QUESTION 1
Aqua-systems Ltd has two divisions. The Pumpworks division manufactures standardised electric water pumps for industrial use and the Agri-water division manufactures irrigation systems for agricultural purposes.
The normal production capacity of Pumpworks is 1 000 units per month, while an average of 970 units are sold. Pricing is based on a set mark-up as prescribed by Aqua-systems Ltd.
During a recent management meeting, the management of Aqua-systems Ltd reviewed the budgeted income statement of Pumpworks for April 2005. The manager of the Pumpworks division explained that the division is slowly but surely turning the corner. The division had improved its performance over the past three months and profitability should improve soon. In fact, the manager of Pumpworks indicated that the loss of the division has decreased and that it should reach a break-even position in five months' time.
However, the management of Aqua-systems Ltd is not convinced of this and they approached you, the management accountant of the company, to advise them on the likelihood that the Pumpworks division will return to profitability soon.
PUMPWORKS DIVISION
BUDGETED INCOME STATEMENT FOR THE MONTH ENDING 30 APRIL 2005
Notes R
Sales (970 units)
Less: Cost of sales
1 703 320
1 578 260
Opening stock (24 casings @ R205 each)
Production cost (1 000 finished units)
Closing stock (30 finished units)
4 920
1 622 000
(48 660)
Gross profit
Insurance claim
Sales and administration cost
Head Office allocation
1
2
3
125 060
54 300
(148 400)
(173 580)
Loss for the month (142 620)
Notes
1 During June 2004 the Pumpworks production facilities were damaged in a fire caused by an electrical fault. After initial problems with the insurance company, Aqua-systems Ltd received a letter from it shortly before the completion of the April budget to the effect that the amount of R54 300 was awarded to the company for the damage.
2 25% of sales and administration costs are variable.
3 Head Office overheads include a fee of R14 per water pump sold. The fee relates to a patent used on one of the components of the water pump.
Pumpworks has received two offers for contracts
1 The SA Mining Ltd offer
Pumpworks has been approached by SA Mining Ltd to supply 200 pumps for a project in the Limpopo Province in April 2005. They need a scaled down version of the water pumps that will be brought into use by the end of April 2005. 200 units will be required for the project, at R1 600 per unit. SA Mining Ltd has indicated that they will approach a competitor of Pumpworks if the latter were not interested in the order.
The following information relates to the normal production costs of Pumpworks and the order from SA Mining Ltd:
The cost of the water pump components and related labour costs are set out below:
(a) Pipe connectors
These units are bought from an external supplier. One connector is used per pump system. Pumpworks recently bought 250 pipe connectors at R20 each for use on the standard system. Unfortunately the units were the wrong size and Pumpworks planned to return them to the supplier. However, the supplier offered Pumpworks a 50% discount on the unit price for keeping the units. In anticipation of the possible contract to supply smaller water pumps to SA Mining Ltd, Pumpworks has now decided to accept the supplier's offer.
(b) Casings
Current casings could be modified to fit the specifications of the order. The modification will cost R54 and entail 30 labour minutes per casing. Information on the 24 standard casings that are in stock are as follows:
Cost
Replacement cost
Net replacement value
R
205 each
230 each
225 each
(c) Impellers
One set of impellers is used per pump. Pumpworks is able to manufacture 1 150 sets of impellers per month, at a total variable cost of R250 per set. It can sell any spare sets of impellers at R370 per set. No impellers are currently in stock. The total fixed cost for the production of impellers amounts to R132 000 per month, and represents depreciation on recently acquired machinery.
(d) Shafts
Shafts are cut from standard steel bars. Each bar is cut into one shaft. According to the stock sheets, the total cost (excluding labour) amounts to R175 per shaft. Pumpworks has the capacity to cut 1 100 standard shafts per month. Depreciation and other fixed costs (excluding labour) related to this activity amount to R160 000 per month.
(e) Electric motors
Electric motors are bought at R450 per unit. One motor is used per pump system.
(f) Labour
• Shaft cutting: Shaft cutting labourers are highly skilled. They are paid R60 per hour and work 160 hours per month. Because of the high cost of training, all five the shaft cutting labourers are full-time employees of the company.
• Casings: A total of 13 labourers are employed in this section. Each labourer receives a salary of R5 000 per month and works 160 hours per month. Each standard casing takes two hours to manufacture. New casing casters can be trained at a cost of R5 000 per employee.
The minimum employment period for these workers is three months.
• Impellers: Labour consists of full-time machine operators. Existing operators will be able to handle any expansion.
• Assembly: Labourers are paid R50 per hour to do the assembly. One pump system takes two hours to assemble. Assembly hours are not limited and can be adjusted as necessary.
2 The Agri-water offer
As an alternative to the SA Mining Ltd order, Agri-water has offered to buy the 200 smaller pumps from Pumpworks at a price of R1 400 per unit. The 200 pumps will be used for an irrigation project in the Makatini area in northern KwaZulu-Natal. Agri-water was approached by the government when the previous contractor became unable to complete the contract. The project is an initiative of the KwaZulu- Natal government and the contract price for the 200 irrigation systems on the Makatini project is R500 000. Agri-water has however been unable to source the correct water pumps for the project from any other supplier. Though the water pumps manufactured by Pumpworks are normally for industrial use and as such very powerful and generally too expensive for agricultural purposes, they could be used for the Makatini project. Agri-water has sufficient capacity to complete the contract.
The cost for one irrigation system is as follows:
Notes R
Material (excluding piping) 1 1 800
Labour 342
Piping 2 174
Manufacturing fixed cost 210
Total cost 2 526
Notes
1 Material cost includes the cost of R1 400 per unit that will have to be paid to Pumpworks.
2 Piping costs consist of both the piping used per unit and the maintenance of equipment. Previous records show that the cost per unit changes with changes in output. At an output of 1 000 units the cost per unit is R185 while the cost per unit at an output of 710 units is R197,68. Further, for every 100 unit increase (or part thereof) in output, maintenance costs increase by R10 000.
REQUIRED
(a) Analyse and discuss the budgeted income statement for April 2005 and the detailed costs of Pumpworks, and
(i) specifically comment on the statement by the manager of Pumpworks that the division is capable of returning to profitability within the next five months, and
(ii) suggest possible actions that could lead to profitability for the division.
(b) Calculate the contribution per unit that Pumpworks would make if it accepted the order from SA Mining Ltd.
(c) Advise the management of Aqua-systems Ltd on whether Pumpworks should supply Agriwater with 200 pumps as opposed to accepting the SA Mining Ltd order. Show all your workings and provide detailed reasons to support your answer.
(d) Comment on the pricing strategy used by Aqua-systems Ltd.