Residual Income

Definition

Residual income is the amount of income that remains after all costs, including the cost of capital employed, have been deducted from revenue. It represents the surplus or profit generated by a business or investment after accounting for the required return on capital invested. This concept is crucial in evaluating the performance of responsibility centers and the viability of operating segments or projects.

5 Must Know Facts For Your Next Test

1. Residual income is a key metric used to evaluate the performance of responsibility centers, such as investment centers and profit centers, within an organization.
2. Residual income provides a more comprehensive assessment of performance than traditional measures like return on investment (ROI) or profit, as it accounts for the cost of capital employed.
3. Analyzing residual income can help managers identify underperforming segments or projects and make informed decisions about resource allocation and investment strategies.
4. Residual income is often used in conjunction with other performance measures, such as ROI and Economic Value Added (EVA), to provide a holistic view of an organization's financial health and value creation.
5. Maximizing residual income is a key objective for many organizations, as it indicates the ability to generate returns in excess of the required rate of return on capital employed.

Review Questions

• Explain how residual income is used to evaluate the performance of responsibility centers within an organization.
  • Residual income is a valuable metric for evaluating the performance of responsibility centers, such as investment centers and profit centers, because it takes into account the cost of capital employed in addition to the income generated. By deducting the required return on capital from the income produced, residual income provides a more comprehensive assessment of the center's ability to generate surplus returns beyond the minimum required return. This allows managers to identify well-performing responsibility centers that are creating value for the organization, as well as those that may be underperforming and require further attention or resource allocation adjustments.
• Describe how residual income, in combination with other performance measures like ROI and EVA, can be used to evaluate the viability of operating segments or projects.
  • When evaluating the performance of operating segments or projects, residual income provides valuable insights that complement other metrics like return on investment (ROI) and economic value added (EVA). While ROI focuses on the efficiency of the investment, and EVA measures the overall wealth generated, residual income specifically highlights the surplus income generated after accounting for the cost of capital employed. By analyzing residual income alongside ROI and EVA, managers can gain a more holistic understanding of the value creation potential of a segment or project, enabling them to make informed decisions about resource allocation, investment strategies, and the overall viability of the business unit or initiative.
• Analyze how the concept of residual income can influence the decision-making process when evaluating the performance of responsibility centers and the feasibility of operating segments or projects.
  • The concept of residual income is a powerful tool that can significantly influence the decision-making process when evaluating the performance of responsibility centers and the feasibility of operating segments or projects. By focusing on the surplus income generated after accounting for the cost of capital employed, residual income provides a more comprehensive and accurate assessment of the value being created. This information can inform critical decisions, such as resource allocation, investment strategies, and the continuation or termination of underperforming business units or initiatives. Managers can use residual income to identify areas where value is being generated, as well as those where the cost of capital is not being sufficiently covered, enabling them to make more informed and strategic choices that align with the organization's overall objectives and maximize long-term profitability and sustainability.

Related terms

Responsibility Center:

A responsibility center is a unit within an organization that is responsible for a specific set of activities and is held accountable for the resources it uses and the results it achieves.

Return on Investment (ROI):

ROI is a performance measure that evaluates the efficiency of an investment by comparing the net return to the cost of the investment.

Economic Value Added (EVA):

EVA is a measure of a company's financial performance based on the residual wealth generated by a business after accounting for the cost of all capital, including equity and debt.