P1 September 2012 - examiner's answer

Operational Level Paper

P1 – Performance Operations September 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 October 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

August credit sales = 200,000 x 60% x 97% = $116,400 September cash sales = 204,000 x 40% = $81,600 Total cash received = $116,400 + $81,600 = $198,000 The correct answer is C.

1.2

Selling price – material costs = $28.50 - $9.25 = $19.25 Return per hour = ($19.25 / 7.8) x 60 = $148.08 The correct answer is D.

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1.3 20% of October sales 65% of November sales 15% of December sales x 0.95 Total cash paid

= $ 56,000 = $162,500 = $ 42,750 = $261,250

The correct answer is B.

1.4

The correct answer is A.

1.5

The correct answer is D.

1.6 (i) Costs that varied with number of parcels = $194,400 x 70% x 60% = $81,648 Cost per parcel last year = $81,648 /15,120 = $5.40 Parcel related cost for next year = $5.40 x 1.03 x 18,360 = $102,118 (ii) Costs that vary with kilometres travelled = $194,400 x 70% x 40% = $54,432 Cost per km = $54,432 / 120,960 = $0.45 Distance related costs for next year = $0.45 x 1.03 x 128,800 = $59,699

1.7 The net present value of the project is $98,200.

If the present value of the contribution was to decrease by more than $98,200 then the project would cease to be viable. As a percentage this is: $98,200 / $389,340 = 25.2% Which represents a decrease in the annual contribution of $108,000 x 0.252 = $27,216

1.8 (i) The labour rate planning variance for August (22,000 units x 0.5) x ($17.50 - $14) = $38,500 A (ii) The labour rate operational variance for August 11,400 hrs x ($17.50 - $15.50) = $22,800 F P1

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(iii) The labour efficiency operational variance for August ((22,000 x 0.5 hour) - 11,400 hrs) x $17.50= $7,000 A

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SECTION B Answer to Question Two

(a) Rationale The question assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates’ ability to calculate the present value of leasing an asset and compare this to the cost of purchasing an asset.

Suggested Approach For Asset 1 candidates should compare the purchase cost of the asset with the present value of the lease cost taking into consideration that the lease payments are made in advance. For Asset 2 candidates should calculate the purchase cost of the asset using the initial payment and the present value of the residual value. This can then be compared to the present value of the lease cost.

Asset 1 Present value of purchase cost = $120,000 Present value of lease cost = $18,000 + ($18,000 x 5.759) = $121,662 Asset 1 should be purchased as the present value of the purchase cost is lower.

Asset 2 Present value of purchase cost = $51,000 - ($20,000 x 0.621) = $38,580 Present value of lease cost = $10,000 x 3.791 = $37,910 Asset 2 should be leased as the present value of the lease payments is lower.

(b)

Rationale Part (i) 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. It examines candidates’ ability to apply the minimax regret criterion to a decision. Part (ii) also 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. It examines candidates’ ability to describe the type of manager who is risk averse.

Suggested Approach In part (i) candidates should prepare a regret matrix that shows the regret under each of the possible customer reactions. They should then identify the maximum regret if each of the agreements were chosen and then chose the agreement that minimises the maximum regret.

In part (ii) candidates should clearly describe a manager who is risk averse.

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(i) Regret Matrix Customer reaction

Agreement A

Agreement B

Agreement C

$

$

$

Strong

12,100

19,900

0

Moderate

0

7,500

2,100

Weak

0

3,700

5,100

The maximum regret if Agreement A is chosen is $12,100 The maximum regret if Agreement B is chosen is $19,900 The maximum regret if Agreement C is chosen is $5,100 To minimise the maximum regret the manager will choose Agreement C. (ii) A risk averse decision maker is one that focuses on the possibility of poor results and seeks to avoid a high degree of risk. A risk averse decision maker faced with a choice between two alternatives with identical expected values will choose the less risky alternative. These decision makers are often viewed as pessimists.

(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 disadvantages of using a centralised purchasing system.

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

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

It may result in increased transport costs with a consequential impact on the environment.

A centralised purchasing system is likely to be more bureaucratic and unable to respond to inventory shortages as quickly as a local buyer.

A local buyer may be more flexible and able to respond to temporary reductions in local prices that a central purchasing manager may be unaware of.

Local buyers may be able to develop stronger relationships with local suppliers thus possibly ensuring greater reliability of supply and the opportunity for JIT purchasing and reduced inventories.

Local suppliers may offer varied products thus enabling differentiation of finished products.

The opportunity to delegate responsibility for aspects of the management of the business and the benefits in terms of management development will not be available.

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•

A centralised purchasing system is not appropriate where managers have been given responsibility for the financial management of their particular operating unit. Where this is the case the responsibility for purchasing and inventory management decisions should also be given to the managers.

(d) Rationale The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines candidates’ ability to explain the limitations of a particular approach that managers may use in setting budgets.

Suggested Approach Candidates should first explain what is meant by incremental budgeting and then consider the potential disadvantages of this approach and the problems that can arise when using this type of budget as a control mechanism.

An incremental approach to budgeting has a number of limitations as follows: •

•

• •

It is based on what has happened in the past therefore the allocation of resources to specific activities is not justified. It is assumed that the activities will continue merely because they were undertaken in the previous year. This is inappropriate in a rapidly changing environment.

Excessive costs included in the previous budget will be carried forward into the next budget. An incremental system does not look at reducing waste and overspending.

Past inefficiencies will be continued as different approaches to achieving the objectives will not be examined.

The performance targets in the budget tend not to be challenging. The approach does not encourage managers to look for ways to improve the business.

It encourages managers to spend up to the budget as they know that if they fail to spend the budget it is likely to be cut in the next period.

(e) Rationale 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 E2(a) identify sources of short-term funding. It examines candidates’ ability to state the advantages of loan finance as a method of financing working capital.

Suggested Approach 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 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 the disadvantages of using loan finance as a method of financing working capital.

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(i) Payment will be received 80 days early.

Number of compounding periods = 365/80 = 4.5625 1+ r = (1.00/0.97)

4.5625

1+ r = 1.14909 The effective annual interest rate of the early settlement discount is 14.9% (ii) Examiners note: the question asks for TWO disadvantages. Examples of points that would be rewarded are given below.

•

The bank will normally include additional conditions such as security in the form of fixed/floating charges and other debt covenants. These are likely to result in reduced financial flexibility for GH.

•

Bank loans will increase the company’s gearing ratio.

•

Interest charges on bank loans are normally based on the bank’s base rate. This makes it harder to forecast the interest payable and exposes the business to future increases in interest rates

•

A bank loan is generally inflexible in terms of amount and time period whereas working capital requirements are likely to fluctuate.

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(f) Rationale The question assesses learning outcome E1(f) analyse the impacts of alternative debtor and creditor policies. It examines candidates’ ability to discuss the advantages and disadvantages of factoring as a method of managing a company’s trade receivables.

Suggested Approach Candidates should firstly consider the potential benefits to a company of using factoring and then contrast with the potential disadvantages that can arise from its use.

Advantages Factoring has the advantage that GH will received 80 – 85% of the cash immediately with the remainder being received when the customer settles the debt thus reducing the need for working capital financing. Factoring can also be provided on a non-recourse basis, i.e. the factor guarantees settlement even if they are not paid by the customers. The factor will also administer GH’s sales ledger including the assessment of credit worthiness of customer, invoicing and collection which will result in reduced administration costs. The factor has considerable expertise in all of these areas that a small business in particular may not have available. Factoring also provides flexibility since as sales increase with the corresponding demand for finance, so finance from this source increases. It may be a cost effective lender to GH, if it has no assets, apart from its receivables, to offer as security.

Disadvantages Factoring is sometimes associated with financial difficulties and many companies are reluctant to use factors for this reason. GH will also lose personal communication with its customers. The services provided by a factor are expensive and may not be cost effective. It may be difficult for GH in the future to withdraw from the arrangement and re-establish a sales ledger function. It may also be difficult to raise more traditional forms of finance except at high interest rates. Debt factoring would involve factoring GH’s total sales ledger. It may be more appropriate to use invoice discounting where only the invoices relating to this contract would be discounted.

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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. Part (b) assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variance, distinguishing between planning and operational variances. It examines candidates’ ability to explain the benefits of splitting the sales volume profit variance into the sales mix profit variance and the sales quantity profit variance. Part (c) assesses learning outcome A1(h) explain the impact of just-in-time manufacturing methods on cost accounting and the use of ‘back-flush 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.

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 why it would be useful to split the sales volume profit variance into its constituent elements using the figures calculates in part (a) to illustrate the answer. In part (c) candidates should clearly explain the reasons why standard costing may be not be considered useful in a modern manufacturing environment.

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(a) $

$

Budgeted profit

$ 206,750

Sales mix profit margin variance (see workings below) Product B Product C Sales quantity profit variance (see workings below) Product B Product C Standard profit on actual sales

26,250 F 28,219 A

1,969 A

13,750 F 12,094 F

25,844 F

23,875 F 230,625 F

Selling price variance Product B: 3,000 units x ($110 - $100) Product C: 1,500 units x ($105 - $107.50) Direct material price variance ((25,600 kg x $5) – $124,800) Direct material usage variance ((3,000 x 5 kg) + (1,500 x 7 kg)) – 25,600 kg) x $5 Direct labour rate variance (9,140 x $7) - $67,980 Direct labour efficiency variance ((3,000 x 2hrs) + (1,500 x 1.5 hours)) – 9,140) x $7.00 Variable overhead expenditure variance (9,140 hours x $1.50) - $14,300 Variable overhead efficiency variance ((3,000 x 2hrs) + (1,500 x 1.5 hours)) – 9,140) x $1.50 Fixed overhead expenditure variance ((2,200 x $8) + (1,800 x $6)) - $27,000 Fixed overhead volume variance Product B: (3,000 – 2,200) x $8 Product C: (1,500 – 1,800) x $6

30,000 F 3,750 A

26,250 F

3,200 F 500 A

2,700 F

4,000 A 6,230 A

10,230 A

590 A 1,335 A

1,925 A

1,400 F 6,400 F 1,800 A

Actual profit

6,000 F 253,420

Workings: Standard selling price per unit Product B: $50 x 2 = $100 Product C: $53.75 x 2 = $107.50 Budgeted profit for the period Product B Sales (units) 2,200 Budgeted profit per unit $50 Total budgeted profit $110,000

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Product C 1,800 $53.75 $96,750

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Total

$206,750

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Actual profit for the period $ Sales Direct materials Direct labour Variable production overheads Fixed production overheads Total production cost Actual profit

$ 487,500

(3,000 x $110) + (1,500 x $105) 124,800 67,980 14,300 27,000

234,080 253,420

Sales mix profit margin variance Actual sales Actual sales @standard @ actual mix mix (units) (units) Product B 2,475 3,000 Product C 2,025 1,500 4,500 4,500

Variance (units)

525 F 525 A

Standard profit $ 50.00 53.75

Variance $

26,250 F 28,219 A 1,969 A

Or alternatively: Weighted average profit per unit $206,750 / 4,000 = $51.6875 Sales mix profit margin variance Actual sales Actual sales @ @standard mix actual mix (units) (units)

Variance (units)

Product B Product C

525 F 525 A

2,475 2,025 4,500

Sales quantity profit variance Actual sales @standard mix (units) Product B 2,475 Product C 2,025 4,500

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3,000 1,500 4,500

Budget sales @ standard mix (units) 2,200 1,800 4,000

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Variance (units)

275 F 225 F 500 F

Standard profit difference $

Variance $

(50.00 – 51.6875) (53.75 – 51.6875)

Standard profit $ 50.00 53.75

886 A 1083 A 1,969 A

Variance $

13,750 F 12,094 F 25,844 F

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Or alternatively: Sales quantity profit variance Actual sales @standard mix (units)

Product B Product C

2,475 2,025 4,500

Budget sales @ std mix (units)

2,200 1,800 4,000

Variance (units)

275 F 225 F 500 F

Weighted average profit per unit $

Variance $

51.6875 51.6875

(b) By separating the sales volume profit variance into the quantity and mix variance, we can explain how the sales volume is affected by a change in the total physical volume of sales and a change in the relative mix of products. The sales quantity profit variance indicates that if the original planned sales mix had been maintained for the actual sales volume of 4,500 units, profits would have increased by $25,844. However because the actual sales mix was not in accordance with the budgeted sales mix, an adverse mix variance of $1,969 occurred. The adverse mix variance arose because there was an increase in the percentage of units sold of Product B which has the lowest profit margin and a decrease in the percentage sold of Product C which has the highest profit margin.

The separation of the sales volume variance into the quantity and mix components demonstrates that increasing or maximising sales volume may not be as beneficial as promoting the sales of the most profitable mix of products.

(c) Examiners note: the question asks for TWO 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 do not 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.

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14,214 F 11,630 F 25,844 F

Periodic financial reports are neither meaningful nor sufficiently timely to facilitate appropriate control action.

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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 and the payback period 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 the difference between the real cost of capital and the money cost of capital.

Suggested Approach In part (a) candidates should firstly calculate the contribution per visitor and inflate this by 4% to calculate the year 1 contribution per visitor. They should then calculate the expected value of the number of visitor for year 1. They can then multiply this by the contribution per visitor to get the Year 1 contribution. The Year 1 contribution should then be inflated by 4% per annum for each year of the project. Maintenance costs should also be inflated by 4% per annum. The lease costs should also be included at $500k for each year. Once the relevant cash flows for each year of the project have been identified they should then calculate the tax depreciation and 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. The cumulative cash flows should also be calculated to enable the calculation of the payback period. In part (c) candidates should clearly explain the difference between the real cost of capital and the money cost of capital.

(a) Year 1 Contribution Visitor numbers Year 1 = (1.2m x 30%) + (0.8m x 50%) + (0.6m x 20%) = 880k Contribution per visitor Year 0 = $60 - $25 = $35 Year 1 = $35 x 1.04 = $36.40 Year 1 total contribution = $36.40 x 880k = $32,032k Fixed Costs Year 1 Maintenance costs = $200k x 1.04 = $208k

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Cash Flows

Contribution

Year 1 $000 32,032

Year 2 $000 33,313

Year 3 $000 34,646

Year 4 $000 36,032

Year 5 $000 37,473

Lease costs

(500)

(500)

(500)

(500)

(500)

Maintenance costs Net cash flows

(208)

(216)

(225)

(234)

(243)

31,324

32,597

33,921

35,298

36,730

Taxation Year 1 $000 31,324

Year 2 $000 32,597

Year 3 $000 33,921

Year 4 $000 35,298

Year 5 $000 36,730

Tax Depreciation Taxable profit

(30,000) 1,324

(22,500) 10,097

(16,875) 17,046

(12,656) 22,642

12,031 48,761

Taxation @ 30%

(397)

(3,029)

(5,114)

(6,793)

(14,628)

Net cash flows

Net present value Year 0 $000 Structure (120,000) cost Net cash 0 flows Tax payment 0

Year 1 $000

Year 2 $000

Year 3 $000

Year 4 $000

Year 5 $000 50,000

31,324

32,597

33,921

35,298

36,730

(198)

(1,514)

(2,557)

(3,396)

(7,314)

0

(199)

(1,515)

(2,557)

(3,397)

(7,314)

(120,000)

31,126

30,884

29,849

29,345

76,019

(7,314)

1.000

0.893

0.797

0.712

0.636

0.567

0.507

(120,000)

27,796

24,615

21,252

18,663

43,103

(3,708)

Tax payment Net cash flow after tax Discount factors @ 12% Present value

Year 6 $000

Net present value = $11,721 The project has a positive net present value and therefore should be accepted

(b) (i) Net cash flow after tax Discount factors @ 20% Present value

(120,000)

31,126

30,884

29,849

29,345

76,019

(7,314)

1.000

0.833

0.694

0.579

0.482

0.402

0.335

(120,000)

25,928

21,433

17,283

14,144

30,560

(2,450)

Net present value = -$13,102

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By interpolation IRR = 12% + (($11,721 / ($11,721 +$13,102)) x (20% - 12%) IRR = 12% + 3.78% IRR = 15.78%

(b) (ii) Year 0 1 2 3 4 Payback period

Cash flow (120,000) 31,126 30,884 29,849 29,345

Cumulative cash flow (120,000) (88,874) (57,990) (28,141) 1,204

= 3 yrs + ((28,141/29,345) x 12) = 3 yrs 11.5 months

(c) The real cost of capital is the rate of return that would be required in the absence of inflation.

If prices rise then investors will demand compensation for general inflation. If the real cost of capital was 8% and the general rate of inflation was 4%, investors will require a return of 1.08 x 1.04 = 1.1232 Investors will be indifferent from a financial perspective as to whether they hold $1,000 now or receive $1,123.20 in one year’s time. The money cash flow of $1,123.20 is equivalent to $1,000 now i.e. the money rate of return is 12.32%. The money rate of return includes a return to compensate for inflation.

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