Paper Company (Copyright 1957 by the President and Fellows of Harvard College. Reproduced by permission.) “If I were to price these boxes any lower than $480 a thousand,” said Mr. Brunner, manager of Birch Paper Company’s Thompson division, “I’d be countermanding my order of last month for our salesmen to stop shaving their bids and to bid full-cost quotations. I’ve been trying for weeks to improve the quality of our business, and if I turn around now and accept this job at $430 or $450 or something less than $480 [ll be tearing down this program I’ve been working so hard to build up. The division can’t very well show a profit by putting in bids which 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 and colored the outside surface of the boxes.

Including Thompson, the company had four producing 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 return on investment. Top management had been working to gain effective results from a policy of decentralizing responsibility and authority for all decisions but 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.

In early 19_7 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 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. Each division manager was normally 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.

In early 19_7 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 business, it would probably buy the linerboard and corrugating medium from the Southern division of Birch. The walls of a corrugated box consist of outside and inside sheets of linerboard sandwiching the fluted corrugating medium. About 70 percent of Thompson’s out-of-pocket cost of $400 represented the cost of linerboard and corrugating medium. Though Southern 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 out-of-pocket costs on both liner and corrugating medium were about 60 percent of the selling price.
The Northern division received bids on the boxes of $480 a thousand from the Thompson division, $430 a thousand from West Paper Company, and $432 a thousand from Erie Papers, Ltd. Erie Papers offered to buy from Birch the outside linerboard with the special printing already on it, but would supply its own inside liner and corrugating medium. The outside liner would be supplied by the Southern division at a price equivalent of $90 per thousand boxes, and would be printed for $30 a thousand by the Thompson division.
Of the $30, about $25 would be out-of-pocket costs.
Since this situation appeared 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 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 Mr. Brunner had on occasion in the past few months been unable to operate the Thompson division at capacity, the vice-president found it odd that Mr. Brunner would add the full 20 percent overhead and profit charge to his out-of-pocket costs. When asked about this, Mr. Brunner’s answer was the statement that appears at the beginning of the case. He 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 good markup on the production of the box itself.
The vice-president explored further the cost structures of the various divisions. He remembered a comment that the controller had made at a meeting the week before to the effect that costs that were variable for one division could be largely fixed for the company as a whole. He knew that in the absence of specific orders from top management, Mr. Kenton would accept the lowest bid, which was that of the West Paper Company 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.
In the controversy described, how, if at all, is the transfer-price system dysfunctional?
. As the commercial vice-president, what action would you take? lop1