Residual income (RI)

Definition

Residual Income (RI) is the net operating income that an investment center earns above the minimum required return on its operating assets. It measures how much income exceeds the expected return based on a company's cost of capital.

5 Must Know Facts For Your Next Test

1. Residual Income helps evaluate the performance of managers by considering both profitability and the cost of capital.
2. RI is calculated as Net Operating Income minus the product of Operating Assets and the Required Rate of Return.
3. A positive RI indicates that the segment or project is generating more than the minimum required return, while a negative RI indicates underperformance.
4. Unlike Return on Investment (ROI), RI accounts for the size of the investment, making it useful for comparing different-sized projects or segments.
5. RI aligns managerial incentives with company goals, encouraging managers to pursue investments that exceed the company's cost of capital.

Review Questions

• What does a positive Residual Income indicate about a project's performance?
• How do you calculate Residual Income?
• Why might a company prefer using RI over ROI for evaluating manager performance?

Related terms

Return on Investment (ROI): A measure of profitability calculated as Net Operating Income divided by Operating Assets.

Economic Value Added (EVA): A financial performance metric that calculates value created beyond the required return on a company's capital.

Net Operating Income: The profit generated from operations before subtracting interest and taxes.