Residual income is a source of revenue that continues even after your work is complete. It can include money from royalties (for example from a book or film), rental income (for example from property) and subscriptions (for software or learning materials). It could also be revenue generated by your existing funds, such as interest on capital.
Below, we detail why residual income is important, the different types of residual income, and explain the residual income formula with examples.
Why is residual income important in business?
“The beauty of creating a residual income stream is that it takes away the time for money pressure,” explains Becky Hope-Ross, a Business Process Specialist with Busy Bees. “It allows business owners to generate income in the background without having to allocate a lot of time to the process, once it’s up and running.”
Residual income also has the potential for scalability, meaning that the income generated can increase over time without needing to allocate significantly more resources or effort.
Viktrs, a tech firm, has created a software enabling video creators to upload content on their website and earn continuous affiliate income when viewers interact with the content. “If someone is watching a wildlife programme, the video player allows them to click and find out which camera is being used, or donate to a charity, or buy a piece of music. That revenue is split between our company and the video owner,” explains Viktrs Founder, Mark Bamford.
What this means is that the video creator can make and publish a video and generate ongoing revenue from that content without any ongoing effort or changes. “The revenue comes from affiliate income, but we also collect a huge volume of data about who is watching the video, and how they are engaging, which we can then sell to clients who want to target those consumers,” Bamford adds.
One of the most important pitfalls to be aware of when generating residual income is that it is entirely without effort, cautions Hope-Ross. “There’s a lot of messaging that suggests you can generate this income with minimal effort, and I would contest that. People need to be aware that although residual income is possible and a great way to scale your business, it isn’t an overnight success.”
Hope-Ross provides an example of an online course that is developed and published on a company website. “The course will need some expense and effort at the start, but it can provide fantastic long-term revenue. However, businesses need to be mindful that these income streams do need periodic maintenance. You need to make sure the content is still relevant and regular marketing is needed to keep the revenue flowing.”
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Types of residual income
Depending on the nature of your business, there are different types of residual income that might be generated. Generally, this type of income tends to come from either physical assets (property), financial assets (capital) or intellectual assets (music, books).
Stock
Residual income can be generated by stock and share investments. Once a business or individual has invested in stock, the dividends paid will form residual income that might be received without any additional investment.
Personal business income
It’s possible to generate earnings without needing ongoing active involvement. For example, personal residual income might come from passive income streams such as investment properties, subscriptions or royalties.
The huge advantage of subscriptions and royalties for a growing business like Viktrs is that it frees up the team’s time to focus on growing the business while income is generated from completed work. “We are very much in start-up mode and looking for our next round of investment, so having revenue that doesn’t require us – or our creators – to be involved on a daily basis is very important,” he says.
If you have an existing product that is sold via a subscription or licensing model then affiliate income can also provide valuable residual income, adds Hope-Ross. “Offering partners the opportunity to sell or license your course, software or content can generate affiliate income, and there can be great power in partnerships in terms of getting your content in front of new people,” she says.
The residual income formula
To calculate a business’s residual income, we use the formula below:
Residual Income = Net Operating Income - (Minimum Required Return x Operating Cost)
Net operating income refers to the income generated by the asset through sales, rentals, and royalties after all operating expenses have been paid.
The minimum required return (MRR) is the rate of return that investors or owners expect to generate from the investment or asset. This is typically based on the risk associated with the activity, and the industry you operate within.
Operating costs include the capital invested in the asset or investment and could include things like property costs, equipment or inventory.
Residual income example
Company A is considering investing in a new software development that will require an upfront investment of £500,000. The product is expected to generate an annual net operating income of £100,000 over the next five years. The company’s minimum required return on investment is 10%.
To calculate the residual income from this new product the business starts by calculating the total net income generated over the life of the investment:
Total Net Operating Income (£100,000) = Annual Net Operating Income x Number of Years (x5) = £500,000
Next, the business will calculate operating costs including upfront investment. In this case, the upfront costs for the project are £500,000.
Using the residual income formula we can calculate the residual income as below:
Residual Income = Net Operating Income (£500,000) – MRR x Operating costs (10% x £500,000) = £500,000 - £50,000 = £450,000
This means the project generates a residual income of £450,000, which is the income generated above and beyond the minimum required return. This indicates that the investment would generate excess income that can be used to reinvest in the business.
Residual income v passive income
Residual income and passive income are sometimes conflated, but not all residual income is passive even though passive income is usually residual.
Take, for instance, landlords earning rental revenue. This is a form of residual income that isn't passive because they still bear expenses like property upkeep and taxes, possibly even hiring staff for management or promotion.
If you are interested in creating residual income for your business, then Hope-Ross advises you to start by researching the marketplace to identify the most appropriate type of residual income for your company, circumstances and industry.
If you opt to create a product or service that will generate ongoing income, she advises businesses to look at the broader market. “Is there a similar offering out there? What do competitors charge?” she says. Next, consider how this investment fits into your wider business strategy. “If the investment is the first step in a lead engaging with your business, it has a lot more value, and so the required rate of return might be lower,” she says.
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