Residual Income (RI)
Before understanding the concept and working of residual income along with the examples, it is necessary that we understand the concept of an investment center. Investment center is a division within a business much like a cost center or a profit center. The only difference is that the performance of the manager of the investment center is assessed based on return on investment (ROI) of the division or the Residual income (RI). The use of residual income is usually to assess the performance of a manager of the investment center.
What is residual income?
Residual income is the net operating income that is earned by the investment center. This income is the earning that is above the minimum target return. This means that a residual income is the excess income earned on the return on investment.
Formula of residual income
Residual income is calculated by the following method:
RI = Operating Income - (Operating Assets x Target Rate of Return)
This method (RI) is an alternative approach to calculate the performance of the investment center. This method is used in comparison to the return on investment (ROI) method. The formula of ROI is:
ROI % = Operating Income / Operating Assets
This clearly shows that assessing the performance of the investment center with residual income (RI) is a better option since it provides a better analysis, and it is better for managers of the investment center to adopt RI when gauging a potential project since it increases the profitability of their division.
While using the residual income as the tool to add performance, the focus is to maximize the income from the project and not the increase in returns. It is also better to use residual income in the undertaking of the new project because the use of ROI will reject any potential projects. The reason for this is that ROI yields lower returns on the initial investment whereas the residual income will maximize the income and not the return on investment.Economic value added (EVA) approach is an adaptation of the residual income. However, since it is a complex terminology and requires a better understanding of categorizing the expenses as the capital expense, this will be best understood after clearing the concepts related to residual income.