Better Food Company recently acquired an olive oil processing company
that has an annual capacity of 2,000,000 liters, and that processed and sold
1,400,000 liters last year at a price of $4 per liter. The purpose of the 
acquisition was to furnish oil for the Cooking Division. The Cooking 
Division needs 800,000 liters of oil per year. It has been purchasing oil
from supplies at the market price. Production costs at capacity of the olive
oil company, now a division, are as follows:  
       
Direct materials per liter $ 1.00  
Direct processing labor $ 0.50  
Variable processing overhead$ 0.24  
Fixed processing overhead $ 0.40  
 Total  $ 2.14  
       
Management is trying to decide what transfer price to use for sales from
the newly acquired company to the Cooking Division. The manager of the
Olive Oil Division argues that $4, the market price, is appropriate. The 
manager of the Cooking Division argues that the cost of $2.14 should be
used, or perhaps a lower price, since fixed overhead cost should be 
recomputed with the larger volume. Any output of the Olive Oil Division not
sold to the Cooking Division can be sold to outsiders for $4 per liter. 
       
Required:     
       
aCompute the operating income for the Olive Oil Division using a 
 transfer price of $4.    
       
bCompute the operating income for the Olive Oil Division using a 
 transfer price of $2.14.    
       
cWhat transfer price(s) do you recommend? Compute the operating
 income for the Olive Oil Division using your recommendation.
    • 6 years ago
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