4Es plc. is a large company that manufactures and sells wooden garden furniture. It has three divisions.

For the
coming financial year, the target rate of return for the divisions and for the company as a whole is 15%.
The Wood Division (WD) purchase logs and produces finished timber as planks or beams. Approximately two-thirds
of its output is sold to the Products Division, with the remainder sold on the open market.
The Product Division (PD) manufactures wooden garden furniture. The policy of 4Es plc. is that the PD must buy all
its timber from WD and sell all its output to the Trading Division.
The Trading Division (TD) sell wooden garden furniture to garden centres, large supermarkets, and similar outlets. It
only sells items purchased from PD.
The current position is that all three divisions are profit centres and 4Es plc uses Return on Investment (ROI)
measures as the primary means to assess the divisional performance. Each division adopts a cost-plus pricing policy
for external sales and for internal transfers between divisions. Mr. Dumay, financial controller of 4Es plc. has stated
that the divisions should consider themselves to be independent businesses as far as possible.
The wood division currently has an annual return on investment (ROI) of 20% on its investment base of $1,200,000.
The following additional projects are being considered:
Project Investment outlay EBIT ROI%
A $300,000 $100,000 33
B $700,000 $210,000 30
C $500,000 $130,000 26
D $200,000 $44,000 22
Division WD is planning to produce 15,600 units (normal capacity). Variable cost per timber is $30 while fixed
production costs of $150,000 are expected in Division WD. Division WD allocates fixed costs on the basis of normal
capacity, regardless of actual production. The sales price for external sales is $55 per unit. For the purposes of
internal pricing the manager of Division WD sets a profit mark-up of 50% on full absorption cost in order to earn a
satisfactory return on divisional assets employed, $1,200,000.
Division PD has in the past purchased all its timber from Division WD. Division PD's costs consist of the transfer-in
cost, additional variable production costs of $48 per furniture, and $160,000 fixed production costs which are
allocated to furniture on an expected annual production basis. Division PD plans to produce 12,000 furniture
products in the coming year. Division PD sells the finished products to Division TD for $180 each. Assets employed
in Division PD total $1,140,000. An external supplier has offered to provide 12,000 of Division PD's timber
requirement for the coming year at a price of $45.
If no new capital expenditure transactions take place, the forecast results for next year are:
Division Capital employed at beginning year Net profit for year (after depreciation)
TD 2,500,000 550,000
Division TD could invest $450,000 now in a new asset so as to increase net profit by $81,000 per annum for five
years. The asset is not expected to have any scrap value.
Required:
1. Which combination of investments will maximize the wood division’s return on investment assuming no
capital rationing is in place?
2. Evaluate whether or not the appropriateness of ROI as a performance measure for the manager of Division
TD. If having risks, advise how these risks may be mitigated.
3. Should Division PD buy its timber from the external supplier or from Division WD? Why?
4. For each division suggests, with reasons, the behavioral consequences that might arise as a result of the
current policy for the structure and performance evaluation of the divisions.
5. The financial controller of 4Es plc. has requested a review of the cost-plus transfer pricing policy that is
currently used. Suggest with reasons, an appropriate transfer pricing policy that could be used for transfer
from PD to TD, indicating any problems that may arise as a consequence of the policy you suggest.