UKZN 2023 Test 3 Question 2

WEEK 17

Timothy Reed (Pty) Ltd (‘Timothy Reed’) is a South African (SA) paint manufacturing company. Founded in
1957, the company was originally family-owned but in 2003, was sold to two private investors. These
investors also serve on the board of directors. The company is well recognized nationwide and comes highly
recommended within the construction industry due to the durability of its product range. This has made
them particularly popular in the coastal regions of South Africa, where the presence of salt deposits in the
atmosphere is known to cause accelerated wear and tear on the exterior of painted buildings.

The company has traditionally focused on 3 commercial product ranges, each with up to 100 different
gradients or paint colours.

Home Basic Designed for budget-conscious individual

consumers.

Home Luxury The premium line is designed for individual

consumers.

Comm – Exterior The main product range is designed for

commercial buildings.

In 2020, during the COVID-19 pandemic, the construction industry in South Africa experienced a drastic
downturn. Lockdown regulations left many large construction contracts being halted. Furthermore, a large
part of the South African workforce worked remotely from home. This resulted in a decline in the demand
for paint maintenance contracts from Timothy Reed’s commercial clients.

In 2021, in order to protect the market value of the business, the private investors of Timothy Reed
instructed management to embark on extensive market research for alternative income streams. This
exercise proved to be fruitful, with the company identifying the opportunity to manufacture a new range
of paints that are specifically designed for arts and crafts. These paints are geared towards private schools
in SA that offer art as a subject. This range was branded as “Edu-paints”. With education being an essential
service, this solidified the company’s efforts to remain profitable while waiting for the construction industry
to fully recover.

In December 2022, the finance director of Timothy Reed sent the following email to the private investors.
In a haste to inform the investors of the financial results the financial manager did not attach “Annexure
One” referred to in the email below.
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 To: [email protected], [email protected]

From: [email protected]

Date: 25 December 2022

Subject: Edu-paints division – 2022 financial results

Dear Team

Great news! Edu-paints has done very well during 2022. We were nervous because of the significant
overhead costs related to this high-volume range, however, we managed to exceed our projected
revenue figures.

The school paints division has been in talks with the Department of Education as they would like for
us to also supply public schools in SA with the same range of paints. The main issue with this is the
current price of our paints. The Department of Education has significantly fewer resources to allocate
towards the purchase of paints than their private school counterparts.

We, therefore, need to consider ways to reduce the overall cost of production so that we can quote a
more competitive price for this contract.

We are currently using volume-based cost allocation drivers for all our products. I strongly believe that
if we adopt an activity-based costing (ABC) system, we would be able to determine a more accurate
cost for our products. Please see Annexure One as an attachment to this email wherein I detail the
benefits of using ABC costing as opposed to our current cost allocation basis.

Management was able to extract the following information relating to the Edu-paints manufacturing
process for the 2023 financial year:

Edu-paints are produced in units of 100ml bottles in either Glossy or Matte. For Glossy paints, it has been
determined that within a single bottle of the product, 75% of the weight of the product is attributed to the
base powder and dye element (semi-solids) whilst the remaining 25% is attributed to the liquid component.
For Matte paints, this proportion changes to 85% of the semi-solids and 15% of the liquid component. The
price of the semi-solid components is R750 per litre. The liquid component is priced at R250 per litre.

The company pays R150 per hour to its semi-skilled workers. Each semi-skilled employee spends 25 minutes
working on one bottle whereas the skilled workers spend 10 minutes working on a bottle. The remuneration

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policy is to pay skilled workers 1,5 times the rate of semi-skilled labour. This is consistent across both the
Glossy and Matte Range.

The following activities have been identified as being relevant to the production process. Total costs have
been determined based on the normal capacity volume of the factory which is 55 000 units of Glossy and
45 000 units of Matte.

ACTIVITY OVERHEAD COST PER ANNUM COST DRIVER

Production stage 1 - Mixing of R3 850 000 Machine A set up

solids and semi solids

Production stage 2 – Bottling and R1 870 000 Machine B set up

labelling

Production stage 3 - Mixing paint R 5 800 000 Mixer rotations

dyes and sealing bottles

Glossy paints require 0,1 machine A setups whilst Matte paints require 0,25 machine A setups per unit.
Glossy paints then require 0,35 machine B setups and Matte requires 0,85 machine B setups per unit. A
unit of Glossy paint requires 9 rotations of the mixer for the dye to be fully bonded with the other raw
materials whereas Matte paint requires 15 rotations per unit.

As part of the ABC costing exercise that was undertaken by management, a bottleneck was recognised in
the process. In order to preserve the main ingredient that contributes to the durability of the paints,
bottling occurs first prior to the dyeing process. This causes a production delay as bottles are then fed into
Stage 3 individually, which slows the overall production time.

The financial director has identified that this bottleneck can be removed by investing in an
APB–5000 model machine. This machine makes use of cutting-edge technology wherein the mixing and
bottling can be performed almost simultaneously while still achieving the same level of paint durability that
the brand is best known for.

The purchase price of the machine is R500 000 which management plans to depreciate over a period of 5
years as this reflects the remaining useful life of the school paints project. The company will claim wear and
tear at a rate of 40% in the first year followed by 20% over the next 3 years. Annual maintenance costs of
the machine are expected to be R25 000 per annum in year 1, with an expected 6% escalation in the cost
year on year from year 2 to year 5. The machine will then be sold for R100 000 at the end of the 5-year

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period. Management has already spent R10 000 in searching out and trialing an appropriate machine that
meets their purpose.

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FINANCING OPTIONS:

The company could opt to take out a special loan immediately to finance the purchase for the full value of
the machine at a rate of 11,5% per annum. The loan will be repaid in 5 equal instalments including both
interest and capital repayments.

The company could choose to lease the machine over the 5-year period for R70000 with an escalation
clause of 6% per annum. The company would need to pay a flat fee of R10 000 per annum towards a
maintenance plan. As the maintenance plan is being provided by a third-party provider, the payments are
required in advance every year. The machine would be returned to the lessor at the end of the lease term.

Assume that cash flows occur at the end of the relevant year unless indicated. There is no time lag in the
taxation of cash flows.

At a recent conference in the USA, one of the private investors of Timothy Reed engaged with the marketing
director of a company that produces a similar machine to the APB–5000. The private investor is of the
opinion that purchasing a similar machine from this supplier would provide long-term benefits to Timothy
Reed as they would have access to the latest technologies available from abroad.

The machine would be available at a cost of USD50 000. The private investor recognizes that this option
would expose the entity to foreign exchange risk and is considering ways to hedge this risk.

The applicable tax rate is 28%.

Sources and acknowledgements:

This is a fictional scenario.