Beech Paper Company

Beech Paper Company

DAVID OTLEY, University of Lancaster

Background

The Beech Paper Company is a medium-sized, partly integrated company producing a variety of specialist papers and paperboard. It is wholly owned by a large conglomerate, but maintains its own Head Office in Warrington, Lancashire, and is subject only to overall financial control by its parent company. It has five operating divisions: the Waste Paper Division, which supplies most of the company’s pulp requirements; the Northern, Western and Southern Divisions which produce paperboard and a variety of other paper products for both outside customers and for internal use by other divisions; and the Carton Division which converts some of the paperboard output of the Southern Division into corrugated boxes with colour-printed outside surfaces. The output of the Carton Division is sold both to external customers and to the Western and Northern Divisions.

Control System

Each of the five divisions is headed by a general manager. Following a reorganisation of the company three years ago, divisional general managers were given considerable autonomy and were told that they were expected to act as if they were the managing directors of independent companies. Each division is regarded by Head Office as a profit centre, and the performance of each divisional general manager is evaluated on the basis of profit performance.

In specific terms, each division is expected to achieve a net return on sales of at least 6 per cent. Operations are planned on an annual basis, linked to a financial year end of 30 June. Prior to the beginning of each year, divisional general managers are required to submit budgets showing the net profit that they expect to earn, in excess of the 6 per cent of sales revenue required. Adjustments are often made to the budgets at this stage as a result of consultation and negotiation between divisional managers and Head Office. Once agreed, this budget forms the basis for evaluating performance in the ensuing year.

Each divisional general manager is primarily responsible to the operations director at Head Office. The operations director reviews divisional budgets and closely monitors actual performance with budget, on a monthly basis. He is also required to resolve problems within a particular division, or between divisions, from time to time. However, he prefers not to interfere in what he considers to be normal operating matters, and has previously refused to intervene in interdivisional squabb1es. This is in keeping with the company philosophy of decentralisation which he was instrumental in establishing two years ago. Under this philosophy, the Head Office is responsible primarily for strategic planning, capital-investment decisions and the overall control of divisions, including, the appointment of divisional general managers.

Interdivisional Transfers

A substantial volume of production is transferred between the divisions within Beech Paper, as it operates as an integrated paper company with each division having specialist skills. The Waste Paper Division provides most of the pulp used by the three paper-making divisions, as. well as supplying external customers. The output of the three paper-making divisions goes to one another as well as to outside customers. The Carton Division does a significant amount of paperboard conversion and printing for Western and Northern Divisions, and usually purchases linerboard from the Southern Division.

These interdivisional transfers present a special problem of management accounting, as the operating divisions are viewed by Head Office as independent profit centres. The problem is resolved by using transfer prices toaccount for the internal transactions. Thus a product which is transferred internally generates a credit for the supplying division, and an equal and opposite debit for the user division.

There are several methods by which transfer prices can be determined. In Beech Paper, consistent with its philosophy of decentralisation, transfer prices are set on a bid-and-negotiate basis. Upon request, the selling division submits a quotation to the buying division; at the same time, the buying. division also solicits quotations from outside suppliers. Beech operates on the general principle that the buying division should attempt to place orders internally where possible. So, where the selling division’s bid is too high, the selling and buying divisions should attempt to reach a mutually acceptable price by negotiation. The problem may also be referred to the operations director, although he may refuse to interfere in what he regards as a normal operating matter. At this point, if agreement is not achieved internally, the buying division is free to accept an outside bid.

Setting

The date is 10 June 1988. Preliminary budgets for the year ending 30 June 1989 have been submitted by the divisions to Mr Hedge, the operations director. The budget of Carton Division is shown in Exhibits 1 and 2; that

of Northern Division in Exhibit 4; and that Of Southern Division in Exhibit. The budgets are still subject to discussion and final agreement.

Role for Mr John Clark

You are the divisional general manager of Beech Paper Company’s Carton Division. Some months ago you became concerned about a widespread tendency amongst your sales staff to discount their prices on boxes. After carefully investigating the issue you wrote a strong memo (Exhibit 3) directing them not to sell boxes below cost plus the normal 20 per cent mark-up. This directive is consistent with your long-standing policy, and is designed to ensure that a fair share of overhead costs and a reasonable profit margin is obtained from each sale. This is important since you and your division are evaluated on your return on sales revenue.

Recently, Mr David Norton, divisional general manager of the Northern Division, put out an order to tender. He received bids from the Scott Packaging Company for £410 per thousand, from the Irish Paper Company for £432 per thousand, and from your own division for £480 per thousand. Since he was aware of the fact that you were currently operating at less than 80 per cent of your capacity, he contacted Mr Hodge, the operations director, to receive guidance on where the contract should be placed. Mr Hodge suggested that Mr Norton should discuss the matter with you. Mr Norton is now

Exhibit 1 Summary Budget: Carton Division (Year Ending 30 June 1989) Sates Revenue

£000s

From external customers outside of Beech3,300

Northern Division720

Western Division1,080

Costs

Manufacturing

Materials2,972

Labour574

Variable overhead286

Fixed overhead210

Marketing

Commissions99

Order-filling111

Advertising33

Other105

Administration260

Share of Head Office costs100

Total costs4,750

Budgeted gross profit margin350

Required profit (6% of sales revenue)306

Budgeted excess/(deficiency)44

Exhibit 2 Budget Supporting Schedules: Carton Division (Year Ending 30 June 1989)

I.Estimated Demand

External customers £

5,500K boxes @ average price of £600/K3,300

Internal sales

Northern Division: 1,500K boxes @ average price of £480/K 720

Western Division: 2,000K boxes @ average price of £540/K1,080

Total demand (9,000K boxes)5,100

Maximum practical capacity is about 11,250K boxes

2.Committed Fixed Costs

£000s

Manufacturing210

Selling35

Other marketing70

Administrative85

Share of Head Office costs100

Northern
Division / Western
Division / External
Customers
Variable costs
Manufacturing
Materials
Linerboard etc.2
Printing materials
Labour
Overhead
Marketing3
Commissions
Order-filling
Administration
Fixed promotion costs3
Total Variable Costs
20% addition for fixed cost recovery and divisional profit margin
Price (per thousand boxes) / 280
20
56
29
5
10
400
80
480 / 305
24
66
33
8
14
450
90
540 / 310
29
65
32
18
16
24
6
500
100
600

Notes

1.Most of these manufacturing costs are separable by customer type as follows:

External customers £90

Northern Division £45

Western Division £50

2. Linerboard is usually purchased from the Southern Division. The variable Costs of production amount to about 60% of the transfer price.

3.Sales commissions, advertising and promotion costs are not incurred on sales within Beech. The £6,000 per thousand boxes fixed cost for advertising represents the £33,000 total fixed costs allowed.

Exhibit 3 Memo

From:John Clark, General Manager, Carton Division

To:All Sales Representatives, Carton Division

Date:20 March 1988

Pricing Policy

1.The prices currently being obtained for our products are not adequate. Our budgeted profit target cannot be achieved unless our normal pricing policy can be re-established. This memorandum is to re-affirm that policy, and to make it clearly understood that I intend to hold all sales representatives accountable for achieving the 20% mark-up included in it.

2.Our pricing structure is intended to provide for three elements:

(a)the variable costs of production and marketing of an order,

(b)a contribution towards the recovery of divisional fixed costs and Head Office costs,

(c)a profit margin.

The current policy is to price at 120% of the identifiable variable costs of production and marketing. The 20% ‘add-on’ cost represents a contribution towards fixed overheads and profit, and is crucial to the continued success of our business. In future, no order will be accepted at a lower price unless specifically authorised by the marketing manager.

3.The reasons I have heard from salesmen for not adhering to this policy are two-fold. Firstly, it has been argued that we need to price lower to meet competition. Secondly, it is stated that we do not adhere to this policy on internal sales.

I have no sympathy with these arguments. If a competitor wishes to fill his plant with low-priced business, then let him. We wish to obtain good quality business, even if that means we sometimes operate at less than maximum production; I would rather turn away such low-margin business in the expectation that we will obtain sufficient full-price business. Given our reputation for quality and service, we should be able to compete effectively with this pricing policy.

Regarding internal sales, I agree that it would be inconsistent, and possibly demoralising, if we did not adhere to the same policy for these sales. Let me assure you that interdivisional sales will be subject to exactly the same pricing policy as external sales.

ALL sales quotations must include the full 20% mark-up.

Role for Mr David Norton

You are the divisional general manager of the Northern Division of the Beech Paper Company. Recently, while examining bids from different companies for a major order of boxes that your division was planning to buy, you discovered the following. One company, Scott Packaging, had submitted a bid for £410 per thousand boxes. A second company, Irish Paper, had bid £432 per thousand boxes. The Carton Division of your own company had also been asked to bid, as was normal practice, but had submitted a bid of £480 per thousand boxes (Exhibit 5).

Exhibit 4 Summary Budget: Northern Division (Year Ending 30 June 1989)

£000s £000s

Sales Revenue

From external customers outside of Beech 6,000
Western Division 500

6,500

Costs

Manufacturing

Materials

Purchased from outside 1,320
Purchased from Carton Division 720
Purchased from Waste Paper Division 1,340
Labour 625
Variable overhead 330
Fixed overhead 470

4,805

Marketing

Commissions 290
Order-filling 150
Advertising 110
Other 125

675

Administration 590
Share of Head Office costs 100

Total costs 6,170

Budgeted gross profit margin 330
Required profit (6% of sales revenue) 390

Budgeted excess/(deficiency) (60)

Exhibit 5 Summary of Bids for Special Display Boxes: Northern Division

Scott Packaging Company£410 per thousand
Irish Paper Company£432 per thousand
Carton Division; Beech Paper£480 per thousand

Note:The Irish Paper Company would buy the ready printed outside linerboard from the Carton Division of Beech Paper, but supply its own internal liner and corrugating material. The outside liner would be supplied by Southern Division at a price equivalent to £90 per thousand and would be printed by the Carton Division for £30 per thousand. Southern and Carton Divisions’ variable costs are about 60% and 5/6 of these prices, respectively.

Since you know that the Carton Division has been operating at only about 80 per cent of its capacity for some time now, you were surprised at this difference in price. You telephoned Mr Hodge, the operations director of your company at Head Office, to ask his advice on how you should proceed, since it seemed undesirable to let the business go outside of the company. He suggested that, consistent with the decentralised philosophy of this company, you should discuss the matter with Mr Clark, the general manager of the Carton Division.

You are now on your way to see Mr Clark. Your objective is to resolve this issue in a way which is best for the company, but you are also very conscious of the fact that you and your division are evaluated according to your return on sales revenue, and that you must remain competitive.

Role for Mr Andrew Sutherland

You are the divisional general manager of the Southern Division of the Beech Paper Company. During the past year your division has been operating at less than its full capacity, due to a lack of orders. However, in the past few weeks you have received a considerable number of enquiries from potential customers and you are now confident that the internal and external business you can expect will enable you to operate at full capacity.

Your normal pricing policy has been to mark up your variable costs of both manufacturing and marketing an order by two-thirds both to cover your heavy fixed costs of plant and machinery, and also to provide you with a profit margin. During the past year you have not always been able to implement this policy and have taken some orders at a lower price so as to ensure that you obtained the business. However, because of the improved order position you now believe that all orders should be priced according to your normal policy, and you have prepared your budget submission on that basis.

You are a strong believer in the policy of decentralisation that has been introduced by your operations director, Mr Hodge, and have been pleased to accept the responsibility of running your division as if it were an independent company, despite your poor performance in the current year which has been mainly due to lack of market demand for your products. But you are not convinced that all your colleagues share these views. You have been approached in the past by the managers of other divisions seeking preferential terms because you are all part of the same company. In your view, this is inappropriate except to the extent that internal prices are lower than external prices because you do not include sales commission, advertising and promotion costs in internal transfer price quotations.

Exhibit 6 Summary Budget: Southern Division (Year Ending 30 June 1989)

Sales Revenue
From external customers outside of Beech
Carton Division
Costs
Manufacturing
Materials
Purchased from outside
Purchased from Western Division
Purchased from Waste Paper Division
Labour
Variable overhead
Fixed overhead
Marketing
Commissions
Order-filling
Advertising
Other
Administration
Share of Head Office costs
Total Costs
Budgeted gross profit margin
Required profit (6% of sales revenue)
Budgeted excess/(deficiency) / £000s
6,865
2,735
400
600
2,600
900
450
2,250
360
150
130
170 / £000s
9,600
7,200
810
690
100
8,800
800
576
224

Role for Mr Jim Hodge

You are the operations director of the Beech Paper Company at the Head Office in Warrington, Lancashire. Recently, Mr David Norton of your Northern Division telephoned you and confronted you with the following facts. In receiving bids for a large order of boxes which his division needed to buy,

he received the following quotations:

Scott Packaging Company£410 per thousand
Irish Paper Company£432 per thousand
Carton Division, Beech Paper£480 per thousand

Since he was aware of the fact that the Carton Division was currently operating at under 80 per cent of its capacity, he felt that this business could best be undertaken internally, and asked for your advice on what should be done.

You recently set up the Beech Paper Company’s system of decentralised management, in which each division is evaluated on its return on sales revenue, and believe that it provides the best structure for flexible and competitive operation. Whilst you could intervene and make special arrangements to adjust the reported profit figures of each division, you are very reluctant to do so. However, it does seem that there is something wrong if the Carton Division cannot compete on the open market, and it concerns you that such a large order might be lost to the company.

You have asked your chief accountant to analyse the situation, and he has produced a schedule of the costs to the company of accepting each alternative (Exhibit 7). Nevertheless, consistent with your style and philosophy of management, you suggest to Mr Norton that he visits Mr Clark, the Carton Division manager, to discuss the matter, and that they handle it themselves. It is possible, however, that they will come back to you later for help.

Exhibit 7

Memo

From:Mr A. Smith, Chief Accountant

To:Mr 1. Hedge, Operations Director

Date:9 June 1988

Comparison of Bids