Understanding the residual income formula

In the previous article in this series, a definition of residual income was outlined, as well as ideas for residual income. A solid background in understanding these concepts is recommended in order to appreciate the background of the residual income formula as well as its application in the business world.

Recently, the analyst adopted the concept of passive income formula in the valuation of a company due to its ability to adjust the value of money over time. Naturally, money losses are valued over time, so a thousand dollars today may not be worth the same amount five years from now.

As a result, households prefer consumption today rather than in the future and this is the basic reason for using the concept of passive income in evaluating the best alternative in investment opportunities.

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

The rate of return on investment is a requirement to determine the viability of a business enterprise. 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 the economist Alfred Marshall, who is the founder of many economic models and principles. The leading company in the assembly of motor vehicles, 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 smooth running of the business and include costs such as salaries, rent, and cost of raw materials, among others.

The required rate of return is the opportunity cost that the business incurs as a result of abandoned alternatives. It is key to bear in mind that a company operates with scarce resources in terms of money, time and employees.

Therefore, it is important to make a decision regarding the best alternatives to which to allocate resources. The alternative that the company gives up as a result of the scarcity of resources is the opportunity cost or the minimum required rate of return.

Business unit operating assets, on the other hand, refer to the asset base of the particular department or the total assets in a specific business unit.

In this sense, a company obtains higher passive income when the unit cost of producing a good is less than the income obtained from the sale of the unit. In simpler terms, to ensure higher revenue, the business must operate at a point where revenue is maximized and costs are minimized.

In this case, the difference between income and expenses is a large positive figure that illustrates the growth of the company’s income. When evaluating projects to invest in, a business unit that has a positive passive income figure is a viable idea, while one with a negative value should be abandoned.

If two similar projects have both positive values, then the one with the higher number should be selected, as it will generate more revenue for the company.

It is important to make a distinction between the passive income of the business and the passive income of the household or, in simple terms, the residual income of a business entity and that of an individual.

The formula above is used to determine the passive income of a business unit. In terms of individual households, the definition of the residual income formula changes to reflect the unique behavior of household consumption.

It is defined as the money that is left after paying utility bills and loans or, in simple terms, what is left after paying debts. In this sense, the residual income formula becomes:

Residual income = Monthly net income – Monthly debts

In this formula, monthly net income is the sum of all passive income earned, which can come from royalties, rental income, interest earned on savings, subscription, or service fee for a service provided.

Monthly debts, on the other hand, relate to expenses incurred to earn the monthly income and could include expenses such as agency fees to the real estate agency.

So how do you ensure revenue growth based on this concept?

The trick is to secure a large difference between monthly income and debt. Try to increase your income as much as possible, but limit your expenses as low as possible and limit borrowing.

The greater the difference between these two, the greater the passive income and, in contrast, as the difference decreases, the residual income also decreases.

The information used to calculate passive income is available in a company’s income statement. The popularity of using the residual income formula to estimate the performance of different departments in a company is due to the simplicity and realistic nature of this technique.

For example, if two departments generate the same level of profit but one department requires more assets in its operation, then the best alternative for the company is the one that uses fewer assets. This is because the additional assets will be an additional expense for the company, reducing profitability.

In the following article, the concept of residual income is used to determine the feasibility of different residual income ideas. Having an idea on how to generate passive income is not enough, before investing your time and money in such an idea, make sure it is a worthy investment by determining how viable it is.

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