Operational Level Paper P1 Performance Operations Examiner s Answers SECTION A Answer to Question One 1.1 The correct answer is D. 1.2 The maximum regret at a selling price of 40 is 20,000 The maximum regret at a selling price of 45 is 10,000 The maximum regret at a selling price of 50 is 20,000 The maximum regret at a selling price of 55 is 30,000 Therefore if the manager wants to minimise the maximum regret, a selling price of 45 will be selected. The correct answer is B. 1.3 The correct answer is A. 1.4 Payment will be made 30 days early. Number of compounding periods = 365/30 = 12.167 1.00 1+ r = 0.97 12.167 1+ r = 1.4486 The effective annual cost of the cash discount is 44.9% The correct answer is C. September 2011 1 P1
1.5 [682,000/365] x 60 = 112,110 [112,110 / (682,000 x 1.15)] x 365 = 52.17 days The correct answer is A. 1.6 Budgeted sales 144,000 units Plus Closing inventory 12,000 units Less Opening Inventory (6,500) units Budgeted Production 149,500 units 149,500 x 2 hours per unit = 299,000 hours 80% x 299,000 = 239,200 hours x 15 = 3,588,000 20% x 299,000 = 59,800 hours x (15 x1.5) = 1,345,500 Total labour cost budget = 4,933,500 1.7 Year(s) Description Cash flow Discount Factor (7%) Present Value 1-6 Interest 8 4.767 38.14 6 Redemption 100 0.666 66.60 PV 104.74 The investor should pay 104.74. 1.8 (i) Expected values (000) Project A (400 x 0.3) + (500 x 0.5) + (600 x 0.2) = 490 Project B (300 x 0.3) + (350 x 0.5) + (400 x 0.2) = 345 Project C (500 x 0.3) + (450 x 0.5) + (650 x 0.2) = 505 (ii) Value of perfect information (000) If weak select Project C = (500 x 0.3) = 150 If average select Project A = (500 x 0.5) = 250 If good select Project C = (650 x 0.2) = 130 Value of perfect information is (530 505) = 25 P1 2 September 2011
SECTION B Answer to Question Two (a) One of the main purposes of budgeting is to act as a control mechanism, with actual results being compared against budget. Another purpose of a budget is to set targets to motivate managers and optimise their performance. The participation of managers in the budget setting process has several advantages. Managers are more likely to be motivated to achieve the target if they have participated in setting the target. Participation can reduce the information asymmetry gap that can arise when targets are imposed by senior management. Imposed targets are likely to make managers feel demotivated and alienated and result in poor performance. Participation however can cause problems; in particular, managers may attempt to negotiate budgets that they feel are easy to achieve which gives rise to budget padding or budgetary slack. They may also be tempted to empire build because they believe that the size of their budget reflects their importance within the organisation. This can result in budgets that are unsuitable for control purposes. (b) Advantages Flexibility: the bank will agree an overdraft limit or facility. The borrower may not require the full facility immediately but may draw funds up to the limit as and when required. If the funds are no longer required they can be repaid without suffering any penalty. Minimal documentation: legal documentation is fairly minimal when arranging an overdraft. The documents will state the maximum overdraft limit, the interest payable and the security required. An overdraft is seen as a relatively cheap source of finance. Banks usually charge between 2 and 5% above base rate depending on the creditworthiness and security offered by the borrower. Savings come from the fact that interest is only paid on the daily outstanding balance therefore a large cash inflow can offset the balance outstanding and temporarily lower the interest payable, whilst still retaining the ability to borrow up to the overdraft limit when required. Disadvantages An overdraft is strictly speaking repayable on demand. The interest rate payable will vary depending on the perceived credit risk of the borrower. Banks will normally expect security either in the form of a fixed charge or a floating charge. September 2011 3 P1
(c) Decision tree: Develop an overseas market or not 500,000 In-line 50% Develop 250,000 284,200 Succeed 70% 406,000 Adverse 30% Favourable 20% 630,000 34,200 Fail 30% 100,000 0 Don t Develop 0 Therefore the overseas market should be developed P1 4 September 2011
(d) Year Discount Factor @ 8% Van A Cash Flows Present Value Van B Cash Flows Present value 0 1.000 (25,000) (25,000) (30,000) (30,000) 1 0.926 (2,000) (1,852) (3,000) (2,778) 2 0.857 (2,000) (1,714) (3,000) (2,571) 3 0.794 (3,000) (2,382) (3,000) (2,382) 4 0.735 5,000 3,675 (4,000) (2,940) 5 0.681 6,000 4,086 Present Value Cumulative discount factor Annualised equivalent (27,273) (36,585) 3.312 3.993 8,234 9,162 The lowest annualised equivalent cost is for Van A therefore the company should replace its fleet of delivery vans with Van A. (e) Default risk This refers to potential doubt about the payment of interest or the eventual repayment of the capital invested. Investments in government securities are generally considered to have very low default risk however the recent financial crisis has shown that even investment in government securities is not risk free. Investment in equities is generally considered high risk and is not a suitable form of short-term investment. Interest rate risk This refers to the risk that market interest rates will change and the investor will be worse off. Interest rates cannot be predicted with any degree of accuracy. Variable rate bank deposits will leave the company vulnerable to a fall in interest rates. If the investment is in a fixed rate term deposit, whilst the investor will receive a guaranteed return, there will be an opportunity cost if market interest rates increase above the fixed rate. September 2011 5 P1
(f) (i) Product A Product B Selling price 46 62 Material cost (18) (16) Throughput contribution 28 46 Machine hours per unit 0.5 hours 0.8 hours Return per machine hour 56 57.50 (ii) Product A Product B Total Return per machine 56 57.50 hour Ranking 2 1 Units produced 3,200 8,000 Machine hours 1,600 6,400 8,000 Contribution per 56 57.5 machine hour Total contribution 89,600 368,000 457,600 Factory costs 248,000 Total profit 209,600 P1 6 September 2011
SECTION C Answer to Question Three (a) Tables (per unit) Chairs (per unit) Sideboards (per unit) Selling price 2,200 320 2,800 Direct material 1,000 160 1,200 Direct labour 400 60 600 Variable overheads 40 6 60 Contribution 760 94 940 Sales Mix Contribution Variance Actual Sales Quantity Actual Sales at budget mix Difference Variance from weighted average contribution per unit Variance 000 Tables 7,200 9,200 2,000 A (760-354.10) 811.80 A Chairs 31,000 29,900 1,100 F (94-354.10) 286.11 A Sideboards 7,800 6,900 900 F (940-354.10) 527.31 F 46,000 46,000 570.60 A Or alternatively: Actual Sales Quantity Actual Sales at budget mix Difference Contribution Variance 000 Tables 7,200 9,200 2,000 A 760 1,520 A Chairs 31,000 29,900 1,100 F 94 103.4 F Sideboards 7,800 6,900 900 F 940 846 F 46,000 46,000 570.6 A Sales Quantity Contribution Variance Budget Sales Quantity Actual Sales at budget mix Difference Contribution Variance 000 Tables 8,000 9,200 1,200 F 760 912 F Chairs 26,000 29,900 3,900 F 94 366.6 F Sideboards 6,000 6,900 900 F 940 846 F 40,000 46,000 6,000 F 2,124.6 F Or alternatively: Budget Sales Quantity Contribution Total Contribution 000 Tables 8,000 760 6,080 Chairs 26,000 94 2,444 Sideboards 6,000 940 5,640 40,000 14,164 Weighted average contribution = 14,164k / 40,000 = 354.10 Sales quantity contribution variance = (46,000 40,000) x 354.10 = 2,124.6 F September 2011 7 P1
(b) The sales quantity contribution variance and the sales mix contribution variance explain how the sales volume contribution variance has been affected by a change in the total quantity of sales and a change in the relative mix of products sold. From the figures calculated for the sales quantity contribution variance in part (a) we can say that the increase in total quantity sold would have earned an additional contribution of 2,124,600, if the actual sales volume had been in the budgeted sales mix. The sales mix contribution variance shows that the change in the sales mix resulted in a reduction in profit of 570,600. The change in the sales mix has resulted in a relatively higher proportion of sales of chairs which is the product that earns the lowest contribution and a lower proportion of tables which earn a contribution significantly higher than the weighted average contribution. The relative increase in the sale of sideboards however, which has the highest unit contribution, has partially offset the switch in mix to chairs. (c) Reconciliation statement for Sideboards Original budget contribution 6,000 units x 940 per unit Sales volume contribution variance (7,800 units - 6,000 units) x 940 Budget contribution at actual level of activity (7,800 units x 940 per unit) Other variances: 000 000 5,640 1,692 F 7,332 Selling price variance 7,800 units x (2,500-2,800) Direct material variance 7,800 x (1,200 1,300) Direct labour rate variance ((7,800 x 600) / 18.75) x (20-18.75) Direct labour efficiency variance (7,800 x (30 hrs per unit 32 hrs per unit)) x 20 Variable overhead expenditure variance (7,800 x 30 hrs) x (2-2.50) Variable overhead efficiency variance 7,800 x (30 hrs per unit 32 hrs per unit) x 2.50 Actual contribution 7,800 units x 520 Workings: 2,340 A 780 A 312 F 312 A 124.8A 31.2 A 4,056 Standard contribution per unit Flexed budget 7,800 units 000 Actual contribution per unit Total actual contribution 000 Sales revenue 2,800 21,840 2,500 19,500 Direct material 1,200 9,360 1,300 10,140 Direct labour 600 4,680 600 4,680 Variable overhead 60 468 80 624 Contribution 940 7,332 520 4,056 P1 8 September 2011
(d) 1. The size of the variance costs tend to fluctuate around a norm and therefore variances may be expected on most costs. The company will need to decide how large a variance must be before it is considered abnormal and worthy of investigation. 2. The likelihood of the variance being controllable managers may know from experience that certain variances may not be controllable even if a lengthy investigation is undertaken to determine their cause. Managers may argue that a material price variance is less easily controlled than a material usage variance as it is determined by external factors. On the other hand a material price variance may be due to the efficiency of the purchasing department and this would only be apparent after further investigation. 3. The likely cost versus the potential benefits of the investigation the cost of the investigation would need to be weighed against the cost that would be incurred if the variance were allowed to continue in future periods. Other acceptable factors could be: The interrelationship between variances The type of standard that was set September 2011 9 P1
Answer to Question Four (a) Year 1 expected sales revenue = (450m x 50%) + (300m x 30%) + (600m x 20%) = 435m Year 2 sales revenue = 435m +100m = 535m Year 3 sales revenue = 535m + 100m = 635m Year 4 sales revenue = 635m + 100 = 735m Contribution Year 1 = 435m x 60% = 261m Contribution Year 2 = 535m x 60% = 321m Contribution Year 3 = 635m x 60% = 381m Contribution Year 4 = 735m x 60% = 441m Fixed Costs Depreciation per annum (600m - 400m) / 4 = 50m Fixed costs excluding depreciation = 150m - 50m = 100m Cash Flows Year 1 Year 2 Year 3 Year 4 m m m m Contribution 261 321 381 441 Fixed Costs (100) (100) (100) (100) Marketing Costs (50) (50) (50) (50) Net cash flows 111 171 231 291 Taxation Year 1 Year 2 Year 3 Year 4 m m m m Net cash flows 111 171 231 291 Tax (150) (113) (84) 147 Depreciation Taxable profit (39) 58 147 438 Taxation @ 30% 12 (17) (44) (131) Net present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 m m m m m m Development (600) 400 and fit out costs Working capital (60) 60 Net cash 111 171 231 291 flows Tax payment 6 (9) (22) (66) Tax payment 6 (8) (22) (65) Net cash flow (660) 117 168 201 663 (65) after tax Discount 1.000 0.926 0.857 0.794 0.735 0.681 factors @ 8% Present value (660) 108 144 160 487 (44) Net present value = 195m P1 10 September 2011
The net present value is positive therefore on this basis the company should go ahead with the project. (b) (i) Year 1 Year 2 Year 3 Year 4 m m m m Fixed costs 100 100 100 100 Year 5 m Total m Tax @ 30% 30 30 30 30 Tax (15) (30) (30) (30) (15) payment Net cash 85 70 70 70 (15) flow Discount 0.926 0.857 0.794 0.735 0.681 Factor @ 8% Present value 79 60 56 51 (10) 236 195 / 236 = 82.6% If fixed costs increase by more than 82.6% the NPV of the project will be negative and the decision will be to reject the project. (ii) Sensitivity analysis recognises the fact that not all cash flows for a project are known with certainty. Sensitivity analysis enables a company to determine the effect of changes to variables on the planned outcome. Particular attention can then be paid to those variables that are identified as being of special significance. In project appraisal, an analysis can be made of all the key input factors to ascertain by how much each factor would need to change before the net present value (NPV) reaches zero i.e. the indifference point. Alternatively, specific changes can be calculated to determine the effect on NPV. (c) (i) Net cash flows Cumulative cash flows Year 0 m Year 1 m Year 2 m Year 3 m Year 4 m Year 5 m (660) 117 168 201 663 (65) (660) (543) (375) (174) Payback period 3 yrs + (174 / 663) x 12 = 3 yr 3 months (ii) Projects which return their cash outlay quicker can be seen as less risky. Payback is therefore used by companies at an early stage to eliminate projects that have unacceptable risk and return characteristics. In this case there is uncertainty surrounding the potential of the market September 2011 11 P1
and the management may be concerned to ensure that the payback period is relatively short in the event that it becomes necessary to withdraw from the market. Alternatively, a long payback period may persuade management not to enter the market in the first place. Payback is also seen as useful when funds are in short supply since early payback of funds allows investment in other profitable opportunities. Payback is also easy to use and is a simple way to communicate project acceptability to managers. P1 12 September 2011
The Senior Examiner for P1 Performance Operations offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper. Section A Question One Compulsory Question One consists of 8 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. Section B Question Two Compulsory Question Two has 6 sub-questions. (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 many conflict. It examines candidates ability to explain the behavioural consequences of budgeting and the difficulties and conflicts that can arise. (b) (c) (d) (e) (f) The question assesses learning outcome E2(a) identify sources of short-term funding. It examines candidates ability to discuss the advantages and disadvantages of an overdraft as a method of short term finance. The question assesses learning outcome D1(f) apply decision trees. It examines candidates ability to use decision trees to evaluate a decision where there is uncertainty regarding expected cash flows. The question assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates ability to compare two alternatives investments that have unequal lives. The question assesses learning outcome E2(b) identify alternatives for investment of short-term cash surpluses. It examines candidates ability to explain the risk factors that a company needs to consider when making short term investment decisions. The question assesses learning outcome A1(a) compare and contrast marginal (or variable), throughput and absorption accounting methods in respect of profit reporting and stock valuation. It examines candidates ability to calculate the return per machine hour using a throughput accounting approach and calculate profit on a throughput accounting basis. Section C Questions Three and Four - Compulsory 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 sales mix and sales quantity variances. 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 explain the meaning of the two variances calculated in part (a).part (c) also assesses learning outcome A1(d) apply standard costing methods, within costing systems, including the reconciliation of budgeted and actual profit margins and examines candidates ability to reconcile the budgeted and actual contribution for one of the products. Part (d) also assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines September 2011 13 P1
candidates ability to explain the factors that a company would use to determine whether a variance was significant and required investigation. 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) assesses learning outcome C1(f) apply sensitivity analysis to cash flow parameters to identify those to which net present value is particularly sensitive. It examines candidates ability to calculate the sensitivity of one variable and then to explain the benefits in carrying out sensitivity analysis. Part (c) (i) also assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates ability to calculate the payback period of a project. Part (c)(ii) assesses learning outcome C2(b) compare and contrast the alternative techniques of investment appraisal. It examines the candidates ability to discuss why payback might be used in practice despite its theoretical disadvantages. P1 14 September 2011