To: Commercial Vice President
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.
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.
Market Price - Sell $280 (70% 400) $480
Transfer Cost $280 (70% 400) $480
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...
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