The residual income approach is the measurement of the net income that an investment earns above the threshold established by the minimum rate of return assigned to the investment. It can be used as a way to approve or reject a capital investment, or to estimate the value of a business.
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.
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.
The residual income approach may not be so superior as was indicated by the preceding example, for two reasons:
- If a business only has a limited amount of cash available for investment in assets, it may have to use a variety of selection criteria to establish the best possible mix of investments, not all of which may be based on residual income. Other factors, such as risk mitigation and compliance with environmental regulations, may also be considered.
- Under throughput analysis, the only factor that matters is the impact of a proposed investment on the ability of a business to increase its total throughput (revenue minus totally variable costs). Under this concept, the main focus is on either enhancing throughput through the bottleneck operation or in reducing operating expenses. This analysis requires a consideration of bottleneck usage by the likely mix of products to be manufactured, and their margins. This is a much more detailed analysis than is contemplated under the more simplistic residual income approach.
- If the residual income method is calculated from estimates of future results, then there is a risk that the estimates will be so inaccurate as to render the results of the analysis invalid.
In personal finance, residual income refers to the amount of cash left after all bills have been paid. This interpretation is frequently used by lenders to ascertain whether an individual has the ability to support payments on another loan.