Birch Paper Company Case
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OBJECTIVE : To evaluate present organizational structure and management control system of Birch Paper Company particularly on the decentralized operations of its divisions with respect to its overall performance.
PROBLEM : What effective management control system or systems should the Company adopt to attain maximum profitability not only of its divisionsâ€™ respective operations but that of the Company as a whole?
AREAS OF CONSIDERATION
1. Company Background
Birch Paper Company is a medium-sized, vertically integrated paper company, producing white and kraft papers and paperboard. It has four producing divisions and a timberland division which supplied part of the companyâ€™s pulp requirement; each division is operating independently headed by its respective division managers.
Birchâ€™s division managers normally were free to buy materials or inputs from whichever supplier they wished, and even on sales within the company; so divisions were expected to meet the going market price if they wanted the business.
Early in the year, its Northern Division designed a special retail display box in conjunction with the Thompson Division, which was equipped to make the box. Thompson, as one of Birchâ€™s four producing divisions converted paperboard output into corrugated boxes. It also printed and colored the outside surface of the boxes. Birchâ€™s Southern Division will supply the lineboard and corrugating medium to Thompson Division in the event the latter got the order from Northern.
2. Decentralization Policy
The Company observes the practice of decentralization where the responsibility and authority in all decision-making for the divisionsâ€™ operations lie in its respective division managers, except those relating to overall company policy.
For several years, top management felt that the decentralization concept had been successfully applied and that the companyâ€™s profits and competitive position had definitely improved.
3. Performance Evaluation
Each divisionâ€™s performance had been judged on the basis of its profit and return on investment for several years. The said practice creates competition among the companyâ€™s divisions because each makes sure that it is more profitable than the others. As such was the case, there was high possibility that one division was enjoying profit at the expense of the other(s).
4. Cost Structure
There was no defined cost structure set by top management for each division. For Northernâ€™s retail display box project in conjunction with Thompson, the two had only an informal agreement that the former had to reimburse the latter of the out-of-pocket cost of its design and development work.
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Birch Company Case Control System Top Management Effective Management Organizational Structure Divisions Thompson Boxes Decision-making
Thompsonâ€™s bid price of $480 for Northernâ€™s box requirement had a mark-up of 20% and Southernâ€™s mark-up for its liner and corrugating medium for Thompson was at around 40% considering that its out-of-pocket costs were about 60% only of its selling price.
The Controllerâ€™s comment on the effect that costs that were variable for one division could be largely fixed for the company as a whole is true.
ALTERNATIVE COURSES OF ACTION AND ANALYSES
1. Adopt Transfer Pricing and Enhance Responsibility Accounting Systems
Adopt Transfer Pricing System
One of the problems encountered in the evaluation of performance of different divisions or business segments in a decentralized business operations is caused by the transfer of goods and/or services between or among the divisions. If only all the divisions transact business with outsiders, there would be no problem at all particularly in the determination of selling price. But if one division furnishes goods or services to another division like in this case, a transfer price must be set to determine the buying divisionâ€™s cost and the selling divisionâ€™s revenue. This concept or system is called transfer pricing.
A transfer price is a price charged for the transfer of output from one division to another of the same company. So if one division charges high price for a component that another division has to buy, ultimately such division is enjoying profit at the expense of the other division. But such scenario is only normal because divisions are generally managed by each manager which performance is evaluated by the profits of the division not of the company as a whole. As such, the top management plays a vital role on in developing a sound transfer pricing system.
No one transfer pricing method will be best for all situations, so criteria for creating a transfer price should be properly outlined by top management. These criteria are the following:
1. Goal congruence. The transfer pricing system should encourage each manager to make decisions that will maximize profits for the Company as a whole. In decentralized organizations, perhaps one of the most difficult tasks is to get everyone to pull toward the common goal â€“ the financial success of the whole firm. Success of each division will not guarantee the optimal success fir the whole firm.
2. Performance evaluation. The transfer pricing system should allow corporate-level managers to measure the performance of division managers in a fair manner.
3. Autonomy. The transfer pricing system should allow division managers to operate their divisions as if they independent businesses.
4. Administrative cost. The transfer pricing system should be easy and inexpensive to operate. Administrative cists also include waiting for decision, hours spend negotiating and internal divisiveness.
These four criteria should be prioritized when forming transfer pricing policies. Different situations will demand different transfer pricing policies. The most common transfer prices are (1) Market Price (2) Cost-based Price (which includes actual full cost, target or predetermined full cost, cost plus a profit and variable cost) (3) Negotiated Price and (4) Dual Prices.
As shown in the attached exhibits, it is apparent that each division is trying to maximize its own profit by posting a high mark-up for its output; with Thompson Division posting 20% on top of its out-of pocket cost and Southernâ€™s 40%. With this set up, it is also obvious that without top managementâ€™s intervention, Northern will buy boxes from West Paper because the latter had the lowest bid price. If this will happen, the Companyâ€™s ultimate goal of maximizing its profits will not be attained. The operations of the two other divisions (Thompson and Southern) will not be maximized when there is already an opportunity. There will be high opportunity loss for the other two divisions. The company as a whole will have to shoulder for the cost of design and development work incurred by Thompsonâ€™s package design and development staff.
However, if Northern gets boxes from Thompson, operating capacity of Thompson will be maximized and excess inventory of Southern will be utilized. Only that, a transfer price should be set. Thompson will still realize profit even if it lowers down its price at West Paperâ€™s offer of $430. Southern Division as well could lower down the price of its linerboard for Thompson. With the companyâ€™s adoption of a transfer pricing system, all these concerns will be addressed. Thompson division need not charge the full 20% of its overhead cost if it is not operating at its full capacity, thus passing on the burden to the other division.
Responsibility Accounting System
Birch Paper Companyâ€™s present structure of decentralization is already in the track of responsibility accounting system. Enhancement of the system is required because responsibility accounting system brings discipline to planning and control tasks. It combines responsibility centers, charts of accounts, control reports, and activity centers and cost-drivers from activity-based costing. Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts. These parts or segments are referred to as responsibility centers that include: (1) revenue centers, (2) cost centers, (3) profit centers and (4) investment centers. This approach allows responsibility to be assigned to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs).
In the case of Birch Paper Company, the responsibility for all decisions except those relating to overall company policy was already delegated to division managers. Each division was both profit and investment centers as for several years it was operating independently form each other and its performance was evaluated on the basis of its profits and return on investments.
Since competition had already become prevalent among divisions because of this practice, employees were more concerned of their individual interests making its respective division to be profitable without thinking of its effects to other divisions and to the company as a whole. Thus, management control such as responsibility accounting system should be efficiently implemented.
2. Change the Present Structure â€“ from Decentralized to Centralized Operations
One of the most striking characteristics of organization over the past thirty years has been the top managementâ€™s desire to grow and yet retain the advantages of smallness. Management of Birch Paper Company, being a huge company comprising of many divisions will find it difficult or impossible to control everything and make all decisions for every aspect of the Companyâ€™s operation. This set-up requires delegation of some decision-making authority to the other members of the organization over some areas of operations. Delegating authority to lower level managers allows higher level managers to pursue other activities such as long term planning and policy making. Employees would not be motivated to work for their divisionsâ€™ profitability as a gauge of their performance as there is no more competition among divisions. Cost minimization which is every divisionâ€™s target to maximize profit in the present set-up will no longer of anyoneâ€™s concern, thus sacrificing the Companyâ€™s overall goal.
Case Study On Birch Paper Company With Regard To Transfer Pricing
Case: Birch Paper Company
1. Calculating all three options based on costs
Linearboard and corrugating medium 168(70%*400)*60%
30% of out of pocket costs 120(30%*400)
Outside linear(Southern div) 54(60%*90)
Printing(Thompson div) 25
Own Supplies 312(432-5-36)
As shown in the calculations above, Northern should accept the bid from Thompson division as it has the lowest cost if all transfer prices within the company were calculated at costs. Incurring the lowest costs would also enable Birch Paper Company to earn the highest profits possible.
2. As alternatives for sourcing exists, Mr. Kenton should be permitted to choose the alternative that is in Northern division's own interests. The transfer price policy gives him the right to deal with either insiders or outsiders at his discretion. If he is unable to get a satisfactory price from the inside source which is Thompson division, he is free to buy from outside.
Mr. Kenton, manager of the Northern division should not accept the bid from Thompson division. The three bids from Thompson division, West Paper Company and Eire Paper Company are $480, $430 and $432 respectively. Accepting the bid from Thompson division would be accepting the highest bid amongst all three offers (highest costs). This would result in the lowest profits. As the Northern division is evaluated as an investment center, it is judged independently on the basis of its profit and return on investment. Mr. Kenton should not accept the bid from Thompson division.
3. The method of using transfer price to decide whether to in source is optimum if the selling profit center can sell all of its products to either insiders or outsiders and if buying center can obtain all of its requirements from either outside or insiders. The market price then represents the opportunity costs to the seller of selling the product inside. In this case, Thompson division had been running below capacity and Southern division also had excess inventory. The transfer price of $480 offered by Thompson division does not represent the opportunity costs of selling inside as there is no demand market for the product outside. Also, the transfer price of $480 is higher than the market price which is around $430. Deciding based on transfer price will not induce goal congruence as the situation is not ideal.
Without any intervention from the vice president of Birch Paper Company, the Northern division would most probably accept the lowest bid from West Paper Company. This might result in the highest profits for Northern division but it is not in the best interests of Birch Paper Company. Accepting the bid from Thompson division would boost demand for the two other divisions. The losses cut...
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