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 market 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 suppliers at the market price. Production costs at capacity of the olive oil company, now a division, are as follows:

Direct materials per liter

$1.00

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.

Question 1: Compute the operating income for the olive oil division using a transfer price of $4.

Question 2: Compute the operating income for the olive oil division using a transfer price of $2.14.

Question 3: What transfer price(s) do you recommend? Compute the operating income for the olive oil division using your recommendation.