Residual Income (RI)

Definition

Residual Income (RI) is a performance measure that calculates the amount of income remaining after accounting for the cost of capital employed in a business or investment. It represents the surplus value created by an operation or project after meeting the required return on the capital invested.

5 Must Know Facts For Your Next Test

1. Residual Income (RI) measures the surplus value created by an operation or project after meeting the required return on the capital invested.
2. RI is calculated by subtracting the cost of capital from the operating income or profit of a business unit or investment.
3. RI is used to evaluate the performance of responsibility centers, operating segments, or investment projects within an organization.
4. A positive RI indicates that the business unit or project is generating more income than the required return on capital, creating additional value.
5. RI is an important metric for evaluating investment decisions and aligning the interests of managers with those of shareholders.

Review Questions

• Explain how Residual Income (RI) is calculated and its significance in evaluating the performance of a responsibility center.
  • Residual Income (RI) is calculated by subtracting the cost of capital from the operating income or profit of a responsibility center. A positive RI indicates that the responsibility center is generating more income than the required return on the capital invested, creating additional value for the organization. RI is an important metric for evaluating the performance of responsibility centers, as it aligns the interests of managers with those of shareholders by incentivizing the generation of surplus income beyond the minimum required return.
• Describe how Residual Income (RI) differs from Return on Investment (ROI) and Economic Value Added (EVA) in evaluating an operating segment or a project.
  • While ROI, RI, and EVA are all performance measures used to evaluate investments, they differ in their approach. ROI focuses on the efficiency of the investment by comparing the net return to the total investment cost. RI, on the other hand, measures the surplus value created by an operation or project after meeting the required return on the capital invested. EVA is a more comprehensive measure that deducts the cost of capital from the operating profit to determine the residual wealth generated. RI and EVA provide a more nuanced view of the value created by an operating segment or project, taking into account the cost of capital employed, whereas ROI is a more straightforward ratio-based metric.
• Analyze how the use of Residual Income (RI) can influence managerial decision-making and the alignment of organizational goals with shareholder interests.
  • The use of Residual Income (RI) as a performance measure can have a significant impact on managerial decision-making and the alignment of organizational goals with shareholder interests. By focusing on generating a surplus income beyond the required return on capital, managers are incentivized to make investment decisions that create additional value for the organization. This encourages them to carefully consider the cost of capital and the potential profitability of projects, aligning their interests with those of shareholders who seek to maximize the wealth generated by the business. Additionally, RI provides a more comprehensive evaluation of performance compared to metrics like ROI, allowing managers to make more informed decisions that prioritize the creation of long-term value over short-term gains.

Related terms

Return on Investment (ROI): ROI is a financial ratio that measures the efficiency of an investment by comparing the net return to the total investment cost. It is used to evaluate the profitability of a project or investment.

Economic Value Added (EVA): EVA is a measure of a company's financial performance based on the residual wealth calculated by deducting the cost of capital from the company's operating profit (adjusted for taxes on a cash basis).

Cost of Capital: The cost of capital is the required rate of return that a business must earn on its investment projects in order to maintain the value of its shares. It represents the minimum acceptable rate of return for a new investment.