QUESTION 1 110 marksAzania Engineering (Pty) Ltd (“Azania”) manufactures and supplies generator sets to customers in the hospitality, retail, telecommunications and health care industries. Over the past 18 months the demand for generator sets (“gensets”) has increased significantly because of the frequent power outages experienced in major cities in South Africa and the perception that electricity demand will outstrip supply in the country over the next five to ten years. Gensets are primarily used as back-up power sources when the electricity supply is disrupted.Azania produces diesel powered gensets at its factory situated in Wadeville, Johannesburg. The sales and marketing, procurement, finance and administrative functions are located in the same building. The business was founded in 1985 by Mr Diggory Lewis and has grown into one of the leading suppliers of diesel gensets. Mr Lewis retired in 2005 and his family trust still retains a 100% shareholding in Azania. The business is run by the executive directors, who have all been employed by Azania for more than ten years.The major components, by value, of a genset are the diesel engine, alternator, sheetwork (metal frames or canopies in which gensets are housed) and the electrical control panel. Azania has always imported diesel engines from various European suppliers renowned for the reliability and quality of engines supplied. Alternators, electrical control panel components and sheetwork are sourced from local suppliers.

Azania designs gensets using computer assisted design software which it then uses for the assembly of the components. All assembly operations, including electrical wiring and instrumentation work, are performed at the Wadeville factory.Azania produces custom-built gensets according to specific requirements of customers. This strategy, as opposed to building standard gensets, has differentiated Azania from other suppliers in South Africa. The company has found that most customers have unique requirements regarding power output, genset design, control systems, sound shields, etc., which are generally not met by standard genset product ranges. While some suppliers do sell standard gensets, this invariably means that their customers either acquire gensets which produce too much power for their needs (and incur unnecessary expense) or that there is some aspect of the standard genset design that does not suit their requirements.In the industries in which most of the company’s customers operate, back-up power is a critical requirement. Customers accordingly place a high value on reliable and high quality gensets and tend to be less price sensitive in procurement decisions. Azania has many long standing customers.Because of the tremendous increase in market demand for gensets, factory staff has worked extensive overtime at the Azania factory during the months of July, August and September. The company is considering expanding its premises and employing more factory staff to increase capacity.Extracts from the detailed management accounts of Azania for the financial year ended 31 December 2005 and the nine months ended 30 September 2006, together with the revised budget for the year ending 31 December 2006, are summarised below:1AZANIA ENGINEERING (PTY) LTDABRIDGED INCOME STATEMENTSNotesActualresultsYear todate resultsRevisedbudgetDecember2005September 2006December2006R’000R’000R’000Revenue42 36055 06075 616Cost of salesRaw materials1(23 383)(32 045)(44 687)Direct labour(4 092)(6 569)(9 140)Manufacturing overheads2(3 274)(3 277)(4 420)Gross profit11 61113 16917 369Non-manufacturing overheads(4 550)(3 822)(5 605)EBITDA7 0619 34711 764Depreciation(660)(480)(640)EBIT6 4018 86711 124Interest income560460590Profit before tax6 9619 32711 714Tax(2 026)(2 706)(3 395)Profit after tax4 9356 6218 319Notes1 Forward exchange contracts (FECs) are taken out specifically for all diesel engines imported from Europe. Azania does not bear any risk relating to fluctuating exchange rates and passes on FEC costs to customers. The contracts are entered into with the bank in the name of Azania and a separate agreement is entered into with each customer to transfer the costs of the relevant FEC to that customer. The euro exchange rate has been particularly volatile during 2006. In early January 2006 the €:ZAR exchange rate was €1:R7,25 but by 30 September 2006 the rate had moved to €1:R9,40. The cost of diesel engines represented 55% of the total cost of sales in the 2005 financial year.2 Manufacturing overheads comprise water and electricity, assessment rates on property, insurance, allocated salaries, depreciation of plant and equipment and premises rental paid. Management is confident that overhead expenditure is accurately allocated to cost of sales and non-manufacturing overheads on the appropriate bases.2Manufacturing overheads are classified into fixed and variable costs:ActualresultsYear todate resultsDecember2005September 2006R’000R’000Fixed costs2 4542 006Variable costs8201 271Total manufacturing overheads3 2743 277Costing systemThe procurement division prepares Excel spreadsheets for each customer order. The cost of the specific engine that will be imported for each particular genset is determined after obtaining supplier quotes and FEC rates from the company’s commercial bank. Supplier quotes for other raw materials are also recorded and accumulated. Labour costs are estimated to a specific percentage of the total cost of raw materials, which was 15% for the 2006 financial year. Manufacturing overheads are also estimated for the purposes of determining the cost of specific gensets. The policy for the past three years has been to include manufacturing overheads at 15% of total raw material costs for the purposes of the costing spreadsheets.Having estimated the total cost of sales for each order, Azania adopts a cost-plus pricing policy. For the past five years the mark-up has been 32,5%. The depreciation of the rand has resulted in increased diesel engines costs – and therefore increased genset costs – during the current financial year.Management analyses and reviews individual cost of sales expense items on a monthly basis to identify any production issues and monitor gross profit margins.Special order: Axw Healthcare LtdAxw Healthcare Ltd (“Axw”) has approached Azania to supply gensets to 15 of its hospitals throughout South Africa. The group has decided to replace some gensets because of the increasing cost of maintaining them and because the gensets are no longer reliable.Azania is currently operating at peak production capacity during normal operating hours. Factory staff is already working overtime during the week and on weekends in order to fulfil customer orders. Axw wants the gensets to be delivered to their hospitals during the three-month period ending 31 March 2007. The procurement division has prepared a detailed costing spreadsheet, the salient information of which is summarised below:3COSTING ESTIMATEFOR Axw HEALTHCARE LTD SPECIAL ORDEROrder number: AZ10092€FEC rateRDiesel engines605 0009,555 777 750Alternators1 425 000Electrical control panels940 000Sheetwork427 500Other raw materials880 000Total raw materials9 450 250Estimated direct labour costs1 417 537Estimated manufacturing overheads1 417 538Total cost of sales12 285 325The executive directors of Azania are uncertain as to how to price this special order. They are keen to secure the order, as it may lead to genset orders for the other 85 hospitals in the Axw group over the next three years. They would also prefer to minimise the potential risk of losing other customers because of an inability to supply them. However, the production manager of Azania, Mr Adam Zebra, has estimated that in order to manufacture and deliver the gensets for Axw during the period January to March 2007, factory staff will have to continue to work overtime. Furthermore, there is a risk that Azania may not have the capacity to accept orders from existing customers that may potentially be placed for delivery during this period.Chinese importsThe executive directors are considering importing fully assembled gensets from Chinese suppliers. This possibility is being considered because of the production capacity problems currently being experienced at the Wadeville factory of Azania – a position which will be exacerbated if Azania accepts the Axw order.Azania has examined and tested a number of different Chinese sourced gensets during the past two months. While the initial results indicate that these gensets should operate to acceptable standards, they are unlikely to meet exact requirements of Azania customers. From those reviewed, the gensets produced by Zhexin Co Ltd (“Zhexin”) were found to have the lowest cost, and they were the second best from a design and operational perspective. Fully assembled gensets can be imported from Zhexin at a price (including import duties) which would on average be 10% lower than Azania’s current total manufacturing cost for similar gensets.The executive directors are uncertain about how much they should mark up the imported gensets from Zhexin.Mr Zebra (the production manager of Azania) recently spent two weeks inspecting the manufacturing facilities of Zhexin in China. The executive directors subsequently discovered 4that Mr Zebra spent an additional week at a holiday resort in Thailand, which was fully paid for by Zhexin. This discovery was made when Mr Zebra sent an e-mail message to friends in which he told them about the resort, and about various deep sea fishing trips and lavish dinners paid for by Zhexin, to which he inadvertently added the e-mail address of the managing director of Azania.Maintenance contractsAzania gensets carry a 12-month warranty for replacement or repair of any defective parts, subject to the gensets being operated in accordance with their design specifications. Azania has not in the past offered customers the additional option of maintenance contracts, but this option is now being explored by Azania. There are currently 750 gensets in use by customers, which Azania has supplied over the years.Maintenance contracts will essentially entail routine three-monthly inspections of customer gensets by Azania personnel, as well as replacement of any worn parts (at the customer’s expense) and general repair work required. Contracts would also provide customers with peace of mind, as Azania will guarantee that service personnel will repair gensets within eight hours of the breakdown being reported. It is expected that proactive and regular maintenance of gensets would be of great benefit to customers, by improving operating performance of equipment and prolonging the useful lives of gensets.The following preliminary abridged budget has been prepared to evaluate the feasibility of establishing a maintenance division and to determine the pricing of maintenance services:AZANIA ENGINEERING (PTY) LTDMAINTENANCE DIVISIONFIRST DRAFT BUDGET2007 yearR’000Maintenance revenue (750 installed gensets @ R1 500 permonth)13 500Gross profit on expected sale of parts4 500Direct labour costs (15 technicians + 15 assistants + supervisor)(6 600)Depreciation of motor vehicles(560)Travelling expenses(920)Contribution9 9205REQUIREDMarks(a)Analyse and compare the gross profit margin for the nine months ended 30 September 2006 with the gross profit margin for the year ended 31 December 2005. Identify possible reasons for the change and list issues that need to be investigated further.15(b)Critically review the costing system currently used by Azania Engineering (Pty) Ltd to estimate genset costs and identify any potential weaknesses in the system. You should also outline possible improvements to the system.15(c)Discuss the factors, other than the pricing of the order, that Azania Engineering (Pty) Ltd should consider in evaluating whether to accept the special order from Axw Healthcare Ltd.10(d)Review the costing for the Axw Healthcare Ltd order and identify issues that should be investigated further or clarified.6(e)List the key factors that should be considered in determining a selling price for the Axw Healthcare Ltd special order. Suggest a pricing range to the executive directors of Azania Engineering (Pty) Ltd and show all workings.8(f)List the issues that should be considered in deciding whether to import gensets from Zhexin Co Ltd for supply to Azania Engineering (Pty) Ltd customers.12(g)Discuss the ethical issues arising from the fact that the stay of Mr Zebra, the production manager, at a holiday resort in Thailand was paid for by Zhexin Co Ltd, from the perspective of Azania Engineering (Pty) Ltd. List any further information you would require in order to evaluate whether his actions were ethical or not.10(h)Critically review and comment on the draft budget prepared for the proposed maintenance division of Azania Engineering (Pty) Ltd. What further information would you require to evaluate the feasibility of establishing the new division?12(i)Identify and explain the key business risks facing Azania Engineering (Pty) Ltd.12(j)Discuss the accounting implications of the FECs taken out for the imported diesel engines in the annual financial statements of Azania Engineering (Pty) Ltd. In your discussion consider recognition, measurement and presentation. Ignore deferred tax.106