or debt. Individuals aiming for financial independence often seek to build streams of income that result in significant personal residual income.

Limitations and Criticisms

While residual income is a robust performance measurement tool, it does have limitations:

• Absolute Measure: Residual income is an absolute dollar figure, which can make it difficult to compare the performance of divisions or companies of vastly different sizes. A larger division might naturally have a higher residual income simply due to its scale, rather than superior management, potentially making performance measurement challenging across diverse units.
• Rel⁶iance on Accounting Data: Although residual income aims to overcome some limitations of traditional accounting profits by incorporating the cost of capital, it still relies on accounting data, which can be subject to manipulation or different accounting policies. For example, the calculation of net income and the value of capital can be influenced by accrual accounting choices.
• Dif⁵ficulty in Determining Cost of Capital: Accurately determining the appropriate required rate of return or cost of capital can be complex and subjective, as it often involves estimating future returns and risk. Inaccuracies in this input can significantly skew the residual income calculation. The CFA I⁴nstitute has discussed potential shortcomings and challenges in applying residual income models.
• Sho³rt-Term Focus: While intended to promote long-term value creation, managers might still be incentivized to focus on short-term gains if residual income is measured over brief periods, potentially leading to decisions that are not optimal for long-term shareholder wealth.

Residual income vs. Disposable income

Residual income and disposable income are both concepts related to leftover income, but they apply in different contexts and refer to different stages of financial allocation.

The core distinction lies in what deductions are considered. Disposable income accounts for taxes, providing a sum that can be spent or saved. Residual income, particularly in personal finance, goes a step further by subtracting all debt payments, offering a more realistic view of the funds truly available for discretionary spending or new obligations.

FAQs

What is the primary difference between residual income and accounting profit?

The primary difference is that residual income considers the cost of capital, including the cost of equity, which is not typically expensed in traditional accounting profit calculations. This makes resid²ual income a measure of economic profit, reflecting whether a company has truly created value beyond what investors expect for the risk taken.

Why is residual income preferred over Return on Investment (ROI) for some performance measurement purposes?

Residual income is often preferred because it encourages managers to invest in projects that generate returns above the company's cost of capital, even if those projects might slightly lower their division's return on investment. This promotes go¹al congruence, aligning divisional decisions with overall company value maximization.

Can residual income be negative?

Yes, residual income can be negative. A negative residual income indicates that the company or business unit is not generating enough net income to cover its explicit cost of capital. This means that while the entity might be reporting an accounting profit, it is economically destroying value because it is not meeting the minimum return required by its capital providers.

How does residual income relate to financial independence?

In personal finance, a key aspect of financial independence is having enough income from passive or recurring sources to cover living expenses without needing to work actively. This "leftover" income after all obligations are met is essentially personal residual income. Building significant residual income streams allows individuals to fund their lifestyle without relying on a traditional salary.