Cape Breton Log Homes

Cape Breton Log Homes (CBLH) is a company that produces log cabins as vacation homes.

Operations began in 1987 when the MacDonald family (Natalie, Lionel, William, and Paulette)

began constructing vacation homes. Consumers have come to appreciate that the warmth of log

homes and the insulation (or R-value) of well-constructed log homes is significantly higher than

that of conventional frame homes. CBLH has developed an exceptional reputation for quality

craftmanship and classic styling.

CBLH is organized into three autonomous divisions: Logging, Milling, and Assembly which are

managed by Natalie, Lionel and William respectively. The process begins in the Logging Division

where the logs are cut from the companys wood lots. The Milling Division selects certain logs

from Logging and debarks them in its processing plant. It also soaks each log in a preservative

solution, cuts them to specified lengths, and mills standardized notches on the corner of each log.

As the Assembly Division constructs new homes, they buy logs from the Milling Division.

The three divisions are treated as profit centers for the purposes of accounting and performance

evaluation. See Exhibit 1 for the most recent years segmented profit statement. Managerial

bonuses to divisional managers are based on the reported profit figure for the division. While each

manager deals with several other outside suppliers and customers, most of the log supply used in

any CBLH home is sourced and milled within the organization. The transfer prices that govern the

transfer of logs between the divisions is therefore the subject of much controversy and many

heated debates.

The President of CBLH, Paulette MacDonald, is wondering how the transfer prices should be set.

The current policy throughout the organization, is to let the managers negotiate freely between

themselves. This has led to some friction amongst the family members and Paulette is displeased.

She has read about other forms of transfer pricing and wonders if CBLH should change their

approach.

The most current dispute is between Lionel in the Milling Division and William in the Assembly

Division. The Assembly Division is currently operating at about 80% of its capacity of 100,000

logs per year and William wants Lionels Milling Division to produce a new version of the

standard notched log that will allow Assembly to offer a new line of homes. These homes would

take less time to construct and could be sold at lower than present prices, allowing William to

operate at capacity.

William states that the most his division can pay for the new style of notched log is $32.30. This

figure is justified by William as follows:

Maximum price people would be willing to pay for a cabin

$84,000

Number of logs in this new style of home

1,000

Maximum selling price per log: $84,000/1,000 =

$84.00

His analysis of the cost to assemble a log home on a per log basis:

Maximum selling price/log

$84.00

Direct labour

$29.90

Variable overhead

4.40

Fixed overhead

7.28

Other Materials (except logs)

1.13

42.71

Profit allowance

8.99

Total

51.70

Maximum price per log

$32.30

Lionel, the Milling Division Manager, refuses to sell William the new notched log for $32.30. The

Milling Division is presently running at 90% of capacity (80,000 logs to William and another

100,000 logs to other customers). He can currently get $42 per log from his outside other

customers. According to Lionel, Being the youngest in the family, I always had to do what my

older brothers and sisters told me to do. Now its gone too far. I have my own family to think

about now. When it comes time to split up the company bonuses at the end of the year, I dont

want my divisional profit to be lower and my bonus to be small just because William has the idea

that he wants to sell a different type of log home. My direct labour and materials would be the

same for the new ones as the regular model. Including what I have to pay Natalie for the logs, it

works out to $20.10 per log. My variable overhead is an additional $5.00 per log and the fixed

overhead gets applied at $10.00 per log. I cant produce logs at a full cost of $35.10 and sell them

to William for $32.30. Id be losing money on every log. It will lower my annual bonus, which is

already based on the lowest segment margin of the three divisions.

Required:

Assume the role of an outside consultant hired by CBLH. Write a report to Paulette MacDonald

providing recommendations to improve CBLHs performance management system. Be sure to

include as part of your report: (i) a full analysis of how overall company profits will be affected

by the expansion into the new line of cabins, and (ii) an analysis and recommendation for Paulette

to help her decide whether to intervene in this or other disputes regarding transfer prices. Be sure

to discuss the advantages and disadvantages of different options for the transfer pricing policy and

how it would likely affect divisional profits and decision making, as well as overall company

profits.