# P1 Performance Operations September 2012 examination

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1 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 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 SECTION A Answer to Question One 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 = \$ \$9.25 = \$19.25 Return per hour = (\$19.25 / 7.8) x 60 = \$ The correct answer is D. September P1

2 1.3 20% of October sales = \$ 56,000 65% of November sales = \$162,500 15% of December sales x 0.95 = \$ 42,750 Total cash paid = \$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, 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 = \$27, (i) The labour rate planning variance for August (22,000 units x 0.5) x (\$ \$14) = \$38,500 A (ii) The labour rate operational variance for August 11,400 hrs x (\$ \$15.50) = \$22,800 F P1 2 September 2012

3 (iii) The labour efficiency operational variance for August ((22,000 x 0.5 hour) - 11,400 hrs) x \$17.50= \$7,000 A September P1

4 SECTION B Answer to Question Two (a) 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 = \$37,910 Asset 2 should be leased as the present value of the lease payments is lower. (b) 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. P1 4 September 2012

5 (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) 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. September P1

6 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) 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) 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. P1 6 September 2012

7 (i) Payment will be received 80 days early. Number of compounding periods = 365/80 = r = (1.00/0.97) r = 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. September P1

8 (f) 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. P1 8 September 2012

9 SECTION C Answer to Question Three 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. September P1

10 (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 Selling price variance Product B: 3,000 units x (\$110 - \$100) Product C: 1,500 units x (\$105 - \$107.50) 26,250 F 28,219 A 1,969 A 13,750 F 12,094 F 25,844 F 23,875 F 230,625 F 30,000 F 3,750 A 26,250 F Direct material price variance ((25,600 kg x \$5) \$124,800) 3,200 F Direct material usage variance ((3,000 x 5 kg) + (1,500 x 7 kg)) 25,600 kg) x \$5 500 A 2,700 F Direct labour rate variance (9,140 x \$7) - \$67,980 4,000 A Direct labour efficiency variance ((3,000 x 2hrs) + (1,500 x 1.5 hours)) 9,140) x \$7.00 6,230 A 10,230 A Variable overhead expenditure variance (9,140 hours x \$1.50) - \$14, A Variable overhead efficiency variance ((3,000 x 2hrs) + (1,500 x 1.5 hours)) 9,140) x \$1.50 1,335 A 1,925 A Fixed overhead expenditure variance ((2,200 x \$8) + (1,800 x \$6)) - \$27,000 1,400 F Fixed overhead volume variance Product B: (3,000 2,200) x \$8 Product C: (1,500 1,800) x \$6 6,400 F 1,800 A 6,000 F Actual profit 253,420 Workings: Standard selling price per unit Product B: \$50 x 2 = \$100 Product C: \$53.75 x 2 = \$ Budgeted profit for the period Product B Product C Total Sales 2,200 1,800 Budgeted profit per unit \$50 \$53.75 Total budgeted profit \$110,000 \$96,750 \$206,750 P1 10 September 2012

11 Actual profit for the period \$ \$ Sales (3,000 x \$110) + (1,500 x \$105) 487,500 Direct materials 124,800 Direct labour 67,980 Variable production overheads 14,300 Fixed production overheads 27,000 Total production cost 234,080 Actual profit 253,420 Sales mix profit margin variance Actual sales actual mix mix Variance Standard profit \$ Variance \$ Product B 2,475 3, F ,250 F Product C 2,025 1, A ,219 A 4,500 4,500 1,969 A Or alternatively: Weighted average profit per unit \$206,750 / 4,000 = \$ Sales mix profit margin variance Actual mix Actual actual mix Variance Standard profit difference \$ Variance \$ Product B 2,475 3, F ( ) 886 A Product C 2,025 1, A ( ) 1083 A 4,500 4,500 1,969 A Sales quantity profit variance Actual mix Budget standard mix Variance Standard profit \$ Variance \$ Product B 2,475 2, F ,750 F Product C 2,025 1, F ,094 F 4,500 4, F 25,844 F September P1

12 Or alternatively: Sales quantity profit variance Actual mix Budget std mix Variance Weighted average profit per unit \$ Variance \$ Product B 2,475 2, F ,214 F Product C 2,025 1, F ,630 F 4,500 4, F 25,844 F (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. P1 12 September 2012

13 Periodic financial reports are neither meaningful nor sufficiently timely to facilitate appropriate control action. September P1

14 Answer to Question Four 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 P1 14 September 2012

15 Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 \$000 \$000 \$000 \$000 \$000 Contribution 32,032 33,313 34,646 36,032 37,473 Lease costs (500) (500) (500) (500) (500) Maintenance (208) (216) (225) (234) (243) costs Net cash flows 31,324 32,597 33,921 35,298 36,730 Taxation Year 1 Year 2 Year 3 Year 4 Year 5 \$000 \$000 \$000 \$000 \$000 Net cash flows 31,324 32,597 33,921 35,298 36,730 Tax Depreciation (30,000) (22,500) (16,875) (12,656) 12,031 Taxable profit 1,324 10,097 17,046 22,642 48,761 30% (397) (3,029) (5,114) (6,793) (14,628) Net present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 \$000 \$000 \$000 \$000 \$000 \$000 \$000 Structure (120,000) 50,000 cost Net cash 0 31,324 32,597 33,921 35,298 36,730 flows Tax payment 0 (198) (1,514) (2,557) (3,396) (7,314) Tax payment 0 (199) (1,515) (2,557) (3,397) (7,314) Net cash flow after tax Discount 12% Present value (120,000) 31,126 30,884 29,849 29,345 76,019 (7,314) (120,000) 27,796 24,615 21,252 18,663 43,103 (3,708) Net present value = \$11,721 The project has a positive net present value and therefore should be accepted (b) (i) Net cash flow (120,000) 31,126 30,884 29,849 29,345 76,019 (7,314) after tax Discount % Present value (120,000) 25,928 21,433 17,283 14,144 30,560 (2,450) Net present value = -\$13,102 September P1

16 By interpolation IRR = 12% + ((\$11,721 / (\$11,721 +\$13,102)) x (20% - 12%) IRR = 12% % IRR = 15.78% (b) (ii) Year Cash flow Cumulative cash flow 0 (120,000) (120,000) 1 31,126 (88,874) 2 30,884 (57,990) 3 29,849 (28,141) 4 29,345 1,204 Payback period = 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 = Investors will be indifferent from a financial perspective as to whether they hold \$1,000 now or receive \$1, in one year s time. The money cash flow of \$1, 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. P1 16 September 2012

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