Problem 2 - Better Food Company recently acquired an olive oil processing compan
ID: 2381064 • Letter: P
Question
Problem 2 - Better Food Company recently acquired an olive oil processing company that has an annual capacity of 3,000,000 liters and that processed and sold 2,300,000 liters last year at a market price of $4.60 per liter. The purpose of the acquisition was to furnish oil for the cooking division. The cooking division needs 1,100,000 liters 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 liter
$1.25
Direct processing labor
0.60
Variable processing overhead
0.36
Fixed processing overhead
0.54
Total
$2.75
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 $4.60, the market price, is appropriate. The manager of the cooking division argues that the cost of $2.75 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 $4.60 per liter.
Question 1: Compute the operating income for the olive oil division using a transfer price of $4.60. (five points)
Question 2: Compute the operating income for the olive oil division using a transfer price of $2.75. (five points)
Question 3: What transfer price(s) do you recommend? Compute the operating income for the olive oil division using your recommendation. (five points)
Direct materials per liter
$1.25
Direct processing labor
0.60
Variable processing overhead
0.36
Fixed processing overhead
0.54
Total
$2.75
Explanation / Answer
Sales: External (1,200,000 x $4) $4,800,000
Internal (800,000 x $4) $3,200,000 $8,000,000
Cost of goods sold:
Variable (2,000,000 x $1.74) $3,480,000
Fixed (2,000,000 x $0.40) $800,000 $4,280,000
Operating income $3,720,000
b Sales: External (1,200,000 x $4) $4,800,000
Internal (800,000 x $2.14) $1,712,000 $6,512,000
Cost of goods sold:
Variable (2,000,000 x $1.74) $3,480,000
Fixed (2,000,000 x $0.40) $800,000 $4,280,000
Operating income $2,232,000
c Due to current demand in excess of the capacity, the Olive Oil Division should not be
penalized by having to sell inside. All sales equivalent to the current external
demand of 1,400,000 should be at the market price.
Current external demand 1,400,000
Current internal demand 800,000
Total demand 2,200,000
Capacity 2,000,000
Excess demand 200,000
Internal demand 800,000
Noncompetitive internal demand 600,000
Sales: External (1,200,000 x $4) $4,800,000
Internal (200,000 x $4) $800,000
Internal (600,000 x $2.14) $1,284,000 $6,884,000
Cost of goods sold:
Variable (2,000,000 x $1.74) $3,480,000
Fixed (2,000,000 x $0.40) $800,000 $4,280,000
Operating income $2,604,000
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