Residual Income

Accounting profit ignores the cost of shareholders' money. Residual income charges for it, so that a business only shows residual income if it earns more than its investors require.

At the company level, residual income is often calculated as net income minus a charge for equity, equal to equity multiplied by the cost of equity. For example, a company with net income of 12,000,000, equity of 80,000,000 and a cost of equity of 10% has residual income of 12,000,000 minus 8,000,000, or 4,000,000.

In management accounting, residual income is used to evaluate divisions, by subtracting a capital charge from their operating profit. Unlike return on investment, it encourages managers to accept any project earning more than the required rate, even if it lowers the division's average return.

Residual income is also the basis of a valuation method, the residual income model, which values a company as its book value plus the present value of expected future residual income. It is closely related to economic profit.