P1 – performance operations - the examiner’s answers - May 2010

Operational Level Paper

P1 –Performance Operations Examiner’s Answers SECTION A Answer to Question One 1.1

The correct answer is D.

1.2

(54 + 46 + 32 + 43 – 67) = 108 days The correct answer is C.

1.3

$46,000/$250,000 = 18·4% The correct answer is A.

1.4

The lowest profit in each case is when the weather is bad. If the maximin rule is applied, the highest profit when the weather is bad is $1,000 i.e. 1,000 burgers.

The correct answer is A.

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1.5 Minimax Regret Table Weather

No of burgers purchased 1,000

2000

3000

4000

Bad

$0

($1,000)

($2,000)

($4,000)

Average

($4,000)

($1,000)

$0

($1,000)

Good

($9,000)

($6,000)

($3,000)

$0

The maximum regret for 1,000 burgers is $9,000 The maximum regret for 2,000 burgers is $6,000 The maximum regret for 3,000 burgers is $3,000 The maximum regret for 4,000 burgers is $4,000 Therefore if he wants to minimise the maximum regret he will purchase 3,000 burgers.

The correct answer is C.

1.6

Payment will be made 50 days early.

Number of compounding periods = 365/50 = 7·3

 1.00  7.3 1+ r =    0.975  1 + r = 1·203 The cost of offering the discount is 20·3%

1.7 $ 140,000 160,000 160,000 160,000 -

$ 50,000 = 50,000 = 60,000 = 70,000 =

$ 90,000 110,000 100,000 90,000

Joint probability is (0·45 x 0·25) = Joint probability is (0·25 x 0·25) = Joint probability is (0·25 x 0·35) = Joint probability is (0·25 x 0·40) =

0·1125 0·0625 0·0875 0·1000 0·3625

Alternatively: $140,000 – $50,000 = $90,000 Joint probability is (0·45 x 0·25) = At cash inflows of $160,000, net cash flows are all greater than $90,000 therefore probability is

0·1125 0·2500 0·3625

The probability is 36·25%

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1.8

Interest is 80/900 i.e. 8·9% plus capital gain at maturity of $100 therefore discount initially at 10%.

Cash flows

Discount rate @ 10%

PV of cash flows $ (900·00) 198·96 737·64 36·60

$ Year 0 Year 1-3 Year 4 NPV

(900) 80 1,080

1·000 2·487 0·683

Discount rate @ 12% 1·000 2·402 0·636

PV of cash flows $ (900·00) 192·16 686·88 -20·96

By interpolation: 10% + (2% (36∙6/(36∙6 + 20∙96)) = 11·27%

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SECTION B Answer to Question Two

(a)

(i) < 1 month $ 145

1- 2 months $ 438

2-3 months $ 0

>3 months $ 118

Balance $ 701

(ii)

Examiner’s note: the question asks for two benefits. Examples of points that would be rewarded are given below.

(a)

(d)

Can be used to help decide what action should be taken about debts that have been outstanding for longer than the specified credit period.

Provides information about the efficiency of cash collection.

Can provide information to assist in setting and monitoring collection targets for the credit control section.

Provides information that can be used in setting a bad debt provision.

(b)

(i)

(b) (c)

EOQ

2x 64,000x150 = 4,000 1.20 Total cost of inventory management is: Cost of ordering inventory + cost of holding inventory DCo ChQ 64,000 × 150 1.2 × 4,000 + = + 2 4,000 2 Q

= $2,400

+

$2,400

= $4,800

(ii)

One week’s usage = 64,000/52 = 1,231 Inventory reorder level = 3 x 1,231 = 3,693 units

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(c)

The traditional approach to determine material requirements is to monitor inventories constantly; whenever they fall to a predetermined level, a preset order is placed to replenish them. This traditional approach (involving re-order levels and economic order quantity calculations) originates in the pre-computer era.

A manufacturing resource planning system is a fully integrated computerised planning approach to the management of all the companyâ&#x20AC;&#x2122;s manufacturing resources including inventory, labour and machine capacity. It seeks to ensure that resources are available just before they are needed by the next stage of production or despatch. It also seeks to ensure that resources are delivered only when required so that raw material inventory is kept to a minimum.

The technique enables managers to track orders through the manufacturing process and helps the purchasing and production control departments to move the right amount of material or sub-assemblies at the right time to the right place.

The current inventory management system relies on the assumption that there is constant demand. An MRP system begins with the setting of a master production schedule specifying both the timing and quantity demanded of each of the finished goods items and then works backwards to determine the resource requirements at each stage of the production process. It aims to generate a planned schedule of materials requirements after taking account of scheduled receipts, projected inventory levels and items already allocated to production. The EOQ model can be used within MRP provided that the major assumption in the EOQ model of constant demand applies.

(d)

Under an activity based budgeting (ABB) system, resource allocation is linked to the strategic plan and is prepared after considering alternative strategies. This approach ensures that new activities that are required to meet the companyâ&#x20AC;&#x2122;s strategic objectives are included in the budget.

Under a traditional incremental budgeting system the focus is on existing resources and operations. Adjustments are then made for changes in activity and price which results in past inefficiencies being perpetuated. Under an activity based budgeting system, only resources that are needed to perform activities required to meet the budgeted production and sales volumes are included.

Activity based techniques including activity based budgeting focus on the outputs of a process rather than the input to the process. This approach provides a clear framework for understanding the link between costs and the level of activity. It allows the ranking of activities and the determination of how limited resources should be allocated across competing activities. Traditional budgeting systems present costs under functional headings i.e. the emphasis is on the nature of the cost. The weakness of this approach is that it gives little indication of the link between the level of activity and the cost incurred.

The approach under a traditional system is to make arbitrary cuts in order to meet overall financial targets. Activity based budgeting allows the identification of value added and non-value added activities and ensures that cuts are made to non-value added activities. ABB is also useful for review of capacity utilisation. If it is known that the resources devoted to a particular activity are greater than those currently required then these resources can be reduced or redeployed.

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(e)

Production cost budget for Quarter 3

Budgeted costs

$

Direct materials Production labour

262,200 219,000

Production overheads

278,000 759,200

Workings: Direct materials Production labour

Variable cost per unit = $12 Variable cost per unit (195,000 – 155,000) / (20,000 – 15,000) = $8 Fixed cost $155,000 – (15,000 x $8) = $35,000

Production overheads

Variable cost per unit (240,000 – 210,000) / (20,000 – 15,000) = $6 Fixed cost $210,000 – (15,000 x $6) = $120,000

Quarter 3 Direct material Production labour Production overheads

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23,000 units x ($12 x 0∙95) = $262,200 23,000 units x $8 = $184,000 + $35,000 = $219,000 23,000 units x $6 = $138,000 + $120,000 + $20,000 = $278,000

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(f)

Decision tree: advertise concert or not

No Increase 40%

5,000 ($35,000)

($9,800)

Increase 60%

7,000 $20,000

$8,400

10,000 $75,000

$16,875

13,000 $135,000

$10,125

Poor 70%

Advertise

No Increase 75% Good 30% Increase 25% Donâ&#x20AC;&#x2122;t Advertise

Poor 70%

Good 30%

$25,600 5,000 ($20,000)

($14,000)

10,000 $90,000

$27,000 $13,000

Therefore the concert should be advertised.

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SECTION C

Answer to Question Three

(a) Reconciliation Statement Budgeted gross profit

$ 432,000

Sales price variance Sales volume profit variance Material price variance ETH 1 Material price variance RXY 2 Material mix variance Material yield variance Fixed overhead expenditure variance Fixed overhead volume variance Actual gross profit

21,300 6,000 2,210 9,580 13,200 18,000 2,000 4,000 457,470

F A A F A F F A

Workings Budgeted sales Budgeted cost of sales Budgeted gross profit

$1,440,000 $1,008,000 $432,000 (or 72,000kg x ($20 - $14))

Sales price variance = ($20·30 - $20·00) x 71,000kg = $21,300 F Sales volume profit variance = (71,000kg – 72,000kg) x ($20 - $14) = $6,000 A Material price variance ETH 1 = ($18·00 - $18·10) x 22,100kg = $2,210 A Material price variance RXY 2 = ($6·00 - $5·80) x 47,900kg = $9,580 F Material mix variance

Raw Material ETH1 Raw Material RXY2

Actual input @ std mix Kg 21,000

Actual input @ act mix kg 22,100

Variance kg

Std Price $

Variance $

1,100 A

18∙00

19,800 A

49,000

47,900

1,100 F

6∙00

6,600 F

70,000

70,000

-

-

13,200 A

Material yield variance Actual total input Standard yield Expected output Actual output Variance Std price per kg Variance

70,000kg 96% 67,200kg 69,000kg 1,800kg F x $10 $18,000 F

Fixed overhead expenditure variance = ($280,000 - $278,000) = $2,000 F Fixed overhead volume variance = (70,000 kg – 69,000kg) x $4 = $4,000 A

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$ 1,441,300 (400,010) (277,820) (278,000) (28,000) 457,470

Actual sales revenue ETH1 RXY2 Fixed o/heads incurred Inventory movement (2,000 units x $14) Actual gross profit

(b) Examinerâ&#x20AC;&#x2122;s note: the question asks for three reasons. Examples of points that would be rewarded are given below.

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 donâ&#x20AC;&#x2122;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 todayâ&#x20AC;&#x2122;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.

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Answer to Question Four

(a) Restaurant:

Number of customers in Year 1 Contribution per meal Total contribution

= (500 x 360) = 180,000 = $4 = $720,000

Cold food outlet:

Number of meals in Year 1 Contribution per meal Total contribution Reduction in contribution

= (1,200 x 360) = 432,000 = $2·50 = $1,080,000 = $1,080,000 x 40% = $432,000

Cash Flows Restaurant contribution Reduction in contribution from cold food Salaries Additional overheads Net cash flows

Year 1 720,000

Year 2 792,000

Year 3 871,200

Year 4 958,320

(432,000)

(475,200)

(522,720)

(574,992)

(80,000) (70,000)

(80,000) (70,000)

(100,000) (70,000)

(100,000) (70,000)

138,000

166,800

178,480

213,328

Year 1 138,000 (87,500)

Year 2 166,800 (65,625)

Year 3 178,480 (49,219)

Year 4 213,328 (117,656)

50,500 15,150

101,175 30,353

129,261 38,778

95,672 28,702

Taxation Net cash flows Tax Depreciation Taxable profit Taxation @ 30%

Net present value Year 0 Net cash (350,000) flows Tax payment Tax payment Net cash (350,000) flow after tax Discount 1∙000 factor Present (350,000) value

Year 1 138,000 (7,575)

Year 2 166,800

Year 3 178,480

Year 4 243,328

Year 5

(15,177)

(19,389)

(14,351)

( 7,575)

(15,177)

(19,389)

(14,351) (14,351)

130,425

144,048

143,914

209,588

0∙926

0∙857

0∙794

0∙735

0∙681

120,774

123,449

114,268

154,047

(9,773)

Net present value = $152,765

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(b) The NPV is the amount by which the present value of the future cash flows exceeds the initial outlay. The cash flows are discounted at the rate that reflects the alternative use of the funds, normally the company’s cost of capital. Investment decisions should be based on NPV since it is the only appraisal method that will ensure the maximisation of shareholders’ wealth. If the decision is based on NPV then either Project B or C should be undertaken. However NPV does not indicate the range of outcomes that may result. While Project A has a lower expected NPV the standard deviation of Project A is also lower and depending on the company’s attitude to risk they may decide to undertake Project A. The standard deviation is a measure of risk. It compares all the possible outcomes with the expected value (or mean outcome). Project B and C have the same NPV therefore it is possible to directly compare the standard deviations. The standard deviation for Project C is lower than that for Project B which means that the outcomes for Project C have less variability. Since Project A has a lower NPV than Project B and Project C it is necessary to calculate the coefficient of variation. The coefficient of variation for Project A and Project C is 6·67% and 16·67% respectively. Therefore, in terms of achieving the expected net present value, Project A is less risky than Project C. We would need however to see the range of possible outcomes since in this case it is the risk of outcomes below the expected outcome that is important.

There is however a trade-off between risk and return. The higher the risk, the higher the potential return. The decision on which project to undertake will depend on the managing director’s attitude to risk. If the Managing Director is risk averse he would choose Project A. If he is risk seeking he would choose Project B as it has the potential for higher returns.

The IRR is the rate of return that equates the present value of future cash flows with the initial outlay. It is the discount rate that will result in a net present value of zero. Project C has the lowest IRR, however as stated above investment decisions should be based on NPV. A limitation of Net Present Value is that it does not consider the life of the project. The longer the project the more uncertain the cash flows are likely to be. The payback method of investment appraisal determines how long it takes for the project to payback its initial investment. It therefore to a certain extent copes with an uncertain future by placing more emphasis on early cash flows.

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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)

examines candidates’ ability to prepare an age analysis of outstanding trade receivables and to state the benefits of this process.

(b)

examines candidates’ ability to apply the EOQ formula and to calculate the cost of holding and ordering the suggested level of stock. The ability to calculate the required re-order level based on information regarding a supplier’s delivery times is also examined.

(c)

examines candidates’ ability to identify and explain the benefits of a manufacturing resource planning system in comparison to a traditional stock management system.

(d)

examines candidates’ ability to identify and explain the benefits of activity based budgeting in comparison to a traditional budgeting system.

(e)

examines candidates’ ability to identify the cost behaviour for different cost items and then apply this knowledge to calculate the budgeted costs for a different activity level.

The ability to apply the high-low method of cost analysis is examined.

(f)

examines candidates’ ability to use decision trees to evaluate a decision where there is uncertainty regarding expected cash flows.

Section C – Questions Three and Four - Compulsory Question Three examines candidates’ ability to calculate variances including both mix and yield variances and, using these variances, to prepare a statement reconciling the budget profit to the actual profit. The problems with using a standard costing system in an advanced manufacturing environment are also examined.

Question Four, in part (a) of the question, examines candidates’ ability to calculate the net present value of a project involving the identification of relevant costs and calculation of the effect of taxation. Part (b) of the question examines candidates’ ability to evaluate three investment project given the projects’ NPV, IRR and standard deviation.

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