P1 Performance Operations May 2013 examination

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1 Operational Level Paper P1 Performance Operations May 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 The Post Exam Guide for this examination, which includes the marking guide for each question, will be published on the CIMA website by early August at SECTION A Answer to Question One 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 received from previous period 460,000 Sales for this budget period 5,400,000 5,860,000 Credit sales not paid until next period (5,400,000 x 80% x 1/12) Total cash received (360,000) 5,500,000 The correct answer is C. The Chartered Institute of Management Accountants 2013

2 1.2 Year 2, quarter 3 is period 7 Trend sales = 22, (7) = 27,600 units Adjusted for seasonal variations = 27,600 x 1.30 = 35,880 units The correct answer is A. 1.3 Trend sales for quarter 2 year 1 = 22,000 x 800(2) = 23,600 units Actual sales for quarter 2 year 1 = 23,600 x 90% = 21,240 units Seasonal variation using additive model = 21,240 23,600 = - 2,360 The correct answer is B. 1.4 The correct answer is C % of invoiced sales = 2,190,000 x 80% = 1,752,000 Outstanding trade receivables = 1,752,000 x 50/365 = 240,000 Interest at 12% per annum = 240,000 x 12% = 28,800 The correct answer is A. 1.6 NPV Probability Deviation from expected Squared deviation Weighted amounts m m m m 2 30% , 3 20% % The standard deviation is = i.e. 871,780 P1 2 May 2013

3 1.7 Project Investment Net present Profitability Ranking index million million A B C D E F G Project Investment Net present Ranking million million C A D F The maximum net present is 28.85million 1.8 (i) If operated for 3 years Year Cash flow Discount factors Present 0 (40,000) (40,000) 1 16, , , , , NPV 17,088 6,436 (ii) If abandoned after 2 years Year Cash flow Discount factors Present 0 (40,000) (40,000) 1 16, , , NPV 27,098 2,100 (iii) If abandoned after 1 year Year Cash flow Discount factors Present 0 (40,000) (40,000) 1 41, NPV 37,149 (2,851) May P1

4 SECTION B Answer to Question Two (a) The question assesses learning outcome E1(a) explain the importance of cash flow and working capital management. It examines candidates ability to explain the meaning of an aggressive policy in respect of the investment in and financing of working capital. Candidates should clearly explain what is meant by an aggressive policy for both the investment in and the financing of working capital. Investment in working capital is normally in inventory, accounts receivable and cash or highly liquid, short-term assets. These are partly financed by accounts payable and overdraft. In conditions of uncertainty, companies must hold some minimum level of cash and inventory. With an aggressive working capital investment policy, a company would hold minimal safety inventories. Such a policy would minimise costs but it could reduce sales as the company could not respond rapidly to changes in demand. Generally, the expected return is higher under an aggressive policy but the risks are also greater. In cash management, an aggressive policy involves holding low levels of cash which would expose the company to the risk that they could not meet payments when they become due. In the case of accounts receivable and account payable, an aggressive policy would mean low levels of receivables in relation to sales and high levels of accounts payable. Working capital financing policy decisions involve the determination of the mix of long-term versus short-term debt. Since the yield curve is usually upward sloping, short-term debt typically costs less than long-term debt. With an aggressive working capital financing policy, the company finances part of its permanent asset base with short term debt. This policy generally provides the highest expected return but it is very risky due to the frequent need to refinance or if the company relied on an overdraft, the risk of withdrawal of that facility at short notice. (b) The question assesses learning outcome E1(g) analyse the impact of alternative policies for stock management. It examines candidates ability to compare and contrast the economic order quantity model and a JIT approach to inventory management. Candidates should clearly explain how both systems operate and highlight the differences between the two approaches. The economic order quantity (EOQ) is based on the assumption that demand for the period is known and constant. Therefore the optimum order quantity will be determined by the costs that are affected by either the quantity of inventory held or the numbers of orders placed. A P1 4 May 2013

5 higher quantity ordered each time will mean fewer orders each year and therefore a reduction in ordering costs. However, this will also result in higher average inventory levels which results in an increase in holding costs. The EOQ therefore is a trade-off between the cost of carrying high inventory against the cost of placing more orders. The optimum order size is the quantity that will result in the total of the ordering and holding costs being minimised. In contrast, a just in time (JIT) inventory management system is based on actual demand rather than an estimated demand level. It seeks to ensure the delivery of materials immediately before their use. By ensuring that production and purchases are timed to coincide with demand the determination of economic order quantities and re-order points is no longer required. JIT purchasing involves having an arrangement with a small number of key suppliers where the supplier is able to provide raw materials or components on demand or with a very short lead time. This means that the company can hold zero or very little inventory thus reducing the costs involved with holding inventory including storage costs, insurance costs and obsolescence costs. The costs involved with ordering inventory may however increase since JIT results in more frequent deliveries from suppliers. This contrasts with an EOQ system where the amount of inventory held is determined by the EOQ formula which aims to balance the costs of holding and ordering inventory. The use of a small number of suppliers however should also reduce administrative costs for the company and may result in greater quantity discounts. The successful operation of a JIT purchasing system involves the company working together with their suppliers to ensure that they can rely on receiving supplies at the right time and at the required quality level. This should also result in a reduction in quality control costs for the company. Quality standards should also improve resulting in lower wastage in the production process and hence reduced wastage costs. (c) The question assesses learning outcome D1(c) analyse risk and uncertainty by calculating expected s and standard deviations together with probability tables and histograms. It examines candidates ability to calculate the expected s of possible outcomes using joint probabilities. Candidates should firstly calculate the profit for each of the combinations of number of units sold, contribution and fixed costs. They should then calculate the joint probability of these outcomes and multiply the profit by the joint probability to calculate the expected. In part (ii) they should sum the probabilities of the outcomes which give a profit, loss and breakeven. May P1

6 (i) Number of units sold (ii) Contribution per unit Fixed costs Profit Joint Probability Expected 18, , , , (0.4 x 0.5 x 0.3) 100, , , ,000 (0.4 x 0.5 x 0.7) 100, , , ,000 (0.4 x 0.5 x 0.3) 100, , (0.4 x 0.5 x 0.7) 80, , , ,400 (0.6 x 0.5 x 0.3) 80, ,000 60, ,600 (0.6 x 0.5 x 0.7) 80, , (0.6 x 0.5 x 0.3) 80, ,000 (100,000) 0.21 (21,000) (0.6 x 0.5 x 0.7) ,000 The probability of a profit is 56% (( ) x 100%) The probability of a loss is 21% (0.21 x 100%) The probability of break-even is 23% (( ) x 100%) (d) The question assesses learning outcome A1(b) discuss a report which reconciles budget and actual profit using absorption and/or marginal costing techniques. Part (i) examines candidates ability to calculate the profit for a period using absorption costing where the production volume and sales volume are different. Part (ii) requires candidates to reconcile the difference in profit for the period using marginal and absorption costing. (i) Candidates should firstly calculate the gross profit per unit based on the budgeted fixed overhead absorption rate. This should then be multiplied by the number of units sold. The under/over absorption should then be calculated based on the number of units produced multiplied by the fixed overhead absorption rate, less the actual overhead incurred. Overheads under absorbed should be deducted from the gross profit and over absorbed overhead should be added back to the gross profit. (ii) Candidates should calculate the difference between the absorption costing profit for April calculated in (i) and the marginal costing profit. The difference should then be reconciled by taking the movement in inventory multiplied by the budgeted fixed overhead absorption rate. P1 6 May 2013

7 (i) Absorption costing profit: 21,000 units x 3.50 per unit 73,500 Plus: over absorption of fixed overheads (23,000 units x 2.50) (52,000) 5,500 79,000 (ii) Marginal costing profit: Contribution (21,000 units x 6) 126,000 Fixed production overheads 52,000 74,000 Difference in profit is 5,000 Opening inventory Closing inventory Inventory increase 1,000 units 3,000 units 2,000 units Fixed overhead absorption rate = 2.50 per unit Difference in profit = 2,000 units x 2.50 = 5,000 Inventory increased, therefore the absorption costing profit is 5,000 higher than the marginal costing profit. (e) The question assesses learning outcome E2(d) illustrate numerically the financial impact of short-term funding and investment methods. It examines candidates ability to calculate the yield to maturity on a bond given the current market and the coupon rate of the bond. Candidates should identify the cash flows if the bond was purchased today and then held until maturity. They should then discount the cash flow using two different discount rates to derive a positive and a negative net present. Candidates should then use interpolation to calculate the internal rate of return of the cash flows. Year(s) Description Cash flow Discount factor (6%) Present Discount factor (8%) Present Value 0 Purchase (106) (106.00) (106.00) 1-5 Interest Redemption NPV 2.40 (5.96) By interpolation 6% + ((2.40 /( )) x 2) = 6.57% The bond s yield to maturity is 6.57% May P1

8 (f) The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines candidates ability to explain the potential benefits of using an activity-based budgeting system rather than an incremental budgeting system. Candidates should clearly explain how each of the budgeting systems operates highlighting the potential benefits of using an activity-based budgeting system. Incremental budgeting is based on what has happened in the past therefore the allocation of resources to specific activities is not justified. It is assumed that activities will continue merely because they were undertaken in the previous year. The result of this is that excessive costs included in the previous budget will be carried forward into the next budget. Under an activity based budgeting system, resource allocation is linked to the strategic plan and is prepared after considering alternative strategies. This approach ensures that new activities that are required to meet the company s strategic objectives are included in the budget. Activity based techniques, including activity based budgeting, focus on the outputs of a process rather than the inputs to the process. In contrast an incremental budgeting system focuses on the inputs to the process. An activity based approach provides a clear framework for understanding the link between costs and the level of activity. It allows the ranking of activities and the determination of how limited resources should be allocated over competing activities. The focus on activities and the drivers of the cost of these activities enables a more informed and accurate budget to be set. Variance analysis will also be more useful and therefore it will ensure greater control of overhead costs which are an increasingly large proportion of total product costs. Activity based budgeting allows the identification of added and non- added activities and ensures that cuts are made to non- added activities. Under an incremental budget the tendency is to make cuts across the board. Activity based budgeting is also useful for the review of capacity utilisation. If it is known that the resources devoted to a particular activity are greater than those currently required then these resources can be reduced or redeployed. P1 8 May 2013

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 variances to enable the reconciliation of budgeted and actual contribution. Part (b), (c) and (d) assess learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. Part (b) examines candidates ability to separate variances into their planning and operational elements. Part (c) examines candidates ability to explain the importance of planning and operational variances. Part (d) examines candidates ability to interpret variances, considering factors such as their possible interrelationship and significance. 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, material and labour. They should then prepare a reconciliation statement starting with the budgeted contribution and adding the favourable sales volume contribution variance to calculate a revised standard contribution. They should then show each of the individual variances to reconcile this standard contribution to the actual contribution. In part (b) candidates should calculate the material usage planning variance and the material usage operational variance. In part (c) candidates should clearly explain why calculating planning and operational variances gives better information for planning and control purposes. In part (d) candidates should explain two factors that should be taken into account before beginning the process of investigating a variance. (a) Statement to reconcile budget and actual contribution for April Budgeted contribution 390,000 Sales volume contribution variance (2,850 units - 2,500 units) x ,600 F Standard contribution on actual sales volume 444,600 Other variances: Selling price variance 2,850 units x ( ) Cost variances: Direct material price variance 24,900 kg x ( ) Direct material usage variance ((2,850 x 8 kg) 24,900 kg) x Direct labour rate variance 18,800 x ( ) Direct labour efficiency variance ((2,850 x 6hr) 18,800) x Actual contribution 42,750 A 42,000 A 28,200 A 23,800 A 49,800 F 357,650 May P1

10 Workings: Budgeted contribution for the period Budgeted Contribution 2,500 units x ,000 Actual contribution for the period Sales 2,850 units x 385 1,097,250 Direct materials 24, ,200 Direct labour 18, ,400 Actual Contribution 357,650 (b) Direct material usage planning variance (2,850 x (8kg 9.25kg)) x 20 Direct material usage operational variance ((2,850 x 9.25 kg) 24,900 kg) x Total direct material usage variance 71,250 A 29,250 F 42,000 A (c) The calculation of planning and operational variances is useful for the following reasons: The use of planning and operational variances will enable management to draw a distinction between variances caused by factors uncontrollable by 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 materials usage variance caused by the substitute material (planning variance) and the variance as a result of efficient or inefficient production. 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 according to 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 standards is required due to environmental changes that were not foreseeable at the time the budget was prepared, the planning variances are uncontrollable. However standards that failed to anticipate known market trends when they were set will reflect faulty standard setting. It could be argued that some of the planning variances due to poor standard setting 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. P1 10 May 2013

11 (d) The size of the variance It is not possible to budget with complete accuracy therefore a company will need to decide how large a variance needs to be before it is considered abnormal and worthy of investigation. The likelihood of the variance being controllable Some variances particularly those that arise as a result of external factors may be uncontrollable and therefore the costs of the investigation would result in no benefit to the company. The likely cost versus the potential benefits of the investigation The company will need to weigh up the costs of the investigation versus the benefit from avoiding the variance occurring in the future. The interrelationship between variances A favourable variance in one area may result in an adverse variance in another area. For example, the decision to use lower quality material may result in a favourable material price variance but an adverse material usage variance. May P1

12 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 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 of the project. Part (b) assesses learning outcome C1(f) apply sensitivity analysis to cash flow parameters to identify those to which net present is particularly sensitive. It examines candidates ability to calculate the sensitivity of net present to a change in passenger numbers. Part (c) 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 explain the benefits of using sensitivity analysis in project appraisal. In part (a) candidates should firstly calculate the passenger numbers for each year and the passenger fare for each year after applying the inflation rate. These can then be multiplied together to derive the total cash inflow each year. They should then deduct the payment to the government and the other fixed costs after adjusting these for inflation. The tax depreciation and tax payments should then be calculated. The total cost of the investment, the residual and the working capital cash outflows and inflows 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 (NPV) of the project. In part (b) candidates should take the cash inflows from passenger fares and adjust these for tax. The cash inflows after tax should then be discounted at the discount rate of 12% to calculate the present of the passenger revenue. The sensitivity of the net present to a change in passenger numbers can then be calculated by dividing the NPV of the project by the present of the passenger revenue. In part (c) candidates should clearly explain the benefits of carrying out a sensitivity analysis before making investment decisions. (a) Cash inflows years 1-6 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Passenger numbers (millions) Passenger fares Total cash inflow 1,700m 1,821m 1,952m 2,090m 2,238m 2,399m Cash flows Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 m m m m m m Total cash 1,700 1,821 1,952 2,090 2,238 2,399 inflow Payment to (1,000) (1,000) (1,000) (1,000) (1,000) (1,000) government Other fixed (720) (749) (779) (810) (842) (876) costs Net cash flow (20) P1 12 May 2013

13 Taxation Depreciation Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 m m m m m m Tax written down Tax depreciation (100) (75) (56) (117) (88) (164) Taxation Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 m m m m m m Net cash flows (20) Tax (100) (75) (56) (117) (88) (164) Depreciation Taxable profit (120) (3) % 36 1 (35) (49) (92) (108) Net present Year 0 Year 1 Year 2 Year 3 Investment / residual Working capital Net cash flows Tax payment Tax payment Net cash flow after tax Discount 12% Present Year 4 Year 5 Year 6 Year 7 m m m m m m m m (400) (300) 100 (80) 80 0 (20) (18) (25) (46) (54) (17) (24) (46) (54) (480) (2) 91 (145) (54) (480) (2) 73 (103) (24) Net present = 106m The net present is positive therefore on this basis the company should go ahead with the tender. May P1

14 (b) Total cash flow from passenger revenue Tax payment Tax payment Net cash flow after taxation Discount factor Present Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 m m m m m m m 1,700 1,821 1,952 2,090 2,238 2,399 (510) (546) (586) (627) (671) (720) (255) (273) (293) (314) (336) (360) (255) (273) (293) (313) (335) (360) 1,445 1,293 1,386 1,483 1,589 1,704 (360) ,290 1, (163) Present of revenue = 5,853 Sensitivity of the proposed investment to a change in passenger numbers is therefore: 106m / 5,853m = 1.8% (c) Sensitivity analysis recognises the fact that not all cash flows for a project are known with certainty. Sensitivity analysis enables a company to determine the effect of changes to variables on the planned outcome. Particular attention can then be paid to those variables that are identified as being of special significance. In project appraisal, an analysis can be made of all the key input factors to ascertain by how much each factor would need to change before the net present (NPV) reaches zero i.e. the indifference point. Alternatively, specific changes can be calculated to determine the effect on NPV. In this case the project is highly sensitive to a change in passenger numbers. A 1.8% change in the passenger numbers would result in the project no longer being viable. The company may decide that this is too high a risk to take and not tender for the franchise. P1 14 May 2013

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