Residual Income

Residual income (RI) is an accounting measure of income minus a dollar amount for required return on an accounting measure of investment.

The required rate of return multiplied by the investment is the imputed cost of the investment. The imputed cost of the investment is a cost recognized in particular situations but not recorded in financial accounting systems because it is an opportunity cost. In this situation, the imputed cost refers to the return Hospitality Inns could have obtained by making an alternative investment with similar risk characteristics.

Assume that each hotel faces similar risks and that Hospitality Inns has a required rate of return of 12%. The RI for each hotel is calculated as the operating income minus the required rate of return of 12% of total assets:

Note that the New Orleans hotel has the best RI. In general, RI is influenced by size: For a given level of performance, larger divisions generate higher RI.

Some companies favor the RI measure because managers will concentrate on maximizing an absolute amount, such as dollars of RI, rather than a percentage, such as ROI. The objective of maximizing RI means that as long as a subunit earns a return in excess of the required return for investments, that subunit should continue to invest.

The objective of maximizing ROI may give managers of highly profitable subunits the incentive to reject projects that, from the viewpoint of the company as a whole, should be accepted. Suppose Hospitality Inns is considering upgrading room features and furnishings at the San Francisco hotel. The upgrade will increase the operating income of the San Francisco hotel by $70,000 and increase its total assets by $400,000. The ROI for the expansion is 17.5% $(\text{\$}70\text{,}000÷\text{\$}400\text{,}000)\text{,}$ which is attractive to Hospitality Inns because it exceeds the required rate of return of 12%. By making this expansion, however, the San Francisco hotel’s ROI will decrease:

The annual bonus paid to the San Francisco manager may decrease if ROI impacts the bonus calculation and the upgrading option is selected. Consequently, the manager may not support the expansion. In contrast, if the annual bonus is a function of RI, the San Francisco manager will favor the expansion:

So, it is more likely that a firm will achieve goal congruence if it uses RI rather than ROI to measure the subunit manager’s performance.

To see that this is a general result, notice that the post-upgrade ROI is a weighted average of the pre-upgrade ROI and the ROI of the project under consideration. Therefore, whenever a new project has a return higher than the required rate of return (12% in our example) but below the current ROI of the division (24% in our example), the division manager is tempted to reject it even though it is a project shareholders would like to pursue.^* On the other hand, RI is a measure that aggregates linearly, that is, the post-upgrade RI always equals the pre-upgrade RI plus the RI of the project under consideration. To verify this in the preceding example, observe that the project’s RI is $\mathrm{\$}\text{70,000}-(12\mathrm{\%}\times \mathrm{\$}\text{400,000})=\$\text{22,000},$ which is the difference between the post-upgrade and pre-upgrade RI amounts. As a result, a manager who is evaluated on residual income will choose a new project only if it has a positive RI. But this is exactly the criterion shareholders want the manager to employ; in other words, RI achieves goal congruence.