Understanding The Residual Income Formula

In the past article in this series, a definition of residual Income and ideas for residual Income were outlined. A strong background in understanding these concepts is recommended to appreciate the experience of the residual income formula and its application in the corporate world.

Recently, the analyst has adopted the concept of a passive income formula in a firm’s valuation due to its ability to adjust for money’s time value. Naturally, money loses 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 opposed to offer, which is a basic reason for using the convince in evaluating the best investment opportunities.

The residual income formula is a concept in managerial accounting used to determine and compare different units’ performance. This formula measures the success of each department against the minimum required rate of return.

The rate of return on investment is required to determine a business venture’s viability. 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 net operating Income—net operating expenses. Operating expenses are incurred to ensure the business’s smooth running, including costs such as wages, rent, and the cost of raw materials.

The required rate of return is the opportunity cost that the business incurs due to foregone alternatives. It is key to note that a company operates on scarce money, time, and employee resources.

It is thus important to choose the best alternatives to allocate resources to. The other options foregone by the company due to resource scarcity are opportunity cost or the minimum required rate of return.

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On the other hand, the business unit’s operating assets 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 from selling the unit. In simpler terms, to ensure higher income earnings, the company should operate when the payment 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 income growth. A business unit with a positive passive income figure is viable in evaluating projects to invest in, while a negative value should be abandoned.

If two similar projects have positive values, 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 an individual.

The above formula is used to determine passive Income for a business unit. For individual households, the 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 savings, 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 costs like agency fees to real estate agencies.

So, how do you ensure income growth based 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 and borrowing as much as possible.

The bigger the difference between these two, the higher the passive Income; in contrast, as the difference decreases, the residual income decreases.

The information used in calculating passive Income is available in a company’s income statement. The popularity of using the residual income formula in estimating the performance of different departments in a business is due to its simplicity and realistic nature.

For instance, if two departments generate the same profits, one requires more assets. The best alternative for the company is the one that uses fewer assets. This is because the extra help will be an additional expense, thus reducing profitability.

In the next article, the concept of residual Income is used to determine the viability of different residual income ideas. Having an opinion about making passive Income is not enough; before investing your time and money in such an idea, ensure it is a worthy investment by determining its viability.

Amaiwe Bryan is a professional Internet marketer and an article writer.