In the past article in this series, a definition of residual income as well as ideas for residual income was outlined. A strong background in the understanding of these concepts is recommended in order to appreciate the background of residual income formula as well as its application in corporate world.
Recently, analyst has adopted the concept of passive income formula in valuation of a firm due to its ability to adjust for time value of money. Naturally, money losses value with time, thus a thousand dollars today may not be worth the same amount five years from now.
As a result, households prefer consumption today as opposed to future and this is the basic reason for using the concept of passive income in evaluating best alternative in investment opportunities.
The residual income formula is a concept in managerial accounting which is used to determine and compare the performance of different units in a business. This formula measures the success of the each department against the minimum required rate of return.
The rate of return on investment is a requirement in determining the viability of a business venture. 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 who is the founder of many economic models and principles. Leading motor vehicle assembly firm General motors’ was the first company to adopt the concept in 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 the net operating income – net operating expenses. Operating expenses are incurred to ensure smooth running of the business and they include costs such as wages, rent, and cost of raw material among others.
Required rate of return is the opportunity cost that the business incurs as a result of foregone alternatives. It is key to note that a business operates on scarce resources in terms of money, time and employees.
It is thus important to make a choice regarding the best alternatives to allocate resources to. The alternatives foregone by the company as a result of scarcity of resources is the opportunity cost or the minimum required rate of return.
The operating assets of the business unit on the other hand refers 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 per unit cost of producing a good is lower than the revenue obtained from selling the unit. In simpler terms, to ensure higher income earnings, the company should operate at a point where the revenue is maximized while the costs are minimized.
In this case, the difference between income and expenditure is a big positive figure illustrating growth in income for the firm. In evaluating projects to invest in, a business unit that has a positive passive income figure is a viable idea while that with a negative value should be abandoned.
If two similar projects both have positive values, then the one with the highest figure should be selected since it will generate more income for the company.
It is important to make a distinction between firm passive income and household passive income or in simple terms the residual income for a business entity and that of an individual.
The above formula is used in determination of passive income for a business unit. In terms of individual households, the definition of residual income formula changes to reflect the unique behavior of household consumption.
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 saving, subscription or service fee for a service rendered.
Monthly debts on the other hand relates to expenses incurred in earning the monthly income and could include expenses like agency fee to real estate agency.
So how do you ensure income growth basing 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 as low as possible as well as limiting borrowing.
The bigger the difference between these two the higher the passive income and in contrast as the difference decreases, the residual income decreases as well
The information used in calculating passive income is available in the income statement of a company. The popularity of using the residual income formula in estimating the performance of different departments in a business is due to the simplicity and the realistic nature of this technique.
For instance, if two departments generate same level of profits but one department requires more assets in its operation, then the best alternative for the company is the one which uses less assets. This is because the extra assets will be an additional expense to the company thus reducing profitability.
In the next article, the concept of residual income is used in determining the viability of different residual income ideas. Having an idea on how to make passive income is not enough, before investing your time and money in such an idea ensure it is a worthy investment by determine how viable it is.