Birch Paper Inc

Constance Cordovilla

BUAD 603

Managerial Accounting

April 13, 2006

Birch Paper Company

Question 1: In the controversy described, how, if at all, is the transfer-price system dysfunctional?

Birch Paper Company's Northern division is faced with a choice between three bids, internal and external, for an upcoming project. As a decentralized profit center, it appeared that accepting the lowest bid would be the most logical step; however, from the stance of the company the higher price from the internal division could also be the best solution. The bids submitted produced a number of possible perspectives and alternatives and it was up to the sectors to work together to promote congruence between the separate divisions and the company goals.

At first glance, Northern would typically accept the offer presented by West Paper based solely on the numbers. As seen in the calculations, West submitted the lowest bid at $430/thousand, Eire papers were a close second to West with a bid of $432/thousand, while Birch subsidiary Thompson submitted the highest bid of $480/thousand. Since each division at Birch is judged independently on the basis of profit and return on investment, selecting the bid from West allows Northern to out perform Southern and Thompson divisions. From the profit center mentality, the higher prices produce no incentives for Northern, even if another selection would be better for the overall firm, because it damages Northern's bottom line and subsequently their "status" within the company's view.

The $480 Thompson bid is actually in the best interest of the firm. It may seem counter-intuitive that the firm actually benefits by paying a higher price, but accepting the Thompson bid results in cost savings of $192 to Birch Paper company because of the revenues of $112 to Southern for providing the liner and corrugating medium to Thompson and $80 from Thompson selling the corrugated box to Northern. This means that the total cost of acquiring the box (from Birch's perspective) is $288. Alternatively, accepting the $430 West bid would result in no incremental contribution margin from either the Southern or Thompson divisions, so the $50 savings (versus the $480 Thompson bid) wouldn't come close to offsetting the total savings Birch would receive from accepting Thompson bid. While the Eire bid of $432 is definitely more attractive than the West offer (from the firm perspective), with incremental contributions of $5 to the Southern Division and $36 to the Thompson division, the total cost savings of $89 would result in a total price to Birch of $391, still greater than the Thompson bid (Appendix).

The pricing issues are further explained with an analysis of the transfer pricing systems in use by the various competitors. The transfer pricing system for 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 and negotiating, although in the long run the company benefits from choosing, either internally or externally, the option with the lowest cost to the firm. The Southern division is currently using a market-based transfer price approach. By purchasing the linerboard and corrugating medium from Southern at the going market rate, Thompson is ultimately subjecting the division to submitting a higher bid than the other two companies. The bids submitted by West and Eire suggest that those companies are using either cost-based or negotiated transfer pricing. Cost-based transfer prices provide no incentive to the supplying division to control costs and could lead to an economic loss to the overall organization. So, based on the information provided, it seems these companies are using negotiated transfer prices, which allow supplying and receiving responsibility centers to negotiate the transfer prices among themselves, in the absence of market prices. This approach can lead to the best transfer price results when the purchasing party is willing to pay the net realizable value of the product (selling price minus all costs remaining to prepare the product for sale). Whatever approach West and Eire are using, it is allowing both companies to lower their production costs to submit much lower bids than Birch's Southern division. If the Southern division abandons its market based transfer pricing, it may lead to increased efficiency, lower inventory costs and most importantly, increased revenue. By using another transfer cost approach, both the Southern division and Birch Paper as a whole could become more profitable.

Question 2: As the commercial vice-president, what action would you take?

To solve this crisis, the commercial vice-president could get involved with the logistics of this project and push the Northern Division to accept the bid presented by Thompson. However, one problem with this approach is that it would seem to run in the face of the company policy regarding decentralization and could indirectly impact the company's overall competitive position. Another problem with simply forcing Northern to accept the Thompson bid is that this bid would provide great benefit to the Thompson division, at the expense of the Northern Division. While the company benefits from Northern getting the box at the lowest possible price to the company as a whole, Northern would be forced to pay $50 more than it would if it were to accept the bid from West. Thompson's manager feels that it would be impossible to sell the box for less that $480/thousand as a price of $430 or even $450 wouldn't even cover the division's total overhead costs, let alone allow a profit for the division. Thus, simply forcing Thompson to lower the price to $430 and allowing this division to take the entire hit, especially when considering that Thompson provided the development work on the box, seems far from equitable.

Rather than simply mandate the price, management should encourage the divisions to negotiate transfer prices. Southern is charging Thompson the market price of $280 for the liner and corrugating medium: a 67% markup over its out-of pocket costs (Appendix). While market prices are usually the preferred transfer price when external markets exist for the intermediate product, Southern is not operating at full capacity, has excess inventory, and the materials in question represent less than 5% of the volume of the division. Even though Southern's manager may be reluctant to do so, if the division