What is residual income in accounting?

February 19, 2012

Learn about residual income and how to calculate it using income from operations, earnings before interest and taxes (EBIT), net operating profit after tax (NOPAT), or net income.

1. Definition of residual income in accounting

In decentralized operations, residual income is the excess of income from operations over the minimum acceptable income.

The concept of residual income dates back Alfred Marshall in the late 1880s. In 1920s General Motors used the concept to evaluate its business segments. Residual income is often called Economic Value Added (EVA) as copyrighted by Stern Stewart & Co, a consulting firm, in 1994.

Residual income is a company or division performance measure. It can also be used to evaluate investment alternatives.

2. Residual income formula

To calculate the residual income, the following formula can be used:

Residual Income = Income from Operations Minimum Acceptable Income

Residual income is a dollar amount, which can be either positive or negative:

  • When a positive residual income takes place, a company (division, segment, investment) is creating wealth.
  • When a negative residual income takes place, a company (division, segment, investment) is consuming capital.

The following residual income calculations exist:

  • Income from operations less minimum acceptable income (i.e., minimum return on operational assets)
  • Net income less equity charge
  • Net operating profits after tax (NOPAT) less capital charge

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.

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