BIRCH PAPER COMPANY

CASE ANALYSIS

1/13/2011

BIRCH PAPER COMPANY Office of the Controller

January 13, 2011 For: Mr. Vice President From: Controller This is to provide some insights to the conflict being faced by our Northern Division regarding whose bid price it should accept for the production of its newly designed special display boxes for one of its papers. The offers are $480 a thousand from our own Thompson Division, $432 from Eire Papers, Ltd., and $430 from West Paper Company. Our review shows the following costs that will be incurred by the company for each of the three sourcing alternatives of Northern Division: Thompson $288; West $430; Eire $391. Thus, considering that the effective cost of producing the boxes is $288, North Division should opt to purchase from Thompson. However, since Thompson insists its offer at $480, North Division would have no other option than to purchase the products outside. Consequently, we propose that the best solution would be for Thompson Division to sell their products at market price which is around $430. We must remember that our overall company interest must be everyones top priority and should not be jeopardized by trying to maximize individual interests. Even though this particular transaction only represents less than 5% of the volume of any of the divisions involved, we have to respond to it by making necessary adjustments to relevant company policies so that the individual means of our divisions in maximizing their profits/performance would also be maximizing that of the entire company. Thus, we recommend that Birch Paper Company re-establish its transfer pricing policy by setting it market price, unless the economy warranted for another but should never fall below the incremental cost of production. And this policy should be properly communicated to each division so as to avoid confusion and conflicts. Because at the end of the day, our company is not just about Northern Division, Thompson Division or any other division, we are but one Birch Paper Company. Details of the analysis and the corresponding recommendations are specified herein. For your guidance and approval. Cordially, Controller

ANALYSIS The Company Birch Paper Company operates decentralized divisions and the top management has been working to gain effective results by giving each division almost full autonomy in making decisions. And our officials so believe that it has resulted in increased company profits and improved competitive position. However, some of our divisions have been operating more independent than what they should be, as evidenced by the issue of Northern Division on supply bids at present. Though my department actually still supports that the decentralized structure fits the company, we insist that the divisions be reminded of the limitation of their authority and that the executive office still has the better judgment relating to implementation of policies that affect the overall interest of the company. The four divisions are properly accounted for as profit centers. Each has outside markets for their products, but it should be noted that the divisions are not achieving full capacity utilization at present. They are all evaluated based on profits and return on investments, which led to the issue at hand: Thompson Division now asserts that it is only willing to transfer their products to Northern Division at a price from which they can earn profits, that is actually far greater than the market. And so the Northern Division, concerned about its profitability will obviously accept offers from outside the company, at market price. This system results in goal incongruence when what is good for one division may not be what is best for the company as a whole.

Supplier Bids Northern Division asked for bids for the production of its newly designed special display boxes for one of its papers from Thompson Division and two outside companies. The offers are $480 a thousand from our own Thompson Division, $432 from Eire Papers, Ltd., and $430 from West Paper Company. So, Northern Division would naturally choose West Paper Companys offer in order to incur the lowest cost and gain the maximum profit. However, reviewing the circumstances tells us that buying from our Thompson Division would actually incur the lowest total cost - and thus the maximum profits for the entire company. Presented below are the costs our company will incur for each of the three sourcing alternatives of Northern Division.
Buy from West Paper Company Variable cost to Northern Division of sourcing the boxes from West Paper

$430

Buy from Thompson Division Thompson Divisions variable costs excluding transfer price ($400*30%)

$120

Southern Divisions variable costs (Transfer price from Southern Division: $400*70% = $280; $280*60%)

$168

Total variable costs for the company

$288

Buy from Eire Papers, Ltd. Variable cost to Northern Division of sourcing the boxes from Eire Papers

$432

Net of: Profit to Southern Division of providing materials to Eire Papers ($90*40%)

($36)

Net of: Profit to Thompson Division of providing printing for Eire Papers ($30-$25) Net variable costs for the company

($5)

$391

Sourcing the boxes from Thompson Division is the best decision for the entire company. However, since our divisions are evaluated on their individual profits, Northern Division will get to choose Thompson Division only if the latter decides to match its transfer price to the lowest bid of $430. But Thompson Division insists on its transfer price that includes full 20% overhead and profit, even despite the fact that it is operating below capacity and thus is not foregoing any external sales. Hence, this calls for intervention which demands us to reconsider how transfer prices are set, so that Thompson Division will be able to match the most competitive bid price.

Setting the Transfer Prices The minimum transfer price should be the incremental costs of production, so that a selling division can agree to produce for the other divisions and be able to recover the costs, plus the opportunity costs selling within the company instead of to the outside market. The opportunity costs shall be the foregone profit from external sales. But since Thompson Division as well as Southern Division that provides Thompsons input materials are operating below capacity, selling within the company would not entail any lost profits from external sales. It should be pointed out to the Thompson Division that they would still be having problem trying to recover their overhead costs even if they dont sell to Northern Division, because they simply cannot make any more sales to the outside market. What more Thompson does not realize is that because of the underutilization of their resources, it is actually already beneficial to sell at market price, because this market price is already above incremental cost. Thus, at a minimum, they should be willing to sell within the company at incremental or variable costs. The maximum transfer price should be the market price, because a buying division would not be willing to pay more than it can if it just buys from the outside market. This explains why Northern Division would not want to buy from Thompson Division. Choosing from this range of possible transfer prices will now just be a matter of deciding how to allocate profits among the divisions involved. So long as the transfer prices are set within this range, total company profits will be the same, which is the best profit level that the company can attain. And so long as the transfer prices are set within this range, Northern Division will choose to buy from Thompson, which is the best decision for its own sake and for the entire companys. Possible options in setting transfer prices are the following: j Normal profit margins can be added onto the divisions incremental costs to arrive at their transfer prices. j The divisions can be allowed to negotiate prices among themselves within these parameters, so that they can come to a compromise between the profit levels that each of them wants to achieve. This would be a better alternative because the divisions will still be granted autonomy in choosing their transfer prices while setting the aforementioned price range. The divisions have the most information about their own costs and their target profit and ROI levels, which will be well taken into consideration when they negotiate transfer prices among themselves. Inefficiencies in Thompson Division Thompson and Eire Papers, ltd. source many of their raw materials from Birch Company, yet Eire is able to offer a bid price of $432, while Thompson sticks with its high $480. The controller department believes that the difference is brought by Thompsons (1) production inefficiencies and (2) departure from the use of standard costing.

Since the two should have more or less the same materials cost, then the difference should lie in their conversion costs. There might be bottlenecks in the production process and or excessive incurrence of fixed costs. Moreover, due to underutilization, Thompsons products are being valued above standard, because the excess capacity, as well as production inefficiencies, is absorbed by the cost per unit of the manufactured goods. This is inappropriate because inefficiencies should be expensed, not capitalized. This may also result in lost bids because we put too high prices on our products to make profit. Another concern raised by Thompson Division is that they feel entitled to a good mark-up on the boxes because they did developmental work on it. However, this argument is invalid and wont hold because Thompson is actually reimbursed by the Northern Division for the design and development work. Finally, Mr. Brunners direction to his salespeople to not shave bids but to insist on full-cost quotations is selfish and ambitious. Mr. Brunner should realize that selling to Northern Division is actually beneficial considering Thompsons under-capacity operations, and supplying their products to Northern Division is whats best for the company.

RECOMMENDATIONS j Set ceiling prices for interdivision sales at market price. Market price is the best transfer price. But sales between divisions may undergo negotiations so long as the benefits will accrue to the company in the end. During upturns, when capacity is full, the divisions will be free to buy and/or sell either from within or from without, and since everyone will have to sell at market rates, anyway, there will be no goal incongruence. During downturns, when divisions will have underused capacity, such ceiling will force divisions to sell to each other at market rate or below. On the part of the buying divisions, goal incongruence will be avoided since prices will be the same whether it buys from within or from outside. On the part of the selling divisions, goal incongruence is still avoided because: o If the market price is above incremental cost, it will be best for the division to sell, as it will add to its profits. And it will also be best for the whole company if the buying division sources internally, as the incremental cost will be lower if the buying division sources from outside. If the market price is below incremental cost, it will be best for everyone involved (buying division, selling division, company as a whole) if the buying division will simply source from outside, as the costs incurred by the company as a whole will be minimized this way.

j Use standard costing. This will greatly improve the pricing mechanism as only the proper or standard costs will be the basis for offering bid price, eliminating the effects of inefficiencies and overhead underutilization. We may benchmark with competitors or the industry standards.

j Investigate inefficiencies in Thompson Divisions production process. We belong to a cyclical industry that is currently on its downturn, which results in the underutilization of two of our

divisions (Thompson and Southern). As such, we have to be able to control our costs. We cannot afford inefficiencies. We cannot afford to fall behind our competitors. And we cannot afford being forced to charge higher than the other paper companies due to our expenses; there is low enough demand as it is.

j Conduct talks, seminars and the like regarding incremental cost-pricing vs. full cost-pricing, their benefits and applications, why the former is needed during downturns, etc. Adequate and appropriate communication of transfer pricing policy should be carried out well to avoid conflicts between departments and to uphold goal congruence. The policy should be wellunderstood by each division for effective and efficient work coordination.