1.

The responsibility structure of the Birch Paper Company and all of its divisions is

an Investment Centre. In the case it is stated that “for several years, each division

had been judged on the basis of its profit and return on investment.” This verifies

that BPC’s structure is an investment centre, since an investment center has a

manager who is responsible for the division’s profits as well as its invested

capital.

However, as stated in class, “some organizations use the terms profit

centre and investment centre interchangeably,” this is evident by the managers of

BPC’s divisions continually stressing profit as a major concern. As James

Brunner, Thompson’s division manager stated, “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.”

By applying the concept of decentralization, each division in the

Birchwood Company was given authority to make decisions except for those

related to overall company policy. By having this authority to make decisions,

each division manager was able to invest in capital that it felt was needed to

maximize overall company profit. Each division manager is evaluated on ROI,

which shows how much profit was generated from the capital invested.

2. Out-of-pocket costs are the payments (usually cash or obligations to pay cash)

made for resources. Out-of-pocket costs can be the same as opportunity costs, but

may not be the some because of imperfect markets and changes in the decision-

making environment between when a resource was acquired and when it is used.
 The following is a calculation of the out-of-pocket costs to Birch Paper Company

on the proposed bids.

BIRCH PAPER COMPANY

Per 1,000 boxes

WEST PAPER CO: Out of pocket Cost to Birch $430

EIRE PAPER, LTD: $432

Less: Southern profit ($90*40%) $36
Thompson profit ($30-$25) 5 $41
Out of pocket cost to Birch $391

THOMPSON $480
Less: Southern profit ($280*40%) $112
Thompson profit ($480-$400) 80 $192
Out of pocket cost to Birch $288

3. The best bid for Birch Paper Company would be with Thompson, one of its own

divisions, since it represents the lowest out of pocket cost to BPC. As well, if the

Northern Division chooses the Thompson division then it may avoid other costs

that may be incurred from choosing an external bid.

4. The Northern Division received bids of $480 from Thompson, $430 from West

Paper Company, and $432 from Eire Papers, Ltd. Since Birch Paper Company’s

responsibility structure is an investment centre as stated above in question one, in

order to maximize divisional profits Northern would chose the $430 bid from

West since it represents the lowest cost, thereby resulting in higher profits.

5. The question of whether or not the vice president of Birch Paper Company

should take action in this matter is a dilemma that has no outright solution, for
 there are pros and cons on each side. If the vice president gets involved in the

bidding process they may face the peril of “undermining the autonomy” of the

division managers. However, by not taking action they will loose the cost saving

associated with in-sourcing to Thompson. Central managers will only want to

intervene if the negative financial consequences are significant. It is stated in the

case that, “the volume represented by the transaction in question was less than

five percent of the volume of any of the divisions involved,” therefore, since it is

a relatively small volume the vice president may feel that their involvement is

unnecessary. However, as stated “other transactions would conceivably raise

similar problems later.” Due to the possible reoccurrence of these problems it is

to the company’s benefit that the vice president should get involved, thereby

setting precedence for all division to follow, avoiding future problems.

6. The transfer pricing system is dysfunctional since it is possible for each internal

division to price their product above the going market price. This ability for

individual price setting deters the divisions from making purchases internally,

although in the long run the company benefits from choosing, either internally or

externally, the option with the lowest cost to the firm. If Thompson was

persuaded to alter their sales cost from $480 to $430 this would make them one of

the lowest bidders and intern Northern would be willing to accept their offer.

This pricing change would allow Northern to go internally without the vice

president’s involvement.
 Shown below are a break-down of the out of pocket cost to Birch and the

reduction of the contribution margin to Thompson.

THOMPSON $430
Less: Southern profit ($280*40%) $112
Thompson profit ($430-$400) 30 $142
Out of pocket cost to Birch $288

Although the Thompson division would lose some profit ($80-$30=$50),

the price reduction still allows for the same out of pocket cost to Birch of $288. If

the price was not changed Northern would have stayed with Western Paper

Company resulting in an out of pocket cost to Birch of $430. The price change

reflects a $142 ($430-$288) cost saving for Birch, more than making up for the

loss of profit to Thompson.

Currently the management for the Thompson division is not following the

market for the pricing of its product, it is possible that Thompson is not operating

at efficient levels and their bid price reflects these inefficiencies. Birch should

implement a system whereby subordinate divisions must adhere to a pricing

strategy that reflects current market prices. This strategy would increase internal

purchasing and help to align each division’s goals with that of the Company’s,

intern, leading to better performance for the company as a whole.

In the case the vice president remembers a comment made by a controller,

“costs which were variable for one division could be largely fixed for the

company as a whole.” This implies that Birch Paper Company is basing its prices

on a full cost approach. When companies use a full cost or absorption cost

approach to setting transfer prices between departments then it may lead to

dysfunctional decision-making behavior, as we can see in this case. Using a full

cost approach has directed the buying division to view non-unit-level costs for the

company as unit-level costs for their division, which intern has lead to faulty

decision making.

Mr. Brunner is adding a 20% overhead and profit charge to his out-of-

pocket costs, even though he is not at full capacity and does not have any

opportunity costs to count for, which is causing the company to charge more than

they should be charging. If this 20% mark up was dropped then the costs could

go down, and the Thompson division could offer the price of $430 or even less to

the Northern division which would be a net advantage for the company as a

whole.