Organizations use various performance measures to motivate managers and other employees to invest their effort and skills into decision-making and work in general. When evaluating business units that have decision making authority over activities that impact revenues, costs, and investments (assets) in those units, organizations can use various performance measures. One of them is residual income, which we will discuss in this article.

1. Residual income: definition and formula

Residual income (RI) is the excess of (accounting) profits over the required rate of return.

Therefore, residual income can be calculated as follows:

Since for-profit organizations need to generate returns to their providers of capital, usually the required rate of return is proxied with the cost of capital. The cost of capital can include the cost of equity or both equity and debt (e.g., weighted-average cost of capital (WACC)). Profit is usually proxied with some accounting measure of income, and investment is proxied with an accounting measure of assets.

Similar to many other performance measures that use accounting numbers, residual income can be calculated in different ways depending on the choice of “income” measure and “asset” measure.  Likewise, the required rate of return can be set at the cost of capital (e.g., WACC) or higher.  Organizations can use different rates of return for different business units when they have different risk profiles. As the result, it is possible to come up with different numbers for residual income depending on the chosen approach.

2. Advantages and disadvantages of the residual income measure

Residual income, as a performance measure, provides some advantages:

• Economic profit: residual income is related to the concept of economic profit that accounts not only for explicit (out-of-pocket) costs but also opportunity costs. Economic profit is revenues (from outputs) minus the cost of inputs and opportunity costs. Because residual income accounts for the cost of investment (i.e., the opportunity cost of using invested capital), it is conceptually related to economic profit.
• Project (investment) selection: residual income provides one advantage over return on investment (ROI) - a comparable performance measure - in that it provides incentives to pursue profitable projects regardless of the business unit’s past performance. As long as residual income is positive, a business unit (manager) will likely agree to implement the project. When using ROI measure, managers will likely select profitable projects with a return above the unit’s past ROI performance and ignore profitable projects with a return below the unit’s past ROI performance (in order to maintain or increase unit’s ROI).
• Adjusting cost of capital for risk: organizations can use different requirements for minimal rate of return for different business units. Organizations can use a higher required rate of return for riskier business units and a lower required rate of return for less risky business units.

Residual income, as a performance measure, has some limitations or disadvantages:

• Business unit size: residual income is usually a bad measure for comparing business units of a different size. Larger business units usually can generate greater profits, given their amount of assets, and hence will likely have larger residual income. Thus, when comparing business units of a different size, residual income could make larger units look to perform better than smaller units even though that might not be true.
• Myopia (short-term outlook): by using accounting numbers for short-term performance evaluation (e.g., quarterly or annual profit and investment measures), organizations may create a short-term outlook or myopia for managers. As the result, managers may make decisions that are not optimal in the long run (e.g., not investing in much needed equipment; not training employees).
• Number choice (subjectivity): similar to many other performance measures that use accounting numbers, organizations can use different proxies for profit and investment. Also, when calculating residual income, organizations can use different proxies for minimum rate of return. As such, it is possible to come up with different residual income measures for the same business unit in the same time period. While residual income is to some extent an objective measure of performance (i.e., we can agree on how the numbers are calculated), it still adds a subjective element to performance evaluation through the choice of accounting or other financial numbers.

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