# Paper Question Solution Marks Part a Analysis of the by icecube

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```									Paper 1 Question 3 Solution

Marks
Part (a)   Analysis of the budget and comments on the statements of the manager

Analysis of budget

•   The budget was drawn up on an absorption basis.                                                   1
•   A better understanding of the budget can only be gained if the variable costing approach is
used. For the analysis and specifically the break-even analysis, the fixed and variable costs     2
need to be split.
•   The stock increased from zero to 30 units. The increase would have had a positive effect on
the absorption profit (fixed cost included in closing stock). This has obviously created the      2
impression, wrongly so, that the position has improved. The position is therefore even
worse than suggested by the loss of R142 620.
•   The insurance income is a once-off item and is obviously in no way sustainable income.            2
Though the April budget will improve, the income should be ignored for purposes of
analysis.
•   Were there any additional costs budgeted for, or any losses in efficiency as a result of the
incident that resulted in the insurance claim.                                                     2
•   The head office allocation should be investigated carefully.                                       1
•   Any other valid comment.                                                                        1 each

For purposes of the analysis and so as to be able to react to the comments of
the manager, it is necessary to calculate the division’s break-even point:

Variable cost
Connectors                                                                                20.00       1
Casings                                                                           225.00/230.00       1
Impellers                                                                                250.00       1
Shafts (175 – 160 000/1000)                                                               15.00       1
Labour: assembly (2 x 50) (all other labour cost is fixed)                               100.00       1
Electric motors                                                                          450.00       1
Variable sales and administration (148 400 x 25%) / 970                                   38.25       1
Head office variable cost                                                                 14.00       1
Total variable cost                                                                    1 117.25
Sales price (1 703 320 / 970)                                                           1756.00       1

Contribution                                                                              638.75

Total fixed cost
Total production cost per unit: 1 622 000/1 000              1 622                                    1
Fixed cost per unit: 1 622–(20+230+250+15+100+450)             557
Total production fixed cost: 557 X 1 000                                                557 000       2
Non-manufacturing fixed cost: 148 400 x 75%                                             111 300
Head office fixed cost: 173 580 – (14x970)                                              160 000       2
Total fixed cost                                                                        828 300

Break even: 828 300 / 638.75                                 1 296.75 units                           1
Marks
Alternate calculation for breakeven

1 000 x 638.75 (contribution)                             638 750                                       1
Sales and admin costs                                    (111 300)
Production fixed costs                                   (557 000)
Negative contribution to head office fixed costs        (R29 950)                                       3

Note
The contribution derived from the sale of spare impellers is irrelevant, as the break-even point is
in excess of the capacity available to produce impellers. Consequently no spare impellers would
exist.

Check for comment explaining breakeven point (allow mark for explanation if calculated above,
or explanation if calculated below):                                                                    1
- Above, or                                                                                         1
- below
2
The break-even point seems very high, which begs the next question whether the division would
have enough capacity to achieve the necessary production level?

Capacity will be limited to the lowest level in the different components:
Impellers                          1150 units
Shafts                             1100 units
Shaft cutting                      No limit                                                             1
Casings (13 x 160 = 2080 / 2) 1040 units                                      testing
Impeller hours                     No limit                                                             1
Assembly                           No limit                                  commentary

The maximum capacity is therefore 1 040 units. With the break-even point of 1 296 units this
implies that the division can never reach the required break-even point at current production
capacity.

Break even excluding fixed head office costs
(828 300 – 160 000) / 638.75 = 1046 units                                                        1
Thus even if the head office fixed cost is ignored, the division would barely break even

A number of questions should be asked
• Why is the division not selling more units?                                                           1
• Can better cost control reduce the fixed cost?                                                        1
• Can the variable cost be reduced?                                                                     1
• If capacity can be increased, could demand be created?                                                1
• Are there alternative uses for the capacity (e.g. supplying agricultural units to Agri-water)?        1
Actions that could lead to profitability:
• Increase selling price, sensitivity issues                                                         1
• Increase volume of sales                                                                           1
• Marketing exercises, intense marketing                                                             1
• Special offers                                                                                     1
• Negotiating input prices with suppliers                                                            1
• Negotiating with unions on wages, incentive pay to increase efficiency                             1

max 5
Questions to be asked and action that could be taken (max 5 marks)

Possible price increase
Shortfall in break-even units = 326 x 638                      207 988 shortfall in contribution         3
Thus: increase in price required: 207 988 / 970                R214.42 per unit
% increase: 214.42 / 1756.00                                   12% increase
However, it is doubtful whether the market would accept such an increase or whether demand               1
would even drop further.

Concluding comment on manager’s statements
The manager’s statements OR reference to the profitability that the division’s profitability had
improved and that break even would be achieved was incorrect (at least not with current                1 each
production capacity and demand levels).
Total    53
Maximum        24
Marks
Part (b) The contribution per unit from accepting the order from
SA Mining Ltd

The calculation is based on the assumption that the order is a once-off
10.00 or
Connectors (assumed NRV = relevant cost, and that NRV = 10)                    R 12.50       1
Casings
Impellers: Variable cost (230 and 54)                                             284.00     2
Opportunity cost ((120 x 180) + (20 x 638))/200 (identifying and estimating)      250.00     2
Patent fee                                                                        171.80     1
Variable sales and administration costs                                            14.00     1
Shafts                                                                             38.25     1
15.00     1
Casing labour cost
(13x160 = 2 080 + 48 hours of units in stock)                             200.00     3
2 128 – (0.5x200 + 200x2 + 970x2) = 312 shortfall
312 / 160 = 1.95 labourers
Thus:Salaries (2x3x5 000)                 30 000
Training (2x5 000)                        10 000
Total                                     40 000 /200 units
OR
Casing : if recognize as a fixed cost and explain why left out                               3

Electric motor                                                                    450.00     1
Total relevant cost                                                             1 433.05
Quoted price                                                                    1 600.00
Contribution                                                                      166.95    1
Total    14
Maximum      9

Part (c)

Step 1 Determine the relevant cost for the SA Mining order (assume once-off)
As per calculation in part (b)                                                    166.95
Step 2 Determine the contribution earned by the internal transfer
of units to Agri-water (assume once-off)
Relevant cost
Variable cost of Pumpworks                   (1433.05-38.25)       1 433.05                 2 (1)
Other material cost                                                   400.00                 1
Piping                                                                 50.00                 1
185 x 1000 = 185 000
197.68 x 710 = 140 352
Difference is 3 increments of 1 000                                                         2
Therefore: 185 000 – (3x10 000) = 155 000                             342.00                2
155 000 – 140 352 = 14648 / 290 = 50.63                                                     1
Labour (assume variable)                                                                    1
Commentary on a high /low range                                                             1
Identifying the extra costs beyond 1 000 units produced
R10 000/200 units = R100 extra cost
Relevant cost per unit                                              2 225,05
Contract price (500 000/200)                                         2500,00                 1
Contribution per unit                                                             274.95
Marks
Thus further processing by Agri-water would result in a higher contribution.                           1
It would therefore be better for the company if the order from SA Mining (group) is not accepted       1
but the units rather transferred internally (divisional) for use on the Makatini project. However,     1
from the point of view of Pumpworks, it would be better to accept the SA Mining order, as the
price offered by Agri-water is lower than the price that Pumpworks can obtain from SA Mining.          1

Other factors to consider:
• Alternative usage of capacity created in Pumpworks for the order                                     1
• Future orders from SA Mining                                                                         1
• Future orders from KZN Government                                                                    1
• Any future orders that could “save” Pumpworks from possible closure.                                 1

Any other relevant point.                                                                    max 5

The advice to management of the company would be to negotiate with Agri-water to increase              2
the offer to Pumpworks from the R1 400 to a minimum price of R1 600 (which would equal the
external offer). At this point Pumpworks will become indifferent to the decision and the
management of Pumpworks could be convinced to accept the internal transaction.

Assuming that Agri-water has spare capacity, it would be willing to take on any new project that       1
yields a positive contribution.
Total     24
Maximum         9
Part (d)

•  The pricing strategy of Aqua-systems is a cost-plus basis.
•  This approach has a number of shortcomings:                                                         1
∗ the demand, competition and competitor prices may not have been considered in setting
the final selling price                                                                         1
∗ inefficiencies in the cost structure (fixed and variable) may be assumed as normal and
included in the pricing of the product                                                          1
∗ no mention is made of the fact that standard cost is used for pricing. Actual cost is not
appropriate and should a cost-plus basis be used, at least standard costs must be used.         1
Consider the stage in the life cycle of the product
Where the is market sensitive to price changes, consider a price skimming strategy                     1

A better approach may be to explore the use of a “target costing” approach. Though the product         1
is already on the market, it may be useful to explore the approach.

Any other relevant point that relates to the pricing strategy.                                         1
Total      7
Maximum        5

SUMMARY OF MARKS                              Marks
Part (a)                                        24
(b)                                        9
(c)                                        9
(d)                                        5

Presentation and language (3 for         3
neat and full answer)
Total                                            50

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