Question 8 [20 Marks]

Background Happy Dairy (Pty) Ltd produces milk powder and sells the powder to retailers in South Africa. The production process for milk powder can be summarised as follows: - Fresh milk is pasteurised and separated into skim milk and cream by using a centrifugal cream separator. - The milk is then preheated to destroy bacteria, inactivates enzymes and improve heat stability. - The milk is then evaporated by boiling it in a vacuum to remove the water as a vapour. - The milk is then spray dried by atomizing the milk concentrate from the evaporator into fine droplets, and then dried further into a powder with very little moisture content.

- The powder is then packed for distribution.

The factory has a capacity to process 100 000 litres of fresh milk per day at a cost of R10 per litre. To ensure a continuous supply of fresh milk, the management of Happy Dairy signed contracts with ten farmers in the district to take their full daily milk production up to 10 000 litres even in the event of a business interruption at the factory. It takes 100 000 litres to produce 15 000kg of powdered milk and 5 000l of cream. Powdered milk is sold at R70 per kg and cream at R60 per litre. Milk not used in production can be sold at R9 per litre for quantities below 20 000 litres but the price declines to R7 per litre for volumes above 20 000 as it floods the market.

The price to sell unprocessed milk is lower than the purchase price as special arrangements need to be made for processing and delivery to the buyers. Turnover R492,750,000 R364,462,894 Opening inventory R 3,116,766 Purchases and production R365,000,000 Closing stock R(3,653,872) Cost of goods sold R128,287,106 Variable cost R 16,616,308 Fixed (standing) cost R 52,781,826 Nett profit R 58,888,972

In a recent risk assessment, Happy Dairy identified significant weaknesses in its business continuity management strategy. To ensure that the company has sufficient insurance cover while correcting the weaknesses, the Board Risk Committee requested that the current business interruption section of the policy must be reviewed. Two scenarios were developed to gain an understanding of the quantum of risk under the scenarios and to serve as guidelines when renewing the policy. The fixed assets are covered under a different section of the policy. Use the difference method to calculate the gross profit for insurance purposes.

Show all calculations.

a. Scenario A There has been a power failure for two weeks. At this stage, Happy Dairy does not have sufficient backup facilities to continue with production. The factory will be closed for the period without power.

Assume there is no damage to the production facilities, and production can continue the day after power supply resumes.

b. Scenario B There is a 100% loss in production due to damage to significant components of the manufacturing process. Management has estimated the probabilities of three scenarios. The best-case scenario (30%) is that full production can commence after four weeks, and the worst-case scenario (20%) is that full production can only be restored after 20 weeks. There is also a 50% likelihood that production can only commence after 12 weeks. Assume that the daily (10 Marks)

reduction in gross profit is R 1 500 000. Argue the appropriate scenario to use as input to arrange business interruption cover for Scenario B.