Birch Paper Company
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