Operational Level Paper
P1 – Performance Operations September 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 inc ludes the marking guide for each question, will be published on the CIMA website by early October at www.cimaglobal.com/P1PEGS
SECTION A Answ An sw er t o Qu est io n On e Rationale 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
Cash paid from previous period Purchases for this budget period Purchases not paid until next period ($6,800,000 x 75% x 1/12) Total cash paid
$ 540,000 6,800,000 7,340,000 (425,000) 6,915,000
The correct answer i s C.
1.2
The
The correct answer is A.
Chartered Institute of Management Accountants 2012
1.3
Variable cost per unit
= ($2,840,000 – $2,420,000) / (190,000 – 160,000) = $420,000 / 30,000 = $14 per unit
Fixed costs
= $2,840,000 – (190,000 x $14) = $180,000
Total costs at 205,000 units
= (205,000 x $14) + $180,000 = $3,050,000
The correct answer is B.
1.4
Cost before stepped increase = $2,840,000 - $30,000 = $2,810,000 Variable cost per unit = ($2,810,000 - $2,420,000) / (190,000 – 160,000) = $390,000 / 30,000 = $13 Fixed costs at 190,000 units = $2,840,000 – (190,000 x $13) = $370,000 Total costs at 175,000 units = (175,000 x $13) + ($370,000 - $30,000) = $2,615,000 The correct answer is C.
1.5
Net Present Value of the project = $280,000 Present value of the annual cash inflow = $320,000 x 3.037 = $971,840 Sensitivity = $280,000/$971,840 = 28.8% The correct answer is D.
1.6
Yield to maturity of similar bonds is 4% therefore use 4% as the discount rate. Year(s)
Description
1-4 4 0
Interest Redemption Market value
Cash flow $ 6 100
Discount Factor (4%) 3.630 0.855
Present Value $ 21.78 85.50 107.28
The current expected market value of the bond is therefore $107.28 Or alternatively:
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Year(s)
Description
1-3 4 0
Interest Redemption & Interest Market value
Cash flow $ 6 106
2
Discount Factor (4%) 2.775 0.855
Present Value $ 16.65 90.63 107.28
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1.7
Inventory Accounts receivable Accounts payable
$30m x 0.7 x 2.5/12 = $4.375m $30m x 2/12 = $5m $30m x 0.7 x 1.5/12 = $2.625m
Total working capital is $4.375m + $5m - $2.625m = $6.75m
1.8
(i)
EOQ =
Where: Co (cost per order) = $70 D = (annual demand) = 40,000 units Ch = (cost of holding one unit for one year) = $1.40
EOQ =
= 2,000 units
(ii) Number of orders = 40,000 / 2,000 = 20 per year Ordering costs = 20 x $70 = $1,400 Holding costs = 2,000 x 0.5 x $1.40 = $1,400 Total ordering and holding costs = $2,800
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SECTION B Answ er t o Qu est io n Tw o
(a) Rationale The question assesses learning outcome E1(a) explain the importance of cash flow and working capital management. It examines candidates’ ability to explain a company’s motives for holding cash. Suggested Approach Candidates should consider each of the three motives for holding cash and clearly explain their meaning. Transaction motive Cash is needed to pay salaries, buy material and non-current assets, pay interest and dividends and for a number of other day-to-day transactions. It is necessary to hold some cash as the daily cash inflows do not normally match the cash outflows and a ‘buffer’ amount of cash is required to enable operations to continue. This is particularly important in seasonal businesses or in businesses where long credit periods are given to customers. Precautionary motive Cash flow forecasting is subject to error and uncertainty. Future cash flows can vary from those originally forecast for a variety of reasons e.g. lower sales demand or failure of a major customer. The inability of a business to meet payments when they fall due may result in loss of settlement discounts, damaged relations with suppliers or staff, bank charges or possibly liquidation. The more vulnerable cash flows are to unpredictable changes the greater the cash balance needed to act as a safety margin. Speculative motive The availability of cash means that a company can potentially invest in unexpected profitable opportunities, for example, to take advantage of unexpected discounts offered for cash payments for materials.
(b) Rationale The question assesses learning outcome D1(e) calculate the value of 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 net present value for each project without perfect information. They should then select the best outcome from each of the possible consumer 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.
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Project A expected value
Project B expected value
Project C expected value
$000s
$000s
$000s
Strong
250
400
300
Good
100
120
150
Weak
70
49
35
Expected value
420
569
485
Consumer reaction
Project B is the best choice (without the benefit of perfect information) as it has the highest expected value (EV) of $569k. With perfect information: If research reveals strong consumer reaction: select B – expected value $400k If research reveals good consumer reaction: select C – expected value $150k If research reveals weak consumer reaction: select A – expected value $70k EV (with perfect information) = $400 + $1 50 + $70 = $620k Value of perfect information is $620k – $569k = $51k
(c) Rationale The question 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 is minimal. It examines candidates’ ability to explain the potential benefits to a company from using a just-in-time production system.
Suggested Approach Candidates should firstly explain how a just-in-time production system operates and then clearly explain the potential benefits of this for the company.
A just-in-time (JIT) production system is based on actual demand. JIT production aims to produce the right parts or finished goods at the right time only when they are needed. A JIT production system is a pull system where parts or goods move through the production system based on demand. The use of a JIT production system should result in the following benefits: • • •
•
Low levels of work in progress and finished goods and consequently a reduction in the costs involved in holding inventory. The elimination of waste which is defined as anything that does not add value to the product. The elimination of any non-value added activities including inspections, movement of materials and part-completed work and storage of inventory. This involves moving from a batch production functional factory layout to a cellular flow line manufacturing system to avoid move times and queue times. An increase in quality since low quality materials will result in disruption to the production process, increased inspection time and wastage.
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JIT production techniques can also lead to JIT purchasing whereby the delivery of materials immediately precede their use. This will bring the following additional benefits: • • •
Low levels of raw materials and of the costs involved with holding raw materials. A reduction in quality control costs for the company as a result of the close relationships with a small number of suppliers. An increase in quality standards resulting in lower wastage in the production process and hence reduced wastage costs.
(d) Rationale The question assesses learning outcome E1(e) analyse trade debtor and creditor information. It examines candidates’ ability to calculate whether it is financially beneficial for a company to use a factor.
Suggested Approach Candidates should firstly calculate the costs if the company uses the factor including the factoring fee, annual interest charge from the factor and the overdraft interest. They should then deduct the saving in credit control costs to arrive at the net cost of factoring. They should then calculate the cost if the company does not use factoring and compare this to the net cost of factoring.
If the company uses factoring: Factoring fee Annual interest Overdraft interest
$2,007,500 x 2% ((80% x $2,007,500) x 50/365) x 12% ((20% x $2,007,500) x 50/365) x 10%
= $40,150 = $26,400 = $ 5,500 $72,050 $30,000 $42,050
Savings in credit control costs Net cost of factoring If the company does not use factoring: The company requires to borrow - $330,000 The cost of borrowing is therefore - $330,000 x 10% = $33,000 There is therefore no financial benefit in factoring as the cost of borrowing is less than the cost of factoring.
(e) Rationale 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. It examines candidates’ ability to produce a pay-off table and then use the pay-off figures to determine the decision that would be made if the minimax regret criterion is
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applied.
Suggested Approach Candidates should firstly complete the pay-off table based on the combination of the number of batches of sandwiches prepared and the demand for sandwiches. They should then prepare a regret matrix showing the regret at each of the different levels of demand. The maximum regret at each of the different number of batches prepared can then be identified. The decision should then be based on the number of batches which will minimise the maximum regret.
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(i)
Demand 20 batches 21 batches 22 batches 23 batches
20 batches $1,200 $1,200 $1,200 $1,200
Number of batches prepared 21 batches 22 batches $1,160 $1,120 $1,260 $1,220 $1,260 $1,320 $1,260 $1,320
23 batches $1,080 $1,180 $1,280 $1,380
20 batches 0 $60 $120 $180 $180
Number of batches prepared 21 batches 22 batches $40 $80 0 $40 $60 $0 $120 $60 $120 $80
23 batches $120 $80 $40 $0 $120
(ii)
Demand 20 batches 21 batches 22 batches 23 batches Maximum regret
To minimise the maximum regret the company should produce 22 batches.
(f) Rationale The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines candidates’ ability to explain the difference between an incremental budgeting system and an activity based budgeting system. Suggested Approach Candidates should clearly explain how each of the budgeting systems operates highlighting the main differences between the two systems.
An incremental budget is normally based on the previous year’s budget for a responsibility centre which is then adjusted for any expected changes e.g. changes in level of activity or changes to operations. The different elements of the budget will also be adjusted for inflation. A key aspect of the incremental budgeting approach is that it builds upon the previous budget and assumes that the activities required in the previous year will continue in the next year. The effect of this is that any previous inefficiencies are perpetuated. Activity based budgeting (ABB) aims to manage costs more effectively by authorising the supply of only those resources that are needed to perform activities required to meet the budgeted production, sales volume or service levels. Cost objects i.e. products or services are the starting point. The necessary activities required will be determined by the different types of products or services that will be produced / sold. The cost driver for each activity will be identified and the volume of cost drivers required for each activity combined with the cost driver rate will then be used to estimate the resources required. The activity based budget approach will also enable the identification of non-value added activities which can be reduced or eliminated.
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SECTION C Answ er t o Qu est io n 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 sa les variances including sales mix and sales quantity variances. It also 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 separate variances into their planning and operational elements. Part (b) also 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 why it is useful to separate the sale volume variance into a sales mix variance and a sales quantity variance. Part (c) also 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 importance of planning and operational variances.
Suggested Approach 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 price, sales quantity and sales mix showing separately the sales quantity planning variance and sales quantity operational variance. They should then prepare a reconciliation statement starting with the budgeted contribution, adding the sales quantity contribution planning 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 use the figures calculated in part (a) to discuss the benefits of separating the sales volume variance into a sales mix and sales quantity variance. In part (c) candidates should clearly explain why calculating planning and operational variances gives better information for planning and control purposes.
(a) Reconciliation statement $
Budgeted contribution
2,550,000
Sales quantity contribution planning variance - Premium - Deluxe - Superfast
280,000 F 260,000 F 480,000 F
Revised budget contribution
1,020,000 F 3,570,000
Operational variances: Sales quantity contribution operational variance - Premium 70,000 A - Deluxe 65,000 A - Superfast 120,000 A Sales mix contribution operational variance - Premium 190,000 F - Deluxe 65,000 A - Superfast 210,000 A
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255,000 A
85,000 A
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Sales price operational variance - Premium - Deluxe - Superfast Actual contribution
110,000 F 60,000 A 180,000 F
230,000 F 3,460,000
Original budgeted contribution for the period $ Premium 7,000 units x $100 700,000 Deluxe 5,000 units x $130 650,000 Superfast 8,000 units x $150 1,200,000 2,550,000 Sales quantity contribution planning variance Original Revised Difference budget budget units units @ original @ original budget mix budget mix Premium 7,000 9,800 2,800 F Deluxe 5,000 7,000 2,000 F Superfast 8,000 11,200 3,200 F 20,000 28,000
Standard contribution $
Variance $
100 130 150
280,000 F 260,000 F 480,000 F 1,020,000 F
Revised budget contribut ion
Premium Deluxe Superfast
9,800 units x $100 7,000 units x $130 11,200 units x $150
$ 980,000 910,000 1,680,000 3,570,000
Sales quantity contribution operational variance Revised budget Actual units Difference units @ budget mix @ budget mix Premium 9,800 9,100 700 A Deluxe 7,000 6,500 500 A Superfast 11,200 10,400 800 A 28,000 26,000 Sales mix contribution operational variance Actual units Actual units @ budget mix @ actual mix
Premium Deluxe Superfast
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9,100 6,500 10,400 26,000
11,000 6,000 9,000 26,000
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Difference
1,900 F 500 A 1,400 A
Standard contribution $ 100 130 150
Variance $
Standard contribution $ 100 130 150
Variance $
70,000 A 65,000 A 120,000 A 255,000 A
190,000 F 65,000 A 210,000 A 85,000 A
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Or alternatively
Weighted average contribution per unit = $3,570,000 / $28,000 = $127.50 Sales mix contribution operational variance Actual units Actual units Difference @ budget mix @ actual mix
Premium Deluxe Superfast
9,100 6,500 10,400 26,000
11,000 6,000 9,000 26,000
1,900 500 1,400
Sales pri ce operational variance Standard Actual selling price selling price Premium $400 $410 Deluxe $450 $440 Superfast $500 $520
Weighted average contribution less standard contribution $ (127.50 – 100) (127.50 – 130) (127.50 – 150)
Difference
$10 F $10 A $20 F
Actual units sold 11,000 6,000 9,000 26,000
Variance $
52,250 A 1,250 A 31,500 A 85,000 A
Variance $ 110,000 F 60,000 A 180,000 F 230,000 F
Ac tu al c on tr ib ut io n f or th e per io d
Premium Deluxe Superfast
11,000 units x $110 6,000 units x $120 9,000 units x $170
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$ 1,210,000 720,000 1,530,000 3,460,000
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(b) The sales volume variance will enable the sales manager to identify the effect on contribution of the sales team’s failure to meet the revised sales budget. By separating this into a sales mix and a sales quantity variance the sales manager will be able to determine how much of the total adverse variance was due to the failure to meet the total budget sales quantity and how much was due to the actual sales being at a different mix from the budget mix. The sales quantity contribution operational variance compares the actual volume sold at the budgeted mix with the budgeted volume at the budgeted mix. The budgeted figures used are the revised budget after taking account of the planning variances. The variance is adverse and indicates that if 2,000 additional units had been sold at the budgeted mix a further $255,000 contribution would have been earned. The sales mix contribution operational variance compares the actual units sold at the budgeted mix with the actual units sold at the actual mix. The budgeted figures used are the revised budget after taking account of the planning variances. It indicates the effect that a change of mix has had on the contribution earned. The variance is adverse as sales of both the deluxe and the superfast models were lower than expected using the budgeted mix. Sales of the premium model were higher than expected under the budget mix but this model has the lowest contribution.
(c) Planning and operational variances provide better information for planning and control purposes for the following reasons: •
The use of planning and operational variances will enable management to draw a distinction between variances caused by factors outside the control of the business and planning errors (planning variances) and variances caused by factors that are within the control of management (operational variances). In this case they can separate the sales quantity contribution variance to show the variance caused by inaccurate planning as a result of not considering the impact of the competitor’s failure on sales volume (planning variance) and the operational variance as a result of efficient or inefficient selling.
•
The managers’ performance can be compared with the adjusted standards that reflect the conditions the manager actually operated under during the reporting period. If planning and operational variances are not distinguished, there is potential for dysfunctional behaviour especially where the manager has been operating efficiently and effectively and performance is being judged by factors outside the manager’s control.
•
The use of planning variances will also allow management to assess how effective the company’s planning process has been. Where a revision of the budget is required due to changes that were not foreseeable at the time the budget was prepared, the planning variances are uncontrollable. However budgets that failed to anticipate foreseeable market trends when they were set will reflect faulty planning. It could be argued that some of the planning variances are in fact controllable at the planning stage.
•
The information used in setting the ex-post standards can be used in future budget periods. The planning variances may also indicate problems in the standard setting process and the reasons for this can be identified and improvement made to the process.
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Answ er t o Qu est io n 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 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(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates’ ability to apply the annualised equivalent method to an asset replacement decision. Part (c) also assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates’ ability to explain the limitations of the annualised equivalent method for making asset replacement decisions.
Suggested Approach In part (a) candidates should firstly calculate the total cost of the investment and residual value of the limousines. They should then calculate the depreciation charge for each limousine and deduct this from the fixed costs. The number of days that the limousines will be operated in each year should then be used to calculate the total contribution for each year. Candidates should then identify the other relevant cash flows for each year of the project. The tax depreciation and tax payments should then be calculated. The net cash flows after tax should be discounted at the discount rate of 12% to calculate the net present value (NPV) of the project. In part (b) candidates should calculate the NPV for a one, two and three year replacement cycle. The NPV should then be divided by the annuity factor to calculate the annualised equivalent cost. The replacement cycle with the lowest annualised equivalent cost should then be selected. In part (c) candidates should clearly explain the limitations of using the annualised equivalent method for asset replacement decisions.
(a) Investment costs
$200k per limousine x 20 = $4,000,000 Residual value = $30k x 20 = $600,000 Fixed co sts
Depreciation per limousine per annum = ($200k – $30k) / 5 = $34k Administration costs = $300k Other fixed costs (excluding depreciation) per annum $45k - $34k = $11k per limousine $11k x 20 = $220k The head office charge is not a relevant cost. Contribu tion years 1 – 5
Contribution per limousine per day = $800 - $300 = $500 Total contribution per day = $500 x 20 = $10,000 Year 1 = 260 days Year 2 = 260 days + 10 days = 270 days Year 3 = 270 days + 10 days = 280 days Year 4 = 280 days + 10 days = 290 days September 2013
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Year 5 = 290 days + 10 days = 300 days Total contribution Year 1 = 260 days x $10,000 = $2,600,000 Year 2 = 270 days x $10,000 = $2,700,000 Year 3 = 280 days x $10,000 = $2,800,000 Year 4 = 290 days x $10,000 = $2,900,000 Year 5 = 300 days x $10,000 = $3,000,000 Cash flows
Contribution Other fixed operating costs Administration costs Net cash flows
Year 1 $k 2,600
Year 2 $k 2,700
Year 3 $k 2,800
Year 4 $k 2,900
Year 5 $k 3,000
(220)
(220)
(220)
(220)
(220)
(300)
(300)
(300)
(300)
(300)
2,080
2,180
2,280
2,380
2,480
Taxation
Net cash flows Tax Depreciation Taxable profit Taxation @ 30%
Year 1
Year 2
Year 3
Year 4
Year 5
$k 2,080
$k 2,180
$k 2,280
$k 2,380
$k 2,480
(1,000)
(750)
(563)
(422)
(665)
1,080
1,430
1,717
1,958
1,815
324
429
515
587
545
Net pr esent value Year 0 Year 1 $k $k Investment (4,000) / residual value Net cash 2,080 flows Tax (162) payment Tax payment Net cash (4,000) 1,918 flow after tax Discount 1.000 0.893 factors @ 12% Present (4,000) 1,713 value Net present value = $2,887k
Year 2 $k
Year 3 $k
Year 4 $k
Year 5 $k 600
Year 6 $k
2,180
2,280
2,380
2,480
(215)
(258)
(294)
(273)
(162)
(214)
(257)
(293)
(272)
1,803
1,808
1,829
2,514
(272)
0.797
0.712
0.636
0.567
0.507
1,437
1,287
1,163
1,425
(138)
The net present value is positive therefore on this basis the company should go ahead with the project.
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(b) Year
0 1 2 3 Net present value Cumulative discount factor Annualised equivalent
Discount Factor @12% 1.00 0.893 0.797 0.712
Replace after Year 1 Cash Present flows value $ $ (30,000) (30,000) 19,500 17,414
Replace after Year 2 Replace after Year 3 Cash Present Cash Present flows value flows value $ $ $ $ (30,000) (30,000) (30,000) (30,000) (1,500) (1,340) (1,500) (1,340) 12,300 9,803 (2,700) (2,152) 5,400 3,845
(12,586)
(21,537)
(29,647)
0.893
1.690
2.402
(14,094)
(12,744)
(12,343)
The lowest annualised equivalent cost occurs if the vehicles are kept for three years. Therefore the optimum replacement cycle is to replace the vehicles every three years.
(c) The annualised equivalent method assumes that the company replaces the assets with an identical asset each time. This however ignores changing technology and the necessary requirement to replace assets with a more up to date model which may be more efficient and have different functions. The method also ignores the effect of inflation which may differ for each of the different variables. This may mean that the optimal replacement period will vary over time. The external environment is uncertain and therefore companies cannot predict with accuracy the environment that they will face in the future. It may not be necessary to replace the assets in the future as they may no longer be required.
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