Strategic Management Accounting · Module 5: Performance management
The Residual Income Trap
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Chapters
- 0:00Question
- 0:26Breakdown
- 1:06Rule
In short
Residual income is operating profit minus a capital charge at the required return on invested capital. To hit a residual income target, add the target to the capital charge: with $5,000,000 invested at 12% and a $150,000 target, the division needs $750,000 of operating profit.
- Capital charge = required return × invested capital.
- Required profit = capital charge + target residual income.
- Zero residual income means earning exactly the required return.
Transcript
0:00Question
Three wrong answers. Each one is a different way to slip on the same formula. Huon Timber's Marine division has $5 million of invested capital. Head office charges 12% on it, and wants residual income of $150,000. What operating profit hits the target exactly? Pick one.
0:26Breakdown
Residual income is the profit left after a charge for the capital you use. The charge: 12% of $5 million is $600,000. Residual income is what's left over, so the target sits on top of the charge. $600,000 plus $150,000: $750,000. A subtracts the target instead of adding it. Cross out A. B is just the charge. That's residual income of zero. Cross out B. C charges 12% on the target too. Cross out C. D, $750,000.
1:06Rule
Residual income sits on top of the capital charge. Zero residual income means you earned exactly the required return. Want more traps like this? Follow for the next one.
Try a question on this lesson
From the EstatePass Strategic Management Accounting bank. Answer it, then read the explanation.
The Marine division of Huon Timber Ltd has invested capital of $5,000,000. Head office charges divisions a required return of 12% on invested capital and has set the division a residual income target of $150,000 for the year ending 30 June 2027. What operating profit must the division earn to meet the target exactly?
Sources
- Residual income (divisional performance measurement)
- CPA question bank: cpa-sma-0430
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