Question

Financial Controllership

Assignment

Case Analysis

Transfer Pricing

BIRCH PAPER COMPANY

“If I were to price these boxes any lower than $480 a thousand,” said James Brunner, manager of Birch Paper Company’s Thompson Division, “I’d be countermanding my order of last month for our salesmen to stop shaving their bids and to bid full-cost quotations. I’ve been trying for weeks to improve the quality of our business, and if I turn around now and accept this job at $430 or $450 or something less than $480, I’ll be tearing down this program I’ve been working so hard to build up. The division can’t very well show a profit by putting in bids that don’t even cover a fair share of overhead costs, let alone give us a profit.”

Birch Paper Company was a medium-sized, partly integrated paper company, producing white and kraft papers and paperboard. A portion of its paperboard output was converted into corrugated boxes by the Thompson Division, which also printed and colored the outside surface of the boxes. Including Thompson, the company had four producing divisions and a timberland division, which supplied part of the company’s pulp requirements.

For several years, each division had been judged independently on the basis of its profit and return on investment. Top management had been working to gain effective results from a policy of decentralizing responsibility and authority for all decisions except those relating to overall company policy. The company’s top officials believed that in the past few years the concept of decentralization had been applied successfully and that the company’s profits and competitive position definitely had improved.

The Northern Division had designed a special display box for one of tis papers in conjunction with the Thompson Division, which was equipped to make the box. Thompson’s staff for package design and development spent several months perfecting the design, production methods, and materials to be used. Because of the unusual color and shape, these were far from standard. According to an agreement between the two divisions, the Thompson Division was reimbursed by the Northern Division for the cost of its design and development work.

When all the specifications were prepared, the Northern Division asked for bids on the box from the Thompson Division and from two outside companies. Each division manager was normally free to buy from whatever supplier he wished, and even on sales within the company, divisions were expected to meet the going market price if they wanted the business.

During this period, the profit margins of such converters as the Thompson Division were being squeezed. Thompson, as did many other similar converters, bought its paperboard, and its function was to print, cut, and shape it into boxes. Though it bought most of its materials from other Birch divisions, most of Thompson’s sales were made to outside customers. If Thompson got the order from Northern, it probably would buy its linerboard and corrugating medium from the Southern Division of Birch. The walls of a corrugated box consist of outside and inside sheets of linerboard sandwiching the fluted corrugating medium. About 70%j of Thompson’s out-of-pocket cost of $400 for the order represented the cost of linerboard and corrugating medium. Though Southern had been running below capacity and had excess inventory, it quoted the market price, which had not noticeably weakened as a result of the over-supply. Its out-of-pocket costs on both liner and corrugating medium were about 60% of the selling price.

The Northern Division received bids on the boxes of $480 a thousand from the Thompson Division, $430 a thousand from West Paper Company, and $432 a thousand from Eire Papers, Ltd. Eire Papers offered to buy from Birch the outside linerboard with the special printing already on it, but would supply its own liner and corrugating medium. The outside liner would be supplied by the Southern Division at a price equivalent of $90 a thousand boxes, and it would be printed for $30 a thousand by the Thompson Division. Of the $30, about $25 would be out-of-pocket costs.

Since this situation appeared to be a little unusual, William Kenton, manager of the Northern Division, discussed the wide discrepancy of bids with Birch’s commercial vice president. He told the vice president: “We sell in a very competitive market, where higher costs cannot be passed on. How can we be expected to show a decent profit and return on investment if we have to buy our suppliers at more than 10% over the going market?”

Knowing that Mr. Brunner on occasion in the past few months had been unable to operate the Thompson Division at capacity, it seemed odd to the vice president that Mr. Brunner would add the full 20% overhead and profit chare to his out-of-pocket costs. When he was asked about this, Mr. Brunner’s answer was the statement that appears at the beginning of the case. He went on to say that having done the developmental work on the box, and having received no profit on that, he felt entitled to a good markup on the production of the box itself.

The vice president explored further the cost structures of the various divisions. He remembered a comment that the controller had made at a meeting the week before to the effect that costs which were variable for one division could be largely fixed for the company as a whole. He knew that in the absence of specific orders from top management Mr. Kenton would accept the lowest bid, which was that of the West Paper Company for $430. However, it would be possible for top management to order the acceptance of another bid if the situation warranted such action. And though the volume represented by the transactions in question was less than 5% of the volume of any of the divisions involved, other transactions would conceivably raise similar problems later.

INSTRUCTIONS:

1. Summarize the case.
2. Answer the questions below.

1. What is the economic impact to Birch Paper Company of the three alternatives for sourcing the product?
2. Does goal congruence exist in this situation?
3. What is an appropriate transfer price for the Thompson Division
4. What changes would you recommend for the transfer pricing system of the company?

Answer 1

Answer (a) : The contention of financial decision making. This statement in itself explains the conjugations and hurdles that an entrepreneur faces while making decisions pertaining to the finance which would then decide the future course of action, finally becoming the source of either profit or loss for the organization. The case of Birch Paper company is a classic case of the same, where we find that the Top management of the Birch Paper company huddle together to find out the suitable bid they need to accept in order to give the contract to a vendor who would supply them with the necessary raw materials, which they require to materialize their production function and output. Here, the managers of the Four internally distributed divisions of the Birch Paper Company are in dilution to decide the best vendor who should be provided the contract for.More than the decision on the Vendors, the heads of the department seem to be more intrigued in to a tussle over which of the production division heads had collected how much of a profit for their divisions and which profit should be attributed to which of the divisions. They make financial transactions between themselves in order to properly evaluate their actual gain or loss. It is over one of such decisions that the Managing director had questioned the Thomson division, over which the division head had justified the over pricing of the cost.

  Answer (b) : The economic impact of Birch Paper company’s three alternatives for sourcing the product is that there are three bidders who have bided for the sourcing. One of the bid’s is perfectly on the benchmark of what the company wishes to source for (i.e. $480), however, the other two bids’ (i.e. $432 and 430$) are way below the desired price expected for the product. Here, if the company agrees to a lower bid, they are arguing that it would not even cover the cost of producing the product.

                                        Goal congruence in the cost estimation refers to the constancy or the situation where all the cost makers or decisions makers are on the same page in maximizing the output and saving cost for the firm. Here, goal congruence is totally missing as the internal divisions are fighting among themselves to justify their over cost structure.

                                        The appropriate transfer price for the Thompson division is $480. This is because, at anything lower than this price, the cost of the production would even not be covered. Therefore, a minimum of $480 must be accepted.

                                        The transfer pricing system should be made more fluent and transparent. The cost structure of the various divisions of the company should be regulated and brought under serious inspection. A transfer pricing unit should be constituted which would focus on all the decisions pertaining to whom the contract should be given to, instead of giving this responsibility on any of the other heads. Moreover, the Transfer pricing should be more affluent with the cost structure, in absence of which, it will be highly difficult for the company to survive in the long run.