P1 May 2012 answers

Operational Level Paper

P1 – Performance Operations May 2012 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 August at www.cimaglobal.com/P1PEGS

SECTION A Answer to Question One

Rationale 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.

1.1

The correct answer is D.

1.2

The correct answer is A.

1.3 Variable costs per unit Fixed costs

=($290,000 – $200,000) / (100,000 – 64,000) = $2.50 =$290,000 – (100,000 x $2.50) = $40,000

At an activity level of 85,000 units, distribution costs will therefore be: (85,000 x $2.50) + $40,000 = $252,500

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The correct answer is A.

1.4 Accounts receivable days

(10

/48) x 365 = 76.0

Inventory days

(8/(48 x 0.6)) x 365 = 101.4

Accounts payable days

(5/(48 x 0.6)) x 365 = (63.4) 114.0

The cash operating cycle is 114 days.

The correct answer is B.

1.5

Annual interest = ($250,000 x 80%) x 10% = $20,000 The correct answer is C.

1.6

Payment will be made 38 days early.

Number of compounding periods = 365/38 = 9.60526 1+ r = (1.00/0.97)

9.60526

1+ r = 1.3399 The effective annual interest rate of the early settlement discount is 34.0%

1.7

The abandonment decision should be based on future cash flows: Year 1 2 3

Cash flow $ (90,000) 60,000 40,000

Discount factor 0.893 0.797 0.712

Present value $ (80,370) 47,820 28,480 (4,070)

As the net present value of the future cash flows is negative the project should be abandoned.

1.8 (i)

The production budget for Product R for next year will be:

Closing inventory Plus: sales

6,000 x 0.90

Less opening inventory Production required

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units 5,400 80,000 85,400 (6,000) 79,400

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(ii)

The purchases budget for Material T for next year will be

Closing inventory Plus: production

79,400 units x 6 kg

Less opening inventory Purchases required

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kg 75,000 476,400 551,400 (60,000) 491,400

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SECTION B Answer to Question Two

(a) Rationale The question assesses learning outcome A1(f) interpret material, labour, variable overheads, fixed overheads and sales variances, distinguishing between planning and operational variances. It examines candidates’ ability to calculate material mix and material yield variances.

Suggested Approach In part (i) candidates should calculate the mix variance by comparing the actual quantity at the standard mix with the actual quantity at the actual mix. The variance calculated in litres for each of the chemicals should then by multiplied the standard cost per litre to calculate the variance for each chemical. These should then be added together to calculate the total mix variance. In part (ii) the standard litres of input per litre of output should be multiplied by the actual output in litres. This should then be compared to the actual litres input. The resultant variance in litres should be multiplied by the weighted average cost per litre of input to calculate the yield variance.

(i) Material mix variance Actual input @standard mix (000 litres) Chemical A 1,791 Chemical B 1,074 Chemical C 895 3,760

Actual input @ actual mix (000 litres)

Variance (000 litres)

Standard cost $

2,144 824 792 3,760

353 A 250 F 103 F

0.60 1.40 1.00

Variance $000

211.8 A 350 F 103 F 241.2 F

Or alternatively: Weighted average cost per litre of input $0.97/1.05 litres = $0.9238 Material mix variance Actual input @standard mix (000 litres) Chemical A 1,791 Chemical B 1,074 Chemical C 895 3,760

Actual input @ actual mix (000 litres) 2,144 824 792 3,760

Variance (000 litres) 353 250 103

Standard cost difference $ (0.60 – 0.9238) (1.40 – 0.9238) (1.00 – 0.9238)

Variance $000

(ii)

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114.3 F 119.1 F 7.8 F 241.2 F

Material yield variance Standard litres of input per litre of output = 1.05 litres 3,300k litres output x 1.05 litres = 3,465k litres input Actual usage = 3,760k litres Variance = 295k litres A Standard cost per litre = $0.9238 Variance = 295k litres x $0.9238 = $272.5k A Or alternatively: 3,760k litres should yield 3,760/1.05 = 3,580.95k litres Actual yield = 3,300k litres Yield variance = 280.95k litres A Standard material cost = $0.97 Yield variance = 280.95k litres x $0.97 = $272.5k A

(b)

Rationale The question assesses learning outcome D1(b) apply sensitivity analysis to both short and long run decision models to identify variables that might have significant impact on project outcomes . It examines candidates’ ability to use calculate the sensitivity of the investment decision to a change in a variable and to identify the benefits of using sensitivity analysis in investment appraisal.

Suggested Approach In part (i) candidates should calculate the net present value of the investment and then express the net present value as a percentage of the present value of the fixed costs. In part (ii) candidates should clearly state the potential benefits that arise as a result of the use of sensitivity analysis in investment appraisal.

(i)

If the present value of the fixed costs were to increase by more than $8,675 then the project would cease to be viable. As a percentage increase this is: $8,675 / $90,125 = 9.6%

(ii) • • • •

Sensitivity analysis enables a company to determine the effect of changes to variables on the planned outcome.

Sensitivity analysis enables a company to assess the risk associated with a project.

Sensitivity analysis enables identification of variables that are of special significance.

Sensitivity analysis enables risk management strategies to be put in place to focus on those variables of special significance.

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(c) Rationale The question assesses learning outcome E1(g) analyse the impact of alternative policies for stock management. It examines candidates’ ability to explain the benefits of a centralised purchasing system.

Suggested Approach Candidates should consider the potential benefits to a company of using a centralised purchasing system compared to the current system in use and clearly explain what the benefits are and why they arise under this system.

The advantages of a centralised purchasing system are as follows: • • • •

•

• •

A centralised buyer is able to order in larger quantities and may be able to negotiate bulk buying discounts.

A centralised buyer may have a wider network of suppliers than a local buyer and should be able to ensure that the best available prices are identified.

With centralised purchasing it is easier to enforce common quality standards for purchased materials.

Centralised purchasing should result in more efficient management of inventory. The buyer should have access to information about the current inventory levels at all locations in the organisation and where appropriate can arrange for inventory to be transferred from one location to another to avoid purchasing additional quantities.

In an organisation where the operating units are all within a small geographical area it should also be possible to operate a single centralised stores location. It should be easier to control inventory levels within a centralised store rather than with several localised stores.

The company should benefit from economies of scale and the reduction in administration costs. As larger orders are being placed with suppliers it will also reduce inventory ordering and handling costs.

Centralised purchasing should enable closer relationships with suppliers and allow the use of JIT inventory management techniques.

(d) Rationale The question assesses learning outcome B1(b) explain the purposes of budgets, including planning, communication, co-ordination, motivation, authorisation, control and evaluation. It examines candidates’ ability to explain the benefits and problem with managers’ participation in setting budgets.

Suggested Approach Candidates should first consider the benefit of management participation in terms of motivation, optimisation of performance and reducing the information asymmetry gap. The potential problems of management participation should then be considered and the conflicts that can arise been management participation and the use of the budget as a control mechanism.

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The participation of managers in the budget setting process has several advantages.

Managers are more likely to be motivated to achieve the budget if they have participated in the budget setting process. Participation can also reduce the information asymmetry gap that can arise when targets are imposed by senior management and should result in more realistic budgets. Imposed budgets 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. Manager participation is only effective if it is true participation.

Pseudo participation can be worse for motivation than no involvement at all. The involvement of managers in the budget setting process is time consuming and the benefits of participation would need to weighed against the cost of the resources used.

(e) Rationale The question assesses learning outcome D1(e) calculate the value of perfect information. It examines candidates’ ability to calculate the value of perfect information where there is uncertainty regarding expected cash flows.

Suggested Approach Candidates should firstly calculate the expected value of the contribution from each package without perfect information. They should then select the best outcome for each of the possible customer reactions 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.

Expected values ($000) Package A ($700 x 0.25) + ($600 x 0.4) + ($400 x 0.35) = $555 Package B ($900 x 0.25) + ($500 x 0.4) + ($300 x 0.35) = $530 Package C ($800 x 0.25) + ($400 x 0.4) + ($500 x 0.35) = $535 Expected value of perfect information ($000) If good select Package B = ($900 x 0.25) = $225 If moderate select Package A = ($600 x 0.4) = $240 If poor select Package C = ($500 x 0.35) = $175 Expected value of perfect information is $225 + $240 + $175 = $640 The maximum amount that should be paid is ($640k – $555k) = $85k

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(f) Rationale The question assesses learning outcome E2(b) identify alternatives for investment of short term cash surpluses. It examines candidates’ ability to explain the factors that a company should consider before deciding how to invest short term surplus funds.

Suggested Approach Candidates should identify three factors that companies would need to consider when deciding to invest short tern cash surpluses. They should define each of the factors and clearly explain why these are important in the investment decision.

Three factors that would need to be considered when deciding how to invest short term cash surpluses are: Maturity A short term investment will involve investing the money for a specified period of time and receiving interest and the payment of the capital at a specified future date. The maturity date of the investment should be no longer than the duration of the cash surplus. If the cash is required before the maturity of the investment and the investment is ‘cashed in’ early, there will be the risk of loss of interest or capital value.

Risk v Return Risk refers to the possibility that the investment might fall in value or that there may be some doubt about the eventual payment of interest or repayment of capital. Generally a higher risk investment will offer a higher return.

Investing in equities is high risk since the value of the equities depends on the profitability and future prospects of the company and stock market movements. Share prices can fall by a large amount in a short period of time therefore equities are generally regarded as an unsuitable form of short-term investment.

Liquidity Liquidity refers to the ease with which an investment can be ‘cashed in’ without any significant loss of value or interest. All short-term investments are less liquid than cash in a bank current account but some are more liquid than others. For example, many savings accounts or deposit accounts are reasonably liquid and a depositor can withdraw cash immediately without penalty or for the loss of only several days’ interest.

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SECTION C Answer to Question Three Rationale 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 reconcile budget and actual profit under a marginal costing system. Part (b) assesses learning outcome A1(b) discuss a report which reconciles budget and actual profit using absorption and/or marginal costing principles. It examines candidates’ ability to explain why the variances are different under absorption and marginal costing systems. It also 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 the revised variances under an absorption costing system. Part (c) 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 explain the arguments for suing absorption costing for inventory valuation and profit reporting purposes.

Suggested Approach 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, variable overheads and fixed 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 clearly explain the difference that arise when calculating variances using an absorption costing system compared to a marginal costing system. In part (c) candidates should calculate the sales volume profit variance and the fixed overhead volume variance. In part (d) candidates should clearly explain the reasons why absorption costing is preferred to marginal costing for profit reporting and inventory valuation.

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(a) $ Budgeted profit

$ 466,000

Add back fixed production overheads

170,000

Budgeted contribution

636,000

Sales volume contribution variance (9,000 units - 10,000 units) x $63.60

63,600 A

Standard contribution on actual sales volume Other variances: Selling price variance 9,000 units x ($184 - $180)

36,000 F

Cost variances: Direct material price variance 74,000 kg x ($10.80 – $11.20)

29,600 A

Direct material usage variance ((9,000 x 8 kg) – 74,000 kg) x $10.80

21,600 A

Direct labour rate variance 10,800 x ($18.00 - $19.00)

10,800 A

Direct labour efficiency variance ((9,000 x 1.25) – 10,800) x $18.00

8,100 F

Variable overhead expenditure variance (10,800 hours x $6) - $70,000

5,200 A

Variable overhead efficiency variance ((9,000 x 1.25) – 10,800) x $6.00

2,700 F

Fixed overhead expenditure variance $170,000 - $168,000

2,000 F

Actual profit

384,000

Workings: Budgeted profit for the period Sales Direct materials Direct labour Variable production overheads Contribution Fixed production overheads Budgeted profit

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10,000 units x $180 10,000 units x $86.40 10,000 units x $22.50 10,000 units x $7.50 10,000 units x $63.60

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$ 1,800,000 864,000 225,000 75,000

(1,164,000) 636,000 (170,000) 466,000

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Actual profit for the period Sales Direct materials Direct labour Variable production overheads Contribution Fixed production overheads Actual profit

9,000 units x $184 74,000 kg @ $11.20 10,800 hours @ $19

$ 1,656,000 828,800 205,200 70,000

(1,104,000) 552,000 (168,000) 384,000

(b) (i) In a standard marginal costing variance statement the sales volume contribution variance is calculated using the standard contribution per unit. In a standard absorption costing variance statement, standard contribution is replaced by the standard profit per unit which includes a fixed overhead absorption rate. The difference in the variance is represented in the absorption costing variance statement by the fixed production overhead volume variance which is calculated as the difference in actual and budgeted volume x the fixed overhead absorption rate. The fixed production overhead volume variance represents a part of the under absorbed fixed overhead as a result of producing a lower volume than budgeted.

(b) (ii) Sales volume profit variance (9,000 units - 10,000 units) x $46.60 = $46,600 A It would also be necessary to include a fixed production overhead volume variance as follows: Fixed production overhead volume variance (9,000 units – 10,000 units) x $17 = $17,000 A

(c) The arguments used in favour of using absorption costing for profit reporting and inventory valuation are as follows: • • • •

Fixed production overheads can be a large proportion of total production costs. It is therefore important that these costs are included in the measurement of product costs as they have to be recovered to make a profit.

Absorption costing follows the matching concept by carrying forward a proportion of the fixed production overhead costs in the inventory valuation to be matched against the sales revenue generated when the items are sold.

It is necessary to include fixed production overheads in inventory valuations for financial statements.

It has been argued that in the longer term all costs are variable and it is appropriate to try to identify overhead costs with the products or services that cause them.

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Answer to Question Four Rationale 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 C1(c) calculate project cash flows, accounting for tax and inflation, and apply perpetuities to derive ‘end of project’ value where appropriate 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. It also requires candidates to calculate the effect of tax and inflation on the cash flows. Part (b) also assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates’ ability to calculate the IRR of a project. Part (c) assesses learning outcome C1(e) explain the financial consequences of dealing with long-run projects, in particular the importance of accounting for the ‘time value of money’. It examines candidates’ ability to explain what determines the time value of money and its importance in appraising investment projects.

Suggested Approach In part (a) candidates should firstly calculate the expected value of the car parking charge and inflate this by 5% to calculate the year 1 parking charge. They should then calculate the number of car parking spaces available each week and multiply this by the charge per week x 52 weeks to get the Year 1 revenue. The revenue should then be multiplied by 80% to get Year 1 contribution. The Year 1 contribution should then be inflated by 5% per annum for each year of the project. Fixed costs excluding the lease cost should also be inflated by 4% per annum. Once the relevant cash flows for each year of the project have been identified they should then calculate the tax payments. The net cash flows after tax should be discounted at a discount rate of 8% to calculate the NPV of the project. In part b) the same cash flows should then be discounted at a higher discount rate and the IRR calculated using interpolation. In part (c) candidates should explain the three elements that determine the time value of money and clearly explain why the time value of money is important in investment appraisal.

(a) Year 1 car parking charges ($60 x 40%) + ($50 x 25%) + ($70 x 35%) = $61 x 1.05 = $64.05 Year 1 sales revenue Year 1 sales revenue = (600 x 0.75) x $64.05 x 52 weeks = $1,499k Year 1 contribution = $1,499k x 0.8 = $1,199k Fixed Costs Year 1 Staff costs = $350k x 1.04 = $364k Year 1 Security system costs = $100k x 1.04 = $104k

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Cash Flows

Contribution Leasing costs Staff costs Security system costs Net cash flows

Year 1 $000 1,199

Year 2 $000 1,259

Year 3 $000 1,322

Year 4 $000 1,388

Year 5 $000 1,457

(50)

(50)

(50)

(50)

(50)

(364) (104)

(379) (108)

(394) (112)

(409) (117)

(426) (122)

681

722

766

812

859

Year 1 $000 681

Year 2 $000 722

Year 3 $000 766

Year 4 $000 812

Year 5 $000 859

(204)

(217)

(230)

(244)

(258)

Taxation

Net cash flows Taxation @ 30%

Net present value Year 0 $000 Land (8,000) purchase and development Net cash flows Tax payment Tax payment

Year 1 $000

Year 2 $000

Year 3 $000

Year 4 $000

Year 5 $000 10,000

681

722

766

812

859

(102)

(108)

(115)

(122)

(129)

0

(102)

(109)

(115)

(122)

Net cash (8,000) 579 512 542 575 10,608 flow after tax Discount 1.000 0.926 0.857 0.794 0.735 0.681 factors @ 8% Present (8,000) 536 439 430 423 7,224 value Net present value = $971k The project has a positive net present value and therefore should be accepted

Year 6 $000

(129) (129) 0.630

(81)

(b)

Net cash flow after tax

Year 0 $000 (8,000)

Year 1 $000 579

Year 2 $000 512

Year 3 $000 542

Year 4 $000 575

Year 5 $000 10,608

Year 6 $000 (129)

1.000

0.893

0.797

0.712

0.636

0.567

0.507

(8,000)

517

408

386

366

6,015

(65)

Discount factors @ 12% Present value

Net present value = -$373k

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IRR = 8% + (($971k/($971k + $373k)) x (12% - 8%)) = 8% + 2.9% = 10.9%

(c) The time value of money relates to the return required by investors and has three main elements: Delayed Consumption There is an opportunity cost involved with the investment of funds. Generally the value of $1.00 now is greater than the value of $1.00 in one year’s time since investors have to give up present consumption. An investor will give up present consumption for the potential of higher future consumption i.e. they need to be rewarded for giving up certain current consumption for certain future consumption.

Inflation If there is inflation then investors also need to be compensated for the loss in purchasing power as well as for time.

Risk The promise of money in the future carries with it an element of risk. The payout may not take place or the amount may be less than expected. An investor therefore needs to be compensated for time, inflation and also risk.

The objective of investment within a company is to create value for its owners. Investors have alternative uses for their funds and therefore have an opportunity cost if money is invested in a corporate project. Investments therefore must generate enough cash for all investors to receive their required returns. The use of net present value in investment appraisal recognises the time value of money and discounts cash flows at the investors’ required rate of return.

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