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
WEST PAPER CO: Out of pocket Cost to Birch
Per 1,000 boxes
$430
EIRE PAPER, LTD:
Less: Southern profit ($90*40%)
Thompson profit ($30-$25)
Out of pocket cost to Birch
$36
5
THOMPSON
Less: Southern profit ($280*40%)
Thompson profit ($480-$400)
Out of pocket cost to Birch
$112
80
3.
$432
$41
$391
$480
$192
$288
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
Less: Southern profit ($280*40%)
Thompson profit ($430-$400)
Out of pocket cost to Birch
$430
$112
30
$142
$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-ofpocket 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.