4. Example of residual income calculation – division level

Let’s assume OverHiking Company (a fictitious entity) has three divisions: Europe & Middle East, Asia & Pacific, and Americas. These divisions have income from operations of $50,000, $20,000, and $30,000, respectively. Also, these divisions have average operating assets of $400,000, $100,000, and $500,000, accordingly.

The company calculates residual income for its divisions as the difference between income from operations and the minimum return on divisional assets. The company established 10% as the minimum rate of return on divisional assets. Hence, in this case the residual income for each division can be calculated as follows:

While all three divisions have income from operations, only two divisions have positive residual income. Division Americas is not profitable in economic sense, even though it has higher income from operations than Division Asia & Pacific. Hence, residual income can be a good performance measure as it encourages management to maximize income from operations.

However, residual income has a weakness as well. Even though it might be reasonable to assume that a company or division should try to maximize its residual income, it is important not to ignore the level of assets utilized by the company or division in generating such a residual income. As we can see from our example, Division Europe & Middle East and Division Asia & Pacific have the same residual income. If we evaluate both divisions based on the residual income value, we will evaluate the performance of these divisions as equal. However, Division Europe & Middle East have more than twice as many operating assets than Division Asia & Pacific to generate the same residual income. Division Asia & Pacific has used substantially fewer assets to generate the same residual income.

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