Operational Level Paper
P1 – Performance Operations November 2014 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 February at www.cimaglobal.com/P1PEGS
SECTION A Answer to Question One
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
The correct answer is C.
1.2
The correct answer is C.
The Chartered Institute of Management Accountants 2013
1.3 Annual production Batch size (units) Number of batches Number of inspections per batch Total number of inspections
Product X 160,000 100 1,600 3 4,800
Product Y 200,000 50 4,000 4 16,000
Product Z 100,000 25 4,000 6 24,000
Total
44,800
Cost driver rate = $150,000 / 44,800 = $3.35 per inspection Cost per unit of Product Y = ($3.35 x 16,000) / 200,000 = $0.27
The correct answer is D.
1.4
(Actual sales volume –budgeted sales volume) x standard contribution per unit (1,630 – 1,500) x ($400 x 0.3) = $15,600 F The correct answer is A.
1.5
At the breakeven point, contribution is equal to fixed costs therefore the contribution to sales ratio is $320,000 / $800,000 i.e. 40% To earn a profit of $200,000 the required contribution is equal to the fixed costs plus the required profit ($320,000 + $200,000) / 0.40 = $1,300,000 The correct answer is B.
1.6
Net present value of the project = $240,000 Present value of the annual cash outflow = $120,000 x 3.605 = $432,600 $240,000/$432,600 = 55.5% The managers would reject the project if the annual cash flows decrease by more than 55.5%.
1.7 Days = 78.2
Accounts receivable days
((6/28) x 365)
Inventory days
(4/(28 x 0.6)) x 365 = 86.9
Accounts payable days
(3/(28 x 0.6)) x 365 = (65.2) 99,9
The cash operating cycle is 100 days.
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1.8 Quarter
Actual sales units 20,250
Variation
1
Trend sales units 18,000
2
21,000
19,425
-7.5%
3
24,000
25,200
+5.0%
4
27,000
24,300
-10.0%
+12.5%
Forecast sales Year 2 Quarter 1 = 15,000 + (3,000 x 5) = 30,000 + 12.5% = 33,750 units Year 2 Quarter 2 = 15,000 + (3,000 x 6) = 33,000 - 7.5% = 30,525 units Year 2 Quarter 3 = 15,000 + (3,000 x 7) = 36,000 + 5.0% = 37,800 units Year 2 Quarter 4 = 15,000 + (3,000 x 8) = 39,000 - 10.0% = 35,100 units
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SECTION B Answer to Question Two
(a) Rationale The question assesses learning outcome E1(g) analyse the impacts of alternative policies for stock management. It examines candidates’ ability to explain the benefits of a decentralised purchasing system.
Suggested Approach Candidates should consider the potential benefits to a company of using a decentralised purchasing system compared to the current system and explain clearly what the benefits are and why they arise under this system.
The benefits of a decentralised purchasing system are as follows: • • • • • • •
It may result in reduced transport costs with a consequential impact on the environment. A decentralised purchasing system is likely to be less bureaucratic and able to respond quickly to inventory shortages. A local buyer may be more flexible and able to respond to temporary reductions in local prices that a central buying 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 levels of inventory. Local suppliers may offer varied products thus enabling differentiation of finished products. The opportunity is available to delegate responsibility for aspects of the management of the business and there may be benefits in terms of management development. Managers who have been given responsibility for the financial management of their particular operating unit will be able to make decisions regarding purchasing and inventory management.
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(b)
Rationale Part (i) assesses learning outcome E1(f) analyse the impacts of alternative debtor and creditor policies. It examines candidates’ ability to calculate the net cost of a change to a company’s credit policy.
Suggested Approach Candidates should first calculate the change in the level of investment in trade receivables if the early settlement discount is offered. The benefit of this, in terms of the reduction in overdraft interest, can then be calculated. This should then be compared to the cost of the cash discount offered and the additional credit control costs.
Current level of investment in trade receivables ($25 million x 60/365)
$000
Proposed level of investment in trade receivables ($15 million x 30/365) ($10 million x 50/365)
$000 4,110
(1,233) (1,370) (2,603) 1,507
Reduction in trade receivables
The reduction in overdraft interest as a result of the reduction in trade receivables will be $1,507,000 x 14% = $210,980 Cost of cash discount offered ($25m x 60% x 2.5%) Additional credit control costs Interest charge savings Net cost of change in policy
375 30 405 (211) 194*
Or alternatively: Current cost of investment in trade receivables: $000 $25m x 60/365 x 14%
$000 575
Cost if proposed policy implemented: Cash discounts ($25m x 60% x 2.5%) Cost of investment in trade receivables $15m x 30/365 x 14% $10m x 50/365 x 14% Credit control costs Net cost of change in policy
375 173 192 30
770 195*
*Rounding differences only
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(c) Rationale The question assesses learning outcome B3(a) prepare a budget for any account in the master budget, based on projections/forecasts and managerial targets. It examines candidates’ ability to prepare a cash budget based on information about the timing of cash flows.
Suggested Approach Candidates should first prepare a format for the cash budget with months along the top and receipts and payments down the side. They should then work out the timing of the cash flows for each of the items. The cash receipts and cash payments should be summed and the net cash flow for each month should be calculated. The opening cash balance and closing cash balance for each month can then be calculated.
Cash budget January
February
March
$
$
$
80% credit sales
128,000
128,000
136,000
20% credit sales
30,000
32,000
32,000
158,000
160,000
168,000
Purchases
42,500
45,000
47,500
Labour & overheads
71,000
74,000
Receipts
Total receipts Payments
Machinery Total payments
76,000 100,000
113,500
119,000
223,500
Opening balance
15,000
59,500
100,500
Net cash flow
44,500
41,000
(55,500)
Closing balance
59,500
100,500
45,000
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(d) Rationale The question assesses learning outcome E2(b) identify alternatives for investment of shortterm cash surpluses. It examines candidates’ ability to compare and contrast two short term investment opportunities in terms of their risk, return and liquidity.
Suggested Approach Candidates should describe each of the investments and indicate clearly how each of them compares in terms of their risk, return and liquidity.
Treasury bills These are issued by the government for terms of up to three months and therefore have minimal capital risk as they are backed by the government. The bills are sold by tender each week at a discount to their nominal value. They are redeemed at their nominal value giving an implied interest rate. They are therefore subject to interest rate risk since if market rates increase the holder loses the opportunity to earn higher rates. Treasury bills are also traded on the money market and so the holder can sell them to obtain immediate cash at any time giving excellent liquidity. However if sold before maturity the holder would also be exposed to capital risk as the value of the bill changes in response to market interest rate movements. Money market deposit A money market deposit is riskier than an investment in treasury bills however as the money market is used largely by banks and other financial institutions the risk is relatively low. The return on money market deposits will be higher than the return on treasury bills. Similar to treasury bills, the deposit is subject to interest rate risk. Money invested in a money market deposit cannot be withdrawn until the deposit matures and is therefore less liquid than treasury bills. However the investment can be made for very short periods of time.
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(e) Rationale The question assesses learning outcome D1(c) analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms. It examines candidates’ ability to calculate the expected value of a decision.
Suggested Approach Candidates should first calculate the expected value of the number of visitors and the expected value of the contribution from sales of souvenirs and refreshments. The total contribution can then be calculated and the specific fixed costs deducted from this to calculate the expected contribution towards general fixed overheads.
Expected value of number of visitors: = (800 x 0.5) + (900 x 0.3) + (1,000 x 0.2) = 870 Expected value of contribution from sales of souvenirs and refreshments: = ($8 x 0.35) + ($10 x 0.40) + ($12 x 0.25) = $9.80 Expected contribution to general overheads: Contribution = ($25 + $9.80) x 870 Less specific fixed costs Additional contribution
Performance Operations
=
$30,276 $30,000 $ 276
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(f) Rationale Part (i) of the question assesses learning outcome D1(d) prepare expected value tables. It examines candidates’ ability to prepare a two way data table. Part (ii) of the question assesses learning outcome D1(c) analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms. It examines candidates’ ability to determine the probability of a particular outcome using joint probabilities.
Suggested Approach In part (i) candidates should calculate the contribution to general fixed overheads, for each of the possible outcomes, by multiplying the number of visitors by the selling price of the ticket plus the contribution from the sales of souvenirs and refreshments. The specific fixed costs should then be deducted from the total contribution. The figures should then be presented in the form of a two way data table. In part (ii) candidates should calculate the joint probability of each of the possible outcomes that produce a positive contribution. The total probability of making a positive contribution can then be calculated.
(i) The contribution to general fixed overheads for each of the combinations is shown in the two way data table below: Contribution $8 per visitor $10 per visitor $12 per visitor
800 visitors ($3,600) ($2,000) ($400)
900 visitors ($300) $1,500 $3,300
1,000 visitors $3,000 $5,000 $7,000
(ii) The joint probabilities of the combinations are shown in the table below:
$8 per visitor $10 per visitor $12 per visitor
800 visitors (0.50 x 0.35) = 0.175 (0.50 x 0.40) = 0.200 (0.50 x 0.25) = 0.125
900 visitors (0.30 x 0.35) = 0.105 (0.30 x 0.40) = 0.120 (0.30 x 0.25) = 0.075
1,000 visitors (0.20 x 0.35) = 0.070 (0.20 x 0.40) = 0.080 (0.20 x 0.25) = 0.050
The probability of making a positive contribution to general fixed overheads is: 0.120 + 0.075 + 0.070 + 0.080 + 0.050 = 0.395 or 39.5%
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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 variances to enable the reconciliation of budgeted and actual contribution margins. Part (b) assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines candidates’ ability to discuss the company’s performance and the reasons why the variances may have arisen. 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 first calculate the budgeted contribution and the actual contribution for the period. They should then prepare a reconciliation statement starting with the budgeted contribution, adjusting for the sales volume contribution variance to calculate a revised contribution and then adjusting for the planning variances. They should then calculate each of the individual operational variances to reconcile the budgeted contribution to actual contribution. In part (b) candidates should discuss the company’s performance in general terms and then identify a possible reason for each of the operational variances as shown by the variances calculated in part (a). In part (c) candidates should explain clearly the potential benefits to a company, in terms of planning and control, of reporting planning and operational variances.
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(a) Reconciliation statement for October $ Budgeted contribution (40,000 units x $15) Sales volume contribution operational variance ((42,000 – 40,000) x $15.00) Standard contribution at actual sales volume (42,000 units x $15) Planning variances: Material usage variance 126,000 A (42,000 units x ($15.00 - $18.00)) Labour rate variance 33,600 F ((42,000 units x 2hrs) x ($15.00 - $14.60)) Revised standard contribution
$ 600,000 30,000 F 630,000
92,400 A 537,600
Operational variances: Sales price variance (($62 - $60) x 42,000) Material price variance (78,000 x ($10.00 - $9.90)) Material usage variance (((42,000 x 1.8 kg) – 78,000) x $10) Labour rate variance (($14.60 - $15.20) x 86,000) Labour efficiency variance (((42,000 x 2 hours) – 86,000) x $14.60)
84,000 F 7,800 F 24,000 A 51,600 A 29,200 A
13,000 A 524,600
Actual contribution
Workings: Actual contribution for October Sales 42,000 units x $62 Less production costs: Direct materials 78,000 x $9.90 Direct labour 86,000 x $15.20 Actual contribution
November 2014
$ 2,604,000 (772,200) (1,307,200) 524,600
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(b) The original budgeted contribution of $600,000 was reduced by $92,400 as a result of the planning changes. The main contributor to the planning variances was the change in the material specification. It is not clear why the specification was changed – perhaps the company hoped to increase the price of the product or maybe there was a lack of availability of an existing material. The sales volume and sales price variances were both favourable. The sales price variance was $84,000 F which may be a result of the change to material specification which has improved the quality of the product and thus allowed an increase in price. The increase in sales volume could be for the same reason. It is arguable that at least part of these variances would be more appropriately treated as planning variances. The material price variance was also favourable which could be explained by suppliers offering a bulk purchase discount due to the increase in the amount of materials purchased as a result of the specification change. The material usage variance was adverse which may be because the labour force was not familiar with the different materials and this resulted in more wastage than was originally expected. The labour rate and the labour efficiency variances were both adverse which could also be explained by the change in specification. Depending on how the company classifies an overtime premium, the labour rate variance may be a result of the need to work overtime as the work was taking longer because of the new material used. If the labour were not accustomed to using the material they may have taken longer to handle it and required more time to produce each unit. Alternatively the variance could be a result of using a different mix of labour from that originally planned.
(c) Standards are normally based on the anticipated environment. It could be argued that if the environment is significantly different from the expected environment, actual performance should be compared with a standard that takes account of these changed conditions. This would provide a more meaningful measure of managerial performance. The planning variance may not be controllable but does provide some useful information to managers on the accuracy of their planning and could help to improve the accuracy of future plans. Operational variances are considered to be controllable and hence they provide a better measure of the operating efficiency. In practice, however, there may be problems with managers trying to suggest that adverse variances have all arisen due to planning errors.
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Answer to Question Four Rationale Part (a) assesses learning outcome 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 cash flows of a project and then apply discounted cash flow analysis to calculate the net present value of the project. Part (b) assesses learning outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. It examines candidates’ ability to apply the annualised equivalent method to choose between two machines which have different useful lives. Part (c) also assesses learning outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. It examines candidates’ ability to explain the limitations of using the annualised equivalent method when making investment decisions.
Suggested Approach In part (a) candidates should first calculate the contribution for each year of the project. They should then deduct the fixed costs after adjusting these for depreciation. The foregone contribution from the existing machine should also be deducted from the cash flows. The tax depreciation and tax payments should then be calculated. The total cost of the investment, the residual value and the sales proceeds from the existing machine should be added to the net cash flows. The net cash flows after tax should then 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 net present value for each of the machines using the company’s cost of capital. They should then calculate the annualised equivalent by dividing the net present value of the machine by the appropriate cumulative discount factor. The machine with the highest annualised equivalent net present value should then be selected. In part (c) candidates should explain clearly the limitations of using the annualised equivalent method in investment appraisal.
(a) Fixed costs Depreciation per annum = ($825k - $45k) / 4 = $195k Fixed costs (excluding depreciation) per annum = $380k - $195k = $185k Contribution Years 1 – 4 Year 1: 18,000 units x $30 = $540,000 Year 2: 24,000 units x $30 = $720,000 Year 3: 26,000 units x $30 = $780,000 Year 4: 22,000 units x $30 = $660,000
Taxation
Contribution Fixed costs Lost contribution Net cash flows Tax depreciation Taxable profit Taxation @ 30%
November 2014
Year 1 $000 540 (185) (90) 265 (206) 59 (18)
13
Year 2 $000 720 (185)
Year 3 $000 780 (185)
Year 4 $000 660 (185)
535 (155) 380 (114)
595 (116) 479 (144)
475 (303) 172 (52)
Performance Operations
Tax depreciation
Investment / WDV Tax depreciation Balancing allowance / (charge) Total tax depreciation
Year 1 $000 825 206 0 206
Year 2 $000 619 155 0 155
Year 3 $000 464 116 0 116
Year 4 $000 348 87 216 303
Total $000
780
Net present value
Investment / residual value Sales proceeds from existing machine Net cash flows Tax payment Tax payment Net cash flow after tax Discount factors @ 12% Present value Net present value = $386k
Year 0 $000 (825) 23 (802)
(802) 1.000 (802)
Year 1 $000
Year 2 $000
Year 3 $000
Year 4 $000 45
265 (9)
535 (57) (9) 469 0.797 374
595 (72) (57) 466 0.712 332
475 (26) (72) 422 0.636 268
256 0.893 229
Year 5 $000
(26) (26) 0.567 (15)
The net present value is positive therefore on this basis ST should go ahead with the introduction of the new product.
(b)
Year
0 1 2 3 Net present value Cumulative discount factor Annualised equivalent
Discount factor @12% 1.000 0.893 0.797 0.712
Machine X Cash Present flows value $000 $000 (200) (200) 200 179 230 183 162
Machine Y Cash Present flows value $000 $000 (240) (240) 200 179 230 183 240 171 293
1.690
2.402
96
122
The higher annualised equivalent net present value occurs if machine Y is purchased and replaced every three years.
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(c) The annualised equivalent method assumes that the company replaces the assets with an identical asset each time. However this 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 in which they will be operating 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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