Question

How is residual income being used in corporations today?

Answer 1

Residual income is a highly attractive way to earn money. This lesson discusses two definitions of residual income and gives many examples of how residual income is earned.

What is Residual Income:-

Residual income can have two different definitions or applications. The first definition, a less common application of residual income, is the money that is left after monthly debts are paid. This calculation is particularly important when a person is seeking financing or a loan based on their income and available money to cover the additional debt. In this scenario, the residual income is calculated by this formula:

Residual Income =Monthly Net Income - Monthly Debts

This calculation takes into account a person's take-home pay and subtracts debts and expenses from that amount. The remaining amount is the residual pay. The remaining money can be used for any other expenses.

The second way that residual income is defined is money that is earned on a continual basis that is often based from one original activity. Often this type of residual income is referred to as passive income. Earning residual income is a critical aspect of compensation for many salespeople, artists, and musicians.

Some perfect examples of residual income include:

Rental income from a home, apartment, or commercial space

Royalties earned for creating intellectual property like books, recordings, music, photographs, movies, television shows, etc.

Subscription services including media, online, or ongoing services

Interest earned on savings or loans made to others

Ongoing income such as retirement, alimony, disability, etc.

Example of the Residual Income Approach

ABC International has invested $1 million in the assets assigned to its Idaho subsidiary. As an investment center, the facility is judged based on its return on invested funds. The subsidiary must meet an annual return on investment target of 12%. In its most recent accounting period, Idaho has generated net income of $180,000. The return can be measured in two ways:

Return on investment. ABC's return on investment is 18%, which is calculated as the $180,000 profit divided by the investment of $1 million.

Residual income. The residual income is $60,000, which is calculated as the profit exceeding the minimum rate of return of $120,000 (12% x $1 million).

What if the manager of the Idaho investment center wants to invest $100,000 in new equipment that will generate a return of $16,000 per year? This would provide residual income of $4,000, which is the amount by which it exceeds the minimum 12% rate of return threshold. This would be acceptable to management, since the focus is on generating an incremental amount of cash.

Companies can use the following income values: income from operations (IFO) or earnings before interest and taxes (EBIT), net operating profit after tax (NOPAT), net income, etc.

The minimum acceptable income is usually determined by multiplying average operating assets by a minimum rate of return (i.e., weighted average cost of capital). For example, if division A has $200,000 of average operating assets and the top management established 10% as the minimum acceptable rate of return (i.e., based on the cost of financing the business operations), then the minimum acceptable income for division A is $20,000 (i.e., $200,000 x 10%).

Instead of the minimum return on operational assets, companies can use an equity charge or capital charge. The equity charge is the estimated cost of equity capital. It is determined by multiplying equity capital by the cost of equity capital. The capital charge is the estimated total cost of capital: it includes both the debt charge and the equity charge.

But what if ABC evaluates its prospective investments based on the return on investment percentage instead? In this case, the Idaho investment center is currently generating a return on investment of 18%, so making a new investment that will generate a 16% return will reduce the facility's overall return on investment to 17.8% ($196,000 total profit / $1.1 million total investment) - which might be grounds for rejecting the proposed investment.

Thus, the residual income approach is better than the return on investment approach, since it accepts any investment proposal that exceeds the minimum required return on investment. Conversely, the return on investment approach tends to result in the rejection of any project whose projected return is less than the average rate of return of the profit center, even if the projected return is greater than the minimum required rate of return.