Residual Income Calculator
Calculate the Residual Income (RI) for a business unit or project. Residual Income is a measure of profitability that subtracts the capital charge (the required rate of return on capital) from the Net Operating Income (NOI).
Enter the Net Operating Income (NOI), the Required Rate of Return (as a percentage), and the Capital Invested.
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Understanding Residual Income & Formula
What is Residual Income?
Residual Income (RI) is a financial performance measure used to evaluate the profitability of a division or project. It represents the profit earned after accounting for the cost of the capital used by that division or project. Unlike metrics like Net Income or Return on Investment (ROI), RI penalizes units for using more capital, encouraging efficient capital deployment.
Residual Income Formula
The formula for Residual Income is straightforward:
Residual Income = Net Operating Income - (Capital Invested × Required Rate of Return)
Where:
- Net Operating Income (NOI): The profit generated by the asset or division before interest and taxes, but after deducting all operating expenses.
- Capital Invested: The total amount of capital (usually equity, but can sometimes include debt) used by the division or project.
- Required Rate of Return: Also known as the cost of capital or hurdle rate, this is the minimum rate of return expected by the company or investors on the capital invested. It's typically expressed as a percentage.
A positive Residual Income indicates that the division/project earned more than the required return on its capital. A negative value means it earned less than the required return.
Why Use Residual Income?
RI is often favored because it encourages managers to invest in projects that earn above the cost of capital, even if those projects lower the overall ROI percentage (especially in larger divisions). It aligns managers' incentives with increasing the absolute dollar value of wealth, rather than just a percentage return.
Residual Income Examples
Click on an example to see the calculation details:
Example 1: Profitable Division
Scenario: Evaluate the performance of a division that generated $150,000 NOI with $1,000,000 invested capital. Required Rate of Return is 10%.
1. Known Values: NOI = $150,000, Capital Invested = $1,000,000, Required Rate = 10%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $150,000 - ($1,000,000 × 10%) = $150,000 - ($1,000,000 × 0.10) = $150,000 - $100,000
4. Result: RI = $50,000.
Conclusion: The division generated $50,000 in income above the required return on capital.
Example 2: Underperforming Project
Scenario: A project generated $80,000 NOI with $1,200,000 invested capital. Required Rate of Return is 8%.
1. Known Values: NOI = $80,000, Capital Invested = $1,200,000, Required Rate = 8%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $80,000 - ($1,200,000 × 8%) = $80,000 - ($1,200,000 × 0.08) = $80,000 - $96,000
4. Result: RI = -$16,000.
Conclusion: The project failed to meet the required rate of return, resulting in a negative Residual Income.
Example 3: Division Meeting Required Return
Scenario: A division has $500,000 NOI and $5,000,000 Capital Invested. Required Rate of Return is 10%.
1. Known Values: NOI = $500,000, Capital Invested = $5,000,000, Required Rate = 10%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $500,000 - ($5,000,000 × 10%) = $500,000 - ($5,000,000 × 0.10) = $500,000 - $500,000
4. Result: RI = $0.
Conclusion: The division earned exactly the required rate of return on its capital.
Example 4: Small Project with High Return
Scenario: A small project with $50,000 Capital Invested generates $10,000 NOI. Required Rate is 15%.
1. Known Values: NOI = $10,000, Capital Invested = $50,000, Required Rate = 15%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $10,000 - ($50,000 × 15%) = $10,000 - ($50,000 × 0.15) = $10,000 - $7,500
4. Result: RI = $2,500.
Conclusion: The project adds $2,500 above the cost of capital, even though the amounts are small.
Example 5: Startup Venture
Scenario: A startup invested $2,000,000 and generated $180,000 NOI in its first year. Required Rate is 12%.
1. Known Values: NOI = $180,000, Capital Invested = $2,000,000, Required Rate = 12%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $180,000 - ($2,000,000 × 12%) = $180,000 - ($2,000,000 × 0.12) = $180,000 - $240,000
4. Result: RI = -$60,000.
Conclusion: The startup did not meet the required return in its first year, resulting in a negative RI.
Example 6: Evaluating a Product Line
Scenario: A product line generated $350,000 NOI and uses $3,000,000 in allocated capital. Required Rate is 9%.
1. Known Values: NOI = $350,000, Capital Invested = $3,000,000, Required Rate = 9%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $350,000 - ($3,000,000 × 9%) = $350,000 - ($3,000,000 × 0.09) = $350,000 - $270,000
4. Result: RI = $80,000.
Conclusion: The product line is generating $80,000 above the cost of capital.
Example 7: Service Department
Scenario: A service department (often treated as a cost center, but here for RI example) is allocated $50,000 capital and 'generated' $15,000 NOI (perhaps internal transfers). Required Rate is 6%.
1. Known Values: NOI = $15,000, Capital Invested = $50,000, Required Rate = 6%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $15,000 - ($50,000 × 6%) = $15,000 - ($50,000 × 0.06) = $15,000 - $3,000
4. Result: RI = $12,000.
Conclusion: Even with allocated capital, the department's 'profitability' exceeds the cost of that capital by $12,000.
Example 8: Comparing Investment Opportunities
Scenario: Compare Option A ($800k Capital, $100k NOI, 10% Required Rate) and Option B ($1.2M Capital, $140k NOI, 10% Required Rate).
1. Known Values (Option A): NOI = $100,000, Capital = $800,000, Required Rate = 10%.
Calculation (Option A): RI = $100,000 - ($800,000 × 10%) = $100,000 - $80,000 = $20,000.
1. Known Values (Option B): NOI = $140,000, Capital = $1,200,000, Required Rate = 10%.
Calculation (Option B): RI = $140,000 - ($1,200,000 × 10%) = $140,000 - ($1,200,000 × 0.10) = $140,000 - $120,000 = $20,000.
Conclusion: Both options yield the same Residual Income, meaning they add the same absolute dollar value above the cost of capital.
Example 9: Project with High Capital Intensity
Scenario: A manufacturing project requires $5,000,000 in capital and generates $400,000 NOI. Required Rate is 7%.
1. Known Values: NOI = $400,000, Capital Invested = $5,000,000, Required Rate = 7%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = $400,000 - ($5,000,000 × 7%) = $400,000 - ($5,000,000 × 0.07) = $400,000 - $350,000
4. Result: RI = $50,000.
Conclusion: Despite the high capital, the project is adding value ($50,000 above the cost of capital).
Example 10: Negative NOI Scenario
Scenario: A new venture had $500,000 Capital Invested and a negative NOI of -$50,000 (an operating loss). Required Rate is 10%.
1. Known Values: NOI = -$50,000, Capital Invested = $500,000, Required Rate = 10%.
2. Formula: RI = NOI - (Capital Invested × Required Rate)
3. Calculation: RI = -$50,000 - ($500,000 × 10%) = -$50,000 - ($500,000 × 0.10) = -$50,000 - $50,000
4. Result: RI = -$100,000.
Conclusion: The venture resulted in a significant negative Residual Income, reflecting both operating losses and failing to cover the cost of capital.
Frequently Asked Questions about Residual Income
1. What is Residual Income (RI)?
Residual Income is a measure of a division's or project's profitability after subtracting the cost of the capital it uses. It shows the absolute dollar amount of profit earned above the required return on invested capital.
2. How is Residual Income calculated?
The formula is: RI = Net Operating Income (NOI) - (Capital Invested × Required Rate of Return).
3. What is Net Operating Income (NOI)?
NOI is typically defined as revenue minus all operating expenses, but before deducting interest expense and taxes. It represents the profit generated purely from the asset's operations.
4. What does the "Required Rate of Return" represent?
This is the minimum acceptable rate of return on the capital invested. It's often the company's cost of capital or a target hurdle rate set by management.
5. What does a positive Residual Income mean?
A positive RI means the division or project is earning a profit that exceeds the required return on the capital it employs. It is adding value to the company.
6. What does a negative Residual Income mean?
A negative RI means the division or project is earning a profit that is less than the required return on the capital it employs. It is not covering its cost of capital and is potentially destroying value.
7. How is Residual Income different from Return on Investment (ROI)?
ROI is a percentage (NOI / Capital Invested). RI is an absolute dollar amount. RI is often preferred because it motivates managers to accept profitable investments even if they might slightly lower the overall ROI percentage for a large division, thus aligning better with maximizing the company's total wealth.
8. Is Residual Income the same as Economic Value Added (EVA)?
EVA is a specific trademarked version of Residual Income that involves several adjustments to GAAP (Generally Accepted Accounting Principles) net income and balance sheet accounts to arrive at a measure closer to "true" economic profit. The core concept (profit minus a capital charge) is the same, but EVA uses specific adjustments.
9. What are the potential drawbacks of using Residual Income?
One drawback is that it is an absolute measure, making it difficult to compare the performance of divisions or projects of vastly different sizes without considering the scale of capital invested. Also, determining the appropriate "Required Rate of Return" and "Capital Invested" can sometimes be subjective or complex.
10. How is Capital Invested typically defined for RI calculation?
This can vary by company policy but is commonly defined as the total assets employed by the division or project, sometimes specifically defined as operating assets, or it could represent total equity or total debt plus equity.
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