Operational Level Paper P1 Performance Operations March 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 April 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 (1 + r) x (1 + i) = (1 + m) (1 + 0.06) x (1 + 0.03) = 1.0918 (1 + m) = 1.0918 m = 0.0918 m = 9.18% The correct answer is D. The Chartered Institute of Management Accountants 2014
1.3 Product R Product S Total Budgeted production 80,000 60,000 140,000 per annum (units) Number of batches 800 1,200 2,000 Number of machine 2,400 3,600 6,000 set-ups Total processing time (minutes) 240,000 300,000 540,000 Cost driver rate = $108,000 / 540,000 = $0.20 Total processing costs = $0.20 x 240,000 = $48,000 Processing costs per unit = $48,000 / 80,000 = $0.60 The correct answer is C. 1.4 Cost driver rate = $180,000 / 6,000 = $30 per set up Total set-up costs = $30 x 3,600 = $108,000 Set up cost per unit =$108,000 / 60,000 = $1.80 The correct answer is B. 1.5 The profitability index The correct answer is C. = net present value of the investment / initial investment = $140,500 / $500,000 = 0.281 1.6 The expected value of cost of the warranty claims is: $2,000,000 x 15% = $300,000 $6,000,000 x 3% = $180,000 $10,000,000 x 2% = $200,000 $680,000 Performance Operations 2 March 2014
1.7 Trade receivable at the end of this year = $862,860 x 55/365 = $130,020 Credit sales for next year = $862,860 x 1.05 = $906,003 Trade receivable days at end of next year = $130,020 / $906,003 x 365 = 52.38 days 1.8 (i) The minimum profit at a selling price of $80 is $50,000 The minimum profit at a selling price of $90 is $60,000 The minimum profit at a selling price of $100 is $70,000 The minimum profit at a selling price of $110 is $75,000 Therefore if the manager wants to maximise the minimum profit a selling price of $110 would be chosen. (ii) A regret matrix can be produced as follows: Competitor Reaction Selling price $80 $90 $100 $110 Strong $10,000 $0 $10,000 $5,000 Medium $30,000 $20,000 $10,000 $0 Weak $10,000 $0 $10,000 $20,000 Maximum regret $30,000 $20,000 $10,000 $20,000 Therefore if the manager wants to minimise the maximum regret a selling price of $100 would be chosen. March 2014 3 Performance Operations
SECTION B Answer to Question Two (a) The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines candidates ability to explain the advantages and disadvantages of zero based budgeting. Candidates should clearly explain two advantages and one disadvantage of zero based budgeting in the scenario described. Examiner s note: the question asks for two advantages and one disadvantage. Examples of points that would be rewarded are given below. Advantages a) It avoids the complacency inherent in the traditional incremental approach where it is assumed that future activities will be very similar to current ones. b) It encourages a questioning approach by focusing attention not only on the cost of the activity but on the benefits is provides. This will force the public sector managers to articulate the benefits encouraging them to think clearly about the activities. c) Preparation of decision packages will normally require the involvement of many employees. This involvement may produce many ideas and promote job satisfaction. Disadvantage a) The creation of decision packages and their subsequent ranking is very time consuming and costly. The public sector organisation will need to assess whether the benefits of the system outweigh the costs involved. b) The ranking process is very difficult and value judgements are inevitable. In a public sector organisation the decision packages are very disparate and difficult to compare. c) In applying ZBB activities may continue to be identified with traditional functional departments rather than cross functional activities and thus distract attention from the real cost-reduction issues. Performance Operations 4 March 2014
(b) 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 cash flows. Candidates should firstly apply the probabilities for the economic conditions to calculate the expected value of the net present value (NPV) for each of the projects without perfect information. They should then select the best outcome for each of the possible economic conditions 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. Economic Conditions Project A Project B Project C $000 $000 $000 Good (30%) 700 800 700 Fair (20%) 400 500 600 Poor (50%) 300 400 500 Expected values ($000) Project A ($700 x 0.3) + ($400 x 0.2) + ($300 x 0.5) = $440 Project B ($800 x 0.3) + ($500 x 0.2) + ($400 x 0.5) = $540 Project C ($700 x 0.3) + ($600 x 0.2) + ($500 x 0.5) = $580 On the basis of expected value Project C would be chosen. Expected value with perfect information ($000) If good select Project B = ($800 x 0.3) = $240 If fair select Project C = ($600 x 0.2) = $120 If poor select Project C = ($500 x 0.5) = $250 Expected value with perfect information is $240 + $120 + $250 = $610 The maximum amount that should be paid is ($610k $580k) = $30k March 2014 5 Performance Operations
(c) Part (i) assesses learning outcome E1(e) analyse trade debtor and creditor information. It examines candidates ability to calculate the effective annual interest rate of an early settlement discount. Part (ii) assesses learning outcome E1(f) analyse the impacts of alternative debtor and creditor policies. It examines candidates ability to identify methods that could be used to reduce a company s trade receivable days. In part (i) candidates should calculate how many days early the payment will be received. They should then divide 365 days by this to calculate the number of compounding periods. The discount rate should then be compounded by the number of periods to calculate the effective annual interest rate. In part (ii) candidates should clearly state two methods that could be used to reduce a company s trade receivable days. (i) Payment will be made 45 days early. Number of compounding periods = 365/45= 8.111 1+ r = (1.00/0.98) 8.111 1+ r = 1.17805 The effective annual interest rate of the early settlement discount is 17.81% (ii) Examiner s note: the question asks for two methods. Examples of methods that would be rewarded are given below. a) Interest penalties for late payment b) Improved credit control procedures c) Reduce the credit terms Performance Operations 6 March 2014
(d) The question assesses learning outcome E1(g) analyse the impacts of alternative policies for stock management. Part (i) examines candidates ability to calculate the economic order quantity (EOQ) for a product. Part (ii) requires candidates to calculate the total inventory holding and ordering costs if the company uses the EOQ. In part (i) candidates should apply the formula for the EOQ given in the question paper to the figures given in the question in order to calculate the EOQ. In part (ii) candidates should firstly calculate the total number of orders that would be required if the EOQ was used. This can then be multiplied by the ordering costs per order to calculate the total ordering costs. In order to calculate the holding costs the EOQ should be divided by two to calculate the average inventory held. This should then be multiplied by the holding cost per unit to calculate the total holding costs. The total ordering cost and total holding costs can then be added together. (i) EOQ = 2C D C o h Where: C o (cost per order) = $150 D = (annual demand) = 30,000 units C h = (cost of holding one unit for one year) = $25 EOQ = 2 150 30, 000 25 = 600 units (ii) Number of orders = 30,000 / 600 = 50 per year Ordering costs = 50 x $150 = $7,500 Holding costs = 600 x 0.5 x $25 = $7,500 Total ordering and holding costs = $15,000 March 2014 7 Performance Operations
(e) The question assesses learning outcome A3(a) apply principles of environmental costing in identifying relevant internalised costs and externalised environmental impacts of the organisation s activities. It examines candidates ability to explain the benefits to a company from using an environmental costing system. Candidates should clearly explain three benefits that may arise for a company that uses an environmental costing system. Examiner s note: the question asks for three benefits. Examples of points that would be rewarded are given below. Increased awareness of the impact of environment related activities on their financial statements Organisations that use an environmental costing system will have greater awareness of the impact of environment related activities on their financial statements. This is because conventional management accounting systems tend to attribute many environmental costs to general overhead accounts with the result that they are hidden from management. Cost control / reduction Organisations which adopt environmental cost management principles are more likely to identify and take advantage of cost reduction and other improvement opportunities. Identifying and monitoring the usage and cost of resources such as water, electricity and fuel will result in better control of the cost of these resources and identification of potential for cost reduction. More accurate product costs / improved decision making A good environmental costing system will produce more accurate product costs. This will reduce the chances of employing incorrect pricing of products and services and taking the wrong options in terms of mix and development decisions. Lack of cost information can result in the cross subsidisation of environmentally damaging products. Environmental risk management Improved environmental cost information will enable environmental considerations to form part of investment decisions. The likelihood and impact of environmental risks can also be assessed. Performance Operations 8 March 2014
(f) Part (i) of the question assesses learning outcome E2(d) illustrate numerically the financial impact of short-term funding and investment methods. Part (ii) assesses learning outcome E2(b) identify alternatives for investment of short-term cash surpluses. Part (i) examines candidates ability to calculate the issue price of a bill of exchange. Part (ii) requires candidates to state two ways in which an accepted bill of exchange can be used by the holder. In part (i) candidates should calculate the discount on the bill by multiplying the face value by the discount yield for 91 days. The discount on the bill should then be subtracted from the face value to calculate the issue price. In part (ii) candidates should clearly state two ways in which an accepted bill of exchange can be used by the holder. (i) If the discount yield is 6% then the discount on the bill will be: $1,000 x 0.06 x 91/365 = $14.96 The issue price of the bill is therefore: $1,000 - $14.96 = $985.04 (ii) Examiner s note: the question asks for two ways. Examples of points that would be rewarded are given below. The holder of an accepted bill of exchange can do one of the following: (i) (ii) (iii) Hold the bill until the due date and collect the money Discount the bill with the bank for immediate payment Transfer the bill to a third party in settlement of an amount due. March 2014 9 Performance Operations
SECTION C Answer to Question Three The question assesses a number of learning outcomes. Part (a) assesses learning outcome A1(d) apply standard costing methods, within costing systems, including the reconciliation of budgeted and actual profit margins. It examines candidates ability to calculate appropriate variances to enable the reconciliation of budgeted and actual profit. Part (b) assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines candidates ability to discuss the reasons the variances may have arisen and the possible interrelationship between the variances. Part (c) assesses learning outcome A1(h) explain the impact of just-in-time manufacturing methods on cost accounting and the use of backflush accounting when work in progress stock is minimal. It examines candidates ability to explain the reasons why standard costing may not be considered useful in a modern manufacturing environment. In part (a) candidates should firstly calculate the budgeted profit and the actual profit for the period. They should then calculate each of the variances for sales, material, labour and production overheads. They should then prepare a reconciliation statement starting with the budgeted profit and then showing each of the individual variances to reconcile the budgeted profit to actual profit. In part (b) candidates should discuss the effect that the Production Director s decision has had on the company performance as shown by the variances. In part (c) candidates should clearly explain the reasons why standard costing may not be considered useful in a modern manufacturing environment. Performance Operations 10 March 2014
(a) (i) Reconciliation statement for February Budgeted gross profit (1,000 units x $60) Sales volume profit variance (1,200 units - 1,000 units) x $60 Sales price variance 1,200 units x ($306 - $300) Direct material price variance 22,000 mtrs x ($9 - $12) Direct material usage variance ((1,400 x 15 mtrs) 22,000 mtrs) x $9 Direct labour rate variance 6,800 hours x ($12 - $15) Direct labour efficiency variance ((1,400 x 5 hrs) 6,800) x $12 Variable overhead expenditure variance (6,800 x $6) $33,000 Variable overhead efficiency variance ((1,400 x 5 hrs) 6,800) x $6 Fixed overhead expenditure variance (1,000 x $15) - $18,000 Fixed overhead volume variance ((1,400 1,000 x 5 hrs) x $3) $ $ 66,000 A 9,000 A 20,400 A 3,000 A 60,000 12,000 F 7,200 F 2,400 F 7,800 F 1,200 F 6,000 F Actual gross profit /(loss) (1,800) Workings: Actual gross profit for the period $ Sales 1,200 units x $306 367,200 Direct materials 22,000 metres x $12 264,000 Direct labour 6,800 hours x $15 102,000 Variable production overheads 33,000 Fixed production overheads 18,000 Closing stock 200 units x $240 (48,000) Actual gross profit (1,800) (b) The Production Director s decision has resulted in a favourable sales volume variance of $12,000 and a favourable sales price variance of $7,200 F which may at least partly be as a result of the improved quality of the product. However, the favourable sales variances have been achieved at a very high cost in terms of material and labour. The Production Director s decision has resulted in a total material cost variance of $75,000 A and a total labour cost variance of $18,000 A. The material price variance is adverse due to the purchase of higher quality materials. However, there is also an adverse material usage variance which may be because the labour force was unfamiliar with handling the new material. The decision to use higher skilled labour has resulted in an adverse labour rate variance which has been only partially offset by a favourable labour efficiency variance. March 2014 11 Performance Operations
(c) In a JIT environment measuring standard costing variances may encourage dysfunctional behaviour. A JIT production environment relies on producing small batch sizes economically by reducing set up times. Performance measures that benefit from large batch sizes or producing for inventory should therefore be avoided. In an AMT environment the major costs are those related to the production facility rather than production volume related costs such as materials and labour, which standard costing is essentially designed to plan and control. Fixed overhead variances don t necessarily reflect under or overspending but may simply reflect differences in production volume. An activity based cost management system may be more appropriate, focusing on the activities that drive the cost. In a total quality environment, standard costing variance measurement places an emphasis on cost control to the detriment of quality. Cost control may be achieved at the expense of quality and competitive advantage. A continuous improvement environment requires a continual effort to do things better rather than achieve an arbitrary standard based on prescribed or assumed conditions. In today s competitive environment cost is market driven and is subject to considerable downward pressure. Cost management must consist of both cost maintenance and continuous cost improvement. In a JIT/AMT/TQM environment the workforce is usually organised into empowered, multiskilled teams controlling operations autonomously. The feedback they require is real time. Periodic financial reports are neither meaningful nor timely enough to facilitate appropriate control action. Performance Operations 12 March 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) assesses learning outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. It examines candidates ability to determine the optimum replacement cycle for a company s non-current assets. In part (a) candidates should firstly calculate the gross profit that would be earned in each year from the online shopping service and deduct the lost profit from existing in-store sales. They should then deduct the payments to PQ and the other operating costs and add on the lease income. The tax depreciation and tax payments should then be calculated. The total cost of the investment, the residual value should be added to the net cash flows. 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 would need to consider before deciding whether to go ahead with the project. In part (c) candidates should calculate the NPV of the cash flows under each of the three alternatives. They should then divide the NPV by the appropriate annuity factor to calculate the annualised equivalent cost. The optimum replacement cycle can then be selected as the alternative with the lowest annualised equivalent cost. (a) Gross profit Years 1 5 Year 1: 100,000 customers x 52 weeks x $200 = $1,040m x 20% = $208m Year 2: 120,000 customers x 52 weeks x $200 = $1,248m x 20% = $250m Year 3: 150,000 customers x 52 weeks x $200 = $1,560m x 20% = $312m Year 4: 160,000 customers x 52 weeks x $200 = $1,664m x 20% = $333m Year 5: 170,000 customers x 52 weeks x $200 = $1,768m x 20% = $354m Taxation Year 1 Year 2 Year 3 Year 4 Year 5 $m $m $m $m $m Gross profit 208 250 312 333 354 Lost profit from (62) (75) (94) (100) (106) existing sales Other operating (60) (65) (70) (75) (80) costs Lease income 20 20 20 20 20 Fee to PQ (30) (30) (30) (30) (30) Fee to PQ (2) (3) (3) (3) (4) Net cash flows 74 97 135 145 154 Tax depreciation (4) (3) (2) (2) (4) Taxable profit 70 94 133 143 150 Taxation @ 30% 21 28 40 43 45 March 2014 13 Performance Operations
Net present value Investment / residual value Net cash flows Tax payment Tax payment Net cash flow after tax Discount factors @ 12% Present Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $m $m $m $m $m $m $m (445) 350 74 97 135 145 154 (11) (14) (20) (22) (23) (10) (14) (20) (21) (22) (445) 63 73 101 103 460 (22) 1.000 0.893 0.797 0.712 0.636 0.567 0.507 (445) 56 58 72 66 261 (11) value Net present value = $57m The net present value is positive therefore the project should go ahead. (b) Two other factors that the company would need to consider are: Quality/ reliability: can the online retailer provide the quality and reliability of service that LM s customers will expect? Financial strength of PQ: LM is reliant on PQ being able to provide the IT technology and delivery service to its customers for at least the five year period of the contract. (c) Year Discount Factor @12% Replace after Year 1 Replace after Year 2 Replace after Year 3 Cash Present Cash Present Cash Present flows value flows value flows value $ $ $ $ $ $ 0 1.000 (25,000) (25,000) (25,000) (25,000) (25,000) (25,000) 1 0.893 10,000 8,930 (6,000) (5,358) (6,000) (5,358) 2 0.797 2,000 1,594 (8,000) (6,376) 3 0.712 (8,000) (5,696) Net present value Cumulative discount factor Annualised equivalent (16,070) (28,764) (42,430) 0.893 1.690 2.402 (17,996) (17,020) (17,664) The lowest annualised equivalent cost occurs if the vehicles are kept for two years. Therefore the optimum replacement cycle is to replace the vehicles every two years. Performance Operations 14 March 2014