In 2002, the profit margins of converters such as the Thompson Division were being squeezed. Thompson, as did many other similar converters, bought the paperboard and linerboard used in making boxes, and its function was to print, cut, and shape the material into boxes.1 Although it bought most of its materials from other Birch divisions, most of Thompsons sales were made 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. Thus, before giving its bid to Northern, Thompson got a quote for materials from the Southern Division. Although Southern had been running below capacity and had excess inventory, it quoted the prevailing market price for materials. Southerns out-of-pocket costs for both liner and corrugating medium were about 60% of its selling price. About 70% of Thompsons out-of-pocket costs of $400 per thousand boxes represented the cost of linerboard and the corrugating medium.

The Northern Division received bids on the boxes of $480 per thousand from the Thompson Division, $430 per thousand from West Paper Company, and $432 per thousand from Eire Papers, Ltd. Eire Papers offered to buy from Birch the outside linerboard with the special printing already on it, but it would supply its own inside liner and corrugating medium. The outside liner would be supplied by the Southern Division at a price equivalent to $90 per thousand boxes, and would be printed for $30 per thousand by the Thompson Division. Of the $30, about $25 would be out-of- pocket costs.

Since the bidding results appeared to be a little unusual, William Kenton, manager of the Northern Division, discussed the wide discrepancy in the bids with Birchs 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% over the going market?

Knowing that Mr. Brunner had been unable to operate the Thompson Division at capacity on occasion during the past few months, it seemed odd to the vice president that Mr. Brunner would add the full 20% overhead and profit charge to his out-of-pocket costs. When he asked Mr. Brunner about this, the answer he received 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 work, 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 of the controller at a meeting the week before, to the effect that costs which 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 although the volume represented by the transactions in question was less than 5% of the volume of any of the divisions involved, future transactions could conceivably raise similar problems.

Use the passage above to answer part a and b.

a. Out of the three bids, which bid should Northern Division (for Birch Paper's interest) accept numerically and why?

b. In the controversy described, how is the transfer price system dysfunctional? Does this problem call for some changes in the transfer pricing policy of the overall firm? If so, what changes do you suggest?