For severalyears, eachdivision had beenjudged independently on the basis of its profit and return on investment. Top managementhad been working to gain effectiveresults from a policy of decentralizing responsibility and authority for all decisionsexcept those relating to overall companypolicy. The company’s top officials believed that in the past few years the concept of decentralization had been applied successfullyand that the company’sprofits and competitive position definitely had improved.
The Northern Division had designeda special display box for one of its papers in conjunction with the ThompsonDivision, which was equippedto make the box. Thompson’sstaff for packagedesign and developmentspent several months perfecting the design, production methods,and materials to be used. Becauseof the unusual color and shape, these were far from standard. According to an agreement between the two divisions, the Thompson Division was reimbursed by the Northern Division for the cost of its design and developmentwork.
When all the specificationswere prepared,the Northern Division askedfor bids on the box from the ThompsonDivision and from two outside companies. Each division manager was normally free to buy from whatever supplier he wished, and evenon saleswithin the company, divisions were expectedto meet the going market price if they wanted the business. During this period, the profit margins of such converters as the Thompson Division were being squeezed. Thompson,as did many other similar converters,bought its paperboard,and its function was to print, cut, and shapeit into boxes.
Though it bought most of its materials from other Birch divisions, most of Thompson’ssaleswere made to outside customers. If Thompsongot the order from Northern, it probably would buy its linerboard and corrugating medium from the Southern Division of Birch. The walls of a corrugated box This case was prepared by William Rotch under the supervision of Neil Harlan, Harvard Business School. Copyright 158-001. by the President and Fellows of Harvard College. Harvard Business School case i Case6-2 Birch PaperCompany 2 consist of outside and inside sheets of linerboard sandwiching the fluted corrugating medium.
About 70 percent of Thompson’s out-of-pocketcostof$400 for the order representedthe cost of linerboard and corrugating medium. Though Southern had beenrunning below capacity and had excess inventory, it quoted the market price, which had not noticeably weakenedas a result of the oversupply. Its out-of-pocket costs on both liner and corrugating medium were about 60 percent of the selling price. The Northern Division receivedbids on the boxesof $480 a thousand from the ThompsonDivision, $430 a thousand from West Paper Company,and $432 a thousand from Eire Papers,Ltd.
Eire Papers offered to buy from Birch the outside linerboard with the specialprinting already on it, but would supply its own inside liner and corrugating medium. The outside liner would be supplied by the Southern Division at a price equivalent of $90 a thousand boxes,and it would be printed for $30 a thousand by the Thompson Division. Of the $30, about $25 would be out-of-pocketcosts. Since this situation appearedto be a little unusual, William Kenton, manager of the Northern Division, discussedthe wide discrepancy of bids with Birch’s commercialvice president.
He told the vice president:”We sell in a very competitivemarket, where higher costscannot be passedon. How canwe be expectedto show a decent profit and return on investment if we have to buy our supplies at more than 10 percent over the going market? ” Knowing that Mr. Brunner on occasionin the past few months had beenunable to operate the Thompson Division at capacity,it seemedodd to the vice president that Mr. Brunner would add the full 20 percent overheadand profit chargeto his out-of-pocketcosts. When he was asked about this, Mr.
Brunner’s answer was the statement that appears at the beginning of the case. He went on to say that having donethe developmentalwork on the box, and having receivedno profit on that, he felt entitled to a goodmarkup on the production of the box itself. The vice president explored further the cost structures of the various divisions. He remembereda comment that the controller had made at a meeting the week before to the effect that costs which were variable for one division could be largely fIXedfor the companyas a whole.
He knew that in the absence of specific orders from top management Mr. Kenton would acceptthe lowest bid, which was that of the West Paper Companyfor $430. However,it would be possiblefor top managementto order the acceptance another bid if the situof ation warranted such action. And though the volume representedby the transactionsin questionwas less than 5 percent of the volume of any of the divisions involved, other transactions would conceivablyraise similar problemslater.
Questions 1. Which bid should Northern Division acceptthat is in the best interests of Birch Paper Company? 2. Should Mr. Kenton acceptthis bid? Why or why not? 3. Should the vice president of Birch Paper Companytake any action? 4. In the controversydescribed,how,if at all, is the transfer price system dysfunctional? Doesthis problem call for somechange,or changes, the transin fer pricing policy of the overall firm? If so, what specific changesdo you suggest?