Better Food Company recently acquired an olive oil processing company that has an annual capacity of 2,000,000 litres, and that processed and sold 1,400,000 litres last year at a price of $4 per litre. The purpose of the acquisition was to furnish oil for the Cooking div'n. The Cooking Div'n needs 800,000 litres of oil per year. It has been purchasing oil from suppliers at the market price. Production costs at capacity of the olive oil company now a division, are as follows:
Direct materials per litre $1.00
Direct Processing labour 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 Div'n. The manager of the Olive Oil Div'n argues that $4, the market price is appropriate. The manager of the Cooking Div'n 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 Div'n not sold to the Cooking Div'n can be sold top outsiders for $4 per litre.
Required:
(a) Calculate the operating income for the Olive Oil Div'n using a transfer price of $4.
(b) Calculate the operating income of the Olive Oil Div'n using a transfer price of $2.14.
(c) What transfer price(s) do you recommend? Calculate the operating income for the Olive Oil Division using your recommendation.