Birch Paper Company Case Study

Background Company

Birch Paper Company was a medium-sized, partly integrated paper company, producing white and kraft papers and paperboards. 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 result from a policy of decentralizing responsibility and authority for all decision except those relating to overall company policy. The company's top officials believed that in the past few years the concpt of decentralization had been applied successfully and that the company's profits and competitive position definitely had improved.

1.2 Problem

Question :

1. Which bid should Northern division accept that is in the best interests of Birch Paper Company?

2. Should Mr. Kenton accept this bid? Why or why not?

3. Should the vice president of Birch Paper Company take any action?

4. In the controversy described, how, if at all, is the transfer price system dysfunctional? Does these problem call for some change, or changes, in the transfer pricing policy of the overall firm? If so, what specific changes do you suggest?

1.3 Learning Objectives

1. It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company costs and revenues.

2. It should induce goal congruent decisions - that is, the system should be designed so that decisions that improve business unit profits will also improve company profits.

3. It should help measure the economic performance of the individual business units.

4. The system should be simple to understand and easy to administer.

Chapter 2

Theory

Transfer Pricing

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.

Objectives of transfer prices :

- it should provide each business unit with the relevant information it needs to determine the optimum trade-off between company cost and revenue

- it should induce goal congruent decisions- that is, the system should be designed so that decisions that improve business unit profits will also improve company profits.

- It should help measure the economic performance of the individual business units

- The system should be simple to understand and easy to administer.

Transfer Pricing Methods :

Fundamental Principle : is that the transfer price should be similar to the price that would be charged if the product were sold to outside customer or purchased from outside vendors.

The Ideal situation :

1. Competent people

2. Good Atmosphere

3. A market price

4. Freedom to source

5. Full information

6. Negotiation

If all of these conditions are present a transfer price system based on market process would induce goal congruent decisions, with no need for central administration.

Constraints on Sourcing :

* Limited Markets

In many companies, markets for the buying or selling profit centers may be limited. There are several reasons for this. In many companies, markets for the buying or selling profit centers may be limited. There are several reasons for this. How does a company find out what the competitive price is if it does not buy or sell the product in an outside market?

1. If published market prices are available, they can be used to establish transfer prices.

2. Market prices may be set by bids.

3. If the production profit center sells similar products in outside markets, is often possible to replicate a competitive price on the basis of the outside price.

4. If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products.

* Excess or shortage of industry capacity

If the selling profit center has the excess capacity while buying profit center purchased from outside vendor, the company profits may not be optimum. The same case happen when buying profit center cannot obtain the product if requires from the outside while the selling profit center is selling to the outside because shortage capacity in the industry.

Cost-based Transfer Prices

If competitive prices are not available, transfer prices may be set on the basis of cost plus a profit, even though such transfer prices may be complex to calculate and the results less satisfactory than a market-based price. Two decisions must be made in a cost-based transfer price system.

The costs basis

The usual basis is standard costs. Actual costs should not be used because production inefficiencies will be passed on to the buying profit center. If standard costs are used, an incentive is needed to set tight standards and improve standards.

The profit markup

In calculating the profit markup, there also two decisions: what the profit markup is based on and the level of profit allowed.

The simplest method and most widely used base is a percentage of costs. Another base is a percentage of investment.

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