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 company’s 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 year’s 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 Lionel’s 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 it’s 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 don’t 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 can’t produce logs at a full cost of $35.10 and sell them to William for $32.30. I’d 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 CBLH’s 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.