Operational Level Paper P1 Performance Operations November 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/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 February 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 Annual purchases this year = 547,800/55 x 365 =3,635,400 Annual purchases next year = 3,635,400 x 1.15 = 4,180,710 Trade payables outstanding = 4,180,710 x 50/365 = 572,700 The correct answer is D. The Chartered Institute of Management Accountants 2013
1.2 Sales revenue for the year 1,500,000 Plus cash received from last year 242,000 Less trade receivables at end of year (1,500,000/365 x 60) (246,575) Cash received from customers 1,495,425 The correct answer is A. 1.3 The correct answer is B. 1.4 The first lease payment is paid in advance i.e. in Year 0 Time Cash flow Discount factor 12% Present value 0 1-300 300 1.0000 1 / 0.12 = 8.3333 300 2,500 Present Value 2,800 The present value of the lease payments is 2,800. The correct answer is B. 1.5 EOQ = 2C D C o h Where: C o = (cost per order) = 150 D = (annual demand) = 15,000 units C h = (cost of holding one unit for one year) = 6.00 EOQ = 2 150 15,000 6 = 866 The correct answer is C. 1.6 Yield to maturity of similar bonds is 7%, therefore use 7% as the discount rate. Year(s) Description Cash flow Discount Factor (7%) Present Value 1-7 Interest 8.50 5.389 45.81 7 Redemption 100 0.623 62.30 0 Market value 108.11 The current expected market value of the bond is therefore 108.11 P1 2 November 2013
1.7 It is necessary to find the annuity factor where the initial investment will be equal to the net cash inflows. 281,000 x four year annuity factor = 800,000 Four year annuity factor = 800,000/281,000 = 2.847 The four year annuity factor for 15% = 2.855 The four year annuity factor for 16% = 2.798 The maximum discount rate at which the project will be financially viable is therefore 15%. Alternatively: Using a 20% discount rate Year Cash flow Discount factor Present value 0 (800,000) 1.000 (800,000) 1-4 281,000 2.589 727,509 (72,491) Using interpolation: 12% + (53,397/(53,397+72,491)) x 8% 12% + 3.39% = 15.39% To the nearest 1%, the discount rate is 15% 1.8 Payment will be made 40 days early. Number of compounding periods = 365/40 = 9.125 1+ r = (1.00/0.98) 9.125 1+ r = 1.20244 The effective annual rate of the early settlement discount is 20.24% The cost of the overdraft is 11% per annum, therefore the company should accept the early settlement discount. Alternatively: If payment is made on the 10 th day the discount is worth 10,000 x 0.02 = 200 Saving on overdraft interest if payment is made on the 50 th day: The daily interest rate = 365 (1+0.11) -1 = 0.000285959 40 days interest = (1 + 0.000285959) 40 1 = 0.01150237 = 9,800 x 0.01150237 = 112.72 Therefore pay on the 10 th day and accept the early settlement discount. November 2013 3 P1
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 incremental budgeting. Candidates should clearly explain one advantage and two disadvantages of incremental budgeting in public sector organisations. Advantage An incremental approach is much easier and quicker to implement than other forms of budgeting approaches e.g. zero based budgeting. Public sector organisations tend to be fairly complex and in many cases outputs cannot be measured in monetary terms therefore the link between inputs and outputs is difficult to establish. An incremental approach can therefore provide a cost effective approach to budgeting. Disadvantages Under an incremental approach to budgeting, existing operations and the current budgeted allowance for these existing activities are taken as the base level for preparing the budget. The base level is then adjusted for known changes and inflation. The main disadvantage of this is that the cost of past activities becomes fixed and any inefficiencies or wastage is perpetuated. The incremental approach means that budget holders in public sector organisations will be encouraged to use up this year s budget to ensure that next year s budget will be as high as possible. Any overspends in the current year will be included in the budget for the following year. For both these reasons the incremental approach does not encourage managers in public sector organisations to look at the efficiency and effectiveness of activities undertaken and how taxpayers can be given value for money. (b) The question assesses learning outcome B2(b) calculate projected revenues and costs based on product/service volumes, pricing strategies and cost structures. It examines candidates ability to calculate budgeted product costs using activity based budgeting. Candidates should firstly identify the cost driver for each of the activities and the number of cost drivers for each product and in total. They should then use the cost driver information to charge the overhead costs to each product. P1 4 November 2013
Number of set ups Product X Product Y Product Z Production units 10,000 16,000 18,000 Batch size 100 200 300 Number of batches 100 80 60 Number of set ups per batch 2 3 6 Total number of set ups 200 240 360 Product X Product Y Product Z Total Set up costs 140,000 168,000 252,000 560,000 Material handling costs (200/800 x 560,000) 72,600 (16,530/55,100 x 242,000) Inspection costs 84,920 (240/800 x 560,000) 91,960 (20,938/55,100 x 242,000) 127,380 (360/800 x 560,000) 77,440 (17,632/55,100 x 242,000) 173,700 242,000 386,000 (1,188/5,400 (1,782/5,400 (2,430/5,400 x 386,000) x 386,000) x 386,000) 297,520 387,340 503,140 1,188,000 (c) The question assesses learning outcome D1(d) prepare expected value tables. It examines candidates ability to prepare a payoff table showing the possible profit at different levels of demand and production. Candidates should firstly calculate the profit per tonne of production sold and the cost per tonne of production unsold. They should then calculate the profit for each of the combinations of levels of demand and production quantities. November 2013 5 P1
Profit per tonne of production sold = 150-70 = 80 Cost per tonne of production unsold = 70 + 20 = 90 Production Demand 80,000 tonnes 60,000 tonnes 40,000 tonnes 72,000 tonnes 5,040,000 (72,000 x 80) (8,000 x 90) 54,000 tonnes 1,980,000 (54,000 x 80) - (26,000 x 90) 38,000 tonnes (740,000) (38,000 x 80) (42,000 x 90) 4,800,000 (60,000 x 80) 3,780,000 (54,000 x 80) (6,000 x 90) 1,060,000 (38,000 x 80) (22,000 x 90) 3,200,000 (40,000 x 80) 3,200,000 (40,000 x 80) 2,860,000 (38,000 x 80) (2,000 x 90) (d) Part (i) of the question assesses learning outcome D1(c) analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms. Part (ii) of 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. Part (i) examines candidates ability to calculate the expected demand and the resultant profit if the decision on production quantity was based on the expected demand. Part (ii) requires candidates to describe the attitude to risk of a decision maker who makes decisions using the expected value decision rule. (i) Candidates should firstly apply the probabilities for the weather conditions to calculate the expected value of demand. They should then establish the production quantity that would be required to meet the expected demand. They should then calculate the profit that would be earned from this combination of demand and production quantity. (ii) Candidates should clearly describe the attitude to risk of a decision maker who applies the expected value decision rule. (i) If the expected value decision rule is used the company would need to apply the probabilities given for each of the weather conditions to calculate the expected value of the demand. Expected value of demand = (72,000 x 30%) + (54,000 x 50%) + (38,000 x 20%) = 56,200 If the expected value of demand is 56,200 the company will produce 60,000 tonnes. P1 6 November 2013
The profit will be: (56,200 x 80) - (3,800 x 90) = 4,154,000 (ii) A decision maker who uses the expected value rule is considered to be risk neutral. A risk neutral person is a person who is indifferent to risk. A person making a decision using the expected value rule would be indifferent between two alternatives that have the same expected values even when they have different dispersions. (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 ways in which an environmental costing system can lead to improved financial performance. Candidates should clearly explain three ways in which an environmental costing system may lead to improved financial performance. Examiner s note: the question asks for three ways. Examples of points that would be rewarded are given below. Cost reduction Organisations that have an effective environmental costing system are more likely to identify and take advantage of cost reduction and other improvement opportunities. Cost reductions will arise as a result of reduction in wastage and disposal costs. Organisations that are aware of environmental costs have benefited from additional revenues as a result of recycling waste. Increased revenues An awareness of the extent of environmental costs may result in the production of products that meet the environmental needs of or concerns of customers. This can result in an improved company image which can lead to increased sales. It may also be possible to sell these products at a premium price. Improved decision making An awareness of environmental costs will also reduce the chances of employing incorrect pricing of products and services and taking the wrong options in terms of mix and development decisions. This in turn may lead to enhanced customer value while reducing the risk profile attaching to investments and other decisions which have long term consequences. Avoidance of costs of failure A lack of awareness of environmental costs can result in environmental failures and significant additional costs, for example the associated costs of clean-up and financial penalties associated with environmental disasters. The well publicised BP oil spill in the Gulf of Mexico has so far cost the oil company billions of dollars in penalties and fines. November 2013 7 P1
(f) The question 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 prioritise projects where some of the projects are mutually exclusive and where there is capital rationing. Candidates should firstly rank the projects based on the profitability index taking into account that projects C and D are mutually exclusive. They should then allocate the available funds based on the ranking taking into account that the projects are divisible. They should then use the profitability index to calculate the net present value of the projects and the maximum net present value that can be earned from the projects. Project Investment Profitability Index Net present Ranking value A 12,000 0.20 2,400 3 B 8,000 0.05 400 4 C 20,000 0.60 12,000 1 D 16,000 0.40 6,400 n/a E 14,000 0.30 4,200 2 The projects should be invested in as follows: Project Investment Net present value Ranking C 20,000 12,000 1 E 14,000 4,200 2 A (x 50%) 6,000 1,200 3 40,000 17,400 The maximum net present value that can be earned is 17,400. P1 8 November 2013
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 variances to enable the reconciliation of budgeted and actual contribution margins. 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 why the variances may have arisen and the possible interrelationship between the variances. Part (c) also assesses learning outcome A1(d) apply standard costing methods, within costing systems, including the reconciliation of budgeted and actual profit margin. It examines candidates ability to calculate labour mix and yield variances. In part (a) candidates should firstly calculate the budgeted contribution and the actual contribution for the period. They should then calculate each of the variances for sales, material and labour. They should then prepare a reconciliation statement starting with the budgeted contribution, adjusting for the sales volume contribution variance to calculate a revised contribution and then showing each of the individual variances to reconcile the budgeted contribution to actual contribution. 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 calculate the total labour efficiency variance, mix variance and yield variance using the further information available about the labour mix. (a) Reconciliation statement Budgeted contribution (38,000 x 44) Sales volume contribution variance (36,000 units - 38,000 units) x 44 88,000 A 1,672,000 Standard contribution on actual sales volume 1,584,000 Sales price variance 36,000 units x (134-136) Material price variance ((76,000 kg x 10) 754,000) Material usage variance ((36,000 x 2 kg) 76,000 kg) x 10 Labour rate variance ((114,000 x 24) - 2,656,000) Labour efficiency variance ((36,000 x 3 hrs) 114,000) x 24 72,000 A 40,000 A 144,000 A 6,000 F 80,000 F Actual contribution 1,414,000 November 2013 9 P1
Workings: Actual contribution for the period Sales 36,000 units x 134 4,824,000 Direct materials 754,000 Direct labour 2,656,000 (3,410,000) Actual contribution 1,414,000 (b) The Production Director s decisions may have contributed to the total material cost variance of 7,200A and the total labour cost variance of 15,600A. The material price variance is favourable due to the purchase of reduced quality materials. However, this has probably contributed to the adverse material usage variance from additional wastage of the material due to its poorer quality and also because the labour force will be unfamiliar with handling the new material. The decision to use lower skilled labour has resulted in a favourable labour rate variance but this has been outweighed by the adverse labour efficiency variance. There could be a number of reasons for the adverse labour efficiency variance. The labour force will be less familiar with the material and therefore slower when working with it but also the less skilled labour would be expected to take longer due to their lack of experience and skills. It could be argued that the Production Director is also responsible for the adverse sales variances. According to the Sales Director the sales price variance reflects the need to reduce selling prices as a result of customer dissatisfaction with the quality of the product. The adverse sales volume variance will at least partly be a result of the customer dissatisfaction and the amount of returned products. The decision will also have resulted in an increase in administration costs relating to the handling of customer complaints and other costs in dealing with the faulty products. These additional costs are not reflected in the production cost variances that have been analysed. (c) (i) Labour efficiency variance Skilled labour ((36,000 x 1.8 hours) 64,000) x 30 = 24,000 F Unskilled labour ((36,000 x 1.2 hours) 50,000) x 15 = 102,000 A Total efficiency variance 78,000 A (ii) Labour mix variance Actual hours @standard mix Actual hours @ actual mix Variance (hours) Standard cost Variance Skilled labour 68,400 64,000 4,400 F 30 132,000 F Semi-skilled 45,600 50,000 4,400 A 15 66,000 A labour 114,000 114,000 0 66,000 F P1 10 November 2013
Or alternatively: Weighted average cost per hour of input 72/3 hours = 24 per hour Labour mix variance Actual hours @standard mix Actual hours @ actual mix Variance (hours) Standard cost Variance Skilled labour 68,400 64,000 4,400 (30 24) 26,400 F Semi-skilled 45,600 50,000 4,400 (15 24) 39,600 F labour 114,000 114,000 66,000 F (iii) Labour yield variance Standard hours of input per unit of output = 3 hours 36,000 units output x 3 hours = 108,000 hours of input Actual hours = 114,000 hours Variance = 6,000 hours A Standard cost per hour = 24 Variance = 6,000 hours x 24 = 144,000 A Or alternatively: 114,000 hours should yield 114,000/3hours = 38,000 units Actual yield = 36,000 units Yield variance = 2,000 units A Standard labour cost per unit = 72 Yield variance = 2,000 units x 72= 144,000 A November 2013 11 P1
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 learning outcome 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) 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) and the discounted payback period for the project. Part (c) assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates ability to explain non-financial factors that a company would need to consider before deciding whether to outsource the production of the product. In part (a) candidates should firstly calculate the contribution for each year of the project. They should then deduct the fixed costs after adjusting these for depreciation. The tax depreciation and tax payments should then be calculated. The total cost of the investment, the residual value and the working capital cash outflows and inflows 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)(i) candidates should use the cash flows calculated in part (a) and discount these at a higher discount rate to get a negative NPV. They should then use interpolation to calculate the IRR of the project. In part (b)(ii) candidates should use the discounted cash flows calculated in part (a) to calculate the cumulative discounted cash flows at the end of each year and the discounted payback period of the project. In part (c) candidates should clearly explain three non-financial factors that the company should consider before deciding whether to outsource production. (a) Fixed costs Depreciation per annum = (20m - 5m) / 5 = 3m Fixed costs (excluding depreciation) per annum = 8m - 3m = 5m Contribution Years 1 5 Year 1: 50,000 units x (500-200) = 15,000,000 Year 2: 60,000 units x (500-200) = 18,000,000 Year 3: 75,000 units x (400-200) = 15,000,000 Year 4: 30,000 units x (400-200) = 6,000,000 Year 5: 30,000,units x (400-200) = 6,000,000 P1 12 November 2013
Taxation Year 1 Year 2 Year 3 Year 4 Year 5 m m m m m Contribution 15 18 15 6 6 Fixed costs (5) (5) (5) (5) (5) Net cash 10 13 10 1 1 flows Tax (5) (3.8) (2.8) (2.1) (1.3) Depreciation Taxable 5 9.2 7.2 (1.1) (0.3) profit Taxation @ 30% (1.5) (2.8) (2.2) 0.3 0.1 Net present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 m m m m m m Investment / (20) 5 residual value Working capital (6) 6 Net cash flows 10 13 10 1 1 Tax payment (0.8) (1.4) (1.1) 0.2 0.1 Tax payment (0.7) (1.4) (1.1) 0.1 Net cash flow (26) 9.2 10.9 7.5 0.1 12.2 after tax Discount 1.000 0.893 0.797 0.712 0.636 0.567 factors @ 12% Present value (26) 8.2 8.7 5.3 0.1 6.9 Net present value = 3.2m The net present value is positive therefore on this basis JK should go ahead with the introduction of the new model. (b)(i) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 m m m m m m Net cash flow (26) 9.2 10.9 7.5 0.1 12.2 after tax Discount 1.000 0.833 0.694 0.579 0.482 0.402 factors @ 20% Present value (26) 7.7 7.6 4.3 0.0 4.9 Net present value = -1.5m By interpolation: IRR = 12% + ((3.2 / (3.2+1.5)) x 8%) = 12% + 5.4% = 17.4% November 2013 13 P1
(ii) Discounted Payback Year Discounted cash flows m Cumulative cash flows m 0 (26) (26) 1 8.2 (17.8) 2 8.7 (9.1) 3 5.3 (3.8) 4 0.1 (3.7) 5 6.9 3.2 Discounted Payback period = 4 years + ((3.7 /6.9) x 12) = 4 years 6 months (c) Examiner s note: the question asks for three factors. Examples of points that would be rewarded are given below. Quality: can the outsourcing company produce the same quality of product as JK s other models? JK has a reputation for high quality and this reputation could easily be destroyed if the outsourcing company are unable to produce the new model to the same quality standard. Reliability: can the outsourcing company be relied on to deliver the products when required by JK s customers? This may especially be a potential problem as the outsourcing company is based overseas and if the product is only for the home market. This may result in the need to maintain high stocks of the product and if the outsourcing company is unable to meet the delivery schedule result in lost sales for this model and potentially in lost sales for JK s other models. Management control: the company would need to manage the relationship with the outsourcing company. The fact that the outsourcing company is based overseas may make the relationship more difficult to manage. This may involve some additional costs that have not been considered in the net present value calculations. Financial strength of the outsourcing company: JK is reliant on the outsourcing company being able to provide the new model for at least the period of the outsourcing contract. P1 14 November 2013