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 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

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.

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.