Operational Level Paper
P1 – Performance Operations
September 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 October 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 B.
1.2
Payment will be made 35 days early.
Number of compounding periods = 365/35= 10.429
10.429
1+ r = (1.00/0.98)
1+ r = 1.2345
The effective annual interest rate of the early settlement discount is 23.45%
The correct answer is C.
 The Chartered Institute of Management Accountants 2014
1.3
Material
A
B
Actual input
@standard
mix (kg)
24,400
36,600
61,000
Actual input
@ actual
mix (kg)
23,000
38,000
61,000
Variance
Kg
Standard cost
$
Variance
$
1,400 F
1,400 A
2.40
1.30
3,360 F
1,820 A
1,540 F
The correct answer is A.
1.4
Weighted average standard cost
(24,000kg x $2.40) + (36,000kg x $1.30) = $104,400
$104,400 / 60,000 kg = $1.74 per kg
Standard kg of input per unit of output = 5kg
12,000 units output x 5kg = 60,000kg of input
Actual input = 61,000 kg
Variance = 1,000kg A
Standard cost per kg = $1.74
Variance = 1,000kg x $1.74 = $1,740 A
Or alternatively:
61,000kg should yield 61,000/5kg = 12,200 units
Actual yield = 12,000 units
Yield variance = 200 units A
Standard material cost per unit = (2kg x $2.40) + (3kg x $1.30) = $8.70
Yield variance = 200 units x $8.70 = $1,740 A
The correct answer is B.
1.5
The maximum regret if 10,000 units are purchased is $180,000
The maximum regret if 15,000 units are purchased is $120,000
The maximum regret if 20,000 units are purchased is $70,000
The maximum regret if 25,000 units are purchased is $105,000
Therefore if the manager wants to minimise the maximum regret 20,000 units will be
purchased.
The correct answer is C.
Performance Operations
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September 2014
1.6
Budgeted maintenance cost for August:
2
y = 22,000 + 0.025x
2
y = 22,000 + 0.025(1,820 )
y = 22,000 + 82,810
y = 104,810
Increase for inflation:
$104,810 x 1.04 = $109,002
The maintenance cost variance for August is therefore:
$109,002 - $106,500 = $2,502 Favourable
1.7
Expected cash inflow in Year 1 = ($200k x 0.2) + ($300k x 0.7) + ($360k x 0.1) = $286k
Expected cash inflow in Year 2 = ($100 x 0.6) + ($320 x 0.4) = $188k
Expected net present value
Year
0
1
2
Net present value
Cash flow
$
(300,000)
286,000
188,000
Discount factor
Present value
$
(300,000)
259,974
155,288
115,262
1.000
0.909
0.826
1.8
(i)
The discount = $1000 x 7% x 91/365 = $17.45
The issue price is therefore $1,000 - $17.45 = $982.55
(ii)
•
•
•
•
•
•
Treasury bills are negotiable instruments issued by the Government
They have a maturity of less than one year, normally 91 days
They have high credit quality and therefore low risk and low return
They are redeemable at face value
They are issued at a discount to face value
There is a large and active secondary market in treasury bills
September 2014
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Performance Operations
SECTION B
Answer to Question Two
(a)
Rationale
The question assesses learning outcome B1(b) explain the purposes of budgeting including
planning, communication, co-ordination, motivation, authorisation, control and evaluation,
and how these may conflict. It examines candidates’ ability to explain two of the purposes of
budgeting and how these may conflict.
Suggested Approach
Candidates should clearly explain two of the stated purposes of budgeting and how these
may conflict with each other.
Planning - Budgeting forces an organisation’s management to look ahead and set
performance targets. This ensures that management anticipates any future problems and
gives the organisation direction. It also ensures that managers are aware of their own targets
and responsibilities and how they relate to those of other managers within the organisation.
Control - The budget acts as a control mechanism, with actual results being compared with
budget. Appropriate actions can then be taken to correct any deviations from plan.
Evaluation - The budget also provides an internal benchmark against which performance can
be evaluated. The performance measured may be that of a department or division or of an
individual manager.
Motivation - Budgeting sets targets to motivate managers and optimise their performance.
The budget is a useful device for influencing managers’ behaviour and motivating managers
to perform in line with the organisation’s objectives. It provides a standard which managers
may be motivated to achieve.
The budget therefore serves a number of different purposes which may conflict with each
other. For example, the planning and motivational roles may conflict, as demanding budgets
that may not be achieved may be appropriate to motivate managers to achieve maximum
performance but are unsuitable for planning purposes.
There is also a conflict between the planning and performance evaluation roles. For planning
purposes budgets are set in advance of the budget period based on an anticipated set of
circumstances and/or external environment. If the circumstances that were anticipated at the
time the budget was prepared have changed then there will be a planning and performance
evaluation conflict.
There may also be a conflict between the performance evaluation and motivation purposes as
the budget can cause inefficiency and conflict between managers particularly if the budget is
imposed from above, whereby it may act as a threat rather than as a challenge. Targets that
are imposed on managers are unlikely to motivate the managers to achieve them.
Performance Operations
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September 2014
(b)
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 use cost volume profit analysis to identify
the sensitivity of budgeted profit figures.
Suggested Approach
Candidates should firstly determine the fixed and variable costs from the budgeted
information given and then calculate the contribution per unit. In part (i) the break even point
can be calculated by dividing the fixed costs by the contribution per unit. In part (ii) the margin
of safety can be calculated by comparing the budgeted sales to the break even sales and
expressing the difference as a percentage of the budgeted sales. In part (iii) the effect of the
changes on the contribution per unit and the fixed costs should be calculated and then a
revised break-even point should be calculated.
(i)
Contribution per unit = $24.00 - $8.60 – $1.20 = $14.20
Break even point = $880,400/ $14.20 = 62,000 units
(ii)
Margin of safety = (90,000 – 62,000) / 90,000 = 31.1%
(iii)
Revised contribution per unit = $25.00 - $8.60 - $2.00 = $14.40
Break-even point = $890,400 / $14.40 = 61,833 units
September 2014
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Performance Operations
(c)
Rationale
The question assesses learning outcome E1(g) analyse the impacts of alternative policies for
stock management. It examines candidates’ ability to discuss the effectiveness of the EOQ
model for inventory management purposes.
Suggested Approach
Candidates should explain how the EOQ model operates and discuss its benefits and
limitations for inventory management purposes.
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
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 costs of
carrying high inventory against the costs 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.
The EOQ model assumes a world of certainty where the usage and delivery of inventory can
be predicted accurately and management can therefore avoid stock-out costs and
concentrate on achieving the optimal balance between ordering costs and holding costs.
However this is unlikely to be the case in reality for most companies. The EOQ model ignores
two types of risk:
a)
Uncertainty over the time it takes for the order to be delivered i.e. the lead time. The
lead time is neither zero as assumed by the model or necessarily predictable.
b)
The rate at which inventory is used may not be constant, demand may be subject to
fluctuations and the overall annual demand may be difficult to predict with accuracy.
The company can cope with these two risk elements, to a certain extent, by holding a buffer
inventory. The buffer inventory level can be calculated by weighing up the cost of stock-outs
and the costs of holding additional inventory. The determination of lead time and dealing with
uncertainty of demand requires subjective managerial judgement as does determining the
cost of stock-outs since many of the costs involved are difficult to quantify.
Performance Operations
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September 2014
(d)
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 net present values.
Suggested Approach
Candidates should firstly apply the probabilities for the demand levels to calculate the
expected value of the net present value for each of the machines without perfect information.
They should then select the best outcome for each of the possible demand levels 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.
Demand
Probability
Machine A
Machine B
Machine C
$000
$000
$000
High
35%
100 x 0.35 = 35
140 x 0.35 = 49
180 x 0.35 = 63
Medium
40%
150 x 0.40 = 60
160 x 0.40 = 64
140 x 0.40 = 56
Low
25%
200 x 0.25 = 50
100 x 0.25 = 25
80 x 0.25 = 20
145
138
139
Expected value
Machine A is the best choice (without the benefit of perfect information) as it has the highest
expected value (EV) of $145k.
With perfect information:
If research suggests high demand: select Machine C and earn $180k
If research suggests medium demand: select Machine B and earn $160k
If research suggests low demand: select Machine A and earn $200k
EV (with perfect information) = ($180k x 0.35) + ($160k x 0.40) + ($200k x 0.25) = $177k
Value of perfect information is $177k – $145k = $32k
Alternatively:
Value of perfect information = (($180k - $100k) x 0.35) + (($160k - $150k) x 0.40) = $32k
September 2014
7
Performance Operations
(e)
Rationale
The question assesses learning outcome E1(d) discuss measures to improve a cash forecast
situation. It examines candidates’ ability to explain the trade off between the cost of holding
too much cash and too little cash.
Suggested Approach
Candidates should clearly explain the costs involved with holding too much cash and how this
needs to be balanced with the costs involved with holding too little cash.
There are a number of costs involved with holding too little cash which a company may incur
as follows:
•
It may not be possible to pay suppliers on time which could lead to reluctance to supply
and eventually to liquidation;
•
It will not have the ability to react quickly to unexpected events e.g. competitor action,
strikes etc;
•
It will potentially miss unexpected opportunities e.g. contracts or lucrative investments;
•
It may not be able to benefit from early settlement discounts from suppliers;
•
It is likely to incur higher cost of borrowing because unexpected cash requirements
need to be met from temporary borrowings;
•
It will incur transaction costs involved with acquiring cash e.g. cost of selling securities
or arrangement fees for overdrafts.
The costs of holding too little cash have to be balanced with the costs of holding cash i.e. the
loss of interest and the loss of purchasing power as inflation erodes the value of cash.
Performance Operations
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September 2014
(f)
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 production budget and a materials usage and purchases
budget.
Suggested Approach
In part (i) candidates should calculate the number of units required to be produced after
adjusting for the change in inventory of finished goods. In part (ii) candidates should calculate
the materials usage budget based on the production budget calculated in part (i). In part (iii)
candidates should calculate the material purchases budget in kg after adjusting for the
change in materials inventory. The material purchases budget in $ can then be calculated by
multiplying the budget in kg by the price per kg of material.
(i)
Product
Sales (units)
Increase / (decrease) in inventory
Production budget (units)
A1
32,000
1,000
33,000
A2
56,000
(2,000)
54,000
(ii)
Material
Production budget
(units)
Kg per unit
Material usage (kg)
A1
33,000
B3
A2
54,000
Total
87,000
A1
33,000
B4
A2
54,000
Total
87,000
8
264,000
4
216,000
480,000
4
132,000
3
162,000
294,000
(iii)
Material
B3
Total
480,000
(30,000)
24,000
474,000
$1.25
$592,500
Material usage (kg)
Less: opening inventory
Plus: closing inventory
Material purchases (kg)
Price per kg
Material purchases $
September 2014
9
B4
Total
294,000
(20,000)
14,700
288,700
$1.80
$519,660
Performance Operations
SECTION C
Answer to Question Three
Rationale
The question assesses learning outcome A1(c) discuss activity-based costing as compared
with traditional marginal and absorption costing methods, including its relative advantages
and disadvantages as a system of cost accounting. Part (a) examines candidates’ ability to
calculate the cost of a product using activity based costing. Part (b) examines candidates’
ability to discuss the differences between the gross profit calculated under the activity based
costing system and that calculated under the traditional absorption costing system. Part (c)
examines candidates’ ability to explain how the information obtained using an activity based
costing system could be used for cost management purposes.
Suggested Approach
In part (a) candidates should calculate a cost driver rate for each of the activities and then
apply this cost driver rate to calculate the overhead cost for each activity per product. The
gross profit for each product can then be calculated. In part (b) candidates should clearly
explain the reasons for the differences between the gross profits calculated using activity
based costing and that calculated using the current absorption costing system. In part (c)
candidates should clearly explain how the information from an activity based costing system
could be used for cost management purposes.
(a)
Budgeted production per annum (units)
Average number of units per order
Number of orders
Parts per unit
Total number of parts
Assembly time per unit (minutes)
Total assembly time (minutes)
Software applications per unit
Total number of software applications
Activity
Manufacturing
scheduling
Parts handling
Activity cost
$000
162
Tablets
Convertible
Laptops
10,000
10
1,000
20
200,000
20
200,000
2
20,000
12,000
6
2,000
35
420,000
40
480,000
3
36,000
Cost driver
Number of orders
2,464
Number of parts
Assembly
4,472
Assembly time
Software
installation &
testing
Packaging
2,000
Number of software
applications
1,302
Number of units
All-inone
PCs
Total
6,000
4
1,500
25
150,000
30
180,000
4
24,000
28,000
4,500
770,000
860,000
80,000
Cost driver rate
$162,000 / 4,500
= $36 per order
$2,464,000 / 770,000
= $3.20 per part
$4,472,000 / 860,000
= $5.20 per minute
$2,000,000 / 80,000
= $25.00 per application
$1,302,000 / 28,000
= $46.50 per unit
10,400
Performance Operations
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September 2014
Manufacturing
scheduling
Parts handling
Assembly
Software
installation &
testing
Packaging
Total production
overhead costs
Sales
Direct material
Direct labour
Production overheads
Gross profit
September 2014
Tablets
Convertible
Laptops
All-in-one
PCs
Total
$000
(1,000 x $36)
36
(200,000 x $3.20)
640
(200,000 x $5.20)
1,040
$000
(2,000 x $36)
72
(420,000 x $3.20)
1,344
(480,000 x $5.20)
2,496
$000
(1,500 x $36)
54
(150,000 x $3.20)
480
(180,000 x $5.20)
936
$000
(20,000 x $25)
500
(10,000 x $46.50)
465
(36,000 x $25)
900
(12,000 x $46.50)
558
(24,000 x $25)
600
(6,000 x $46.50)
279
2,681
5,370
2,349
2,464
4,472
2,000
1,302
10,400
Tablets
Convertible
Laptops
All-in-one
PCs
Total
$000
3,640
800
300
2,681
(141)
$000
12,480
2,800
1,200
5,370
3,110
$000
9,880
2,200
800
2,349
4,531
$000
26,000
5,800
2,300
10,400
7,500
11
162
Performance Operations
(b)
Tablets
Convertible
Laptops
All-in-one
PCs
$364
$146
$108
$1,040
$416
$291
$1,647
$659
$488
Gross profit %
29.8%
27.9%
29.6%
Activity based costing (per unit)
Selling price
Production overhead cost
Gross profit
$364
$268
$(14)
$1,040
$448
$259
$1,647
$392
$755
(3.9%)
24.9%
45.9%
Products
Current system of
absorption costing (per unit)
Selling price
Production overhead cost
Gross profit
Gross profit %
It can be seen from the figures in the table above that under the activity based costing system
there is a completely different picture of the profitability of each of the products. Under the
traditional absorption costing system each of the products was making a very similar gross
profit margin of around 30%. However under the activity based costing system, Tablets are
now shown to be loss making and all-in-one PCs are making a significantly higher gross profit
margin, at 45.9%, than originally thought. The gross profit margin for convertible laptops has
declined slightly from 27.9% to 24.9%.
Under the traditional absorption costing system, production overheads were charged to
products based on sales revenue. This meant that Tablets which has a relatively low
proportion of the total sales revenue (14%) was charged a relatively low level of fixed
production overheads. When the activity based costing system is used and the actual
consumption of activities is considered Tablets are charged significantly more production
overheads than before. Whilst Tablets has the lowest number of cost drivers for most of the
activities it also has a relatively lower selling price than the other products. For example the
ratio of parts per unit is 20:35:25 for Tablets, convertible laptops and all-in-one PCs but the
ratio of selling prices is 12:34:54. All-in-one PCs gross profit percentage is significantly higher
under activity based costing since whilst it has the second highest number of cost drivers for
parts per unit and assembly time per unit it has the highest selling price per unit compared to
the other two products.
This information will be useful for the company when making decisions about product pricing
and product mix.
(c)
The activity based costing system provides information about the various activities and the
cost drivers for each activity. The information about the cost of activities enables the company
to focus on those activities with the highest costs and to determine whether they can be
eliminated or performed more efficiently. Activities can be classified as value-added and nonvalue added. Companies can take action to reduce or eliminate the non-value added
activities.
The information ascertained about the cost drivers will also be useful for cost control
purposes. The company can try to reduce the number of cost drivers for each product through
process or product redesign. The cost driver rate can also be used as a measure of cost
efficiency.
Performance Operations
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September 2014
Answer to Question Four
Rationale
Part (a) assesses learning outcomes C1(b) apply the principles of relevant cash flow analysis
to long-run projects that continue for several years and 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 explain other factors that the company would need to consider
before deciding whether to go ahead with the project. Part (c) also assesses learning
outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It
examines candidates’ ability to calculate the internal rate of return (IRR) for the project and
the sensitivity of the investment decision to a change in the cost of capital.
Suggested Approach
In part (a) candidates should firstly calculate the number of units sold and the contribution
that would be earned from the product in each year. They should then deduct the fixed costs
after adjusting for depreciation. The contribution and fixed costs should then be adjusted for
inflation from year 2 of the project. The total cost of the investment and the residual value
should then be added to the net cash flows. The working capital should be shown as a cash
outflow in Year 0 and the additional amount required as a result of inflation, shown as a cash
outflow each year. The total working capital throughout the period of the project should then
be shown as a cash inflow in Year 5. The tax depreciation and tax payments should then be
calculated. 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 clearly
explain two other factors that the company should consider before making a decision about
the investment project. In part (c)(i) candidates should discount the cash flows after tax at a
lower discount factor than 12% and then, using interpolation, calculate the internal rate of
return (IRR) for the project. In part (c)(ii) candidates should calculate the difference between
12% and the IRR and express this as a percentage of 12%.
(a)
Contribution Years 1 – 5
Year 1: 100,000 x $20 = $2,000k
Year 2: 100,000 x 1.2 = 120,000 x $20 = $2,400k x 1.04 = $2,496k
2
Year 3: 120,000 x 1.2 = 144,000 x $20 = $2,880k x 1.04 = $3,115k
3
Year 4: 144,000 x 1.2 = 172,800 x $20 = $3,456k x 1.04 = $3,888k
4
Year 5: 172,800 x 1.2 = 207,360 x $20 = $4,147k x 1.04 = $4,852k
Fixed Costs
Depreciation per annum = ($10m - $1.5m) / 5 = $1.7m
Fixed costs (excluding depreciation) per annum
= $2.5m - $1.7m = $0.8m
September 2014
13
Performance Operations
Taxation
Contribution
Fixed costs
Net cash flows
Tax depreciation
Taxable profit
Taxation @ 30%
Year 1
$000
2,000
(800)
1,200
(2,500)
(1,300)
390
Year 2
$000
2,496
(832)
1,664
(1,875)
(211)
63
Year 3
$000
3,115
(865)
2,250
(1,406)
844
(253)
Year 4
$000
3,888
(900)
2,988
(1,055)
1,933
(580)
Year 5
$000
4,852
(936)
3,916
(1,664)
2,252
(676)
Net present value
Investment
/ residual
value
Working
capital
Net cash
flows
Tax cash
flow
Tax cash
flow
Net cash
flow after
tax
Discount
factors @
12%
Present
value
Year 0
$000
(10,000)
Year 1
$000
Year 2
$000
Year 3
$000
Year 4
$000
Year 5
$000
1,500
Year 6
$000
(3,000)
(120)
(125)
(130)
(135)
3,510
1,200
1,664
2,250
2,988
3,916
195
32
(127)
(290)
(338)
195
31
(126)
(290)
(338)
(13,000)
1,275
1,766
2,024
2,437
8,298
(338)
1.000
0.893
0.797
0.712
0.636
0.567
0.507
(13,000)
1,139
1,408
1,441
1,550
4,705
(171)
Net present value = - $2,928k
The net present value is negative therefore the project should not go ahead.
(b)
The project is concerned with the education of children in computer science and with
encouraging them to be involved in computer science at an early age. This is a new market
for the company and may have long term benefits if children start to use full scale computers
at an earlier age than normally would be expected.
Whilst the project makes a negative net present value the company may be able to improve
its brand image if it is seen to be supplying relatively low cost computers to the education
market. The company could benefit from being involved in this project as they are being seen
to be concerned with the education needs of children.
Performance Operations
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September 2014
(c)
(i)
The net present value is negative at 12% therefore use a lower discount factor.
Net cash
flow after
tax
Discount
factors @
4%
Present
value
Year 0
$000
(13,000)
Year 1
$000
1,275
Year 2
$000
1,766
Year 3
$000
2,024
Year 4
$000
2,437
Year 5
$000
8,298
Year 6
$000
(338)
1.000
0.962
0.925
0.889
0.855
0.822
0.790
(13,000)
1,227
1,634
1,799
2,084
6,821
(267)
Net present value at 4% discount rate = $298k
By interpolation:
IRR = 4% + (($298k / ($298k + $2,928)) x 8) = 4.74%
(ii)
The cost of capital is 12%.
(12 – 4.74) / 12 = 61%
For the project to be accepted the cost of capital would need to reduce by 61%.
September 2014
15
Performance Operations