Operational Level Paper P1 Performance Operations September 2014 examination Examiner s Answers Note: Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike. These Examiner s answers should be reviewed alongside the question paper for this examination which is now available on the CIMA website at www.cimaglobal.com/p1papers The Post Exam Guide for this examination, which includes the marking guide for each question, will be published on the CIMA website by early October at www.cimaglobal.com/p1pegs SECTION A Answer to Question One Question One consists of eight objective test sub-questions. These are drawn from all sections of the syllabus. They are designed to examine breadth across the syllabus and thus cover many learning outcomes. 1.1 The correct answer is B. 1.2 Payment will be made 35 days early. Number of compounding periods = 365/35= 10.429 1+ r = (1.00/0.98) 10.429 1+ r = 1.2345 The effective annual interest rate of the early settlement discount is 23.45% The correct answer is C. The Chartered Institute of Management Accountants 2014
1.3 Material Actual input @standard mix (kg) Actual input @ actual mix (kg) Variance Kg Standard cost $ Variance $ A 24,400 23,000 1,400 F 2.40 3,360 F B 36,600 38,000 1,400 A 1.30 1,820 A 61,000 61,000 1,540 F The correct answer is A. 1.4 Weighted average standard cost (24,000kg x $2.40) + (36,000kg x $1.30) = $104,400 $104,400 / 60,000 kg = $1.74 per kg Standard kg of input per unit of output = 5kg 12,000 units output x 5kg = 60,000kg of input Actual input = 61,000 kg Variance = 1,000kg A Standard cost per kg = $1.74 Variance = 1,000kg x $1.74 = $1,740 A Or alternatively: 61,000kg should yield 61,000/5kg = 12,200 units Actual yield = 12,000 units Yield variance = 200 units A Standard material cost per unit = (2kg x $2.40) + (3kg x $1.30) = $8.70 Yield variance = 200 units x $8.70 = $1,740 A The correct answer is B. 1.5 The maximum regret if 10,000 units are purchased is $180,000 The maximum regret if 15,000 units are purchased is $120,000 The maximum regret if 20,000 units are purchased is $70,000 The maximum regret if 25,000 units are purchased is $105,000 Therefore if the manager wants to minimise the maximum regret 20,000 units will be purchased. The correct answer is C. Performance Operations 2 September 2014
1.6 Budgeted maintenance cost for August: y = 22,000 + 0.025x 2 y = 22,000 + 0.025(1,820 2 ) y = 22,000 + 82,810 y = 104,810 Increase for inflation: $104,810 x 1.04 = $109,002 The maintenance cost variance for August is therefore: $109,002 - $106,500 = $2,502 Favourable 1.7 Expected cash inflow in Year 1 = ($200k x 0.2) + ($300k x 0.7) + ($360k x 0.1) = $286k Expected cash inflow in Year 2 = ($100 x 0.6) + ($320 x 0.4) = $188k Expected net present value Year Cash flow Discount factor Present value $ $ 0 (300,000) 1.000 (300,000) 1 286,000 0.909 259,974 2 188,000 0.826 155,288 Net present value 115,262 1.8 (i) The discount = $1000 x 7% x 91/365 = $17.45 The issue price is therefore $1,000 - $17.45 = $982.55 (ii) Treasury bills are negotiable instruments issued by the Government They have a maturity of less than one year, normally 91 days They have high credit quality and therefore low risk and low return They are redeemable at face value They are issued at a discount to face value There is a large and active secondary market in treasury bills September 2014 3 Performance Operations
SECTION B Answer to Question Two (a) The question assesses learning outcome B1(b) explain the purposes of budgeting including planning, communication, co-ordination, motivation, authorisation, control and evaluation, and how these may conflict. It examines candidates ability to explain two of the purposes of budgeting and how these may conflict. Candidates should clearly explain two of the stated purposes of budgeting and how these may conflict with each other. Planning - Budgeting forces an organisation s management to look ahead and set performance targets. This ensures that management anticipates any future problems and gives the organisation direction. It also ensures that managers are aware of their own targets and responsibilities and how they relate to those of other managers within the organisation. Control - The budget acts as a control mechanism, with actual results being compared with budget. Appropriate actions can then be taken to correct any deviations from plan. Evaluation - The budget also provides an internal benchmark against which performance can be evaluated. The performance measured may be that of a department or division or of an individual manager. Motivation - Budgeting sets targets to motivate managers and optimise their performance. The budget is a useful device for influencing managers behaviour and motivating managers to perform in line with the organisation s objectives. It provides a standard which managers may be motivated to achieve. The budget therefore serves a number of different purposes which may conflict with each other. For example, the planning and motivational roles may conflict, as demanding budgets that may not be achieved may be appropriate to motivate managers to achieve maximum performance but are unsuitable for planning purposes. There is also a conflict between the planning and performance evaluation roles. For planning purposes budgets are set in advance of the budget period based on an anticipated set of circumstances and/or external environment. If the circumstances that were anticipated at the time the budget was prepared have changed then there will be a planning and performance evaluation conflict. There may also be a conflict between the performance evaluation and motivation purposes as the budget can cause inefficiency and conflict between managers particularly if the budget is imposed from above, whereby it may act as a threat rather than as a challenge. Targets that are imposed on managers are unlikely to motivate the managers to achieve them. Performance Operations 4 September 2014
(b) The question assesses learning outcome D1(a) analyse the impact of uncertainty and risk on decision models that may be based on relevant cash flows, learning curves, discounting techniques etc. It examines candidates ability to use cost volume profit analysis to identify the sensitivity of budgeted profit figures. Candidates should firstly determine the fixed and variable costs from the budgeted information given and then calculate the contribution per unit. In part (i) the break even point can be calculated by dividing the fixed costs by the contribution per unit. In part (ii) the margin of safety can be calculated by comparing the budgeted sales to the break even sales and expressing the difference as a percentage of the budgeted sales. In part (iii) the effect of the changes on the contribution per unit and the fixed costs should be calculated and then a revised break-even point should be calculated. (i) Contribution per unit = $24.00 - $8.60 $1.20 = $14.20 Break even point = $880,400/ $14.20 = 62,000 units (ii) Margin of safety = (90,000 62,000) / 90,000 = 31.1% (iii) Revised contribution per unit = $25.00 - $8.60 - $2.00 = $14.40 Break-even point = $890,400 / $14.40 = 61,833 units September 2014 5 Performance Operations
(c) The question assesses learning outcome E1(g) analyse the impacts of alternative policies for stock management. It examines candidates ability to discuss the effectiveness of the EOQ model for inventory management purposes. Candidates should explain how the EOQ model operates and discuss its benefits and limitations for inventory management purposes. The economic order quantity (EOQ) is based on the assumption that demand for the period is known and constant. Therefore the optimum order quantity will be determined by the costs that are affected by either the quantity of inventory held or the numbers of orders placed. A higher quantity ordered each time will mean fewer orders each year and therefore a reduction in ordering costs. However, this will also result in higher average inventory levels which results in an increase in holding costs. The EOQ therefore is a trade-off between the costs of carrying high inventory against the costs of placing more orders. The optimum order size is the quantity that will result in the total of the ordering and holding costs being minimised. The EOQ model assumes a world of certainty where the usage and delivery of inventory can be predicted accurately and management can therefore avoid stock-out costs and concentrate on achieving the optimal balance between ordering costs and holding costs. However this is unlikely to be the case in reality for most companies. The EOQ model ignores two types of risk: a) Uncertainty over the time it takes for the order to be delivered i.e. the lead time. The lead time is neither zero as assumed by the model or necessarily predictable. b) The rate at which inventory is used may not be constant, demand may be subject to fluctuations and the overall annual demand may be difficult to predict with accuracy. The company can cope with these two risk elements, to a certain extent, by holding a buffer inventory. The buffer inventory level can be calculated by weighing up the cost of stock-outs and the costs of holding additional inventory. The determination of lead time and dealing with uncertainty of demand requires subjective managerial judgement as does determining the cost of stock-outs since many of the costs involved are difficult to quantify. Performance Operations 6 September 2014
(d) The question assesses learning outcome D1(e) calculate the value of information. It examines candidates ability to calculate the value of perfect information where there is uncertainty regarding expected net present values. Candidates should firstly apply the probabilities for the demand levels to calculate the expected value of the net present value for each of the machines without perfect information. They should then select the best outcome for each of the possible demand levels and apply the probabilities to these to calculate the expected value with perfect information. The value of perfect information can then be calculated as the difference between the expected value with perfect information and the best of the expected values without perfect information. Demand Probability Machine A Machine B Machine C $000 $000 $000 High 35% 100 x 0.35 = 35 140 x 0.35 = 49 180 x 0.35 = 63 Medium 40% 150 x 0.40 = 60 160 x 0.40 = 64 140 x 0.40 = 56 Low 25% 200 x 0.25 = 50 100 x 0.25 = 25 80 x 0.25 = 20 Expected value 145 138 139 Machine A is the best choice (without the benefit of perfect information) as it has the highest expected value (EV) of $145k. With perfect information: If research suggests high demand: select Machine C and earn $180k If research suggests medium demand: select Machine B and earn $160k If research suggests low demand: select Machine A and earn $200k EV (with perfect information) = ($180k x 0.35) + ($160k x 0.40) + ($200k x 0.25) = $177k Value of perfect information is $177k $145k = $32k Alternatively: Value of perfect information = (($180k - $100k) x 0.35) + (($160k - $150k) x 0.40) = $32k September 2014 7 Performance Operations
(e) The question assesses learning outcome E1(d) discuss measures to improve a cash forecast situation. It examines candidates ability to explain the trade off between the cost of holding too much cash and too little cash. Candidates should clearly explain the costs involved with holding too much cash and how this needs to be balanced with the costs involved with holding too little cash. There are a number of costs involved with holding too little cash which a company may incur as follows: It may not be possible to pay suppliers on time which could lead to reluctance to supply and eventually to liquidation; It will not have the ability to react quickly to unexpected events e.g. competitor action, strikes etc; It will potentially miss unexpected opportunities e.g. contracts or lucrative investments; It may not be able to benefit from early settlement discounts from suppliers; It is likely to incur higher cost of borrowing because unexpected cash requirements need to be met from temporary borrowings; It will incur transaction costs involved with acquiring cash e.g. cost of selling securities or arrangement fees for overdrafts. The costs of holding too little cash have to be balanced with the costs of holding cash i.e. the loss of interest and the loss of purchasing power as inflation erodes the value of cash. Performance Operations 8 September 2014
(f) The question assesses learning outcome B3(a) prepare a budget for any account in the master budget, based on projections/forecasts and managerial targets. It examines candidates ability to prepare a production budget and a materials usage and purchases budget. In part (i) candidates should calculate the number of units required to be produced after adjusting for the change in inventory of finished goods. In part (ii) candidates should calculate the materials usage budget based on the production budget calculated in part (i). In part (iii) candidates should calculate the material purchases budget in kg after adjusting for the change in materials inventory. The material purchases budget in $ can then be calculated by multiplying the budget in kg by the price per kg of material. (i) Product A1 A2 Sales (units) 32,000 56,000 Increase / (decrease) in inventory 1,000 (2,000) Production budget (units) 33,000 54,000 (ii) (iii) Material B3 B4 A1 A2 Total A1 A2 Total Production budget 33,000 54,000 87,000 33,000 54,000 87,000 (units) Kg per unit 8 4 4 3 Material usage (kg) 264,000 216,000 480,000 132,000 162,000 294,000 Material B3 B4 Total Total Material usage (kg) 480,000 294,000 Less: opening inventory (30,000) (20,000) Plus: closing inventory 24,000 14,700 Material purchases (kg) 474,000 288,700 Price per kg $1.25 $1.80 Material purchases $ $592,500 $519,660 September 2014 9 Performance Operations
SECTION C Answer to Question Three The question assesses learning outcome A1(c) discuss activity-based costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting. Part (a) examines candidates ability to calculate the cost of a product using activity based costing. Part (b) examines candidates ability to discuss the differences between the gross profit calculated under the activity based costing system and that calculated under the traditional absorption costing system. Part (c) examines candidates ability to explain how the information obtained using an activity based costing system could be used for cost management purposes. In part (a) candidates should calculate a cost driver rate for each of the activities and then apply this cost driver rate to calculate the overhead cost for each activity per product. The gross profit for each product can then be calculated. In part (b) candidates should clearly explain the reasons for the differences between the gross profits calculated using activity based costing and that calculated using the current absorption costing system. In part (c) candidates should clearly explain how the information from an activity based costing system could be used for cost management purposes. (a) Tablets Convertible Laptops All-inone PCs Total Budgeted production per annum (units) 10,000 12,000 6,000 28,000 Average number of units per order 10 6 4 Number of orders 1,000 2,000 1,500 4,500 Parts per unit 20 35 25 Total number of parts 200,000 420,000 150,000 770,000 Assembly time per unit (minutes) 20 40 30 Total assembly time (minutes) 200,000 480,000 180,000 860,000 Software applications per unit 2 3 4 Total number of software applications 20,000 36,000 24,000 80,000 Activity Activity cost Cost driver Cost driver rate $000 Manufacturing scheduling 162 Number of orders $162,000 / 4,500 = $36 per order Parts handling 2,464 Number of parts $2,464,000 / 770,000 = $3.20 per part Assembly 4,472 Assembly time $4,472,000 / 860,000 = $5.20 per minute Software installation & testing 2,000 Number of software applications $2,000,000 / 80,000 = $25.00 per application Packaging 1,302 Number of units $1,302,000 / 28,000 = $46.50 per unit 10,400 Performance Operations 10 September 2014
Tablets Convertible Laptops All-in-one PCs Total Manufacturing scheduling Parts handling Assembly Software installation & testing $000 $000 $000 $000 (1,000 x $36) (2,000 x $36) (1,500 x $36) 36 72 54 162 (200,000 x $3.20) (420,000 x $3.20) (150,000 x $3.20) 640 1,344 480 2,464 (200,000 x $5.20) (480,000 x $5.20) (180,000 x $5.20) 1,040 2,496 936 4,472 (20,000 x $25) 500 (10,000 x $46.50) 465 (36,000 x $25) 900 (12,000 x $46.50) 558 (24,000 x $25) 600 2,000 (6,000 x $46.50) 279 1,302 Packaging Total production overhead costs 2,681 5,370 2,349 10,400 Tablets Convertible Laptops All-in-one PCs Total $000 $000 $000 $000 Sales 3,640 12,480 9,880 26,000 Direct material 800 2,800 2,200 5,800 Direct labour 300 1,200 800 2,300 Production overheads 2,681 5,370 2,349 10,400 Gross profit (141) 3,110 4,531 7,500 September 2014 11 Performance Operations
(b) Products Tablets Convertible Laptops All-in-one PCs Current system of absorption costing (per unit) Selling price $364 $1,040 $1,647 Production overhead cost $146 $416 $659 Gross profit $108 $291 $488 Gross profit % 29.8% 27.9% 29.6% Activity based costing (per unit) Selling price $364 $1,040 $1,647 Production overhead cost $268 $448 $392 Gross profit $(14) $259 $755 Gross profit % (3.9%) 24.9% 45.9% It can be seen from the figures in the table above that under the activity based costing system there is a completely different picture of the profitability of each of the products. Under the traditional absorption costing system each of the products was making a very similar gross profit margin of around 30%. However under the activity based costing system, Tablets are now shown to be loss making and all-in-one PCs are making a significantly higher gross profit margin, at 45.9%, than originally thought. The gross profit margin for convertible laptops has declined slightly from 27.9% to 24.9%. Under the traditional absorption costing system, production overheads were charged to products based on sales revenue. This meant that Tablets which has a relatively low proportion of the total sales revenue (14%) was charged a relatively low level of fixed production overheads. When the activity based costing system is used and the actual consumption of activities is considered Tablets are charged significantly more production overheads than before. Whilst Tablets has the lowest number of cost drivers for most of the activities it also has a relatively lower selling price than the other products. For example the ratio of parts per unit is 20:35:25 for Tablets, convertible laptops and all-in-one PCs but the ratio of selling prices is 12:34:54. All-in-one PCs gross profit percentage is significantly higher under activity based costing since whilst it has the second highest number of cost drivers for parts per unit and assembly time per unit it has the highest selling price per unit compared to the other two products. This information will be useful for the company when making decisions about product pricing and product mix. (c) The activity based costing system provides information about the various activities and the cost drivers for each activity. The information about the cost of activities enables the company to focus on those activities with the highest costs and to determine whether they can be eliminated or performed more efficiently. Activities can be classified as value-added and nonvalue added. Companies can take action to reduce or eliminate the non-value added activities. The information ascertained about the cost drivers will also be useful for cost control purposes. The company can try to reduce the number of cost drivers for each product through process or product redesign. The cost driver rate can also be used as a measure of cost efficiency. Performance Operations 12 September 2014
Answer to Question Four Part (a) assesses learning outcomes C1(b) apply the principles of relevant cash flow analysis to long-run projects that continue for several years and C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates ability to identify the relevant costs of a project and then apply discounted cash flow analysis to calculate the net present value of the project. Part (b) assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates ability to explain other factors that the company would need to consider before deciding whether to go ahead with the project. Part (c) also assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates ability to calculate the internal rate of return (IRR) for the project and the sensitivity of the investment decision to a change in the cost of capital. In part (a) candidates should firstly calculate the number of units sold and the contribution that would be earned from the product in each year. They should then deduct the fixed costs after adjusting for depreciation. The contribution and fixed costs should then be adjusted for inflation from year 2 of the project. The total cost of the investment and the residual value should then be added to the net cash flows. The working capital should be shown as a cash outflow in Year 0 and the additional amount required as a result of inflation, shown as a cash outflow each year. The total working capital throughout the period of the project should then be shown as a cash inflow in Year 5. The tax depreciation and tax payments should then be calculated. The net cash flows after tax should then be discounted at the discount rate of 12% to calculate the net present value (NPV) of the project. In part (b) candidates should clearly explain two other factors that the company should consider before making a decision about the investment project. In part (c)(i) candidates should discount the cash flows after tax at a lower discount factor than 12% and then, using interpolation, calculate the internal rate of return (IRR) for the project. In part (c)(ii) candidates should calculate the difference between 12% and the IRR and express this as a percentage of 12%. (a) Contribution Years 1 5 Year 1: 100,000 x $20 = $2,000k Year 2: 100,000 x 1.2 = 120,000 x $20 = $2,400k x 1.04 = $2,496k Year 3: 120,000 x 1.2 = 144,000 x $20 = $2,880k x 1.04 2 = $3,115k Year 4: 144,000 x 1.2 = 172,800 x $20 = $3,456k x 1.04 3 = $3,888k Year 5: 172,800 x 1.2 = 207,360 x $20 = $4,147k x 1.04 4 = $4,852k Fixed Costs Depreciation per annum = ($10m - $1.5m) / 5 = $1.7m Fixed costs (excluding depreciation) per annum = $2.5m - $1.7m = $0.8m September 2014 13 Performance Operations
Taxation Year 1 Year 2 Year 3 Year 4 Year 5 $000 $000 $000 $000 $000 Contribution 2,000 2,496 3,115 3,888 4,852 Fixed costs (800) (832) (865) (900) (936) Net cash flows 1,200 1,664 2,250 2,988 3,916 Tax depreciation (2,500) (1,875) (1,406) (1,055) (1,664) Taxable profit (1,300) (211) 844 1,933 2,252 Taxation @ 30% 390 63 (253) (580) (676) Net present value Investment / residual value Working capital Net cash flows Tax cash flow Tax cash flow Net cash flow after tax Discount factors @ 12% Present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $000 $000 $000 $000 $000 $000 $000 (10,000) 1,500 (3,000) (120) (125) (130) (135) 3,510 1,200 1,664 2,250 2,988 3,916 195 32 (127) (290) (338) 195 31 (126) (290) (338) (13,000) 1,275 1,766 2,024 2,437 8,298 (338) 1.000 0.893 0.797 0.712 0.636 0.567 0.507 (13,000) 1,139 1,408 1,441 1,550 4,705 (171) Net present value = - $2,928k The net present value is negative therefore the project should not go ahead. (b) The project is concerned with the education of children in computer science and with encouraging them to be involved in computer science at an early age. This is a new market for the company and may have long term benefits if children start to use full scale computers at an earlier age than normally would be expected. Whilst the project makes a negative net present value the company may be able to improve its brand image if it is seen to be supplying relatively low cost computers to the education market. The company could benefit from being involved in this project as they are being seen to be concerned with the education needs of children. Performance Operations 14 September 2014
(c) (i) The net present value is negative at 12% therefore use a lower discount factor. Net cash flow after tax Discount factors @ 4% Present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $000 $000 $000 $000 $000 $000 $000 (13,000) 1,275 1,766 2,024 2,437 8,298 (338) 1.000 0.962 0.925 0.889 0.855 0.822 0.790 (13,000) 1,227 1,634 1,799 2,084 6,821 (267) Net present value at 4% discount rate = $298k By interpolation: IRR = 4% + (($298k / ($298k + $2,928)) x 8) = 4.74% (ii) The cost of capital is 12%. (12 4.74) / 12 = 61% For the project to be accepted the cost of capital would need to reduce by 61%. September 2014 15 Performance Operations