1 CPA – Part 2

Certified Public Accountants (Part II – Mock Exam)

Strategic Management Accounting
Time allowed; 3 Hour
Maximum Marks 100
Question -1
(a) A company is proposing to increase the credit period that it gives to customers from one calendar month to
one and a half calendar months in order to raise sales from the present annual figure of $24 million
representing 4m units per annum. The price of the product is $6 and it costs $5.40 to make. The increase in
the credit period is likely to generate an extra 150,000 unit sales. Is this enough to justify the extra costs given
that the company's required rate of return is 20%?
Assume no changes to inventory levels, as the company is increasing its operating efficiency.
Assume that existing customers will take advantage of the new terms.

Advise the company on whether or not it should extend the credit period offered to customers.
(5 marks)

(b) The finance director of Widnor Co has been looking to improve the company’s working capital management.
Widnor Co has revenue from credit sales of $26,750,000 per year and although its terms of trade require all
credit customers to settle outstanding invoices within 40 days, on average customers have been taking longer.
Approximately 1% of credit sales turn into bad debts which are not recovered.
Trade receivables currently stand at $4,458,000 and Widnor Co has a cost of short-term finance of 5% per
year.
The finance director is considering a proposal from a factoring company, Nokfe Co, which was invited to tender
to manage the sales ledger of Widnor Co on a with-recourse basis. Nokfe Co believes that it can use its
expertise to reduce average trade receivables days to 35 days, while cutting bad debts by 70% and reducing
administration costs by $50,000 per year. A condition of the factoring agreement is that the company would
also advance Widnor Co 80% of the value of invoices raised at an interest rate of 7% per year. Nokfe Co
would charge an annual fee of 0·75% of credit sales.
Assume that there are 360 days in each year.
Required:
Advise whether the factor’s offer is financially acceptable to Widnor Co. (5 marks)
(Total = 10 marks)
Question -2
Heat Co specialises in the production of a range of air conditioning appliances for industrial premises. It is about
to launch a new product, the ‘Energy Buster’, a unique air conditioning unit which is capable of providing
unprecedented levels of air conditioning using a minimal amount of electricity. The technology used in the Energy
Buster is unique so Heat Co has patented it so that no competitors can enter the market for two years. The
company’s development costs have been high and it is expected that the product will only have a five-year life
cycle.

Heat Co is now trying to ascertain the best pricing policy that they should adopt for the Energy Buster’s launch
onto the market. Demand is very responsive to price changes and research has established that, for every $15
increase in price, demand would be expected to fall by 1,000 units. If the company set the price at $735, only 1,000
units would be demanded.
2 CPA – Part 2

The costs of producing each air conditioning unit are as follows:

$
Direct materials 42
Labour 12 (1.5 hours at $8 per hour. See note below)
Fixed overheads 6 (based on producing 50,000 units per annum)
Total cost 60

Note
The first air conditioning unit took 1·5 hours to make and labour cost $8 per hour. A 95% learning curve exists, in
relation to production of the unit, although the learning curve is expected to finish after making 100 units. Heat Co’s
management have said that any pricing decisions about the Energy Buster should be based on the time it takes to
make the 100th unit of the product. You have been told that the learning co-efficient, b = –0·0740005.

All other costs are expected to remain the same up to the maximum demand levels.
Required
(i) Establish the demand function (equation) for air conditioning units; (2 marks)
(ii) Calculate the marginal cost for each air conditioning unit after adjusting the labour cost as required by the
note above; (6 marks)
(iii) Equate marginal cost and marginal revenue in order to calculate the optimum price and quantity.
(2 marks)
(Total marks= 10 marks)
Question-3
The company plans to launch two new products, Alpha and Beta, at the start of July 2005, which it believes will
each have a life-cycle of four years. Alpha is the deluxe version of Beta. The sales mix is assumed to be constant.
Expected sales volumes for the two products are as follows.

Year 1 2 3 4
Alpha 60,000 110,000 100,000 30,000
Beta 75,000 137,500 125,000 37,500

The standard selling price and standard costs for each product in the first year will be as follows.
Product Alpha Beta
£/unit £/unit
Direct material costs 12·00 9.00
Incremental fixed production costs 8·64 6·42
Total absorption cost 20·64 15·42
Standard mark-up 10·36 7·58
Selling price 31·00 23·00

ARG traditionally operates a cost-plus approach to product pricing.

Incremental fixed production costs are expected to be £1 million in the first year of operation and are apportioned
on the basis of sales value. Advertising costs will be £500,000 in the first year of operation and then £200,000 per
year for the following two years. There are no incremental non-production fixed costs other than advertising costs.

In order to produce the two products, investment of £1 million in premises, £1 million in machinery and £1 million
in working capital will be needed, payable at the start of July 2005. The investment will be financed by the issue of
£3 million of 9% debentures, each £100 debenture being convertible into 20 ordinary shares of ARG Co after 8
years or redeemable at par after 12 years.
3 CPA – Part 2

Selling price per unit, direct material cost per unit and incremental fixed production costs are expected to
increase after the first year of operation due to inflation:

Selling price inflation 3·0% per year

Direct material cost inflation 3·0% per year
Fixed production cost inflation 5·0% per year

These inflation rates are applied to the standard selling price and standard cost data provided above. Working
capital will be recovered at the end of the fourth year of operation, at which time production will cease and ARG
Co expects to be able to recover £1·2 million from the sale of premises and machinery. All staff involved in the
production and sale of Alpha and Beta will be redeployed elsewhere in the company.

ARG Co pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in machinery
attracts a first-year capital allowance of 100%. ARG Co has sufficient profits to take the full benefit of this allowance
in the first year. For the purpose of reporting accounting profit, ARG Co depreciates machinery on a straight- line
basis over four years. ARG Co uses an after-tax discount rate of 13% for investment appraisal.

Required:
(a) Calculate the net present value of the proposed investment in products Alpha and Beta. (20 marks)
(b) Identify and discuss any likely limitations in the evaluation of the proposed investment in Alpha and
Beta. (5 marks)
(Total = 25 marks)
Question -4
County Preserves produce jams, marmalade and preserves. All products are produced in a similar fashion; the
fruits are low temperature cooked in a vacuum process and then blended with glucose syrup with added citric acid
and pectin to help setting.
Margins are tight and the firm operates a system of standard costing for each batch of jam.
The standard cost data for a batch of raspberry jam are:
Fruit extract 400 kg at £0.16 per kg
Glucose syrup 700 kg at £0.10 per kg
Pectin 99 kg at £0.332 per kg
Citric acid 1 kg at £2.00 per kg
Labour 18 hrs at £3.25 per hour

Standard processing loss 3%.

The summer proved disastrous for the raspberry crop with a late frost and cool, cloudy conditions at the ripening
period, resulting in a low national yield. As a consequence, normal prices in the trade were £0.19 per kg for fruit
extract although good buying could achieve some savings. The impact of exchange rates on imports of sugar has
caused the price of syrup to increase by 20%.

The actual results for the batch were:

Fruit extract 428 kg at £0.18 per kg
Glucose syrup 742 kg at £0.12 per kg
Pectin 125 kg at £0.328 per kg
Citric acid 1 kg at £0.95 per kg
Labour 20 hrs at £3.00 per hour

Actual output was 1164 kg of raspberry jam.

4 CPA – Part 2

You are required to

(a) calculate the ingredients planning variances that are deemed uncontrollable;
(4 marks)
(b) calculate the ingredients operating variances that are deemed controllable; (4 marks)
(c) comment on the advantages and disadvantages of variance analysis using planning
and operating variances; (4 marks)
(d) calculate the mixture and yield variances; (5 marks)
(e) calculate the total variance for the batch. (3 marks)
(Total 20 marks)
Question -6
Static Co is a multinational consumer goods company. Traditionally, the company has used a fixed annual
budgeting process in which it sets quarterly sales revenue targets for each of its product lines. Historically, however,
if a product line fails to reach its sales revenue target in any of the first three quarters, the company’s sales director
(SD) and finance director (FD) simply go back and reduce the sales revenue targets for the quarter just ended, to
make it look like the target was reached. They then increase the target for the final quarter to include any shortfall
in sales from earlier quarters.
During the last financial year ended 31 August 20X6, this practice meant that managers had to heavily discount
many of their product lines in the final quarter in order to boost sales volumes and meet the increased targets.
Even with the discounts, however, they still did not quite reach the targets. On the basis of the sales targets set at
the beginning of that year, the company had also invested $6m in a new production line in January 20X6. However,
to date, this new production line still has not been used. As a result of both these factors, Static Co saw a dramatic
fall in return on investment from 16% to 8% in the year.
Consequently, the managing director (MD), the FD and the SD have all been dismissed. Two key members of the
accounts department are also on sick leave due to stress and are not expected to return for some weeks. A new
MD, who is inexperienced in this industry, has been appointed and is in the process of recruiting a new SD and a
new FD. He has said:
‘These mistakes could have been largely avoided if the company had been using rolling budgets, instead of
manipulating fixed budgets. From now on, we will be using rolling budgets, updating our budgets on a quarterly
basis, with immediate effect.’
The original fixed budget for the year ended 31 August 20X7, for which the first quarter (Q1) has just ended, is
shown below:

Budget Y/E 31 August 20X7

Q1 Q2 Q3 Q4 Total
$000 $000 $000 $000 $000
Revenue 13,425 13,694 13,967 14,247 55,333
Cost of sales (8,055) (8,216) (8,380) (8,548) (33,199)
–––––– –––––– –––––– –––––– ––––––
Gross profit 5,370 5,478 5,587 5,699 22,134
Distribution costs (671) (685) (698) (712) (2,766)
Administration costs (2,000) (2,000) (2,000) (2,000) (8,000)
–––––– –––––– –––––– –––––– ––––––
Operating profit 2,699 2,793 2,889 2,987 11,368
–––––– –––––– –––––– –––––– ––––––

The budget was based on the following assumptions:

1. Sales volumes would grow by a fixed compound percentage each quarter.
2. Gross profit margin would remain stable each quarter.
3. Distribution costs would remain a fixed percentage of revenue each quarter.
4. Administration costs would be fixed each quarter.
5 CPA – Part 2

The actual results for the first quarter (Q1) have just been produced and are as follows:
Actual results Q1
$000
Revenue 14,096
Cost of sales (8,740)
––––––
Gross profit 5,356
Distribution costs (705)
Administration costs (2,020)
––––––
Operating profit 2,631
––––––
The new MD believes that the difference between the actual and the budgeted sales figures for Q1 is a result of
incorrect forecasting of prices, however, he is confident that the four assumptions the fixed budget was based on
were correct and that the rolling budget should still be prepared using these assumptions.
Required:
(a) Prepare Static Co’s rolling budget for the next four quarters. (10 marks)
(b) Discuss the problems which have occurred at Static Co due to the previous budgeting process and the
improvements which might now be seen through the use of realistic rolling budgets. (6 marks)
(c) Explain the terms ‘incremental budgeting’ and ‘zero-based budgeting’. (4 marks)
(Total = 20 marks)

Question -7
The following information relates to Preston Financial Services, an accounting practice. The business specialises
in providing accounting and taxation work for dentists and doctors. In the main the clients are wealthy, self-
employed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and aggressive sole
practitioner. He feels that promotion of new products to his clients would be likely to upset the conservative nature
of his dentists and doctors and, as a result, the business has been managed with similar products year on year.
You have been provided with financial information relating to the practice in appendix 1. In appendix 2, you have
been provided with non-financial information which is based on the balanced scorecard format.
Appendix 1: Financial information
Current year Previous year
Turnover ($’000) 945 900
Net profit ($’000) 187 180
Average cash balances ($’000) 21 20
Average debtor / trade receivables days (industry average 30 18 days 22 days
days)
Inflation rate (%) 3 3
Appendix 2: Balanced Scorecard (extract)
Internal Business Processes
Current year Previous year
Error rates in jobs done 16% 10%
Average job completion time 7 weeks 10 weeks
Customer Knowledge
Current year Previous year
Number of customers 1220 1500
Average fee levels ($) 775 600
Market Share 14% 20%
Learning and Growth
6 CPA – Part 2

Current year Previous year

Percentage of revenue from non-core work 4% 5%
Industry average of the proportion of revenue from non-core work 30% 25%
in accounting practices
Employee retention rate . 60% 80%

Notes
1. Error rates measure the number of jobs with mistakes made by staff as a proportion of the number of clients
serviced
2. Core work is defined as being accountancy and taxation. Non-core work is defined primarily as pension advice
and business consultancy. Non- core work is traditionally high margin work
Required:
(a) Using the information in appendix 1 only, comment on the financial performance of the business (briefly
consider growth, profitability, liquidity and credit management).
(b) Explain why non- financial information, such as the type shown in appendix 2, is likely to give a better indication
of the likely future success of the business than the financial information given in appendix 1.
(c) Using the data given in appendix 2 comment on the performance of the business. Include comments on
internal business processes, customer knowledge and learning/growth, separately, and provide a concluding
comment on the overall performance of the business.

(Total= 20 marks)