Managerial Accounting: 11.5: Using Residual Income to Evaluate Performance - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how to use  residual income to evaluate investment centers. And  

investment centers, I have got a series of videos  on this, investment centers are those divisions, or  

subunits, or segments, that are responsible for  not only profits and costs, but also for the  

investments in long-term assets. And there are many  different measures that can be used to evaluate  

investment centers and the managers of investment  centers. And this is one of them. Residual income,  

as I just mentioned, is another method that can be  used to evaluate manager performance, for managers  

of investment centers. And it is the dollar  amount of the division operating profit that  

is in excess of the divisions cost of getting  capital to purchase its operating   

assets. So right here, third bullet point, is where  you will see the equation to calculate residual  

income. And it is simply the operating income, minus  the percent cost of capital, and that is typically  

calculated by most companies by looking at the  cost of their debt and the cost of their equity  

and taking some kind of average. That is a whole  different lecture but that is where it comes  

from. And we multiply that percent cost of capital  times the average operating assets. The goal then  

is for each division manager to increase  residual income over time. So let's take a look  

at an example of how to calculate residual  income on the next slide. I have been using  

this same company for all of the examples  of how to evaluate an investment center. So  

you will see the exact same dollar amounts and  same numbers, they all tie together. The company  

is called Game Products, Incorporated, and this  company has three different divisions. We have  

got the Sporting Goods division that you'll see  right here, we have got the Board Games division,  

and the Computer Games division. And what we are  going to do here is to calculate the residual  

income for each of these divisions. And as I  mentioned, I have a video on how to find the  

operating profit margin ratio, then evaluating the  divisions just using that, I have got a video on  

how to use return on investment to evaluate each  of these divisions. So you can take a look at that  

as well and now we are looking at how to find  the residual income for each division. And again  

the residual income formula is right up here, you  will see it here, it is the operating income, minus  

the percent cost of capital, times the average  operating assets. So we are going to assume here  

that the percent cost of capital for all three  divisions is 8%. The operating income numbers  

are shown here. So we'll just take a look at the  Sporting Goods division and then you can look at  

the other divisions separately if you like to  see how those calculations are done. But we'll  

focus on Sporting Goods division here. Residual  income then is the operating income, that is this, 

these are in thousands, $3,295,000, minus  the 8%, times the average operating assets. And  

I have a separate video that talks about,  I believe it is the return on investment  

video, that talks about where we get the average  operating assets, so I am not going to focus too  

much on that here. But these are the operating  assets that are used for the daily operations of  

the business of this particular division. So the  average operating assets for the Sporting Goods  

division is $29,350,000 so we multiply that by  8%, and that gives us 2,348,000, we subtract that  

from the operating income, and that means we have  residual income or income leftover of $947,000. So  

that is how we find the residual income for the  Sporting Goods division. We then run the same  

calculation for the other two divisions. And you will  see that the Board Games division has a residual  

income of $516,000, these are all in thousands, and  that the Computer Games division actually has a  

loss of four hundred, or residual income that's  negative of $419,000. There are some limitations  

to using residual income. And the first is that  it is stated in dollars rather than as a ratio,

so it is pretty tough to compare divisions,  because again you have got to factor in things  

like the dollar amount of assets in place that  is needed to create the residual income that we  

have. And so that gets a little bit complicated to  compare divisions across the board. One division  

may have high residual income, simply because it  has a larger asset base. So it is that whole idea  

of making sure we include assets in the equation  and return on investment is an excellent way to  

do that, that's again a separate video. So division  managers, if we are going to use residual income,  

should be evaluated based on how effectively  they increase, hopefully increase, residual  

income from one period to the next. And that  is typically how it is used, to take a look at  

how a particular manager is doing with a division  over time, by looking at residual income over time.