QUESTION

You have recently joined Slam (Pty) Ltd, a company that manufactures and distributes brake pads to the automotive industry, as a financial accountant. The managing director and majority shareholder has asked you to assist him in interpreting the draft financial results for the year ended 28 February 2003 and to review the budget for the new financial year.

As part of his preparations for the budget for the financial year ended 28 February 2003, the previous accountant completed a breakeven analysis and concluded that the breakeven production and sales volumes amounted to 20 500 units. The fact that the company only sold 20 000 units but is reporting a preliminary profit of R130 000 for the year ended 28 February 2003, has raised a concern about the integrity of the information generated by your department.

You have been able to establish the following:

1 The draft income statement for the year ended 28 February 2003 is as follows:
R
Sales
Cost of sales
2 000 000
1 700 000
Production costs
Inventory at beginning of year
Raw materials
Direct labour costs
Production overheads absorbed
Inventory at end of year: Finished products
-
500 000
600 000
1 025 000
(425 000)
Gross profit
Production overheads - over-recovery
Administration costs
Selling costs
300 000
90 000
(80 000)
(180 000)
Net income before tax 1 3 0 0 0 0

2 Sales and production had been budgeted for the 2003 year at 22 000 units. The budgeted selling price for the 2003 financial year was R100 per unit.

3 The company has access to a reliable supply of raw materials and therefore does not carry any raw materials inventory. There were no work-in-progress inventories at the beginning or end of the year.

4 Actual production volumes amounted to 25 000 units.

5 The actual unit costs and selling prices as well as fixed costs were all equal to budgeted amounts.

6 Production overheads and selling costs comprise both fixed and variable costs. Selling costs would have amounted to R190 000 at budgeted sales volumes of 22 000 units.

7 Administration costs are fixed.

8 For financial accounting purposes fixed production overhead absorption rates were set at R30 per unit at the beginning of the 2003 financial year. This was based on planned production volumes of 22 000 units.

9 Total actual and budgeted fixed production overhead costs incurred amounted to R660 000.

10 Production volumes of between 20 000 and 25 000 units per annum are regarded as being within the range of normal capacity.

Budget for 2004

As a result of the unexpected profit, a review of the 2004 budget was deemed necessary. Based on a discussion with the managing director and the sales and production managers, the following key assumptions were agreed upon:

1 Unit sales prices are expected to increase by 8%.

2 Sales volumes are expected to be 22 000 units.

3 Raw materials costs are expected to increase by 20%. All other unit variable costs are expected to increase by 10%.

4 A key objective in the forthcoming financial year is to achieve a net income before tax of 5% of turnover.

5 All fixed costs are expected to increase by 5%.

6 Production volumes of 21 000 units are forecast.

Special order

As a result of the supply disruptions caused by the recent liquidation of one of its competitors, Slam (Pty) Ltd has been invited to quote for a special order of 4 000 units, which is to be supplied during the course of the 2004 financial year. Product specifications vary from the existing brake pads that are produced and will accordingly require different machine settings. Therefore labour and variable production overhead costs are expected to be 50% higher for the first batch of 1 000 units than for the existing product. Thereafter an 80% learning curve is expected to reduce unit costs. Material costs are not expected to differ from the existing product. No variable selling costs will be incurred.

This special order was not taken into account in the 2004 budget. Because of current industry conditions, bidding for this order is likely to be highly aggressive. Slam (Pty) Ltd regards this order as an opportunity to gain a foothold in that market, which offers great expansion opportunities. As a consequence the managing director wants to quote the minimum price that can be charged while still producing profits that conform to the overall financial objectives of the company.

REQUIRED

(a) Reperform the calculation of the breakeven production and sales volumes based on the 2003 budget assumptions.

(b) Discuss, with reasons, the apparent contradiction between the budgeted breakeven sales and production volumes and the preliminary profit achieved in the 2003 financial year.

(c) Calculate the budgeted profit before tax for the 2004 financial year. Ignore the effect of the special order.

(d) Advise the managing director on possible steps that could be taken to enable the company to achieve its targeted profit before tax of 5% of turnover. Support your advice with calculations on how the target profit could be achieved. Ignore the effect of the special order.

(e) Discuss the factors to be considered in determining a selling price that should be quoted for the special order.

(f) Discuss whether closing inventories at 28 February 2003 have been appropriately valued at R425 000 in terms of the South African Statements of Generally Accepted Accounting Practice.