Brich Paper Company Case Study

1. The responsibility structure of the Birch Paper Company and all of its divisions is an Investment Centre. In the case it
is stated that “for several years, each division had been judged on the basis of its profit and return on investment.” This
verifies that BPC’s structure is an investment centre, since an investment center has a manager who is responsible for the
division’s profits as well as its invested capital.
However, as stated in class, “some organizations use the terms profit centre and investment centre interchangeably,” this is
evident by the managers of BPC’s divisions continually stressing profit as a major concern. As James Brunner, Thompson’s
division manager stated, “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.”
By applying the concept of decentralization, each division in the Birchwood Company was given authority to make decisions
except for those related to overall company policy. By having this authority to make decisions, each division manager was able
to invest in capital that it felt was needed to maximize overall company profit. Each division manager is evaluated on ROI,
which shows how much profit was generated from the capital invested.

2. Out-of-pocket costs are the payments (usually cash or obligations to pay cash) made for resources. Out-of-pocket
costs can be the same as opportunity costs, but may not be the some because of imperfect markets and changes in the
decision-making environment between when a resource was acquired and when it is used. The following is a calculation of the
out-of-pocket costs to Birch Paper Company on the proposed bids.
BIRCH PAPER COMPANY
Per 1,000 boxes
WEST PAPER CO: Out of pocket Cost to Birch $430

EIRE PAPER, LTD: $432

Less: Southern profit ($90*40%) $36
Thompson profit ($30-$25) 5 $41
Out of pocket cost to Birch $391
THOMPSON $480
Less: Southern profit ($280*40%) $112
Thompson profit ($480-$400) 80 $192
Out of pocket cost to Birch $288

3. The best bid for Birch Paper Company would be with Thompson, one of its own divisions, since it represents the
lowest out of pocket cost to BPC. As well, if the Northern Division chooses the Thompson division then it may avoid other
costs that may be incurred from choosing an external bid.

4. The Northern Division received bids of $480 from Thompson, $430 from West Paper Company, and $432 from Eire
Papers, Ltd. Since Birch Paper Company’s responsibility structure is an investment centre as stated above in question one, in
order to maximize divisional profits Northern would chose the $430 bid from West since it represents the lowest cost, thereby
resulting in higher profits.

5. The question of whether or not the vice president of Birch Paper Company should take action in this matter is a
dilemma that has no outright solution, for there are pros and cons on each side. If the vice president gets involved in the
bidding process they may face the peril of “undermining the autonomy” of the division managers. However, by not taking
action they will loose the cost saving associated with in-sourcing to Thompson. Central managers will only want to intervene
if the negative financial consequences are significant. It is stated in the case that, “the volume represented by the transaction
in question was less than five percent of the volume of any of the divisions involved,” therefore, since it is a relatively small
volume the vice president may feel that their involvement is unnecessary. However, as stated “other transactions would
conceivably raise similar problems later.” Due to the possible reoccurrence of these problems it is to the company’s benefit
that the vice president should get involved, thereby setting precedence for all division to follow, avoiding future problems.
6. The transfer pricing system 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 from choosing, either internally or externally, the option with the lowest cost to
the firm. If Thompson was persuaded to alter their sales cost from $480 to $430 this would make them one of the lowest
bidders and intern Northern would be willing to accept their offer. This pricing change would allow Northern to go internally
without the vice president’s involvement.
Shown below are a break-down of the out of pocket cost to Birch and the reduction of the contribution margin to Thompson.

THOMPSON $430
Less: Southern profit ($280*40%) $112
Thompson profit ($430-$400) 30 $142
Out of pocket cost to Birch $288

Although the Thompson division would lose some profit ($80-$30=$50), the price reduction still allows for the same out of
pocket cost to Birch of $288. If the price was not changed Northern would have stayed with Western Paper Company resulting
in an out of pocket cost to Birch of $430. The price change reflects a $142 ($430-$288) cost saving for Birch, more than
making up for the loss of profit to Thompson.
Currently the management for the Thompson division is not following the market for the pricing of its product, it is possible
that Thompson is not operating at efficient levels and their bid price reflects these inefficiencies. Birch should implement a
system whereby subordinate divisions must adhere to a pricing strategy that reflects current market prices. This strategy
would increase internal purchasing and help to align each division’s goals with that of the Company’s, intern, leading to better
performance for the company as a whole.
In the case the vice president remembers a comment made by a controller, “costs which were variable for one division could
be largely fixed for the company as a whole.” This implies that Birch Paper Company is basing its prices on a full cost
approach. When companies use a full cost or absorption cost approach to setting transfer prices between departments then it
may lead to dysfunctional decision-making behavior, as we can see in this case. Using a full cost approach has directed the
buying division to view non-unit-level costs for the company as unit-level costs for their division, which intern has lead to
faulty decision making.
Mr. Brunner is adding a 20% overhead and profit charge to his out-of-pocket costs, even though he is not at full capacity and
does not have any opportunity costs to count for, which is causing the company to charge more than they should be charging.
If this 20% mark up was dropped then the costs could go down, and the Thompson division could offer the price of $430 or
even less to the Northern division which would be a net advantage for the company as a whole.

1. Calculating all three options based on costs

BIRCH PAPER COMPANY

Per 1,000 boxes
WEST PAPER CO: Out of pocket Cost to Birch $430

EIRE PAPER, LTD: $432

Less: Southern profit ($90*40%) $36
Thompson profit ($30-$25) 5 $41
Out of pocket cost to Birch $391
THOMPSON $480
Less: Southern profit ($280*40%) $112
Thompson profit ($480-$400) 80 $192
Out of pocket cost to Birch $288

As shown in the calculations above, Northern should accept the bid from Thompson division as it has the lowest cost if all
transfer prices within the company were calculated at costs. Incurring the lowest costs would also enable Birch Paper
Company to earn the highest profits possible.
2. As alternatives for sourcing exists, Mr. Kenton should be permitted to choose the alternative that is in Northern
division's own interests. The transfer price policy gives him the right to deal with either insiders or outsiders at his discretion.
If he is unable to get a satisfactory price from the inside source which is Thompson division, he is free to buy from outside.

Mr. Kenton, manager of the Northern division should not accept the bid from Thompson division. The three bids from
Thompson division, West Paper Company and Eire Paper Company are $480, $430 and $432 respectively. Accepting the bid
from Thompson division would be accepting the highest bid amongst all three offers (highest costs). This would result in the
lowest profits. As the Northern division is evaluated as an investment center, it is judged independently on the basis of its
profit and return on investment. Mr. Kenton should not accept the bid from Thompson division.

3. The method of using transfer price to decide whether to in source is optimum if the selling profit center can sell all of
its products to either insiders or outsiders and if buying center can obtain all of its requirements from either outside or
insiders. The market price then represents the opportunity costs to the seller of selling the product inside. In this case,
Thompson division had been running below capacity and Southern division also had excess inventory. The transfer price of
$480 offered by Thompson division does not represent the opportunity costs of selling inside as there is no demand market
for the product outside. Also, the transfer price of $480 is higher than the market price which is around $430. Deciding based
on transfer price will not induce goal congruence as the situation is not ideal.

Without any intervention from the vice president of Birch Paper Company, the Northern division would most probably accept
the lowest bid from West Paper Company. This might result in the highest profits for Northern division but it is not in the best
interests of Birch Paper Company. Accepting the bid from Thompson division would boost demand for the two other
divisions. The losses cut would most probably be more than the costs saved by Northern division which is $50 ($480-$430).

The vice president should give specific orders to Northern division to accept the bid from Thompson division. However, as the
transaction in this case represents less than 5% of the volume of any of the divisions involved, it might not be possible for the
vice president to intervene other transactions when similar problems arise.

4. Ideally, when there is an availability of market price, the division should use it. However, Thompson used a cost-based
transfer price instead. Cost-based transfer price should only be used when the market price is not available. The problem with
Birch's transfer pricing system is that they allow each division to set their own price freely which is inline with the company's
policy to decentralize responsibility and authority. When each division can set their own price, conflicts and disagreements
can occur on a frequent basis and each division could make decisions that only benefit their own division rather than the
company as a whole.

Firstly, we look at the transfer price that Thompson quoted. It is about $50 more than the market price. This shows that their
price is not competitive enough. Thompson is operating below capacity and yet it quoted a price which is higher than the
market price. The reason given was that anything less than $480, they will not be able to earn a profit and also, given that they
did not get any profit from developing the product for Northern, Brunner feels that they are entitled to a good markup. This is
inconsistent with the expectation that the division must meet the market price if they wanted the business. Market price
should be used as it reflects how well is the division doing as compared to competitors.

The amount of upstream fixed costs and profits that are included in the final price that was sold to the outside customer could
be substantial if Thompson's bid was accepted. And Northern might not be willing to reduce its own profit to optimize
company profit. Hence, Thompson, if unwilling to follow the market price blindly, could use the two-step pricing to calculate
their transfer price. That is, transferring the goods to Northern on standard variable cost on a per unit basis and fixed cost and
profit on a lump sum basis.
In this way, Thompson will not be transferring majority of their fixed cost to Northern because they are operating on excess
capacity. But of course, this method must be discussed with Northern.

It was mentioned that Southern quoted the market price to Thompson even though they are operating on excess capacity. This
will not pose a problem as the market price reflects the demand and supply situation of the market and is adjusted
automatically by the demand and supply. Also, account must be taken into of the fact that Thompson will not be able to get a
better price from other outside sources as most will follow the market price too.

The underlying problem of the transfer price system could be that each division is judged based on profits and return on
investment. This causes the division to over-emphasize on profits and encourages goal incongruence. Each division aims at
achieving short-term profits so as to look better in the company's eyes. In their bid to achieve a high profit figure, they fail to
optimize the company's profit as a whole. This will affect the company long-term profits.

Hence, the company should not just assess each division based solely on financial figures like profit and return on investment.
The company should assess them based on other non-financial things like quality so as to divert the division's emphasis on
profits. In addition, the company should allow the divisions concerned to negotiate between themselves as they are the ones
closest to the situation, rather than just asking the divisions to meet the market price.

Key Point: Brich Paper Company

Background
 Mideum sized, partly integrated company
 3 products – white and Kraft papers and paperboards

Brich Paper
Copmpany

Northern Southern Thompson Division 4 Timberland

Working and
Assessment
 Judgment based on Profit and Return on Investment (ROI)
 Concept of decentralization – Both authority and responsibility
 Improvement attributed to above factor

Situation
 Northern and Thompson together designed box for Northern division
 Thompson division was reimbursed by Northern Division for its designing and development
 After finalization, apart from Thompson’s bid it also get offers from two outside companies
 Company policy where each diviosn manager had full freeedon and discreation to buy from anywhere
 Thompson’s most material from with company, but sales mostly to outsiders
 If Thompson gets bit maretials to be procured from southern division
 70% of out-of-pocket cost of $400 were of above materials
 This constituted 60% of selling price for southern division

BIDS (per 1000)

 Thompson - $400
 West Paper Company - $432
 Eire Paper Company - $430 (conditions apply)

Eire Paper Company and dilemma

 It would buy outside liner board from Brich with special printing (to be done by Thompson) @ a cost of $90 per
thousand and $30 for printing
“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 ROI if we have to buy our supplies at more than 10% over the going market?”
- William Kenton (Manager, Northern Division)

Other factors
 Thompson division felt not received profit for their development work, hence entitled to mark up on production of
box.
 Without orders from top management Kenton would accept the lowest bid
 Transactions involved only 5% of volume of divisions involved

“Cost variable for one division could be largely fixed for company as a whole”
- Controller
Which Bid to accept?
 Thompson Division – even though the bid from West Paper seems at first to be the best choice
 Calculation at cost shows that Thompson actually has the lowest costs associated with them.

What Bid should Mr. Kenton accept?

 West Paper bid
 As he is not aware of the cost mark-up
 It’s in the best interest for his division
But
 If he accepts bid from Thompson
o Its lowest cost
o Encourages buying from within the company

Any actions from Vice President?

 Yes
 No orders from Top – Mr. Kenton would accept the lowest bid
 VP should take action to resolve overall problem associated with the transfer pricing policy

Is Transfer Pricing System Dysfunctional?

 To an extent – yes
 It focuses too much on individual sectors making profits and ROI
 Some alternatives should be present which strikes a balance between both