BIRCH PAPER

COMPANY
CASE ANALYSIS
 BIRCH PAPER COMPANY
Office of the Controller

January 13, 2011

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 everyone’s 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 Company’s 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

($400*30%)

Southern Division’s variable costs $168

(Transfer price from Southern Division: $400*70% = $280;

$280*60%)

Total variable costs for the company $288

Buy from Eire Papers, Ltd.

Net of: Profit to Southern Division of providing materials to ($36)

($90*40%)

Net of: Profit to Thompson Division of providing printing for ($5)

($30-$25)
Net variable costs for the company $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
Thompson’s 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 don’t 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 company’s. Possible options in setting
transfer prices are the following:

 Normal profit margins can be added onto the divisions’ incremental costs to arrive at their
transfer prices.
 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 Thompson’s (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, Thompson’s 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 won’t hold because
Thompson is actually reimbursed by the Northern Division for the design and development work.

Finally, Mr. Brunner’s 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 Thompson’s under-capacity operations, and supplying their products to Northern Division is
what’s best for the company.

RECOMMENDATIONS

 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.
o 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.

 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.
 Investigate inefficiencies in Thompson Division’s 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.

 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 well-
understood by each division for effective and efficient work coordination.