Management Level Paper P2 Performance Management May 2013 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/p2papers The Post Exam Guide for this examination, which includes the marking guide for each question, will be published on the CIMA website by early August at www.cimaglobal.com/p2pegs SECTION A Answer to Question One The question examines candidates knowledge and understanding of customer profitability analysis and of different approaches to measuring profitability and performance. The learning outcome tested is B1(l), analyse direct customer profitability and extend this analysis to distribution channel profitability through the application of activity- based costing ideas. Candidates need to carefully read the question and using the data provided, construct a customer profitability statement showing the profit for each customer. Candidates then need to perform a number of calculations to measure the performance of each customer, such as profit per order, profit per shrub. A brief discussion of the resulting figures is then required. The Chartered Institute of Management Accountants 2013
B C $ $ Gross Revenue 57,600 39,000 Discounts allowed 8,640 7,800 Net Revenue 48,960 31,200 Cost of shrubs 24,000 16,250 Delivery costs 4,000 0 Order processing 800 1,000 Net profit 20,160 13,950 No. of shrubs sold 960 650 Profit per shrub sold $21 $21.46 Number of orders 8 10 Profit per order $2,520 $1,395 Profit per $1 gross revenue $0.35 $0.36 Comments: There is very little difference between the profit per $ of gross revenue from customers B and C. Customer B earns the lower profit per shrub. This is despite the large discount given to C for using their own transport. The discount offered to Customer C seems generous. The discount costs the farm $7,800 in lost revenue but only saves (based on the order frequency shown) $5,000 in delivery costs. Why has this discount been given? Is the transport being used to full capacity and it is not possible to make the sale unless the customer collects the shrubs themselves? Is C situated a large distance away from the farm? The analysis shows that B earns the higher absolute profit for the farm because of the higher number of shrubs purchased. However C earns the highest profit per shrub. The analysis could be used by the farm to assess the impact of the discounts it offers to the customers. For example, what would be the impact on delivery schedules and costs of reducing the discount offered on orders for more than 100 shrubs? It would appear that the farm is happy to earn a profit margin of 35% and to offer incentives to achieve that margin. P2 2 May 2013
Answer to Question Two The question examines candidates knowledge and understanding of the learning curve and sensitivity analysis. The learning outcome tested is B1(e), apply learning curves to estimate time and cost for new products and services. Candidates needed to carefully read the question to fully appreciate what was required. In part (i) candidates needed to calculate the maximum reduction in the labour rate that could take place to allow the company to generate a profit of $75,000. The change needed to be measured against the rate of $40 per labour hour. In part (ii) candidates needed to establish by how much the learning rate could fall, and still allow the company to generate a profit of $75,000. To fully answer the question the change (fall) in the learning rate needed to be measured against the original 90%. (i) Cumulative average time for 64 units = 119.58 hours Total time for 64 units = 119.58 *64 = 7,653.12 hours The target profit of $75,000 is earned by 7,653.12 hours. This represents $9.80 per hour. The hourly rate could rise by $9.80 before the profit is eroded. The sensitivity is therefore 9.80/40.00 = 24.5% (ii) Total labour cost of 64 units = 7,653.12 * $40 = $306,124.8 The labour cost could rise to $306,124.8 + $75,000 = $381,124.8, before no profit is earned. This equals $381,124.8/$40 = 9,528.12 hours This is an average of 9,528.12/64 hours per unit = 148.88 hours per unit. Cumulative average time for 64 units/ average time for the first unit = 148.88/225 = 0.6617 An output of 64 units represents six doublings and therefore the learning rate is the sixth root of 0.6617 6 0.6617 = 0.9335 Therefore the learning rate can fall to 93.35%. The sensitivity is therefore 3.35/90 = 3.72% May 2013 3 P2
Answer to Question Three The question examines candidates knowledge and understanding of zero based budgeting (ZBB) when set in a Research and Development environment. The learning outcome tested is C3(d), discuss the criticisms of budgeting, particularly from the advocates of beyond budgeting techniques. Candidates needed to carefully read the question and fully understand the scenario described. In particular, the question specifically requested candidates to discuss the disadvantages of implementing ZBB in a Research and Development setting. Both generic and specific disadvantages needed to be considered. A step-by-step description of the implementation of ZBB is not required, e.g. a description of a decision package. Zero based budgeting (ZBB) can be an effective way of allocating resources and controlling discretionary costs. It is often thought that research and development is a discretionary cost. However the benefits of ZBB are often viewed from the company s perspective rather than that of the Director of a division or a budget holder. Adopting ZBB could have major disadvantages for the Director. There are two immediate issues that the director needs to be aware of: it will involve a great deal of time. it requires management and accounting expertise. The Director may not have all of these skills. There are four stages in the implementation of ZBB: Activities have to be specified and evaluated Decision packages have to be drawn up for each activity Each package has then to be evaluated and ranked Resources are then awarded to the preferred packages. Possible disadvantages: The need to specify projects could stifle creativity. This could have a major impact on PP and consequently the Research and Development Division. The outcome of many projects could be difficult to forecast. Requesting funds for projects that do not have a clearly defined commercial outcome could be problematic given the use of decision packages within a zero based budgeting system. The Director would have to seek approval for funding for specified projects and would need to justify the request on a continuing basis. This loss of autonomy could be demotivating and increase pressure to achieve results. P2 4 May 2013
Answer to Question Four The question examines candidates knowledge and understanding of methods of dealing with uncertainty and risk and of how these methods are linked to attitude. The learning outcome tested is A2(d), analyse the impact of uncertainty and risk on decision models based on CVP analysis. Candidates needed to carefully understand the data provided, and note particularly that the figures provided were included to assist with answering the question. Additional calculations were not required. The requirement was quite specific and needed the four methods requested to be linked to attitude. Z could use any of the following three approaches to dealing with uncertainty: Maximin : the decision maker will look at the options and choose the one that has the highest minimum return. This type of decision maker is a pessimist and will look at the worst outcome for each of the options and seeks to get the best of the worst. Maximax : the decision maker will look at the options and choose the one that has the highest return. This type of decision maker is an optimist. Minimax Regret : the decision maker will analyse the options and choose the option so that if it is the wrong choice the regret will not be as big as if the others had been chosen and they were wrong. This type of decision maker seeks to minimise the post-event regret of having made a wrong decision. If probabilities can be assigned to the outcomes then uncertainty will become risk. It will then be possible to calculate expected values. The decision maker will choose the outcome that has the highest expected value. This assumes that the decision maker is risk neutral. The expected value of an option does not give any indication of the risk associated with the option. The risk, or spread, of the possible outcomes of each option can be measured by calculating the standard deviation. A risk minimiser would choose the option with the lowest standard deviation. The trade off between risk and return can be evaluated by calculating the coefficient of variation (standard deviation divided by expected value). May 2013 5 P2
Answer to Question Five The question examines candidates knowledge and understanding of Beyond Budgeting when set in the modern dynamic business environment. The learning outcome tested is C3(c) compare and contrast traditional approaches to budgeting with recommendations based on the balanced scorecard. A careful read through the brief scenario was essential to understand the setting for this Beyond Budgeting (BB) question. It was important that candidates did not simply write all they knew about BB, and fail to relate their answer to the scenario. Beyond Budgeting (BB) is a responsibility culture in which managers are given goals that have been derived from benchmarks linked to competitors and world class performance. This culture requires an adaptive approach whereby authority is devolved to managers and the organisation s structure will be a network rather than hierarchical. The principles of BB are: The organisation structure should have clear principles and boundaries. Everyone should have defined areas of responsibility. Managers should be given targets that are linked to the organisation s strategy. Such targets should be based on key performance indicators and should be part of a balanced scorecard. Managers should be given a high degree of freedom to make decisions. The organisation chart should be flat. Responsibility for decisions that generate value should be placed with front line teams. These teams should be made responsible for managing relationships with business partners (customers, suppliers, etc). Information support systems should be transparent. For example, an activity based accounting system would enable reports to be generated to show the costs/revenues for activities which are the specific responsibility of identified managers. It can be argued that in the modern dynamic business environment it is vital that management can react to changes in the market and allocate resources accordingly. BB will allow this to happen. The benefits that should accrue from the adoption of the principles of BB are faster response times, better innovation, lower costs and improved customer and supplier loyalty. All of these are of great importance in the modern dynamic business environment. P2 6 May 2013
SECTION B Answer to Question Six The question examines candidates knowledge and understanding of a limiting factor situation to maximise company profit, aspects of linear programming and the use of Value Analysis. The learning outcomes tested are: Part (a) A2(b), interpret variable/fixed cost analysis in multiple product contexts to break-even analysis and product mix decision making, including circumstances where there are multiple constraints and linear programming methods are needed to identify optimal solutions. Part (b) A2(c), discuss the meaning of optimal solutions and how linear programming methods can be employed for profit maximising, revenue maximising and satisfying objectives. Part (c) B1(g), explain how process re-engineering can be used to eliminate non valueadding activities and reduce activity costs. Part (a) Carefully read the question to understand clearly what is required and complete two limiting factor calculations to identify the financial impact of making component F internally as opposed to buying it. Part (b) Understand the changes to the figures in part (a) and apply linear programming skills to construct the objective function and the constraints to be used in a linear programming model and address the issue described in part b(ii). Part (c) This part required knowledge of Value Analysis in that a description of the process is required. (a) Buying in the component D E F Total Contribution per unit 54 72 35 Skilled labour hours per unit 1 1.5 0.5 Contribution per skilled labour hour 54 48 70 Rank 2nd 3rd 1st Output (units) 2,400 1,000 3,000 Contribution $ 129,600 72,000 105,000 306,600 Making the component D E F Total Contribution per unit 54 72 78 Skilled labour hours per unit 1 1.5 1.5 Contribution per skilled labour hour 54 48 52 Rank 1st 3rd 2nd May 2013 7 P2
Output (units) 2,400 0 2,000 Contribution $ 129,600 0 156,000 285,600 In Month 1 the optimum production plan is to buy in the component and make 2,400, 1,000 and 3,000 units of D, E and F respectively. This will earn a profit of $156,600 (b)(i) Objective function: Maximise 54D + 72E, where D and E are the number of units of those products to be produced. Subject to: Direct materials Skilled labour Unskilled labour Machine hours Demand for D Demand for E 3D+4E 16,000 1D+1.5E 5,400 1.5D+1E 5,000 4D+4E 19,600 D 3,000 E 3,000 (b)(ii) The optimum will be at the point where the binding constraints intersect. The binding constraints are: 1D + 1.5E = 5,400 (Equation 1) 1.5D + 1E = 5,000 (Equation 2) Multiply equation 1 by 1.5 gives: 1.5D + 2.25E = 8,100 (Equation 3) Equation 3 Equation 2 gives: 1.25E = 3,100 and therefore E = 2,480 Therefore by substitution into any of the equations gives D = 1,680 The resulting profit is (1,680 * $54)+(2,480 * $72) - $150,000 = $119,280. (c) The stages in a value analysis exercise are: Determine the function of the product and of each part/component in the product. The main issue is to identify the function of each component. Determine the costs of each part/component that makes up the function. Develop alternative ways of performing the function of each part. Evaluate the alternatives. Recommend / implement the results. P2 8 May 2013
Answer to Question Seven The question examines candidates knowledge and understanding of transfer pricing, in particular adopting an opportunity costing approach. The learning outcomes tested are Part (a) & (b) D3(c), discuss the likely consequences of different approaches to transfer pricing for divisional decision making, divisional and group profitability, the motivation of divisional management and the autonomy of individual divisions. Part (c) D3(d) discuss in principle the potential tax and currency management consequences of internal transfer pricing policy. For part (a), carefully read and understand the data provided and assemble the figures to show the profitability of two divisions, at three different levels of output with one division supplying to a second division. Part (b) requests candidates to consider the impact of the receiving division deciding to purchase components externally as opposed to purchasing from the other division. Part (c) requires an explanation of arm s length pricing and the methods that can be used to determine an arm s length price. (a) Workings Given the demand figures for the finished product and the components it can be seen that both divisions will be working at full capacity. The only changes to the profits of both divisions will be caused by the transfer prices used for the components. S Division $000 External sales 15,000 @ $200 3,000 Variable costs 35,000 @ $105 3,675 Fixed costs 1,375 Loss before internal sales -2,050 R Division $000 Revenue 10,000 @ $800 8,000 Own variable costs 10,000 @ $250 2,500 Fixed costs 900 Profit before cost of components 4,600 The transfer prices used will generate revenues for S Division and costs for R Division. The prices used will be based on opportunity cost and these will be determined by reference to the demand made by external customers for the components and S Division s capacity. For example if external demand is for 19,000 components, S will only be able to supply 15,000 and therefore there is an opportunity cost of 4,000 components at $200 each because of the fixed capacity of 35,000 components. External demand for components 15,000 19,000 35,000 Components transferred at $200 0 4,000 20,000 Components transferred at $105 20,000 16,000 0 Internal revenues and costs $ 000 2,100 2,480 4,000 May 2013 9 P2
Answer S Division External demand for components 15,000 19,000 35,000 $ 000 $ 000 $ 000 Loss before internal sales -2,050-2,050-2,050 Internal sales 2,100 2,480 4,000 Profit 50 430 1,950 R Division External demand for components 15,000 19,000 35,000 $ 000 $ 000 $ 000 Profit before cost of components 4,600 4,600 4,600 Cost of components 2,100 2,480 4,000 Profit 2,500 2,120 600 (b) External demand for components 15,000 19,000 35,000 $ 000 $ 000 $ 000 Extra cost of external purchases 1,300 1,300 1,300 20,000*(170-105) Extra contribution by S external 0 380 1,900 Total impact -1,300-920 600 (c) The OECD guidelines are based on the arm s length price principle, that is a price that would have been arrived at by two unrelated companies acting independently. There are three methods that the tax authorities can use: 1. The comparable uncontrolled price method (which uses externally verified prices of similar transactions involving unrelated companies) 2. The resale price method (which deducts a percentage from the selling price from the final product to allow for profit) can be used when goods are sold on with little further processing 3. The cost-plus method: an arm s length gross margin is established and is applied to the seller s manufacturing cost. The OECD guidelines state that whenever possible the comparable uncontrolled price method should be used and if there is no market price, preference should be given to costplus. P2 10 May 2013