Birch Paper Company - box design.

University Degree Business and Administrative studies

Company Background

Birch Paper Company (Birch) is a five-division pulp and paper corporation that produces white and kraft paper as well as paperboard. Birch is comprised on four production divisions, including Northern, Southern and Thompson, as well as a pulp supplying timberland division. Each division is considered a profit center. The managers of each division control both the revenue and costs for their particular divisions and they are judged based on divisional profits and returns on investment. Strategically, Birch has been moving towards a more decentralized management scheme, so much of the decision-making authority has been pushed down the corporate hierarchy to lower level managers. The division managers in the company are free to purchase raw materials from whatever supplier they chose to do business with. Given the composition of the company the division managers were also free to purchase raw materials internally. The internal suppliers were expected to meet the going market prices for the raw materials.

Problem

Northern has solicited bids from three suppliers for the production of a “special display” box. Thompson, an internal Birch division, assisted with the original design and was compensated for cost incurred for the design and development work.. Bids were sought internally from Thompson, and externally from West Paper Company (West), and Eire Papers, Ltd (Eire). A wide variance between the internal and external pricing was experienced. The bid breakdowns are as follows:

Northern directly purchases boxes from West at a price of $430 per 1000 boxes.
Northern purchases boxes from Eire for a price of $432 per 1000 boxes. Eire utilizes Birch’s Southern Division for outside linerboard and Thompson for printing services.
Northern purchases boxes from Thompson for a price of $480 per 1000 boxes. Thompson utilizes Southern for linerboard and corrugated medium.

Northern’s Division Manager, Mr. Kenton, must evaluate each of the bids to determine which bid would be best to accept. An initial review of the bids would lead him to select the lowest ...

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Northern directly purchases boxes from West at a price of $430 per 1000 boxes.
Northern purchases boxes from Eire for a price of $432 per 1000 boxes. Eire utilizes Birch’s Southern Division for outside linerboard and Thompson for printing services.
Northern purchases boxes from Thompson for a price of $480 per 1000 boxes. Thompson utilizes Southern for linerboard and corrugated medium.

Northern’s Division Manager, Mr. Kenton, must evaluate each of the bids to determine which bid would be best to accept. An initial review of the bids would lead him to select the lowest of the three bids, West’s $430/1000 boxes. However, given the discrepancy amongst the bid prices, Mr. Kenton has decided to further research the bids. Given that one of the bids is from an internal Birch supplier, another step should be taken to evaluate the bids. The method that will be utilized is cost based transfer pricing.

Approach to Transfer Pricing

Transfer pricing is a method an organization uses to assign revenues to divisions and costs or prices to products transferred amongst internal company divisions. Transfer pricing can be divided into four approaches; market-based, cost-based, negotiated, and administered. Birch’s situation warrants use of cost-based transfer pricing based on several key circumstances. In this particular situation, Thompson’s bid seems to be higher than the going market price, so an alternative to consider would be transfer pricing based on marginal costs. Marginal costs are the increases in cost per unit produced and in this case they are easily discernable. Several of the divisions are operating at less than capacity, so they can base more of their production decision on cost rather than profit. There are drawbacks to consider when using the cost based transfer pricing method like an increased difficulty in calculating unit income or performance measures. The information and figures in this case lead to the use of cost based transfer pricing as the most accurate method at this time.

Problem Analysis

Exhibit 1 illustrates the production flow for each of the three bids. From this point forward, all dollars are based on a “per 1000 boxes” basis. The first bid is from West. West will manufacture the boxes for Northern, independent of any Birch Divisions, and offer them at a price of $430. The second bid is from Eire. Eire will utilize Thompson for printing, Southern for outside linerboard and corrugated medium. Eire’s price is $432 and takes into accounts $90 for the price of outside linerboard and corrugated medium as well as a price of $30 for printing. The final bid is from Thompson. Thompson will utilize Southern for liner and corrugated medium. Thompson’s price is $480 and includes a price of $280 for Southern’s liner and corrugated medium. In order to effectively use the cost based transfer pricing, marginal costs must be determined.

Exhibits 2 thru 4 breakdown the particular costs associated with each bid. Exhibit 2 illustrates the cost analysis for the West bid. The cost based transfer pricing method is not useful in analyzing the West bid because it is an external supplier. Birch realizes no economic gain from using the external supplier. Exhibit 3 illustrates the cost analysis for the Eire bid. Eire is an outside supplier but they utilize two internal Birch divisions in the production of the Northern boxes. The cost based transfer pricing method will be used to determine the marginal costs involved in this bid. The Southern division provides linerboard at a cost of $54. The Thompson division provides the printing at a cost of $30. The total cost of the bid from Eire is $391. Exhibit 4 illustrates the cost analysis for the Southern bid. The Southern division provides corrugated medium and linerboard at a cost of $168. The Thompson division provides the boxes at a cost of $120. The total cost of the bid from Southern is $288.

As shown in Exhibits 2-4 and explained above, the initial price quoted to Northern did not necessarily represent the true cost to Northern. Exhibit 5 summarizes the price, economic gain and total cost associated with the three bids.

Exhibit 5.

Conclusion

Mr. Kenton utilizing the cost based transfer pricing system should choose the bid from Thompson. That bid truly only costs the company $288 compared with the $430 bid from West that would have initially been chosen. Birch should in the near future develop a company policy with regards to the purchase of raw materials. The company needs to develop an accurate transfer pricing method and disseminate the information to every level of the organization. Given the inherent drawbacks of the cost based transfer-pricing method the divisions should be forced to supply bids for supplies at the going market price. When possible, the divisions should purchase raw materials/supplies internally unless there are capacity constraint issues.