In the past article in this series, a definition of residual income and ideas for residual income were outlined. A strong background in the understanding of these concepts is recommended to appreciate the background of residual income formula and its application in the corporate world.
Recently, the analyst has adopted the concept of passive income formula in the valuation of a firm due to its ability to adjust for money’s time value. Naturally, money losses value with time. Thus a thousand dollars today may not be worth the same amount five years from now, Page Pap.
As a result, households prefer consumption today as oppose to offer, and thiswhichbasic reason for using the concincome in evaluating the best alternative in investment opportunities instead.
The residual income formula is a concept in managerial accounting used to determine and compare the performance of different units in a business. This formula measures the success of each department against the minimum required rate of return.
The rate of return on investment is a requirement in determining the viability of a business venture. In simple terms, before investing your money in an idea, it is important to determine if the expected return is worth the risk.
The residual income formula is attributed to Economist Alfred Marshall, the founder of many economic models and principles. Leading motor vehicle assembly firm General motors’ was the first company to adopt the concept in the valuation of its business units. The basic formula is:
RI = Operating income – (Operating Assets x Target Required rate of return)
In this formula, operating income refers to the net operating income – net operating expenses. Operating expenses are incurred to ensure the business’s smooth running, and they include costs such as wages, rent, and cost of raw material, among others.
The required rate of return is the opportunity cost that the business incurs due to foregone alternatives. It is key to note that a business operates on scarce resources in money, time, and employees.
It is thus important to choose the best alternatives to allocate resources to. The alternatives foregone by the company as a result of scarcity of resources is the opportunity cost or the minimum required rate of return.
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The operating assets of the business unit, on the other hand, refer to the asset base of the particular department or the total assets in a specific business unit.
In this regard, a company earns higher passive income when the per-unit cost of producing a good is lower than the revenue obtained from selling the unit. In simpler terms, to ensure higher income earnings, the company should operate when the revenue is maximized while the costs are minimized.
In this case, the difference between income and expenditure is a big positive figure illustrating the firm’s growth in income. In evaluating projects to invest in, a business unit with a positive passive income figure is a viable idea, while that with a negative value should be abandoned.
If two similar projects have positive values, then the one with the highest figure should be selected since it will generate more income for the company.
It is important to distinguish between firm passive income and household passive income or, in simple terms, the residual income for a business entity and that of an individual.
The above formula is used in the determination of passive income for a business unit. In terms of individual households, the definition of residual income formula changes to reflect household consumption’s unique behavior.
It is defined as money left over after paying utility bills and loans or, in simple terms, what is left after paying debts. In this regard, the residual income formula becomes:
Residual Income = Monthly Net Income – Monthly Debts
In this formula, the monthly net income is the sum of all passive income earned, which can be from royalties, rental income, interest-earning on saving, subscription, or service fee for a service rendered.
On the other hand, monthly debts relate to expenses incurred in earning the monthly income and could include expenses like agency fees to real estate agencies.
So how do you ensure income growth basing on this concept?.
The trick is to ensure a big difference between monthly income and debts. Try to increase your income as much as possible but limit your spending as low as possible and limit borrowing.
The bigger the difference between these two, the higher the passive income, and in contrast, as the difference decreases, the residual income decreases.
The information used in calculating passive income is available in the income statement of a company. The popularity of using the residual income formula in estimating the performance of different departments in a business is due to the simplicity and the realistic nature.
For instance, if two departments generate the same profits, one department requires more assets in its operation. The best alternative for the company is the one that uses fewer assets. This is because the extra assets will be an additional expense to the company, thus reducing profitability.
In the next article, the concept of residual income is used in determining the viability of different residual income ideas. Having an idea on making passive income is not enough; before investing your time and money in such an idea, ensure it is a worthy investment by determining how viable it is.
Amaiwe Bryan is a professional Internet marketer and an article writer.