Every entity is evaluated based on the profit and return on investment (ROI) they produce, despite facing pressure from external firms to decrease their prices. Within the division, a competitive strategy exists as they have the option to purchase boxes from either within or outside of the company. To ensure profitability, alternative strategies had to be explored, leading to concerns about transfer prices, out-of-pocket costs, and the resulting profit and ROI for the Thompson division.
Firms external to BPCS provide a reduced price compared to the internal company price. The Northern department collaborated with the Thompson department to develop a unique display box for one of their finished papers. Thompson, one of the four departments, transformed paperboard into wholesale cardboard boxes and also added color and printing to the box’s exterior region.
Southern department provided Thompson with linebackers – a type of paperboard used in making boxes. They also supplied corrugating medium, which gives the paperboard its wavy ridges through a corrugating machine. Thompson used a transfer price of $480 to calculate costs, considering the trade of supplies and labor between the departments. This agreed price was set by Thompson to charge Northern. In order to maintain a competitive advantage, the transfer price should closely match the market price.
The text explains that Northern had the freedom to choose between two external companies, West Paper Co. and Erie Papers Inc., for their purchases. The price offered by Thompson, an internal option, was $50 higher than the competitive market price. Without any specific instructions from top management, it was deemed acceptable for Northern to buy from the lowest bidder, which in this case was West Paper Co. The bids were as follows: Thompson (Internal) – $480, West Paper Co. (External) – $430, and Erie Papers Inc. (External) – $432. Additionally, Southern division accounted for 70% of the cost and charged $90 per box. Thompson’s variable cost was $30, with a 25% rate. In terms of problem analysis, the company employed a decentralization strategy, which granted division managers responsibility and authority for their departments, except for matters related to overall company policy. Each department’s performance was evaluated based on profit and return on investment, resulting in interdepartmental competition.
The management believed they had successfully implemented the system, expecting it to improve profits and competition. However, internal competition caused employees to focus on departmental profits, neglecting the negative impact on other departments and the company as a whole. Therefore, it is crucial to effectively implement a responsibility accounting system. BPCS utilized a decentralized system where each department was accountable for their own accounting system.
The need for improvement of this system arises from the potential it has to instill self-control in planning and responsibilities. A crucial aspect of a decentralized firm involves responsibility centers, namely cost, profit, revenue or investment centers. These centers’ performance is assessed using various accounting measures like divisional profits, standard costs, and ROI. In the case of BPCS, department managers have individual accountability for decision-making. Each department is both a profit and investment center, functioning independently and being evaluated based on ROI and profits.
Management of BPCS encountered difficulties in controlling all departments and every aspect. Consequently, it is advisable to delegate decision-making authority to lower level employees in certain areas of the extensive company. This would enable top managers to concentrate on core strategies like long term planning and policy development. The benefits and drawbacks of decentralization are as follows. Advantages: 1. Decisions become more effective and timely due to the manager’s proximity to local conditions; 2. Top managers are not diverted by routine, local decision issues; 3. Managers experience increased motivation as they gain more control over outcomes; 4.
The text highlights the significance of enhancing decision making to improve the preparation of managers for higher-level roles in the future. Nevertheless, there are multiple drawbacks that should be taken into account. These include a lack of consensus on objectives among managers in various areas of the organizations, inadequate availability of information to top management resulting in higher costs for obtaining detailed information, and a lack of coordination among managers in different sections of the organization. Moreover, Birch Paper Company faced challenges regarding performance evaluation and transfer pricing strategy between departments.
When departments within a company engage in business with external companies, determining the selling price is not an issue. However, internal transactions between departments, such as providing goods and services to each other, require the establishment of a transfer price. A transfer price manages the purchasing cost for one department and the revenue for the selling department within the same company. If a department sets a high price for another department’s purchase, it ultimately leads to the selling department making a profit at the expense of the buying department.
In a decentralization strategy, each department is typically controlled by its manager. The manager’s performance evaluation focuses on the department’s profit rather than the company’s overall profit. Consequently, it is crucial for top management to establish an appropriate transfer pricing scheme that benefits the entire company.
According to the book “Managerial Economics & Organizational Architecture” by Prickly, Smith & Zimmerman, there are four possible methods for determining a transfer price: market price, marginal production cost, full cost, and negotiated pricing.
It is clear from the above that BPCS utilized a Market-based transfer pricing strategy. The company manufactured the products internally due to the significant interdependencies and synergies among its departments. Market-based transfer pricing approach involves setting the transfer price with reference to the well-defined, competitive, and stable market price for the product. However, in the case of BPCS, the outside market was neither stable nor competitive.
The use of market-based transfer pricing, where two external companies were offering lower prices, distorted internal decision making. It is important for top management to carefully review the criteria used to establish transfer prices. These criteria should promote goal congruence, ensuring that transfer pricing encourages managers to make decisions that benefit the entire company. However, in the case of BPCS and its decentralized strategy, it is challenging to align decision making with the overall financial success of the company.
The overall success of the company cannot be guaranteed by the success of individual divisions. The transfer pricing system should be used for performance evaluation and to treat department managers fairly, as well as allowing for autonomy among departments. Moreover, the system should not be excessively complex or expensive to implement. In the case of BPCS, each department prioritized maximizing their own profit at the detriment of others.
Thompson increased its out of pocket cost by 20% and Southern increased it by 40% (100% – 60%). As a result, it was important for top management to intervene in order to prevent Northern from purchasing boxes from West Paper, which had the lowest bid price. If Northern did business with West Paper, it would hamper the operations of both Thompson and Southern, who had the opportunity to do business together. This would result in significant opportunity loss for both companies. Consequently, the entire company would have to cover the costs of development, design work, and staff in the Thompson department.
Alternatively, if Northern were to purchase their boxes from Thompson, it would benefit the operating volume of Thompson. This would maximize their profit while utilizing the high inventory of Southern. As a result, a transfer price needs to be determined. Thompson must reduce its selling price, while also lowering the prices of their goods, in order for both parties to achieve their goal of profitability. Furthermore, if Thompson is not operating at full capacity, they should not allocate the full 20% overhead cost to ensure fairness among other departments.
The company lacked a clear cost structure. Northern and Thompson informally collaborated, with Northern compensating Thompson for the out-of-pocket cost of their design and development work. Thompson’s bid price for Northern box requirement included a 20% increase, while Southern marked up their liner and corrugating medium by approximately 40%. This markup was based on Thompson’s out-of-pocket cost, which constituted only 60% of the selling price. The Controller noted that costs that were variable for one division were mostly fixed for the entire company.
Recommendations:
1. Implement Transfer pricing and quality control system: BPCS, being a huge company with different departments in charge of their own profit and ROLL, conducts business with each other. To determine cost, a transfer price is used, which should not vary significantly from the market price. If it does, one department will suffer a loss. To maintain performance, departments should buy at the dominant or current market price or sell below the market price.
To implement a quality control system that is aligned with the BPCS strategy, it is necessary to ensure that decision-making authority is not delegated to profit centers. Instead, this authority should reside solely with the CEO. By doing so, the CEO can effectively oversee decisions made by profit centers regarding whether to pursue internal or external options. This approach also helps prevent any overriding of decision-making authority granted to profit centers. Another aspect of the proposed changes is transitioning from a decentralized to a centralized system. In a centralized system, all significant decisions and actions at lower levels require approval from top management.
It is recommended that James Brenner, the CEO of BPCS, implement alternative 1 to ensure that the lower level employees effectively execute the decisions made by the top executives in areas such as finance, marketing, and production. The objective of transfer pricing is to facilitate optimal decision making within a decentralized organization, ultimately maximizing overall organizational profit and enabling control over profit centers based on quality.
By generating separate profit figures for each division, it becomes possible to evaluate the performance of each department individually. Additionally, transfer prices help coordinate production, sales, and pricing decisions across different departments by making managers aware of the value that goods and services have for other segments of the company. Through transfer pricing, the company can generate profit or cost for each department separately. It’s important to note that the transfer price not only impacts the reported profit of each center but also influences the allocation of resources within the company.
The extra expense for BPCS would be incurred if Northern purchased the boxes from West Paper or Erie Papers Inc. instead of Thompson. From a divisional perspective, the costs would be $480 for West, $430 for Erie and $432 for Thompson. From the overall company perspective, the costs would be $120 for external costs with Thompson, $25 for variable costs with West (with a potential profit of $30), and $168 for variable costs with Southern (with a potential profit of $90). The cost to the company would be $288 for West and $391 for Erie. It is important for the transfer price to consider goal congruence, which means ensuring profit internally for departments and profit externally for the entire company. In conclusion, unless there are specific instructions from Mr. James Brenner of BPCS, Mr. Kenton of Northern would opt to purchase from West Paper at a price of $430 since they offer the lowest bid.
