residual income


residual income
= residual return
The net income that a subsidiary undertaking or division of an organization generates after being charged a percentage return for the book value of the net assets or resources deemed to be under its control. The residual income approach by the headquarters or holding company of an organization is to require the subsidiary or division to maximize its profits after the charge for the use of those assets. This approach is very similar to the Economic Value Added technique.
example
A company has two divisions. The managers of Division X have to decide whether or not to invest £1,000,000 in a project with a profit before interest and tax of £200,000. The managers of Division Y have a similar decision: whether to invest £1,000,000 in a project with a profit before interest and tax of £100,000.
The calculation indicates that the residual income of Division X will increase if the project is accepted. Managers should therefore accept the investment. By contrast, the residual income of Division Y will decrease if the project is accepted. Managers should therefore reject the investment.
Note that it is possible to have a different cost of capital percentage for each division. For example, if investments in Division Y are seen as having a higher risk than investments in Division X, the company can increase the cost of capital charge for Division Y. This is one reason why managers may choose residual income rather than return on capital employed ROCE when measuring the performance of divisions. Recent surveys suggest that even though residual income can be regarded as theoretically superior to ROCE, the latter is preferred by managers.

Accounting dictionary. 2014.

Look at other dictionaries:

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