Birch Paper Company – Case Study

Birch Paper Company

Although the current financial implications for Birch Paper Company are not substantial, as the contract in question is less than 5% of the volume in any division, it is imperative that Birch Company establishes and addresses its transfer price policies and procedures with each division. This will ensure that the divisions are not putting their objectives ahead of the Company’s and as a result, not maximizing the overall revenues and profits of Birch Paper Company. This report will highlight the issues while providing a complete analysis and recommendation for you to consider.

Sincerely,

In examining the information provided by Birch Paper Company (BPC) it became apparent that due to the decentralized manner in which BPC operates its four production divisions, the overall maximization of profits for BPC could be jeopardized if policies and procedures are not immediately established for setting transfer prices between divisions. Although, the decentralization of BPC’s divisions certainly have proved successful in the past, it is critical for BPC to establish more concise guidelines to ensure that all the decisions that are made by each division are goal congruent and maximizing BPC’s profits.

The transfer price issue has come to your attention as a result of the Northern Division’s request for bids on corrugated boxes from the Thompson Division and from two outside companies, West Paper Company and Eire Papers Limited. Because each Birch Division manager is encouraged to go with the most cost effective supplier, Mr. Kenton was troubled, as he did not find the current internal transfer price competitive, as the offer was 10% over the going market rate. As a result of the current dysfunctional transfer pricing policy, the division would undoubtedly go with an external supplier, even though it may not be in the best interest of BPC. Thus, the transfer pricing policy must be examined and addressed to insure the long-term growth and sustainability of BPC is not being compromised for short-term divisional gains.

This analysis will first examine the market rate transfer prices and determine which bid the Northern Division would have made. The analysis will than examine the transfer prices at cost (“out of pocket costs” or variable costs) and determine which bid the Northern Division would have made. Finally, the analysis will highlight, which transfer price strategy would result in BPC maximizing profits and why.

Exhibit 1

Market Price – Sell $280 (70% 400) $480

Transfer Cost $280 (70% 400) $480

Market Price

Variable Costs $168 (60% 280) $120 (30% 400) $288

Variable Costs – Out of Pocket Costs

$430 $391* ($432 – $36 – $5)

On analyzing the Southern Division’s cost structure, it was determined, that they have variable costs of $168 / 1000 boxes. The Division than marks up its products to the going market rate of $280 / 1000 boxes to either sell externally or transfer internally to the Thompson Division. (Exhibit 1) The Division is also running below capacity and has excess inventory, which is the first indication that the prevailing market rate may not always be the optimal price to charge for internal transfers.

On analyzing the Thompson Division’s cost structures, it was determined that they have variable costs of $120 / 1000 boxes, as well as having transferred in costs of $280 / 1000 boxes from the Southern Division. The Division than marks up its products to $480 / 1000 boxes to either sell externally or transfer internally to the Northern Division. (Exhibit 1) It is also important to note, that the division has not been at capacity the past few months and that the selling price or market transfer prices of the products are actually higher than the going market rate.

On evaluating the Northern Division’s bid options, Mr. Kenton has an internal bid from the Thompson Division of $480 / 1000 boxes and two external bids: West Paper Company at $430 / 1000 boxes and Eire Papers Limited at $432 / 1000 boxes, with contract contingencies that would see Eire Papers Limited purchase both the outside liner from the Southern Division and contract the printing to the Thompson Division which would in turn bring down the offer to $391 / 1000 boxes. (Exhibit 1) Based on the current market rate transfer prices, the Northern Division would have selected the bid from Eire Papers Limited at $391. Although this contract would have minimized the division’s costs, it is not the contract that is in the best interest of BPC. (Exhibit 2 & 3)

By using market based transfer prices it does allow BPC to determine the true opportunity cost and market value of the transfer and thus eliminating valuation issues with non-arm’s length transactions. It also allows for each division to assess their performance and minimizes the potential for misallocation of resources based on defective performance measures. However, the disadvantages of market prices are evident in this case, as BPC was clearly not competitive with the prices its divisions set, and as a result, could be losing internal bids and opportunities to maximize profits. It is important to note, that the Thompson Division was setting its transfer prices even higher than the market rate, which again would result in dysfunctional decisions.

As well, the market rate transfer prices are also not reflecting whether the divisions are at capacity or have excess inventory, which significantly affects the transfer prices. Because the Southern Division is operating below capacity and has excess inventory, it could establish its transfer prices at its variable costs, to ensure that it at least sells its excess inventory. The Thompson Division because it is also not operating at full capacity, could potential price its transfers at the incremental costs of fulfilling the order, if the contract bid prices with outside suppliers were close.

Although, each specific division may not increase its reported bottom line, BPC would at least be able to determine if internal bids were competitive with external bids, and thus eliminate the possibility that a bid was contracted out to an external party, due to incorrect pricing. When examining possible one-time orders, it is critical to analyze capacity and the incremental costs associated with fulfilling the orders. It is also important to evaluate whether these one time orders could effect the demand for the products in the long run because if such orders did effect the demand, it would be imperative, that full costs and a reasonable profit were recovered.

In analyzing the internal transfer prices if they were calculated based on variable costs, the Thompson Division’s bid would have resulted in a very competitive bid of $288 / 1000 boxes. The bid would have comprised of $168 / 1000 boxes in costs in the Southern Division and $120 / 1000 boxes in costs in the Thompson Division. (Exhibit 1) As a result of this pricing strategy, the Northern Division would have selected the contract internally from the Thompson Division. Using this pricing strategy, BPC’s costs would not only be minimized, the company would also be maximizing its revenue and profit potential. (Exhibit 2 & 3)

On determining which internal pricing strategy would maximize the overall profits for BPC while also examining the effects on the various divisions, Exhibit 2 and 3 highlights the costing implications for both the transfer prices being set at market prices and at variable costs. It becomes evident that when the transfer price is at the market price, the Southern and Thompson Divisions would have benefited the most, however, it would have been at the cost of the Northern Division. The impact on BPC would have been an expense of $391 / 1000 boxes. When the transfer price is at the variable cost, the Northern Division would benefit, however, the distinction is that BPC, as a whole would incur expenses of $288 in comparison to $391 / 1000 boxes, under the market price strategy. As a result, of the analysis, it is
very clear that the current transfer pricing strategy is dysfunctional, as optimal decisions are not being made.

Exhibit 2

Transfer Price @ Market Price

(Eire Bid Selected @ $391)

Sales $280 $480

* Eire Contract Bid $ 90 $ 30 $120

Cost of Goods Sold $168 $400 $391 $432

* Eire Contract Bid $ 54 $ 25 00 $ 79

Gross Profit $148 $ 85

Expense / 1000 Boxes ($391)

Exhibit 2

Transfer Prices @ Variable Cost

(Thompson Division Bid Selected @ $288)

Sales $168 $288

Cost of Goods Sold $168 $288 $288 $288

Gross Profit $ 0 $ 0

Expense / 1000 Boxes ($288)

Based on the above analysis, the correct decision for the Northern Division is to accept the Thompson Division’s bid because it is the lowest bid and would therefore result in BPC incurring the lowest costs while also enabling BPC to earn the highest possible income. However, because of the current dysfunctional transfer pricing strategy the prices set by the individual divisions are not competitive and lead to inaccurate transfer prices. This is a direct result of BPC’s current divisional evaluation policy. Because each division is more concerned with its own bottom line, the decisions they are making are actually resulting in BPC’s profits and long term sustainability being threatened.

In making a recommendation, it is important to note, that the financial objective of BPC is to maximize profits. Thus, the overall goal and objective of BPC must be aligned with the various divisions. Because the evaluations of the divisions are completed independently, BPC ‘s divisions are making sub optimal decisions with the current transfer price strategy. It is imperative that BPC establish new measures in which the various divisions can be evaluated, whether it’s through non-financial measures such as quality or service. By concentrating on these non-financial measures it will allow BPC to shift its focus from the divisionally goal incongruent profit figure to measures that will enable better and more congruent decision-making. Management may oppose, as the autonomy of the division may seem as though it is getting compromised, however, it is imperative that they realize the current pricing implications and the effects they are, and could have on BPC’s profits.

Transfer price strategies could involve having negotiated prices between divisions, in which the divisions themselves could establish the rates, as they would have a more thorough understanding of the cost drivers. When evaluating whether to fulfill a contract internally or outsourcing, it would be beneficial for a cost analysis to be conducted which factored in capacity, inventory levels, and incremental variable costs to determine what would be most profitable alternative for BPC both in the short and long term.