Definition
Residual income is the operating profit of an investment center minus a charge for the capital it uses, calculated as its operating assets multiplied by a required rate of return. A positive figure means the division earns more than the minimum the company expects, so any project that adds residual income creates value for the whole business.
How it works
Return on investment (ROI) divides profit by operating assets and gives a percentage. It is easy to compare across divisions, but it can lead a manager to reject a project that earns more than the company's cost of capital simply because it would lower the division's current ROI.
Residual income avoids that trap: it rewards every project whose return exceeds the required rate. Its weakness is size: large divisions naturally show larger residual income, so compare it with the division's budget rather than across divisions of very different sizes.
Ledgeriano's segment and responsibility reports cover cost, revenue, profit and investment centers in contribution format, with ROI and residual income for investment centers; see the management accounting guide.
Formula
Residual income = Operating profit - (Operating assets × Required rate of return)
ROI = Operating profit ÷ Operating assets
Example: a project ROI would reject
A division has operating assets of 1,000,000 and operating profit of 180,000: ROI of 18%. The company requires 12%. A new project needs 200,000 of assets and earns 30,000, a 15% return.
| Without project | With project | |
|---|---|---|
| ROI | 18.0% | 210,000 ÷ 1,200,000 = 17.5% |
| Residual income | 180,000 - 120,000 = 60,000 | 210,000 - 144,000 = 66,000 |