Measures of Residual Income
Look again, closely, at the 20X5 segment data for the illustrated company. In particular, note that the electrical segment produced operating income of $7,282,000. This compares to $9,556,000 for the galvanizing group. Even though the relative profitability bobbles a bit from year to year, the two units are not terribly far apart in overall profits. What is most interesting is that the electrical products segment deployed $79,424,000 in assets versus the $45,042,000 in use by galvanizing. In this context, it is quite apparent that galvanizing is producing a better rate of return on the invested assets (i.e., fewer assets produced more income). A good manager would probably take note of this conclusion by careful inspection of the data. However, a managerial reporting technique, known as residual income, is sometimes used to flesh out these effects.
Residual income is not a GAAP concept. It is an internal financial assessment technique to help scale the relative success or failure of specific business activities. It adjusts income for a presumed cost of capital (or other threshold rate of return). Although there are many variations of the residual income calculations, the general approach is portrayed by the following formula:
Residual Income = Operating Income - (Operating Assets X Cost of Capital)
For purposes of this illustration, assume that the company's cost of capital (or minimum required rate of return) is 10%. The accompanying table reveals the residual income for each segment. This information sheds a completely different light on the relative performance of each unit. Remember the opening observation: the two units are not terribly far apart in overall profits. Once the cost of capital is placed on the evaluative scale, it appears that one unit is doing far better than the other.
Keeping Residual Income in Perspective
Residual income is a powerful tool for identifying and ranking the performance of business units. However, a manager must be very careful in utilizing these calculations. First, there is the usual issue of short run vs. long run considerations. The preceding illustration painted the electrical segment in a less favorable light than galvanizing; repeat the analysis using the 20X3 data, and the situation reverses. A single year's residual income data is rarely conclusive in and of itself. And, managers need to be savvy to the impact of accounting rules. For instance, the electrical products segment may be investing heavily in research toward new products. These costs would be expensed as incurred, thereby substantially reducing operating income in current periods. As such, the unit's residual income would suffer relative to other units that might be investing in tangible assets! Finally, the 10% rate is an arbitrary hurdle rate. Selecting an alternative rate will change the measure of residual income. Despite its inherent limitations, reports of residual income can be very helpful in clearly and quickly pinpointing areas of management concern.
Concepts in Allocating Service Department Costs
Not all discrete units within a business organization are focused on production of the end product. Janitorial departments, cafeterias, maintenance/repair shops, health clinics, and countless other units support the productive units. How are the costs of such service departments to be considered in forming judgments about the success or failure of the various operating units?
In general, service department costs are allocated to operating units via some adopted allocation scheme. This allocation occurs to support measurement of full product cost (as contemplated by GAAP), to make managers of operating units aware of the complete cost of their activities, and to discourage waste and inefficiency by over utilization of service departments. The allocation scheme will generally be based on either a direct or step allocation approach.
The Direct Method of Allocating Service Department Cost
The direct method transfers the cost of a service department directly to the productive departments that rely on the services. The allocation is usually based upon some logical benchmark. For example, janitorial services may be allocated to productive departments based on square footage used by the productive departments. Cafeteria costs may allocated based on the number of employees within each production department. Hopefully, the base selected bears a logical relationship to the consumption of services and their costs. Assume that Benjamin Printing
Company has two production departments: printing and binding. Printing is highly automated, with a number of complex printing presses. Binding also relies on mechanized devices, but is overall a far more labor intensive department. These departments are supported by maintenance and cafeteria service units. Maintenance activities are driven by the amount of machinery requiring service and repair. The utilization of cafeteria services is directly related to the size of the labor pool. As a result, a decision was reached to allocate costs incurred by the Maintenance Department based on number of machines used by each productive department. Cafeteria costs are allocated based on number of employees. The following table shows how the total costs were directly allocated to production activities:
DIRECT ALLOCATION OF SERVICE DEPARTMENT COSTS
The Step Method of Allocating Service Department Cost
The direct approach ignores one potentially important issue. Some service departments may provide support to other service departments. For instance, Benjamin's maintenance employees likely eat in the cafeteria, too! This issue is mitigated by a step method of allocation. With the step method, an identified service department's cost is first allocated to other units, including other service departments. Then, the "resulting costs" of the other service departments are allocated to production. This step allocation process is demonstrated for Benjamin, assuming that cafeteria costs benefit maintenance, printing, and binding operations:
STEP ALLOCATION OF SERVICE DEPARTMENT COSTS
Multiple Steps and Simultaneous Allocations
A large organization can have many service departments, and it is quite possible to identify a number of interactions between various service departments. The design to achieve a logical allocation of costs can entail numerous sequential steps (e.g., Department A serves Departments B, C, D, and E; then Department B serves Departments C, D, and E, etc.). Or, it may be observed that service departments benefit each other (e.g., the maintenance staff eats in the cafeteria, but the cafeteria utilizes maintenance employees to repair ovens). There is no mathematical limit to the number of step allocations that can be made. In the alternative, calculus could be used to achieve numerous simultaneous allocations. These situations provide intellectually stimulating challenges, but they may not be worth the cost of implementation. As a result, companies are usually content to rely on direct or very simplified step allocations of service department costs.