Birch Paper Company

OBJECTIVES

Today's organizational thinking is oriented towards decentralization. One of the principal challenges in operating a decentralized system is to devise a satisfactory method of accounting for the transfer of goods and services from one profit center to another in companies that have a significant number of these transactions.

The objectives of this case is whether the Northern Division of Birch Paper Company should buy

corrugated boxes for a new product internally from the Thompson Division at a transfer price higher than the market price, or from one of their external suppliers. Also, should the vice president of Birch Paper Company take any action on the bidding price or final purchase decision for one internal division to another internal division?

EXECUTIVE SUMMARY

Birch Paper Company is a medium sized, partly integrated paper company which contained four production divisions, including Thompson division, and a timberland division. Each division is encouraged to base its transfer price on the current market price and is judged independently on the basis of its profit and return on investments. After reviewing the Birch paper company case we feel that from the company perspective is to accept the Thompson bid. The Thompson bid is in the best interest of the company in terms of cash flows and long-term profit.

PROBLEM IDENTIFICATION

The problem facing this company is whether its decentralized divisions should buy from one another and help the company as a whole, or buy from an outside third party and possibly increase the profits of one division while neglecting the other divisions of the company. The Northern Division, while seeking a company to manufacture new boxes it needs, has obtained bids from three companies: the West Paper Company; the Thompson Division of Northern's parent company, Birch; and the Eire Papers company. Below the total outlay costs of accepting each bid has been summarized:

Buy from West

Northern Division --- $430

Thompson Division --- $0

Southern Division --- $0

Paid to West $430

Total outlay costs to Birch Paper: $430

Buy from Thompson

Northern Division --- $480

Outlay cost of production (60% * $280) $168

Thompson Division

Outlay cost of production ($400 - 70% * $400) $120

Southern Division

Total outlay costs to Birch Paper: $288

Buy from Eire

Northern Division

Paid to Eire $432

Thompson Division

Revenue from Eire ($30)

Outlay cost of work done for Eire $25

Southern Division ---

Revenue from Eire ($90)

Outlay cost of work done for Eire (60% of $90) $54

Total outlay costs to Birch Paper: $391

This shows that while the bid from West Paper Company may look to be the best for the Northern division, it is in fact better for the company as a whole to buy internally from the Thompson division.

SOLTUION IDENTIFICATION

The decision to choose among the three alternatives depends on the objectives of top management and their decentralization policy. Transfer price systems can range from simple to extremely complex. The independent divisions can seek to maximize their individual division's profits by charging full market price for their products to other divisions of the same company, or the divisions can choose to charge a price lower than the current market price but still substantial enough to cover their own costs and possibly a small profit to the other divisions.

The transfer pricing system used by the divisions of Birch Paper Company is dysfunctional since it is possible for each internal division to price their product above the going market price. This ability for individual price setting deters the divisions from making purchases internally although in the long run the company benefits. By having this form of price setting, the divisional manager may choose to increase