Residual Income (RI)

Residual income measures the excess of the income earned over the desired income.

The desired income is based on some minimum required rate of return.

Unlike the return on investment (ROI) that computes for a percentage or rate, the residual income (RI) computes for an absolute dollar value.

Residual Income (RI) Formula

The formula in computing for the residual income is:

RI = Operating income - Desired income

where: Desired income = Minimum required rate of return x Operating assets

Note: In most cases, the minimum required rate of return is equal to the cost of capital. The average of the operating assets is used when possible.

Example: Computation of RI

Compute for the residual income of an investment center which had operating income of $500,000 and operating assets of $2,500,000. The cost of capital is 12%.

Desired income = Minimum required rate of return x Operating assets
  = 12% x $2,500,000
Desired income = $300,000
RI = Operating income - Desired income
  = $500,000 - $300,000
RI = $200,000

The investment made $200,000 above its desired or minimum income.

Analyzing the RI

The calculation of residual income results in a dollar value. A positive amount indicates that the subunit or investment was able to generate more than its minimum or desired income. The higher the residual income, the better.

When evaluating investment using return on investment (ROI) and residual income (RI), some investments that failed in the ROI test because of low rates may pass the RI test if they have positive amounts.

The major disadvantage, however, of residual income is that it cannot be used in evaluating investments of different sizes. The results would favor bigger investments because of the larger dollar amounts involved.

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