Birch Paper Company (Evaluate Transfer Pricing Policy and Use of Responsibility Centers):

"If I were to price these boxes any lower than $480 a thousand," said James Brunner, manager of Birch Paper Company's Thompson Division. "I'd be counter- manding my order for last month for our sales force to stop shaving their bids and to bid full-cost quotations. If I turn around now and accept this for something less than $480. I'll be tearing down my own orders. 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." Birch Paper Company was a medium-sized. partly integrated paper company. producing white and kraft papers and paperboard. A portion of its paperboard output was converted into corrugated boxes by the Thompson division, which also printed the outside surface of the boxes. Including Thompson, the company had four produc- ing divisions and a timberland division, which supplied part of the company's pulp requirements. For several years, each division had been judged independently on the basis of its profit and ROI. Top management had been working to gain effective results from a policy of decentralizing responsibility and authority for all decisions except those relating to overall company policy. The company's top officials felt that in the past few years the concept of decentralization had been successfully applied and that the company's profits and competitive position had definitely improved. Early in the year, the Northern Division designed a special display box for one of its papers in conjunction with the Thompson Division, which was equipped to make the box. Thompson's package design and development staff spent several months perfecting the design, production methods, and materials that were to be used: because of the unusual color and shape, these were far from standard. According to an agreement between the two divisions, the Thompson Division was reimbursed by the Northern Division for the out-of-pocket cost of its design and development work.

When the specifications were all prepared, the Northern Division asked for bids on the box from the Thompson Division and from two outside companies. West Paper Company and Erie Papers, Inc. Each division manager normally was free to buy from whichever supplier he wished, and even on sales within the company, divisions were expected to meet the going market price if they wanted the business. At this time, the profit margins of converters such as the Thompson Division were being squeezed. Thompson, as did many other similar converters, bought its board, liner, or paper; and its function was to print, cut. and shape it into boxes. Though it bought most of its materials from other Birch divisions, most of Thompson's sales were to outside customers. If Thompson got the order from Northern, it probably would buy its linerboard and corrugating medium from the Southern Division of Birch. The walls of a corrugated box consist of outside and inside sheets of liner- board sandwiching the corrugating medium.

About 70 percent of Thompson's variable cost of $400 a thousand for the order represented the cost of linerboard and corrugating medium. Though Southern Divi- sion had been running below capacity and had excess inventory, it quoted the market price, which had not noticeably weakened as a result of the oversupply. Its variable costs on liner and corrugating medium were about 60 percent of selling price. The Northern Division received bids on the boxes of $480 a thousand from the Thompson Division, $430 a thousand from West Paper, and $432 a thousand from Erie Papers. Erie offered to buy from Birch the outside linerboard and corrugating medium. The outside liner would be supplied by the Southern Division at a price equivalent to $90 a thousand boxes and would be printed for $30 a thousand by the Thompson Division. Of the $30, about $25 would be variable costs. Since this situation appeared to be a little unusual, William Kenton, manager of the Northern Division, discussed the wide discrepancy of bids with Birch's commercial vice president. He told the commercial vice president, "We sell in a very competitive market, where higher costs cannot be passed on. How can we be expected to show a decent profit and return on investment if we have to buy our supplies at more than 10 percent over the going market?" Knowing that Brunner had on occasion in the past few months been unable to operate the Thompson Division at capacity, the commercial vice president thought it odd that Brunner would add the full 20 percent overhead and profit charge to his variable costs. When he asked Brunner about this over the telephone, his answer was the statement that appears at the beginning of the case. Brunner went on to say that having done the developmental work on the box, and having received no profit on that, he felt entitled to a normal markup on the production of the box itself.

The vice president explored further the costs of the various divisions. He remembered a comment the controller had made to the effect that costs that for one division were variable could be largely fixed for the company as a whole. He knew that in the absence of specific orders from top management, Kenton would accept the lowest bid; namely, that of West Paper for $430. However, it would be possible for top management to order the acceptance of another bid if the situation warranted such action. And though the volume represented by the transactions in question was less than 5 percent of the volume of any of the divisions involved, other transactions could conceivably raise similar problems later.

Required:

Does the system motivate Mr. Brunner in such a way that actions he takes in the best interests of the Thompson Division are also in the best interests of the Birch Paper Company? If your answer is no, give some specific instances related as closely as possible to the type of situation described in the case. Would the managers of other divisions be correctly motivated? What should the vice president do?