Question

Exercise 12-2 : Juniper Design Ltd. of Manchester, England, is a company specializing in providing design services to residential developers. Last year the company had net operating income of $600,000 on sales of $3,000,000. The company’s average operating assets for the year were $2,800,000 and its minimum required rate of return was 18%.

1. Required: Compute the company’s residual income for the year—use the worksheet below and information given.

Average operating assets
Net operating income
Minimum required return: 18% × $2,800,000
Residual income	$   96,000

2. Below is the worksheet calculating the residual income of above

Average operating assets.................................	$2,200,000
Net operating income......................................	$400,000
Minimum required return: 16% × £2,200,000.......................................	352,000
Residual income..............................................	$ 48,000

Assume the residual income changes to $60,000, what could have caused it to happen?

Increase in Revenue: Yes or No         

Decrease in minimum required rate: Yes or No            

Increase in Operating Assets: Yes or No

                    

Assume there are two divisions, one with operating assets of 10 million and the other with operating assets of 2 million. Which will likely have a higher residual income in actual dollars, even though they were equally efficient?

Answer 1

Answer 1:

Residual Income is calculated as below:

Answer 2:

Residual Income = Net operating income - Average operating assets * Minimum required return

From above equation, we observe that:

An increase in residual income can happen:

• If there is an increase in net operating income and/or
• Decrease in average operating asset and /or
• Decrease in Minimum required return

Further operating income = Sales - Cost of Goods sold - Operating expense.

As such an increase in sales normally leads to increase to operating income, which will result in higher residual income.

Hence:

When residual income increases from $48,000 to $60,000, the cause could be:

Increase in Revenue: Yes   

Decrease in minimum required rate: Yes

Increase in Operating Assets: No

Residual income is function of Net operating income, Operating assets and Minimum required return.

If other factors are similar, division with lower operating assets is likely to have a higher residual income. If other factors including efficiencies are similar the division with operating assets of 2 million will likely have higher residual income than division with operating assets of 10 million.