Question

Use the following information to answer 3 questions:

Chiang Rai Forest Company (CRFC), a very large integrated wood and lumber products company with substantial timber holdings, has two divisions: Forest and Lumber. Forest division manages the timber holdings, maintains the land and plants and harvests trees.

Forest Division’s total asset value is stated on CRFC’s balance sheet as $2.2 billion. Most of the timber the Forest division harvests is sold internally to the Lumber division. Any timber not sold to the Lumber division can be sold externally. The Lumber division can purchase the timber from outside suppliers at the market price, but has sourced internally during the past few years. Last year, the 8 Forest division sold 200 million board feet of timber to external customers at $4.50 per board foot. A board foot is a standard unit of measure in the timber business.

Forest division sold another 800 million board feet of timber to the Lumber division. The Forest division’s operating expenses last year totaled $2 billion. The Lumber division only purchases timber from the Forest division. The company (CFRC) has decided that the purchase price paid by Lumber to Forest should be computed as Lumber’s proportionate share of Forest’s operating costs. The share of operating cost is based on Lumber’s fraction of Forest’s total board feet harvested.

That is, the transfer price is (# of board feet purchased by Lumber from Forest/ Total # of board feet produced by Forest) x Total operating cost of Forest Lumber sells the timber after cutting and processing.

Lumber’s total revenues are $7.6 billion, other operating expenses (excluding the cost of timber) are $3.5 billion and assets are $2.7 billion, respectively. CRFC uses Residual Income to evaluate and reward the performance of the senior managers of the two divisions. The required rate of return used in the calculation is 15% for Forest and 20% for Lumber. The manager who consistently shows the better divisional performance is most likely to be promoted to the General Manager position

Questions:
1) Calculate the residual income for both divisions. You may ignore income taxes
2) Which division is more profitable? Why? Explain in detail using supporting calculations for all alternatives you consider.
3) Are there any incentive issues likely to arise in the company? Based on your analysis in (2) above, what suggestions do you have for CRFC? Be very specific in your recommendations with explanations for why you consider them useful. Vague or general suggestions will not get credit

Answer 1

1. Total Operating expense of Forest Division = $ 2 Billion or $ 2000 Million

Lumber's proprtionate share of Forest's Operatingn Expenses = (Total Operating Expenses / Total board feet of Timber harvested and sold internally and externally) X Total board feet of Timber sold to Lumber division

= (2000 / (200 + 800) ) X 800

= $ 1600 Million

Total Revenu of Forest Division = Total board feet of Timber sold externally X Rate per board feet of Timber

= 200 Million X $ 4.50 per board feet

= $ 900 Million

Total Expenses of Forest Division = Total operating Expenses - Operating Expenses share of Lumber Division

= $ 2000 Million - $ 1600 Million

= $ 400 Million

Total operating Income of Forest Division = Revenue - Expenses

= $ 900 Million - $ 400 Million

= $ 500 Million

Required rate of return for forest division = 15%

Total Asset of Forest Division = $ 2.2 Billion or $ 2200 Million

Required return of Forest Division = Total operating Assets X Required Rate of Return

= $ 2200 Million X 15%

= $ 330 Million

Residual Income of Forest Division= Operating Income - Required Income

= $ 500 Million - $ 330 Million

   = $ 170 Million

Total Revenu of Lumber Division = $ 7.6 Billion or $ 7600 Million

Total Expenses of Lumber Division = Operating Expenses share from Forest Division + Other operating Expenses

= $ 1600 Million + $ 3500 Million

= $ 5100 Million

Total operating Income of Lumber Division = Revenue - Expenses

= $ 7600 Million - $ 5100 Million

= $ 2500 Million

Required rate of return for Lumber Division = 20%

Total Asset of Lumber Division = $ 2.7 Billion or $ 2700 Million

Required return of Lumber Division = Total operating Assets X Required Rate of Return

= $ 2700 Million X 20%

= $ 540 Million

Residual Income of Forest Division= Operating Income - Required Income

= $ 2500 Million - $ 540 Million

   = $ 1960 Million

2. Total Board Feet of Timber sold externally by Forest Division = 200 Million

Total operating Income of Forest Division = $ 500 Million

Total Operating Income per Board Feet sold externally of Forest Division = $ 500 Million / 200 Million

= $ 2.50 per board feet

Total Residual Income of Forest Division = $ 170 Million

Total Residual Income per Board Feet sold externally of Forest Division = $ 170 Million / 200 Million

= $ 0.85 per board feet

Total Board Feet of Timber sold by Lumber Division = 800 Million

Total operating Income of Lumber Division = $ 2500 Million

Total Operating Income per Board Feet sold of Lumber Division = $ 2500 Million / 800 Million

= $ 3.125 per board feet

Total Residual Income of Lumber Division = $ 1960 Million

Total Residual Income per Board Feet sold of Lumber Division = $ 1960 Million / 800 Million

= $ 2.45 per board feet

Hence, Lumber Division is more profitable as the operating income as well as residual income per board feet of Timber sold is higher of Lumber division then of Forest Division.

3. CRFC usses residual income to evaluate and reward the performance of the senoir managers of the two divisions. As per the calculations made in 1 & 2 above the residual income of Lumber division is higher than the Forest Division, hence, CRFC will reward the senior manager of Lumber Division.

No incentive issues is likely to arise in the company as the company is giving incentive based on the residual income and as per our calculaion of CRFC the residual income and operating Income both are higher of Lumber Division only, hence no issue is going to arise.

CRFC should try to sale all the Timbers harvested in Forest Department internally to Lumber Division only as the operating income is higher of Lumber Division which in turn will result in increase of overall operating profit of the company as a whole.