Birch Paper Company
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OBJECTIVES
Todays 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 Northerns 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 divisions 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