Management
Accounting
Residual
Income (RI)
Part A:
In Part A you will find discussion and explanations of
basic theories including relevant formulas.
Part B:
In Part B you will find 5 Illustrations with Solutions.
Introduction
Residual Income (RI) is one of the measures for the purpose of
evaluating the performance of divisional managers. It is defined as
controllable profit less a cost of capital charge on the investment
controllable by the divisional managers. If residual income is used to measure
the managerial performance of investment centres, there is a greater
probability that managers will be encouraged, when acting in their own best
interests, also to act in the best interests of their own divisions as well as
the company as a whole.
The basic assumption of the residual income model of performance
measurement of the divisional managers is that wealth generation stems from the
economic profits of the business which is the difference between “true profits”
of the business and “interest of the capital employed”. Economic profits of a
business may be defined more specifically as the difference between two
quantities which are net income before interest and taxes and the charge for capital.
This is the basis for the measure called “residual income”, which is understood to be the
operating income less a charge for invested capital, where, charge for
invested capital is calculated by the firm’s weighted average cost of capital
(which is also the minimum rate of return required by the firm).
The formula for Residual Income (RI):
|
RI = |
Operating Income – (Minimum Required Rate of Return × Average
Operating Assets) |
|
|
=
EBIT – (kr × Average Operating Assets) |
Where,
|
EBIT = |
Earnings before interest and taxes |
|
kr = |
Minimum required rate of return |
|
Av. Operating Assets = |
The total value of the assets the division uses to generate its income, averaged over a specific period (e.g., a year). These assets include items like cash, accounts receivable, inventory, and fixed assets, among others. |
|
|
|
Interpretation
Positive
Residual Income:
It indicates that the
division is earning more than the minimum required return, suggesting that it
is creating value for the company.
Negative
Residual Income:
It indicates that the
division is not earning enough to meet the minimum required return, suggesting
that it may not be creating value for the company and might need to be reviewed
and improved.
Management
Accounting
Residual
Income (RI)
Selected Problems and Solutions
Illustration: 1
A company provides you
the following information about the performance of one of its divisions during
the year 2024. Compute the residual income of the division.
|
Particulars |
Rs |
|
Sales of the year |
4,80,000 |
|
Cost of goods sold for
the year |
2,22,000 |
|
Selling and
administration expenses for the year |
2,10,000 |
|
Book value of operating
assets as on 01.01.2024 |
2,77,000 |
|
Book value of operating
assets as on 31.12.2024 |
3,23,000 |
Minimum required rate of
return is 12%.
Solution: 1
Computation of operating
income of the division for the year 2024
|
Particulars |
Rs |
|
Sales of the year |
4,80,000 |
|
Less: Cost of goods
sold for the year |
2,22,000 |
|
Gross margin |
2,58,000 |
|
Less: Selling and
administration expenses for the year |
2,10,000 |
|
Operating income (EBIT) |
48,000 |
Average operating assets
of the division for the year 2024
= (Rs 2, 77,000 + Rs 3,
23,000) ÷ 2
= Rs 3, 00,000
Therefore,
Residual income of the division
= EBIT – (kr × Average Operating Assets)
= Rs 48,000 – (0.12 × Rs 3, 00,000)
=
Rs 12,000
Illustration: 2
A Division of an
Investment Company has average operating assets of Rs 8, 00,000, and made
profits before interest and tax of Rs 1, 60,000. The notional cost of capital
is 12%.
Required:
Calculate and comment on
the RI (Residual Income) of the Division for the period.
Solution: 2
Average operating assets
= Rs 8, 00,000
EBIT = Rs 1, 60,000
kr = 12% i.e.
0.12
Therefore,
Residual income (RI) of the division
= EBIT – (kr × Average Operating Assets)
= Rs 1, 60,000 – (0.12 × Rs 8, 00,000)
=
Rs 64,000
Comment:
Residual income of the Division is positive which indicates that the division is earning
more than the minimum required return, suggesting that it is creating value for
the company.
Illustration: 3
A Division of an
Investment Company has average operating assets of Rs 8, 00,000, and made
profits before interest and tax of Rs 1, 60,000. The notional cost of capital
is 12%.
An opportunity has arisen
for the Division to invest in a new project costing Rs 1, 00,000. The project
would have a four-year life, and would make profits of Rs 15,000 each year.
What would be the
residual income of the Division with and without the investment in the new project?
Should the Division Manager undertake the investment in the new project?
Solution: 3
Computation of Residual
Income (RI)
a) Without the investment
|
|
(Rs) |
|
EBIT |
1,60,000 |
|
Notional Interest (kr × Average Operating Assets) [0.12 × Rs 8,00,000] |
96,000 |
|
Residual Income |
64,000 |
b) With the investment
|
|
(Rs) |
|
EBIT [Rs 1,60,000 + Rs
15,000] |
1,75,000 |
|
Notional Interest (kr × Average Operating Assets) [0.12 × Rs 9,00,000] |
1,08,000 |
|
Residual Income |
67,000 |
Comment:
The Division Manager
should undertake the investment in the new project, because RI increases by Rs
3,000 as a result of the investment.
Illustration: 4
Acme, a division of Ace
Manufacturing, has average operating assets of Rs 2, 25,000 and an operating
income of Rs 55,000. If the minimum required rate of return is 12%, what is the
division’s residual income?
Solution: 4
EBIT (Operating Income) =
Rs 55,000
Average Operating Assets
= Rs 2, 25,000
kr (Minimum
Required Rate of Return) = 12% i.e. 0.12
Therefore,
Residual income (RI) of the division
= EBIT – (kr × Average Operating Assets)
= Rs 55,000 – (0.12 × Rs 2, 25,000)
=
Rs 28,000
Illustration: 5
A division of a company
has the following: Operating Income: Rs 50,000, Average Operating Assets: Rs
500,000, and Minimum Required Rate of Return: 15%.
Calculate residual income
of the division and comment on the result obtained.
Solution: 5
EBIT (Operating Income) =
Rs 50,000
Average Operating Assets
= Rs 5, 00,000
kr (Minimum
Required Rate of Return) = 15% i.e. 0.15
Therefore,
Residual income (RI) of the division
= EBIT – (kr × Average Operating Assets)
= Rs 50,000 – (0.15 × Rs 5, 00,000)
=
− Rs 25,000
Comment:
Residual income is
negative. This indicates that the division is not earning enough to meet the
minimum required return, suggesting that it may not be creating value for the
company and might need to be reviewed or improved.
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