ADVANCED LEVEL EXAMINATION

TUESDAY 19 JULY 2022

(3½ HOURS)

STRATEGIC BUSINESS MANAGEMENT

This exam consists of two questions (100 marks).

Marks breakdown

Question 1 54 marks
Question 2 46 marks

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Question 1

Assume the date is 19 July 2022

Xavi plc is listed on the London Stock Exchange. It provides parcel delivery services.

You are an ICAEW Chartered Accountant who recently joined Xavi as an assistant manager
in its business and financial strategy department (BFSD).

The head of BFSD, Marcus Morris, calls you into his office and opens the meeting:

“The Xavi board has identified digital technology as a key area of risk and opportunity. A
number of issues have recently arisen in respect of the board’s digital transformation strategy
and it has requested BFSD to consider these.

“I realise that you are new to Xavi, so I have prepared background information about the
company (Exhibit 1).

“I have also provided you with information on a number of specific matters:

• The Xavi board decided to outsource a new digital platform and associated data
processing services. Tender bids have been received and I would like you to evaluate
these, so we can choose a supplier. I have provided supporting details on the tender and
the responses received (Exhibit 2).

• As part of the tender process, BFSD staff have commenced due diligence on two
potential suppliers. I have set out the matters that have arisen (Exhibit 3).

• The board has concerns about foreign exchange risks arising from one of the tender bids.
I have prepared my proposal for the board on how Xavi might hedge these risks and I
have set out a request for help (Exhibit 4).

• A sensitive ethical issue has arisen with respect to the tender process. As you are an
ICAEW Chartered Accountant, I would appreciate your opinion and I have prepared
background information (Exhibit 5).

“In respect of all these matters, I have set out instructions in a briefing note, explaining in
more detail what I would like you to do (Exhibit 6).”

Requirement

Respond to the instructions from the head of BFSD, Marcus Morris (Exhibit 6).

Total: 54 marks

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Exhibit 1: Background information about Xavi – prepared by Marcus Morris

Xavi offers parcel delivery services for businesses and individuals, mainly within the UK.

Xavi’s services include collection and delivery of parcels. These services are based on both
one-off and long-term contracts.

Operations are supported by an existing information system which records basic customer
and delivery details. Parcels are only tracked at a few key stages in their movement. There is
no real-time information on the progress and location of deliveries for Xavi’s employees and
customers.

There are concerns about the efficiency and data security of the existing information system.
Xavi suffered a cyber-attack in March 2021, which resulted in unauthorised access to
customer data and temporary loss of access to systems by all users.

As a result of the cyber-attack, a new chief executive, John Lightfoot, was appointed. He
previously worked for a global retail company. John initiated a strategic review, including an
assessment of the information system.

The strategic review concluded in November 2021 and recommended rapid digital
transformation. As a result, the Xavi board is in the process of implementing significant
investment in new digital hardware, software and supporting services.

Xavi has an accounting year end of 30 June and its functional currency is the £.

The board

The Xavi board comprises:

Director Position

John Lightfoot Chief Executive

Gabi Fogan Finance director
Tom Shilling IT director
Nancy Noon Procurement director
Ruijia Hassan Non-executive chairperson
Linda Lister Non-executive director

Gabi Fogan is an ICAEW Chartered Accountant.

Extracts from Xavi financial statements for years ended 30 June

2022 2021
£m £m
Revenue 2,280 2,340
Operating profit 151 162

Property, plant and equipment 767 754

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Exhibit 2: Tender for new digital information system – prepared by Marcus Morris

Background

As part of its digital transformation strategy, Xavi’s board decided to procure a new digital
platform and associated data processing services from a third-party supplier.

The contract will be awarded following a competitive tender process. In February 2022, an
invitation to tender document was issued to potential suppliers. The tender was given a high
level of publicity to ensure that all suitable companies were aware of the opportunity to
submit an outline bid in March 2022.

The new digital platform will offer improved tracking and data analysis facilities to monitor
real-time progress of individual parcel deliveries. It will also provide improved data security
and better management information for monitoring performance.

The Xavi board is extremely concerned about the risk of another cyber-attack as it estimated
that the previous cyber-attack cost £12 million. The board is therefore keen to improve data
security by implementing a new digital platform as soon as possible.

Key terms of the tender

There are two elements of the tender:

• the supply of a digital platform; and
• data processing services for three years, managed from a data centre provided by the
successful bidder.

An overall contract will be awarded to only one bidder. However, separate prices are required
for each element, based on the following proposed terms:

Element Tender pricing basis Date payable

Digital platform Fixed fee • 75% on implementation date

• 25% one year after
implementation date

Data processing services Fee per one million Annually in arrears

items processed

The planned implementation date is 1 January 2023.

The board estimates that data processing services will be needed for 65 million items each
year. This amount is uncertain, but there is a 95% probability that between 58 million and 72
million items per year will be processed each year. These estimates are based on an
approximate normal distribution.

Bids can be submitted in any currency.

The chosen supplier will be required to sign a service level agreement, which will include a
clause specifying penalties to be charged if agreed service standards are breached.

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The draft service level agreement includes the following proposed key penalty:

Breach of service standards Penalty

Cyber-attack involving significant loss of Repayment of the cost of each cyber-

customer data within the contract period. attack, up to a maximum of £10 million
per cyber-attack.

Bidders are permitted to suggest variations to the proposed terms and penalties as part of
their bid.

Awarding the tender contract

Price is a key factor in selecting the successful supplier. However, non-financial benefits and
risks will also be considered, so the contract will not necessarily be awarded to the lowest
bidder.

The Xavi board set up an evaluation committee to oversee the tender process, determine the
successful bidder and finalise contract terms.

The evaluation committee comprises:

• Gabi Fogan – finance director (evaluation committee chair)
• Tom Shilling – IT director
• Marcus Morris – head of BFSD

BFSD will support the evaluation committee in providing analysis and information during the
tender process.

The evaluation committee set out four stages in the tender process as follows:

Stage Stage completion date Description

Evaluation committee considers all outline bids

Stage 1 1 April 2022 submitted and selects a shortlist of suitable
suppliers to go forward to Stage 2.

Shortlisted suppliers prepare more detailed

Stage 2 1 June 2022 proposals and confirm a confidential final bid
price.

BFSD completes due diligence procedures.

Stage 3 1 September 2022 Evaluation committee reviews detailed
proposals and selects the preferred supplier.

Evaluation committee finalises contract terms

Stage 4 1 November 2022 and authorises contract signature.

The bidders

At Stage 1, ten suppliers submitted an outline bid.

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The evaluation committee reviewed these outline bids and selected two potential suppliers to
be shortlisted and go forward to Stage 2. These were:

DataSoft plc – A large UK listed technology company with a good track record in
delivering similar projects in a range of industries, including for competitors of Xavi.

Info Economy Software Inc (IES) – A large, US-based technology company with global
operations. IES is known for low-price bids and for delivering basic, but adequate,
products and services.

Bid summary sheet

The key aspects of the more detailed proposals prepared by the two shortlisted suppliers are:

Item DataSoft IES

Currency of bid £ US$

Digital platform – fixed £12.4 million US$8.2 million

fee

Data processing services £650,000 per one million US$870,000 per one million
fee items processed. items processed.

Period of data processing 3 years 3 years

contract

Payment terms – platform Willing to accept proposed Unwilling to accept proposed

fixed fee payment terms. payment terms.

Instead proposed that the

platform fixed fee should be
paid 100% on implementation
date.

Penalties Willing to accept penalty Unwilling to accept the

terms in the draft service
level agreement.
penalty for cyber-attack
outlined in the draft service
agreement.
Instead offered maximum
penalty of £5 million per
cyber-attack.

Other suggested new key
terms not in draft service
level agreement.
None IES will sub-contract the data
processing services element
of the contract to a small UK
supplier, but IES will retain
responsibility for service
delivery.

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 IES will receive the fee for
data processing services
from Xavi. IES will then pay
the subcontractor under a
separate agreement.

Working assumptions

• Xavi uses a discount rate of 10% per annum to evaluate projects.

• The exchange rate that will apply over the three-year period of the data processing
contract is: £1 = US$1.30

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Exhibit 3: Due diligence matters that have arisen – prepared by Marcus Morris

The evaluation committee selected DataSoft and IES as the two potential suppliers to be
shortlisted in the tender process. Xavi will carry out due diligence procedures.

Due diligence for DataSoft

On 15 July 2022, Xavi’s due diligence team were provided with the annual report and audited
financial statements of DataSoft for the year to 30 April 2022, which have just been issued.

DataSoft’s strategic report stated that the company is developing a new digital platform which
will be introduced in March 2024.

The new digital platform is expected to be radically different from the current version of the
platform that formed the basis of the tender bid to Xavi.

Producing this new digital platform requires significant further investment by DataSoft and, as
a result, it will need to borrow substantial sums. DataSoft also has an overdraft.

The DataSoft audit report was modified for a material uncertainty relating to going concern.
This was in respect of the ability to renegotiate an existing loan for £20 million owed to
DataSoft’s bank. The loan is repayable on 31 December 2022.

DataSoft’s bid team did not mention the above matters in the detailed tender proposal that
they submitted to Xavi.

Due diligence for IES

The Xavi due diligence team inquired about IES’s arrangement to subcontract the data
processing element of the contract. The IES board informed them that the intended
subcontractor is a small, UK-based company, Hibbert Ltd. IES and Hibbert have not worked
together previously.

Hibbert did not bid on the Xavi contract as it does not have the capability to provide the digital
platform. It carries out data processing services for one of Xavi’s smaller rivals, using a
similar digital platform provided by another third party.

Hibbert had annual revenue of £32 million for the year ended 30 June 2022, and it has been
growing in recent years.

The Xavi due diligence team intend to visit Hibbert’s data centre next week and they are
planning their due diligence procedures for the visit.

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Exhibit 4: Foreign exchange risk – prepared by Marcus Morris

Gabi, the Xavi finance director, is concerned about foreign exchange risk relating to the initial
payment for the platform, if IES is selected.

She has suggested that a £/US$ currency option should be entered into now, to hedge the
currency risk in advance of the tender being awarded.

Gabi has asked me to provide a briefing paper to explain the consequences and desirability
of a currency option and to provide an illustrative example for the board.

The paper should be based on the following working assumptions and illustrative data:

• Xavi will use a currency option to hedge foreign exchange risk on the US$ payment for
the digital platform
• The US$ payment to IES on 1 January 2023 will be US$8,200,000
• A currency option, with an expiry date of 1 January 2023, will be entered into on 1 August
2022
• The option is a traded sterling currency option
• The standard contract size is £10,000
• The £/US$ spot rate at 1 August 2022 will be £1 = US$1.3153–1.3156
• Interest should be ignored
• The following option premiums are quoted in cents per £1 and are payable on 1 August
2022, with a 1 January 2023 expiry date:

Strike Price Call Premium Put Premium

136 1.03 6.14

The strike price of 136 corresponds to an exchange rate of £1 = US$1.36

Request for help

To help me provide briefing notes for Gabi, I would like you to:

(a) Use the illustrative data and working assumptions to prepare calculations of the overall
cost (for the digital platform and the currency option), in £, based on each of the
following alternative £/US$ spot rates at 1 January 2023:
Alternative (1) £1 = US$1.2600 – 1.2620
Alternative (2) £1 = US$1.4100 – 1.4120

(b) Explain the factors that Xavi should consider in deciding whether to enter into the
currency option. Refer to your calculations in (a) and provide reasoned advice.

(c) Assuming that Xavi enters into the currency option, briefly set out and explain the
appropriate financial reporting treatment of the option in Xavi’s financial statements for
the year ending 30 June 2023, for each of the two alternatives in (a) above.

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Exhibit 5: An ethical issue – prepared by Marcus Morris

I have made the following notes to record an ethical issue that has arisen.

On 6 June 2022

The Xavi chief executive, John Lightfoot, expressed surprise that Toller Ltd, one of the 10
companies that made a Stage 1 outline tender bid, was not shortlisted by the evaluation
committee. John called the finance director, Gabi Fogan, and me (Marcus Morris) into his
office and said:

“I am really disappointed in the evaluation committee’s decision not to shortlist Toller.

This is just poor judgement. I have done business with Toller in the past and they are
a great company. I know Toller’s chief executive well and I was very reassuring to him
when we discussed the tender. I told him that Toller had a good chance of making a
successful bid. I have just found out that Toller did not even get through shortlisting,
which makes me look foolish.

“I want the evaluation committee to meet and reconsider this poor decision.

“If you cannot come to the right decision, I will demand that the board appoints me to
the evaluation committee. I will also invite Nancy Noon, the procurement director, to
join the committee. She used to work for Toller, so she knows them well.”

On 12 July 2022

The evaluation committee held a meeting. After some debate, both Tom Shilling, the IT
director, and I said we were happy with our original decision. We therefore both voted to
maintain DataSoft and IES as the only two shortlisted suppliers. Gabi Fogan, the finance
director, told us that she had changed her mind and voted to add Toller to the shortlist.

Proposed future board meeting

John Lightfoot has put an item on the agenda of the next board meeting, to be held on 3
August 2022, to discuss the tender. John is proposing that he and Nancy Noon should join
the evaluation committee.

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Exhibit 6: Instructions – prepared by Marcus Morris

(1) I would like you to:

• Evaluate and explain the factors that Xavi should consider in deciding whether to
award the tender contract to DataSoft or IES. Show supporting calculations.

• For each of the matters identified in Exhibit 3, identify and explain key risks for
Xavi. For each risk, set out due diligence procedures that BFSD should perform.
Include any information and explanations that will be required from the
management of DataSoft, IES and Hibbert.

Ignore the information in Exhibits 4 and 5.

(2) In respect of the foreign exchange risk relating to the initial payment for the platform,
respond to my request for help (Exhibit 4).

(3) Set out and explain any ethical issues for John Lightfoot that arise from the matters
described in Exhibit 5. Recommend the actions that I (Marcus Morris) should now
take.

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Question 2

Assume the date is 19 July 2022

LVL Ltd is a small, start-up company. It operates as a wholesaler of kitchen electrical

appliances.

You are Alex Ramsden, an ICAEW Chartered Accountant working in the business
development department of Banford and Wright LLP (B&W), a firm of ICAEW Chartered
Accountants. LVL is a new client, but not an audit client, of B&W.

You receive the following email from Nancy Wong, a manager at B&W.

To: Alex Ramsden

From: Nancy Wong
Date: 19 July 2022
Subject: LVL Ltd

B&W has been engaged to provide advice to LVL. I am the engagement manager and I
would like you to work with me on this engagement.

Last week, I met Louis Green, the founder, chief executive and sole shareholder of LVL.
Louis was previously employed by a large company assembling electrical products. Following
my conversation with him, I prepared background notes on Louis and LVL (Exhibit 1).

Louis has ambitious growth targets for LVL’s business. However, he is concerned about the
risks involved.

Louis is quite pleased with LVL’s trading for Quarter 1 (1 January 2022 to 31 March 2022).
However, he is disappointed about performance in Quarter 2 (1 April 2022 to 30 June 2022)
when sales decreased. Louis has provided his records showing sales deliveries by product
for each of Quarter 1 and Quarter 2 in spreadsheet format. (See pre-populated
spreadsheet.)

Louis would like our help in analysing the spreadsheet and other data to gain a better
understanding of quarterly financial performance, with respect to revenue and gross profit. I
have provided further information relating to the six months ended 30 June 2022 (Exhibit 2).

Louis has plans for 2023, including selling online directly to UK consumers (Exhibit 3). He is
concerned about LVL’s working capital management with respect to the existing business
and the impact on working capital arising from selling directly to consumers.

Louis has also set out two separate proposals, which are for extended warranties and leasing
a new warehouse. He has requested advice on each of these (Exhibit 4).

In respect of all these matters, I have set out instructions in a briefing note, explaining in
detail what I would like you to do (Exhibit 5).

Nancy

Requirement

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Respond to the instructions in the briefing note from the engagement manager, Nancy Wong
(Exhibit 5).
Total: 46 marks

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Exhibit 1: Background notes on Louis and LVL – prepared by Nancy Wong

On 1 October 2021, Louis Green resigned from his job as chief distribution manager for a
large UK electrical products company.

During 2021, Louis identified an opportunity, using his industry experience and contacts, to
establish a start-up company, LVL Ltd. Following negotiations with Foyita, a global Japanese
company, LVL was awarded a one-year contract to act as European distributor for a limited
number of Foyita’s branded kitchen electrical products.

LVL’s contract with Foyita

The following terms were agreed:

• LVL was granted sole European distribution rights for three of Foyita’s kitchen electrical
products: fridges; washing machines; and cookers.
• All goods delivered to LVL by Foyita must be sold under the Foyita brand.
• The contract has a one-year term, commencing with the first deliveries arriving in the UK
on 1 January 2022.
• Foyita will make deliveries by ship from Japan, once a month, to LVL. Quantities
requested by LVL each month will vary according to Louis’ expectations of customer
demand. To allow time for order processing and shipping, LVL must place orders at least
45 days in advance of the expected arrival date into the UK port of Southampton, on the
south coast of England.
• The price per item, charged by Foyita to LVL, is fixed in £ sterling for the initial one-year
contract period.
• Foyita has offered LVL credit terms of 60 days after the date on which the goods arrive in
the UK. This was agreed by Foyita to help LVL finance initial working capital and establish
the business.
• The contract may be renewable after the first year, but this would be subject to possible
changes in contract terms.

The three products forming part of the contract are specific Foyita models and are to be sold
only in the geographical areas specified in the contract. The details are:

Product Product type Cost to LVL Geographical sales area

code £

Product 1 Fridge 286 UK only

Product 2 Washing machine 367 UK only

Product 3 Cooker 470 Europe, excluding the UK

LVL’s business model

LVL operates as a wholesaler, selling Foyita branded products to other businesses, including
housebuilders, property developers and retailers. LVL does not currently sell to individual
consumers.

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Goods are transported from the UK port of Southampton to LVL’s warehouse, which is
located nearby. Inventories are stored there. The warehouse is rented on a short-term lease.
Delivery services to LVL’s customers from the Southampton warehouse are provided by
third-party transport companies.

Customers require delivery within a few days of making an order with LVL. Given the long
lead times, Louis tries to have sufficient inventory to meet customer demand, but sometimes
actual demand is higher than anticipated.

LVL receives only one customer order every few days. There is a minimum order size of four
items, but some orders are for over 50 items.

LVL negotiates credit terms with each customer separately, depending on the size of the
customer order and the terms that the customer will accept. Typically, the credit period is
between 30 days and 45 days from the date of delivery to the customer.

Financial reporting

LVL has a 31 December accounting year end and it reports in accordance with IFRS. Its
functional currency is £ sterling.

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Exhibit 2: Information relating to the six months ended 30 June 2022

Louis has provided basic sales delivery records on a spreadsheet for Quarter 1 (1 January
2022 to 31 March 2022) and Quarter 2 (1 April 2022 to 30 June 2022). (See pre-populated
spreadsheet.)

Each customer order is for one type of product and each order is delivered separately.
Therefore, there is no mixing of different product types in the same delivery to LVL’s
customers.

Louis monitors performance on a quarterly basis, based on revenue and gross profit.

Louis expects some quarter-to-quarter variations in sales volumes, but he does not believe
that there are any strong seasonal effects.

Selling prices per item for each product type were as follows:

Product Product type Selling price

code Quarter 1 Quarter 2
Product 1 Fridge £357 £389
Product 2 Washing machine £434 £434
Product 3 Cooker €575 €575

Louis was pleased with the sale volumes for fridges in Quarter 1. However, he decided to try
to increase margins and so, for deliveries after 1 April 2022, he increased the selling price of
fridges from £357 to £389.

Cookers are invoiced to LVL customers in euro (€). Exchange rates in the six months to 30
June 2022 were as follows:

Quarter 1 €1 = £0.92 average

Quarter 2 €1 = £0.81 average

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Exhibit 3: Plans for 2023, including selling online directly to UK consumers – prepared
by Louis Green

Online sales

To expand the business, I am planning to update LVL’s website to sell directly to consumers
(B2C) from 1 January 2023. Online sales will be for UK consumers only, and so will comprise
fridges and washing machines.

The fridges and washing machines that LVL will sell to individual consumers will be identical
to those which LVL currently sells to its business customers.

I am uncertain about online sales volumes, but I expect monthly sales to be volatile.

A key concern is working capital management, including inventory management. Both

business customers and consumers expect delivery of the goods promptly once their order
has been placed. I therefore need to make sure that LVL has sufficient inventory, but I am
concerned about high inventory holding costs.

Individual consumers will pay in advance, just prior to delivery.

Foyita contract renegotiation

I am currently negotiating a new one-year contract with Foyita from 1 January 2023. Foyita
has already made it clear that, after 1 January 2023, it will offer credit terms of 90 days from
the date on which the goods are loaded onto a ship in Japan.

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Exhibit 4: Two proposals – prepared by Louis Green

Louis has set out two separate proposals: (1) extended warranties; and (2) leasing a new
warehouse.

Proposal 1 – Extended warranties

Foyita had some bad trade press publicity in June 2022 regarding the reliability of its
products.

LVL’s products are currently covered by a warranty from Foyita for two years from the date of
purchase. Under this warranty, Foyita guarantees to pay for any repair costs if the consumer
has a fault with a product.

To build consumer confidence and increase sales volumes, I am considering providing a free
one-year extended warranty. The selling price of the products will not change because of the
warranty.

The combination of the two-year manufacturer warranty from Foyita and the additional one-
year extended warranty from LVL would give consumers a three-year guarantee overall.

My proposal is to provide the warranty for all sales that take place during the year ending 31
December 2023. I will then appraise whether it has had a favourable impact and decide if I
wish to continue to provide the extended warranty in future years.

Not all consumers will register for the extended warranty.

I estimate 1,500 items will need to be repaired under the extended warranty provided for
2023 sales. The repair costs incurred by LVL will vary, but I estimate that they will average
£25 per item repaired. The cash flows for repair costs can be assumed to occur at 31
December 2025.

Request for advice

• Briefly set out and explain the key factors that I should consider in deciding whether to
provide the extended warranty for 2023 sales.
• Set out and explain the appropriate treatment in the financial statements of LVL for all
the financial years affected by the proposal to provide extended warranties for sales
made in 2023.

Proposal 2 – Leasing a new warehouse

LVL needs to move to a new larger warehouse and I have identified a suitable property,
which is very close to LVL’s existing warehouse. I have a choice of two alternative lease
contracts for the same new warehouse.

Lease A
This lease contract is for three years from 1 January 2023. There are only two rental
payments, each of £36,000, payable on 31 December 2023 and 31 December 2024. On 31
December 2025, the warehouse will be returned to the owner.

Lease B

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This lease contract is for two years from 1 January 2023. There is only one rental payment of
£50,000, payable on 1 January 2023. On 31 December 2024, the warehouse will be returned
to the owner.

Request for advice

• Briefly explain the key factors that I should consider in deciding which of the two lease
contracts to accept. Provide supporting calculations.
• For each of Lease A and Lease B, set out and explain the appropriate financial
reporting treatment in the financial statements of LVL for all affected financial years.

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Exhibit 5: Briefing note – Instructions from the engagement manager, Nancy Wong

(1) Using relevant information, including the pre-populated spreadsheet data, analyse and
compare LVL’s revenue and gross profit in Quarter 1 (1 January 2022 to 31 March
2022) and Quarter 2 (1 April 2022 to 30 June 2022). Include explanations and a
summary of your data analysis to provide Louis with a better understanding of LVL’s
performance in each quarter. Ignore Exhibits 3 and 4.

(2) Prepare a risk register for LVL which identifies and explains the key risks relating to
the existing business. Set out how each risk can be mitigated most appropriately.
Ignore Exhibits 3 and 4.

(3) Explain the working capital management issues that are likely to arise for LVL in 2023.
Include both the existing business and the potential impact on working capital of
selling directly to individual consumers (Exhibit 3). Provide reasoned advice to LVL on
how to manage these working capital issues. Calculations are not required. Ignore
Exhibit 4.

(4) Respond to the ‘requests for advice’ for each of Proposal 1 and Proposal 2 in Exhibit
4. Use an annual discount rate of 8% where appropriate.

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