Suppose a manager's performance is to be evaluated by residual income. Which of the following will NOT result in an increase in the residual income figure for this manager, assuming other factors remain constant?

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BlackTom AI · Accepted Answer

To understand how residual income is affected, recall the formula: Residual Income (RI) = Operating Income − (Minimum Required Rate of Return × Operating Assets). This means RI rises when operating income grows or when the capital charge (minimum rate × assets) falls, and RI falls when the capital charge increases.
Option 1: A decrease in expenses. Lower expenses boost operating income, which directly increases RI, assuming other factors stay the same. So this option would lead to a higher RI, not lower it.
Option 2: An increase in sales. Higher sales generally raise operating income (assuming costs don’t rise proportionally), which increases RI as long as the asset base and required return remain constant. Hence, this option also increases RI.
Option 3: A decrease in operating assets. Reducing the asset base lowers the capital charge (minimum rate × assets), which raises RI if operating income stays constant. Therefore this option increases RI.
Option 4: An increase in the minimum required rate of return. Elevating the hurdle rate increases the capital charge term, which subtracts more from operating income and reduces RI. This is the scenario that does not result in an increase in residual income; it actually lowers RI even if operating income remains the same.

Suppose a manager's performance is to be evaluated by residual income. Which of the following will NOT result in an increase in the residual income figure for this manager, assuming other factors remain constant?

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