What is the formula to calculate residual income (RI)?

The formula for calculating residual income (RI) is designed to determine the amount of income generated by an investment or project after accounting for the cost of capital. The concept emphasizes the importance of not only generating profit but also covering the cost of the capital used to earn that profit.

Residual income is calculated by taking the controllable profit, which represents the income generated by a division or investment that is under the manager's control, and subtracting the notional interest cost. The notional interest cost reflects the required return on the capital employed in the business, fundamentally representing what the capital could earn in an alternative investment.

Thus, the formula encapsulates the idea that residual income goes beyond just profitability; it gauges whether the investment generates more profit than the minimum required return. This reinforces the decision-making process for managers, guiding them on whether to continue, invest further, or divest in the investment based on its ability to create wealth above the cost of capital.

This understanding of residual income aids in evaluating performance, making it an essential metric in performance management and investment decision-making.