Q. Explain about Residual income?
Residual income is profit earned by a division less a "notional interest charge" for investment of finance within it.
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Profit before interest and tax (PBIT) X
Capital employed x head office % interest charge (X)
Residual income X
Residual income uses the same profit before interest and tax and capital employed value as the ROCE measure. Residual income is an absolute measure which deducts from profit before tax andinterest, an imputed "notional" interest charge using a cost of capital or return required. The more capital employed the division consumes then the lower the residual income due to a higher absolute interest charge. In effect residual income forces managers to understand the cost of finance when undertaking investment decisions.