P1 – performance operations - the examiner’s answers - November 2010

Operational Level Paper

P1 –Performance Operations Examiner’s Answers SECTION A Answer to Question One 1.1

The correct answer is D.

1.2

$40,000 x 3.791 = $151,640 $50,000 / $151,640 = 0.3297 = 33.0% The correct answer is C.

1.3

$10,500 / 1.05 = $10,000 $13,390 / 1.03 = $13,000 Using the high-low method ($13,000 – $10,000) / (8,000 – 6,000) = $ 1.50 per unit At inflation index of 1.06 = $1.50 x 1.06 = $1.59 The correct answer is B.

1.4

The sales price variance is: ($6.60 – $6.00) x 15,750 = $9,450 Favourable The correct answer is B.

1.5

The sales volume contribution variance is: (15,750 – 15,000) x $2.00 = $1,500 Favourable Budgeted sales were 15,750/1.05 = 15,000 units The correct answer is A.

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1.6

Materials Usage 12,000 units x 4kg = 48,000kg Opening inventory = 3,000kg Closing inventory = 12,000/12 x 4kg x 1.1 = 4,400kg

Material Purchases Budget (kg) Material usage Plus closing inventory Less opening inventory

48,000kg 4,400kg (3,000)kg 49,400kg

Material Purchases Budget ($) 49,000kg x $8 = $392,000 400kg x $7.50 = $3,000 Total $395,000

1.7

Yield to maturity of similar bonds is 3%, therefore use 3% as the discount rate.

Year(s)

Description

1-4 4

Interest Redemption

0

Market value

Cash flow $ 6 100

Discount Factor (3%) 3.717 0.888

Present Value $ 22.3 88.8 111.1

The current expected market value of the bond is therefore $111.10

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1.8 Probability

Project A

Project B

Project C

$000

$000

$000

Preferences 1

0.3

400

800

500

Preferences 2

0.2

500

300

600

Preferences 3

0.5

700

200

400

570

400

470

Expected Value

Project A is the best choice (without the benefit of perfect information) as it has the highest expected value (EV) of the NPV of $570k.

With perfect information: If market research say preferences 1: select B and earn $800k – probability 0.3 If market research say preferences 2: select C and earn $600k – probability 0.2 If market research say preferences 3: select A and earn $700k – probability 0.5 EV (with perfect information) = ($800k x 0.3) + ($600k x 0.2) + ($700k x 0.5) = $710k Value of perfect information is $710k – $570k = $140,000

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SECTION B Answer to Question Two

(a) There are three main stages in the budget setting process in a zero based budgeting system: Description of activities in decision packages The activities that are being proposed are described in a decision package. There will often be more than one decision package proposed e.g. one based on providing services at a minimum level and others at incremental levels above the minimum.

Some of these packages will be mutually exclusive and will require management to select the best solution to the issue involved. For example options for debt collection could be in-house or outsourced solutions and a decision package will be needed for each.

Evaluation and ranking Each decision package is evaluated. Its costs are compared to its benefits and net present values or other measures calculated. The non-financial aspects are also considered as some packages might have legal obligations attached e.g. updating accounting systems.

Management will rank each package based on the benefits to the organisation. They may decide to reject packages even though the activity was undertaken last year. In this way the organisation is said to be starting from a zero base with each package given due consideration.

Allocation of resources Once management decide which packages to accept a budget can be prepared for the resources required. This should include costs, revenues and other resource allocations necessary.

(b) (i)

If AP applied the maximin decision criterion it would order at the medium level. The worst result is a profit of $300 and this is the best “worst result�.

(ii)

If AP applied the maximax decision criterion it would order at the high level, since the maximum return of $600 is to be gained at this level.

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(iii) Minimax Regret Table Demand level

Level of order High

Medium

Low

Good

0

$300

$500

Average

$200

0

$300

Poor

$400

0

$100

The maximum regret if AP orders at the high level is $400 The maximum regret if AP orders at the medium level is $300 The maximum regret if AP orders at the low level is $500 Therefore if AP wants to minimise the maximum regret it will order at the medium level.

(c) (i)

Expected values represent a long-run average outcome but decisions should not be made solely on expected values as they do not take account of the attitude to risk. In addition to expected value decision makers should consider measures of dispersion and the probability distribution of the outcomes of the various courses of action. A risk neutral decision maker will tend to ignore risk and choose the course of action that gives the highest expected value.

(ii)

A risk seeker is a decision maker that is interested in the best possible outcomes no matter how unlikely they are to occur. They are not put off with the low probability of an outcome but choose to focus on potential large returns instead. A risk seeker faced with a choice between two alternatives with identical expected values will choose the riskier investment with the highest possible outcome and ignore the downside risk.

These decision makers are often viewed as optimistic.

A risk averse decision maker is one that focuses on the poor results and seeks to avoid high degrees 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 pessimistic.

(d) (i)

Trade receivable at end of the year = $492,750 / 365 x 60 = $81,000 Bad debts = ($492,750 – $81,000) x 5% = $20,587.50 Cash collected = $83,000 + $492,750 - $81,000 - $20,587.50 = $474,162.50

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(ii) Examiner’s note: the question asks for two methods. Examples of methods that would be rewarded are given below.

To reduce the incidence of bad debts RX could: • • • • •

Ensure that all new customers have a full credit rating check before the granting of credit.

This can be achieved by the use of credit rating organisations or by the taking of references from the prospective customer.

Carry out routine credit ratings checks on existing customers, in particular the slow payers.

Ensure that debt collection procedures are efficient in chasing up late payers.

Charge penalties for late payment or offer discounts to encourage customers to pay early.

Ensure that credit limits are allocated to customers and enforced by the credit control department. No sales should be allowed if credit limits have been exceeded, effectively putting the account on “stop” should this happen.

(e) The returns given are over different time periods. We need to calculate an annual rate to enable the investments to be compared.

4

The annual return on the deposit account is (1.011) = 1.044731 or 4.47% per annum.

The annual return on the bond is 2.5% x 2 = 5% per annum.

The deposit account has two main types of risk. Firstly, the interest rate could change and this will introduce variability in the return, although this is likely to reflect market rates. Secondly, after the world banking crisis in 2008/2009 it is now conceivable for a bank to fail. This introduces another, albeit small, element of risk in that there is liquidation risk of the bank itself.

A government bond is generally considered to be risk free. However the bonds are fixed dated and cannot be cashed in early. Therefore the bonds lack flexibility. Although the return is fixed, market interest rates may rise with the result that the return on the bond is below market rates. If they are a tradable item, the bonds could be sold to another investor through a broker. However this would incur sales costs and expose the company to price movements which will reflect the change in market interest rates.

The choice of investment will depend on the company’s attitude to risk and whether they prefer to have a fixed return. The bond currently offers a higher return but may not continue to do so in the future. It also offers less risk as the return is guaranteed.

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(f)

The number of days for each component of the working capital cycle is as follows:

Component

Calculation

Days

Raw material inventory days

85/915 x 365

33.9

Finished goods inventory days

90/1215 x 365

27.0

Receivable days

185/(0.80 x 1,400) x 365

60.3

Payables days

125/(0.95 x 915) x 365

Working capital cycle

-52.5 68.7

The working capital cycle is therefore 68.7 days.

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SECTION C

Answer to Question Three

(a) Hip

Knee

Shoulder

$

$

$

Fee charged to patient

8,000

10,000

6,000

Surgeon’s fee

(1,200)

(1,800)

(1,500)

Fee for follow-up consultations

(24)

(15)

(30)

Medical supplies

(400)

(200)

(300)

(5,200)

(6,500)

(3,900)

1,176

1,485

270

Overhead cost Profit per procedure

Follow-up consultations working: Hip - $300 per consultation x 8% = $24 Knee - $300 per consultation x 5% = $15 Shoulder - $300 per consultation x 10% = $30 Overhead cost workings:

Sales revenue

Hip

Knee

Shoulder

Total

$

$

$

$

$8,000 x 600 = $4,800,000

$10,000 x 800 = $8,000,000

$6,000 x 400 = $2,400,000

Overheads Overheads / sales revenue Cost per procedure

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$15,200,000 $9,880,000 65%

$8,000 x 65% $5,200

$10,000 x 65% $6,500

8

$6,000 x 65% $3,900

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(b) Cost Driver

Theatre preparation for each session

Number of theatre preparations

Operating theatre usage

Procedure time

1,449

Nursing and ancillary services Administration

In-patient days

5,428

Sales revenue

1,216

Other overheads

Number of procedures

Overhead cost per procedure Theatre preparation for each session Operating theatre usage Nursing and ancillary services Administration Other overheads Total overhead cost per procedure

Profit per procedure per (a) above Add back overhead cost per (a) above Less overhead cost using ABC Profit per procedure using ABC

(c)

No. of cost drivers

Overheads $000 864

Activity

(600/2 + 800/1 + 400/4) = 1,200

(600 x 2hrs) + (800 x 1.2hrs) + (400 x 1.5hrs) = 2,760 (600 x 3) + (800 x 2) +(400 x 1) = 3,800 15,200,000

923

(600 + 800 + 400) = 1,800

Cost per driver $ $720 per theatre preparation

$525 per hour

$1,428 per day

$0.08 per $ sales revenue $513 per procedure

Hip

Knee

Shoulder

$720/2 = $360 ($525 x 2) = $1,050 ($1,428 x 3) =$4,284 (8,000 x $0.08) = $640

$720/1 = $720 ($525 x 1.2) =$630 ($1,428 x 2) =$2,856 (10,000 x $0.08) = $800

$720/4 = $180 ($525 x 1.5) = $788 ($1,428 x 1) =$1,428 (6,000 x$ 0.08) = $480

$513

$513

$513

$6,847

$5,519

$3,389

Hip

Knee

Shoulder

$

$

$

1,176

1,485

270

5,200

6,500

3,900

(6,847)

(5,519)

(3,389)

(471)

2,466

781

Under an activity based costing (ABC) system the various support activities that are involved in the process of making products or providing services are identified. The cost drivers that cause a change to the cost of these activities are also identified and used as the basis to attach activity costs to a particular product or service. Through the tracing of costs to product in this way ABC establishes more accurate costs for the product or service.

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The identification of cost drivers provides information to management to enable them to take actions to improve the overall profitability of the company. Cost driver analysis will provide information to management on how costs can be controlled and managed. Variance analysis will be more useful as it is based on more accurate costs. The establishment of more accurate procedure costs should also help hospital managers to assess procedure profitability and make better decisions concerning pricing and procedure mix decisions.

In the above example, the use of an ABC system has resulted in different levels of profit for each of the procedures. It is apparent that the knee replacement procedure and the shoulder replacement procedure are more profitable than was thought under the absorption costing system. The shoulder replacement procedure however is making a significantly lower margin that the knee replacement procedure. The hip replacement procedure is now shown to be loss making. This additional information will enable management to make important decisions regarding pricing of the procedures. The price of the knee replacement procedure could potentially be reduced to make it more competitive and increase volumes. The price of both the hip replacement and shoulder replacement procedures could be increased to make these procedures more profitable. Before making any decision regarding pricing however they would need to review market prices and consider the effect any adjustment would have on the company’s market position. If market conditions would not allow an increase in price of both hip and shoulder replacement procedures they could look at ways to reduce the costs of these procedures. ABC gives more detailed information about how costs are incurred and the potential for cost reduction by reducing activity levels. Alternatively they may want to consider whether to discontinue the hip replacement procedures altogether and replace them with a more profitable use of resources. This decision may not be appropriate however if part of the marketing strategy is for the company to provide a range of complementary procedures.

An activity based costing system can be extended beyond product and service costing to a range of cost management applications known as activity based management. These include the identification of value added and non value added activities and performance management in terms of measuring efficiency through cost driver rates.

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Answer to Question Four

(a)

Project 1 Internal Failure Cost Savings: Current Expected Value ($300k x 0.5) + ($500k x 0.3) + ($700k x 0.2) = $440k Expected Savings Year 1 = $440k x 80% x 1.04 =$366k External Failure Cost Savings: Current Expected Value ($1,300k x 0.6) + ($1,900k x 0.3) + ($3,000k x 0.1) = $1,650k Expected Savings Year 1 = $1,650k x 80% x 1.04 = $1,373k Raw Material Cost: Expected savings Year 1 = 50,000 x $62 x 1.04 =$3,224k Net cash flows Year 1 $366,080 + $1,372,800 + $3,224,000 = $4,963k

(b)

Project 2

(i)

Component Costs: Expected savings Year 1 = 50,000 x $110 x 1.04 =$5,720k Depreciation per annum = $15,000,000 / 5 = $3,000k Additional fixed costs (excluding depreciation) per annum = $5,000k - $3,000k $2,000k

Net Present Value Year 0 $000 Initial (15,000) Investment Working (1,000) capital Cost savings Fixed costs Net cash flows Discount Factor @ 8% Present value

Year 1 $000

Year 2 $000

Year 3 $000

Year 4 $000

Year 5 $000

1,000 5,720

5,949

6,187

6,434

6,691

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(16,000)

3,720

3,949

4,187

4,434

5,691

1.000

0.926

0.857

0.794

0.735

0.681

(16,000)

3,445

3,384

3,324

3,259

3,876

Net present value = $1,288k

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(ii)

Net cash flows Discount Factor @ 12% Present value

Year 0 $000 (16,000)

Year 1 $000 3,720

Year 2 $000 3,949

Year 3 $000 4,187

Year 4 $000 4,434

Year 5 $000 5,691

1.000

0.893

0.797

0.712

0.636

0.567

(16,000)

3,322

3,147

2,981

2,820

3,227

Net present value = - $503k

IRR NPV at 8% = $1,288k NPV at 12% = -$503k By interpolation 8% + (1,288/(1,288 + 503)) x 4% =10.9%

(c) The general rule in discount cash flow analysis where projects are mutually exclusive is that the project with the highest net present value should be selected. In this case project 1 has a NPV of $1,338K and project 2 has a NPV of $1,288K. Therefore on the basis on NPV alone project 1 should be selected.

Project 2 requires an investment of $16m while project 1 requires an investment of $20m.

While project 2 has a marginally lower NPV than alternative 1, if the additional $4m of funds can be invested in other projects with NPVs in excess of this difference, it would be worthwhile investing in project 2.

The company directors will also have to consider the risk of the two projects and other nonfinancial factors.

(d) The IRR measures the project return as a percentage whereas NPV measures the absolute amount. This can result in a problem if the IRR is used to select projects where the projects are mutually exclusive. Decisions based on IRR may result in the selection of a project with a lower investment and a higher return, when it may be preferable to invest a greater sum which generates a lower percentage return but produces a greater absolute amount. Where projects are mutually exclusive NPV should be used to select projects.

Even if mutually exclusive projects have the same initial investment, NPV and IRR can give conflicting results due to the assumption regarding the reinvestment of surplus cash flows generated by an investment. The assumption if the NPV method is adopted is that the cash flows generated by an investment will be reinvested at the cost of capital. The IRR method assumes that cash flows generated by the investment will be reinvested at the IRR of the original project. IRR may favour an investment with high early cash flows, reinvested at the IRR, while NPV may prefer a different project with later cash flows. The NPV ranking of the projects depends on the discount rates used. When the discount rate exceeds a certain level the choice of projects will change and the conflict will no longer exist.

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The Senior Examiner for P1 – Performance Operations offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper.

Section A – Question One – Compulsory 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.

Section B – Question Two – Compulsory Question Two has 6 sub-questions. (a)

The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines the candidates’ ability to explain the different stages in a budget setting process for a company that uses zero based budgeting.

(b)

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 apply various decision making criterion to a particular decision.

(c)

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 explain the effect that a decision maker’s attitude to risk will have on the chosen decision.

(d)

The question assesses learning outcome E1(e) analyse trade debtor and creditor information. Part (i) of the question examines candidates’ ability to calculate expected cash receipts from credit customers given information relating to bad debts and trade receivable days. Part (ii) of the question examines candidates’ ability to describe methods that a company could use to reduce the occurrence of bad debts.

(e)

The question assesses learning outcome E2(b) identify alternatives for investment of short-term cash surpluses. It examines candidates’ ability to compare two potential short term Investment opportunities and explain the advantages and disadvantages of each.

(f)

The question assesses learning outcome E1(b) interpret working capital ratios for business sectors. It examines candidates’ ability to calculate working capital ratios and the working capital cycle.

Section C – Questions Three and Four - Compulsory Question Three Part (a) of the question assesses learning outcome A1(a) compare and contrast marginal (or variable), throughput and absorption accounting methods in respect of profit reporting and stock valuation. It examines candidates’ ability to calculate the cost of a service using a traditional method of overhead absorption. Part (b) 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. It requires candidates to be able to apply activity based costing to the calculation of a service costs. Part (c) assesses learning outcome A1(c) discuss activitybased costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting. It

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examines candidates’ ability to explain the potential benefits of the information for management decision making.

Question Four Parts (a) and (b) of the question assess learning outcomes C1(a) explain the processes involved in making long-term decisions and C2(a) evaluate project proposals using the techniques of investment appraisal. They examine candidates’ ability to identify relevant costs and calculate the net present value and IRR of a project. Part (c) of the question assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates’ ability to evaluate two investment projects based on their NPV and IRR. Part d) of the question assesses learning outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. It requires candidates to discuss the reasons why conflicts arise between the ranking of projects based on their IRR and NPV.

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