STRATEGIC MANAGEMENT

ICMA. ACCOUNTING (AF-601)

SEMESTER-6
Pakistan SPRING (AUGUST) 2014 EXAMINATIONS
Monday, the 18th August 2014
Extra Reading Time: 15 Minutes Maximum Marks: 100 Roll No.:
Writing Time: 03 Hours
(i) Attempt all questions.
(ii) Answers must be neat, relevant and brief.
(iii) Use of non-programmable scientific calculators of any model is allowed.
(iv) Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper.
(v) In marking the question paper, the examiners take into account clarity of exposition, logic of arguments,
effective presentation, language and use of clear diagram/ chart, where appropriate.
(vi) DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script.
(vii) Question Paper must be returned to invigilator before leaving the examination hall.
Answer Script will be provided after lapse of 15 minutes Extra Reading Time (9:15 a.m. or 2:15 p.m. [PST] as the case may be).
Marks
Q. 1 Excellent Engineering Limited is a medium sized, well established company, producing high
quality products. The company is performing quite well in terms of market share and
profitability during the last many years in the competitive environment. The management of
the company has a team of professionals and all the decisions are taken on merit taking into
account the pros and cons of a scenario. You are the management accountant of the
company and responsible to provide the various financial analyses to the management for
decision making.
Pricing of Product:
A board meeting is to be held in the next week where they will decide the pricing of a product
for the next period after considering the various options.
The following information is available from the records: Rupees
Previous Period Current Period
No. of units 100,000 106,000
Sales price per unit 26 26
Sales revenue 2,600,000 2,756,000
Costs 2,000,000 2,154,800
Profit 600,000 601,200

You find that between the previous and current periods there was 4% general cost inflation
and it is forecasted that costs will rise a further 6% in the next period. As a matter of policy,
the company did not increase the selling price in the current period although competitors
raised their prices by 4% to allow for the increased costs. A survey by economic consultants
was conducted and it is revealed that the demand for the product is elastic with an estimated
price elasticity of demand of 1.5 (i.e., the rate of change in demand is 1½ times of the price
change rate). However, there will be no change in demand if the Excellent Engineering Ltd.,
increases the price with its competitors.
Special Machinery Order:
Excellent Engineering Ltd., has just completed an order for a piece of special machinery for
Friends Engineering Ltd., and learnt that the company has defaulted on the order due to
bankruptcy. The selling price of the said order is Rs. 145,000 and Excellent Engineering Ltd.,
has right to forfeit the deposit of Rs. 14,500 as per contract agreement. The product manager
of the Excellent Engineering Ltd., has identified the costs already incurred in the production of
the special machinery for Friends Engineering Ltd., as follows:

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Rupees
Direct material 33,200
Direct labour 42,800
Manufacturing overhead applied:
Variable 21,400
Fixed 10,700 32,100
Fixed selling and administrative costs 10,810
Total 118,910

Another company, Novelty Engineering Ltd., is also interested to buy the special machinery if
it is reworked to Novelty’s specifications. Excellent Engineering Ltd., offered to sell the
reworked machinery to Novelty as a special order for Rs. 136,800. However, Novelty would
pay the price when it takes delivery in two months. The additional identifiable costs to rework
the machinery to Novelty’s specifications are as follows: Rupees
Direct material 12,400
Direct labour 8,400
Total 20,800

A second alternative available to Excellent Engineering Ltd., is to convert the special

machinery to the standard model, which sells for Rs. 125,000. The additional identifiable costs
for this conversion are as follows: Rupees
Direct material 5,700
Direct labour 6,600
Total 12,300

A third alternative for Excellent Engineering Ltd., is to sell the machine as it is for a price of
Rs. 104,000. However, the potential buyer of the unmodified machine does not want it for 60
days. This buyer has offered a Rs. 14,000 down payment, with the remainder due upon
delivery.
The sales commission rate on sales of standard models is 2%, while the rate on special order
is 3%. Normal credit terms for sales of standard models are 2/10, net/30. In general,
customers pay the bills for the standard model within discount period. However, credit terms
for a special order are negotiated with the customer(s). The time required for rework is one
month.
The allocation rates for manufacturing overheads and fixed selling and administrative costs
are as follows:
Manufacturing costs:
Variable 50% of direct labour cost
Fixed 25% of direct labour cost
Fixed selling and administrative costs 10% of the total of direct material, direct
labour, and manufacturing overhead costs

Marketing a New Product:

Excellent Engineering Ltd., is also considering whether to develop and market a new product
Liphon. Development costs are estimated to be Rs. 360,000, and there is a 0.75 probability
that the development effort will be successful and a 0.25 probability that the development
effort will be unsuccessful. If the development is successful, the product will be marketed, and
its possible outcome would be as under:
Possible Outcome Profit/ (Loss) (Rs.) Probability
Very successful 1,080,000 0.4
Moderately successful 200,000 0.3
Failure (800,000) 0.3
Each of the above profit and loss calculations is after taking into account the development
costs of Rs. 360,000.

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Required:
(a) What would be the financial outcome if the company maintains the Rs. 26 selling price
for the next period whereas competitors will increase their prices by 6%. Would your
financial outcome be different if the company also raises its price by 6%? 14
(b) Write a short report to the board, with appropriate figures, recommending whether the
company should maintain the selling price of Rs. 26 or raise it by 6%. 03
(c) State what assumptions you have used in fixing the selling price for the next period. 03
(d) Determine the net contribution each of the three alternatives of piece of special
machinery will add to Excellent Engineering Ltd.’s profit before tax. 07
(e) If Novelty makes a counteroffer, what is the lowest price Excellent Engineering Ltd.,
should accept for the reworked machinery? Explain your answer. 04
(f) Discuss the influence of fixed manufacturing overhead cost should have on the sales
price quoted by Excellent Engineering Ltd., for special orders. 02
(g) Demonstrate the viability of launching the new product Liphon by a decision tree. 07

Q. 2 (a) Syed Ltd., sells books and software over the Internet. The CEO of the company was on
business tour in Dubai where he learned that his company is not efficient in inventory
handling costs. Companies in the same business have an average on purchasing,
warehousing, and distribution costs 13% of sales and these companies were quite
efficient as compared to Syed Ltd.’s results for the past year. The following information
is available for the year just ended:
Cost Driver Cost Driver Allocation
Activities Cost Driver
Quantity Cost (Rs.) Books Software
Receiving No. of purchase orders 2,000 600,000 70% 30%
Warehousing No. of inventory moves 9,000 720,000 80% 20%
Outgoing shipments No. of shipments 15,000 450,000 25% 75%
The company sold books of Rs. 7,800,000 and software turnover was Rs. 5,200,000
during the year. An analysis of the company’s activities revealed various inefficiencies
with respect to the warehousing of books and outgoing shipments of software. These
inefficiencies resulted in an extra 550 inventory moves and 250 shipments, respectively.
Required:
(i) Describe the activity based management. Explain a non-value-added activity. 02
(ii) How much did non-value-added activities cost Syed Ltd., in last year? 02
(iii) Will the elimination of non-value-added activities allow Syed Ltd., to achieve a 13%
cost percentage for each of the product lines? Show calculations. 08
(iv) How much additional cost cutting is required to achieve the target percentage?
What methods might the company use to reduce the cost? 01

(b) Alliance Industries manufactures components for the heavy goods vehicle industry. The
company has set its annual goals for next year to increase its turnover by 25 to 30% and
enhance its profit at least by 15%. A substantial amount has been allocated for
promotional activities. The CFO of the company has suggested in the board meeting
that we should identify the most profitable customer or group of customers to allow
marketing efforts. The following annual information regarding three of its key customers
is available:
Customers X Y Z
Gross margin (Rs.) 947,000 1,120,000 1,106,000
General administration costs (Rs.) 70,000 134,000 112,000
Units sold (Nos.) 2,300 2,900 1,900
Orders placed (Nos.) 150 160 240
Sales visits (Nos.) 40 25 50
Invoices raised (Nos.) 155 195 525

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The company uses an activity based costing system and the analysis of customer
related costs is as follows: Rupees
Sales visits (per visit) 840
Order processing (per order placed) 380
Despatch costs (per order placed) 700
Billing and collections (per invoice raised) 194

Required:
How would you rank the customers using customer profitability analysis (CPA)? 05

Q. 3 The management of XYZ Ltd., recently decided to adopt a just-in-time (JIT) inventory policy to
overcome steadily rising costs and free up cash tied up in inventory for the purpose of
investment. The production manager is quite confident that inventory will decrease from
Rs. 7,200,000 to 1,200,000. It is expected that released funds could be invested @ 12% per
annum. The additional information on yearly basis is as under:
 The company would have savings in insurance and property taxes of Rs. 54,000 due to
reduction in inventories.
 XYZ Ltd., will lease 75% of an existing warehouse space to another firm for Rs. 8 per
square foot. The warehouse has 15,000 square feet.
 XYZ Ltd., is to remodel production and receiving dock facilities at a cost of Rs. 1,200,000
to accommodate the increased number of small shipment from the suppliers. The
construction costs will be depreciated over a 10-year life.
 A shift in suppliers will cause the purchase and use of more expensive raw materials
causing extra burden to the company of Rs. 200,000. However, these materials should
give rise to fewer warranty and repair problems after XYZ Ltd.’s finished product is sold,
resulting in net savings for the firm of Rs. 50,000.
 Three store men will be directly affected by the adoption of JIT decision. Two store men
will be transferred to other position with XYZ Ltd., and one will be terminated. Each
employee is earning Rs. 60,000 per annum.
 It is forecasted that reduced raw material inventory levels and resulted stockouts will cost
XYZ Rs. 140,000.
Required:
(a) Compute the annual financial impact of XYZ’s decision to adopt a JIT inventory system. 05
(b) If the JIT system is implemented in its true sense, what is the likelihood of excessive raw
material stockouts? 01
(c) Adoption of a JIT purchasing system will often result in less need for the inspection of
incoming materials and parts. Why? 01

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Q. 4 You are the newly appointed Management Accountant of Gama Ltd., a company provides
consultancy services to NGOs and various small industries. The operating statement for its IT
division which operates as profit centre for the year ended June 30, 2014 is as under:
Rupees
Budget Actual Variance
Chargeable consultancy hours 2,400 2,500 100
Central administration costs – fixed 30,000 31,500 1,500 (A)
Consultants’ salaries – fixed 160,000 168,000 8,000 (A)
Casual wages – variable 1,920 1,200 720 (F)
Motor and travel costs – fixed 8,800 8,800 -
Telephone – fixed 1,200 1,600 400 (A)
Telephone – variable 4,000 4,300 300 (A)
Printing, postage & stationery – variable 5,280 5,180 100 (F)
Depreciation of equipment – fixed 6,400 7,160 760 (A)
Total costs 217,600 227,740 10,140 (A)
Fees charged 360,000 400,000 40,000 (F)
Profit 142,400 172,260 29,860 (F)

The IT division’s manager Mr. Kamal Alvi, having the IT background, does not know how
flexible budget differs from the static budget. In the beginning of July 2013, he was assigned
the budget and he is extremely happy that the actual profit has exceeded the budget
expectations by Rs. 29,860. He is keen to know how this has been achieved.
You have determined that central administration costs are not directly attributable to the profit
centre but depreciation of equipment is an attributable cost. However, depreciation is not a
controllable cost since the profit centre manager has no control over investment decisions.
Required:
(a) Explain the present approach to budgeting adopted in Gama Ltd., and discuss the
advantages and disadvantages of involving consultants in the preparation of future
budgets. 07
(b) Prepare an alternative statement for the profit centre which distinguishes clearly
between controllable profit and attributable profit and which provides a realistic measure
of the variances for the period. 08

Q. 5 (a) Spices Food Ltd., is a local fast food chain. The company have many outlets across the
city, being managed as divisions. The performance of each division manager is
evaluated on the basis of Return on Investment (ROI) for award of bonus. The company
as a whole produced a 13% return on its investment.
Recently, the company’s Alpha Division was approached by Ehsan Ltd., a company in
the same business, and offered to sell its running business. The following data is
available to recent performance of Alpha Division and the Ehsan Ltd.:
Rs.‘000’
Alpha Division Ehsan Ltd.
Sales 16,800 10,400
Variable costs (% of sales) 70% 65%
Fixed costs 4,300 3,340
Invested capital 3,700 1,250

The management of Alpha Division has determined that in order to upgrade the Ehsan
Ltd., to the standards of Spices Food Ltd., an additional capital of Rs. 750,000 would be
needed.

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Required:
(i) Compute the current ROI of the Alpha Division and ROI after the acquisition of
Ehsan Ltd. What is the likely reaction of Alpha Divisional management towards the
acquisition? Why? 06
(ii) What is the likely reaction of Spices Food Ltd.’s management towards the
acquisition? Why? 04
(iii) Would the division be better off if it does not upgrade the Ehsan Ltd., to Spices
Food Ltd.’s standards? Show computations to support your answer. 02
(iv) Assume that Spices Food Ltd., uses residual income to evaluate performance and
desires a 12% minimum return on invested capital. Compute the current residual
income of the Alpha Division and its residual income if the Ehsan Ltd., is acquired.
Will divisional management be likely to change its attitude towards the acquisition?
Why? 03

(b) Delta Division operates as an investment centre. The managing director of the division
attended a seminar last week on Economic Value Added (EVA), a tool of performance
measure and was quite impressed by the idea. He has asked you to calculate the EVA
of Delta Division. The requisite information are as under:
 The book value of the non-current assets is Rs. 166,000 but their replacement value
is estimated to be Rs. 196,000. Working capital in the division has a value of
Rs.38,000.
 The operating profits of the division for the year just ended were Rs. 37,000, after
charging historical cost depreciation of Rs. 16,200 and the costs of a major
advertising campaign is Rs. 12,000. The advertising campaign is expected to boost
revenues for two years. An economic depreciation charge for the period would have
been Rs. 24,600. The risk adjusted weighted average cost of capital (WACC) for the
company is 11% per annum. Ignore taxation.
Required:
Calculate the Economic Value Added (EVA) for Delta Division. 05

THE END

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