Each being judged by the profit and ROI they generate. However, outside firms seems to tackle/squeeze them price-wise. Within the division there is a competitive strategy because they can buy boxes in or outside the company. Since these had to generate profit they had to look for other strategies to accomplish this but there were issues of transfer prices, out-of -pocket costs and the profit and ROI. The Thompson division worried about the transfer price it had to use in order to gain profit.
Firms outside BPCS offer a lower price than the price used within the company. Northern department designed a special wholesale display box for one of its finished papers together with the Thompson department, which was appointed o make the boxes. Thompson as one of the four departments changed paperboard into new output that were wholesale cardboard boxes. It also colored and printed the exterior area of the boxes.
Southern department on the other side was able to provide Thompson with linebackers, a type of paperboard used in making the boxes and corrugating medium to give the paperboard its wavy ridges through a corrugating machine. Because of the trade of supplies and labor between the departments, a transfer price of $480 was used by Thompson to determine costs. This is the price at which Thompson agreed to charge Northern. To have a competitive advantage, the transfer price may not differ much from the price in the market.
However, Northern was free to do business with two outside companies, which are West Paper Co. For $430 and Erie Papers Inc. For $432. So, Thompson was obviously $50 higher than the competitive market price. Therefore, if no instruction was given from Top management of the company, it was acceptable that Northern would purchase from the lowest bid that is from West Paper Co. Bids: 1. Thompson (Internal)- $480 (20% rate) Buys from Southern division ( 70% of $400 cost) Southern cost are 60 % of transfer/ selling price 2. West paper Co. External)- $430 3. Erie Papers Inc. (External)- $432 $90 per box from Southern $30 from Thompson (25% is variable) Problem Analysis Decentralization strategy With a decentralization strategy the responsibility and authority of each department was in the hands of the division managers, besides for those relating to overall company policy. The performance of each department was evaluated based on its profit and return on investment which created competition between the departments, because each wanted to be more profitable than the rest.
For some years, top management thought that they had been successfully adopted this system and that with this profits and competition would improve. Due to the internal competition that had become dominant among them, employees laid the emphasis on making profits for their department and overlooked the negative consequences for the other departments and the whole company. Therefore, responsibility accounting system should be efficiently carried out. BPCS used a decentralization system, so each department was responsible for their own accounting system.
This system must be improved because this system loud bring with it self-control in planning and responsibilities. Important characteristics of a decentralization firm are responsibility centers, which are cost, profit, revenue or investment centers. The performance of these centers is evaluated on the basis of various accounting numbers such as divisional profits, standard costs and ROI. In the case of BPCS, the department managers are each responsible for their decision-making. Each department was both profit and investment centers; they were operating independently and their performance was valued based on the ROI and profits.
Management of BPCS found difficulties in controlling all the departments for every part. As a result, decision rights should be given to other lower level employees over some areas of the huge company. This could allow top managers to focus on core strategies such as long term planning and policy making. The advantages and disadvantages of decentralization are as follows. Advantages 1 . Decisions are better and more timely because of the manager’s proximity to local conditions; 2. Top managers are not distracted by routine, local decision problems; 3. Managers’ motivation increases because they have more control veer results; 4.
Increase decision making provides better training for managers for higher level positions in the future. Disadvantages 1 . Lack of goal congruence among managers in different parts of the organizations; 2. Insufficient information available to Top management; increased costs of obtaining detailed information; 3. Lack of coordination among managers in different parts of the organization. Evaluation of performance and transfer pricing In the evaluation of performance, Birch Paper Company faced a problem which was caused by the transfer pricing strategy among departments.
If the departments were only doing business with outside companies, there would be no problem at all especially in determining the selling price. But if they are doing business internally such as delivering goods and services together, a transfer price must be created to control department’s buying cost and the selling’s department’s revenue. A transfer price is the price determined by one department to another of the same company. So, if one department ask high price to the buying department, ultimately the selling department is making profit on the expense of the buying department.
However, this situation is normal in a decentralization strategy, because each department is controlled by each manager which performance is evaluated by the profit of the department and not of the company as a whole. As such, the top management must take action to create an appropriate transfer pricing that benefit the whole company. According to the book, Managerial Economics & Organizational Architecture (Prickly, Smith & Zimmerman) there are at least four methods to set a transfer price which is: market price, marginal production cost, full cost, and negotiated pricing.
As shown above, it is obvious that BPCS used a Market-based transfer pricing. The products were manufactured inside the company because there are important synergies among the departments and interdependencies. Market-based Transfer Pricing When the outside market for the product is well-defined, competitive, and stable, the companies often use the market price as an upper bound of the transfer price. In the case of BPCS, the outside market was not stable and competitive.
As a result, internal decision making internal was distorted by reliance of market based transfer pricing, because there are two outside companies who were ailing the boxes at lower prices. There are criteria which can be used to create transfer prices and top management should review them carefully. They are as follows: 1. Goal congruence: transfer pricing must motivate managers to make decisions to benefit the whole company. In the case of BPCS with a decentralized strategy, it is difficult to work toward the financial success of the whole company.
Success of each division does not promise the triumph of the whole company. 2. Performance evaluation: the transfer pricing system must be used as a tool to measure the performance of department managers in a neutral manner. . Autonomy: here the transfer pricing system must be used as if departments were independent from each other. 4. Administrative cost: transfer pricing must not be difficult and expensive to use. In the case of BPCS, each department made an effort to maximize its own profit on the expense of the others.
Thompson added 20 % on top of its out of pocket cost and Southern 40% (100 %- 60%). Therefore, involvement of top management was necessary to prevent that Northern was going to buy the boxes from West Paper, because the latter had the lowest bid price. The operations of Thompson ND Southern could not be maximized if Northern was doing business with West Paper, while there was an opportunity to do so. Both would incur high opportunity loss. The consequence is that the whole company would have to cover the costs for the development and design work and for the staff of the Thompson department.
On the other hand, if Northern bought their boxes from Thompson, operating volume of Thompson would benefit from this. Their profit would be maximized while high inventory of Southern would be used. In this way, a transfer price should be fixed. Thompson must lower its selling price, but Thompson must rower the prices of its goods as well, so that both could still realize their goal which was making profit. Thompson must not use its full 20 % overheads cost, if it’s not operating at its full capacity, so that that the other departments would not have a disadvantage too.
Cost structure The company did not have a concrete cost structure. There is an informal cooperation between Northern and Thompson that the former had to compensate the latter of the out of pocket cost of its design and development work. Thompson bid price of $480 for Northern box requirement had a argue of 20% and Southern mark- up for its liner and corrugating medium for Thompson was at around 40% considering that it’s out of pocket cost were about 60% only of its selling price. According to the Controller, costs that were variable for one division could be largely fixed for the company as a whole.
Recommendations 1 . Implement Transfer pricing and quality control system: when different departments of a huge company as BPCS are in charge of their own profit and ROLL As a result, departments are conducting business with each other; a transfer price is used to determine cost. Transfer price must not differ much from the market price; otherwise one of the departments will have a loss. They will buy from the dominant or current market price or sell below the market price, which will affect their performance.
To add a quality control system linked to the strategy of BPCS, where the decision rights are not taken by the profit centers. These decision rights should only be taken by the CEO. The CEO will than can control the decision of the profit centers whether to go internal or external. This can also avoid overruling the decision rights which are delegated to the profit centers. 2. Change the decentralized to centralized system; centralization means that all important decisions and actions at the lower level needs approval from the top management.
The lower level employees must be instructed first to implement the decisions made by the top such as finance, marketing and production. Our conclusion is to recommend the CEO of BPCS, James Brenner to implement alternative 1, because the basic purpose of transfer pricing is to bring the ideal decision making in a decentralized organization that is to maximize profit of the organization as a whole. Also to have control over the profit centers based on quality. Purposes of Transfer Pricing 1 .
Generate separate profit figures for each division and thereby evaluate the performance of each department separately; 2. Help coordinate production, sales and pricing decisions of the different departments via an appropriate choice of transfer prices. Transfer prices make managers aware of the value that goods and services have for other segments of the company; 3. Transfer pricing allows the company to generate profit or cost for each department separately; 4. The transfer price will affect not only the reported profit of each center, but will also affect the allocation of a company’s resources.
The additional cost to BPCS if Northern had bought the boxes from West or Erie rather than from Thompson Thompson West Paper Erie Papers Inc. Divisional perspective Cost $480 $430 $432 Company overall perspective Cost external Thompson variable costs $120 $25 ($30) Southern variable costs $168 $54 ($90) Cost to company $288 $391 Transfer price should allow for goal congruence that is profit internal for departments and profit external for the whole company. Conclusion: without specific orders from Mr.. James Brenner of the BPCS, Mr.. Kenton of Northern would buy from West Paper for $430, because they offer the lowest bid.