P1 – Performance Operations Examiner’s Answers Sept 2011

Operational Level Paper

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

The correct answer is D.

1.2

The maximum regret at a selling price of $40 is $20,000 The maximum regret at a selling price of $45 is $10,000 The maximum regret at a selling price of $50 is $20,000 The maximum regret at a selling price of $55 is $30,000 Therefore if the manager wants to minimise the maximum regret, a selling price of $45 will be selected.

The correct answer is B.

1.3

The correct answer is A.

1.4

Payment will be made 30 days early.

Number of compounding periods = 365/30 = 12.167

 1.00  12.167 1+ r =    0.97  1+ r = 1.4486 The effective annual cost of the cash discount is 44.9% The correct answer is C.

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1.5

[$682,000/365] x 60 = $112,110 [$112,110 / (682,000 x 1.15)] x 365 = 52.17 days The correct answer is A.

1.6 Budgeted sales Plus Closing inventory Less Opening Inventory Budgeted Production

144,000 12,000 (6,500) 149,500

units units units units

149,500 x 2 hours per unit = 299,000 hours 80% x 299,000 = 239,200 hours x $15 = $3,588,000 20% x 299,000 = 59,800 hours x $(15 x1.5) = 1,345,500 Total labour cost budget = $4,933,500

1.7 Year(s)

Description

Cash flow $

Discount Factor (7%)

1-6 6 PV

Interest Redemption

8 100

4.767 0.666

Present Value $ 38.14 66.60 104.74

The investor should pay $104.74.

1.8 (i)

Expected values ($000) Project A ($400 x 0.3) + ($500 x 0.5) + ($600 x 0.2) = $490 Project B ($300 x 0.3) + ($350 x 0.5) + ($400 x 0.2) = $345 Project C ($500 x 0.3) + ($450 x 0.5) + ($650 x 0.2) = $505

(ii)

Value of perfect information ($000) If weak select Project C = ($500 x 0.3) = $150 If average select Project A = ($500 x 0.5) = $250 If good select Project C = ($650 x 0.2) = $130 Value of perfect information is ($530 – $505) = $25

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SECTION B Answer to Question Two

(a) One of the main purposes of budgeting is to act as a control mechanism, with actual results being compared against budget. Another purpose of a budget is to set targets to motivate managers and optimise their performance. The participation of managers in the budget setting process has several advantages. Managers are more likely to be motivated to achieve the target if they have participated in setting the target. Participation can reduce the information asymmetry gap that can arise when targets are imposed by senior management.

Imposed targets are likely to make managers feel demotivated and alienated and result in poor performance. Participation however can cause problems; in particular, managers may attempt to negotiate budgets that they feel are easy to achieve which gives rise to ‘budget padding’ or budgetary slack. They may also be tempted to ‘empire build’ because they believe that the size of their budget reflects their importance within the organisation. This can result in budgets that are unsuitable for control purposes.

(b) Advantages Flexibility: the bank will agree an overdraft limit or facility. The borrower may not require the full facility immediately but may draw funds up to the limit as and when required. If the funds are no longer required they can be repaid without suffering any penalty.

Minimal documentation: legal documentation is fairly minimal when arranging an overdraft.

The documents will state the maximum overdraft limit, the interest payable and the security required.

An overdraft is seen as a relatively cheap source of finance. Banks usually charge between 2 and 5% above base rate depending on the creditworthiness and security offered by the borrower. Savings come from the fact that interest is only paid on the daily outstanding balance therefore a large cash inflow can offset the balance outstanding and temporarily lower the interest payable, whilst still retaining the ability to borrow up to the overdraft limit when required.

Disadvantages An overdraft is strictly speaking repayable on demand.

The interest rate payable will vary depending on the perceived credit risk of the borrower.

Banks will normally expect security either in the form of a fixed charge or a floating charge.

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(c) Decision tree: Develop an overseas market or not

$500,000 In-line 50% Succeed 70%

$406,000

$630,000 Favourable 20%

Develop $250,000

Adverse 30%

$284,200

$100,000 $34,200

Fail 30% $0 Don’t Develop $0

Therefore the overseas market should be developed

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(d) Year

0 1 2 3 4 5 Present Value Cumulative discount factor Annualised equivalent

Discount Factor @ 8% 1.000 0.926 0.857 0.794 0.735 0.681

Van A Cash Flows Present $ Value $ (25,000) (25,000) (2,000) (1,852) (2,000) (1,714) (3,000) (2,382) 5,000 3,675 (27,273)

Van B Cash Flows Present $ value $ (30,000) (30,000) (3,000) (2,778) (3,000) (2,571) (3,000) (2,382) (4,000) (2,940) 6,000 4,086 (36,585)

3.312

3.993

8,234

9,162

The lowest annualised equivalent cost is for Van A therefore the company should replace its fleet of delivery vans with Van A.

(e) Default risk This refers to potential doubt about the payment of interest or the eventual repayment of the capital invested. Investments in government securities are generally considered to have very low default risk however the recent financial crisis has shown that even investment in government securities is not risk free. Investment in equities is generally considered high risk and is not a suitable form of short-term investment.

Interest rate risk This refers to the risk that market interest rates will change and the investor will be worse off.

Interest rates cannot be predicted with any degree of accuracy. Variable rate bank deposits will leave the company vulnerable to a fall in interest rates. If the investment is in a fixed rate term deposit, whilst the investor will receive a guaranteed return, there will be an opportunity cost if market interest rates increase above the fixed rate.

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(f) (i) Product A $ 46 (18) 28 0.5 hours 56

Selling price Material cost Throughput contribution Machine hours per unit Return per machine hour

Product B $ 62 (16) 46 0.8 hours 57.50

(ii)

Return per machine hour Ranking Units produced Machine hours Contribution per machine hour Total contribution Factory costs Total profit

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Product A

Product B

$56

$57.50

2 3,200 1,600 $56

1 8,000 6,400 $57.5

$89,600

$368,000

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Total

8,000

$457,600 $248,000 $209,600

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SECTION C Answer to Question Three

(a) Tables (per unit) $ 2,200 1,000 400 40 760

Selling price Direct material Direct labour Variable overheads Contribution

Chairs (per unit) $ 320 160 60 6 94

Sideboards (per unit) $ 2,800 1,200 600 60 940

Sales Mix Contribution Variance Actual Sales Quantity

Actual Sales at budget mix

7,200 31,000 7,800 46,000

9,200 29,900 6,900 46,000

Tables Chairs Sideboards

Difference

2,000 A 1,100 F 900 F

Variance from weighted average contribution per unit ($760 - $354.10) ($94 - $354.10) ($940 - $354.10)

Variance $000

811.80 A 286.11 A 527.31 F 570.60 A

Or alternatively: Actual Sales Quantity Tables Chairs Sideboards

7,200 31,000 7,800 46,000

Actual Sales at budget mix 9,200 29,900 6,900 46,000

Difference

Contribution $

Variance $000

760 94 940

1,520 A 103.4 F 846 F 570.6 A

2,000 A 1,100 F 900 F

Sales Quantity Contribution Variance

Tables Chairs Sideboards

Budget Sales Quantity 8,000 26,000 6,000 40,000

Actual Sales at budget mix 9,200 29,900 6,900 46,000

Difference 1,200 F 3,900 F 900 F 6,000 F

Contribution $ 760 94 940

Variance $000 912 F 366.6 F 846 F 2,124.6 F

Or alternatively: Budget Sales Quantity Tables Chairs Sideboards

8,000 26,000 6,000 40,000

Contribution $ 760 94 940

Total Contribution $000 6,080 2,444 5,640 14,164

Weighted average contribution = $14,164k / 40,000 = $354.10 Sales quantity contribution variance = (46,000 – 40,000) x $354.10 = $2,124.6 F

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(b) The sales quantity contribution variance and the sales mix contribution variance explain how the sales volume contribution variance has been affected by a change in the total quantity of sales and a change in the relative mix of products sold. From the figures calculated for the sales quantity contribution variance in part (a) we can say that the increase in total quantity sold would have earned an additional contribution of $2,124,600, if the actual sales volume had been in the budgeted sales mix. The sales mix contribution variance shows that the change in the sales mix resulted in a reduction in profit of $570,600. The change in the sales mix has resulted in a relatively higher proportion of sales of chairs which is the product that earns the lowest contribution and a lower proportion of tables which earn a contribution significantly higher than the weighted average contribution. The relative increase in the sale of sideboards however, which has the highest unit contribution, has partially offset the switch in mix to chairs.

(c) Reconciliation statement for Sideboards $000

$000

Original budget contribution 6,000 units x $940 per unit Sales volume contribution variance (7,800 units - 6,000 units) x $940 Budget contribution at actual level of activity (7,800 units x $940 per unit) Other variances:

5,640 1,692 F 7,332

Selling price variance 7,800 units x ($2,500 - $2,800) Direct material variance 7,800 x (1,200 – 1,300) Direct labour rate variance ((7,800 x $600) / $18.75) x ($20 - $18.75) Direct labour efficiency variance (7,800 x (30 hrs per unit – 32 hrs per unit)) x $20 Variable overhead expenditure variance (7,800 x 30 hrs) x ($2 - $2.50) Variable overhead efficiency variance 7,800 x (30 hrs per unit – 32 hrs per unit) x $2.50 Actual contribution 7,800 units x $520

2,340 A 780 A 312 F 312 A 124.8A 31.2 A 4,056

Workings:

Sales revenue Direct material Direct labour Variable overhead Contribution

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Standard contribution per unit $ 2,800 1,200 600 60 940

Flexed budget 7,800 units $000 21,840 9,360 4,680 468 7,332

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Actual contribution per unit $ 2,500 1,300 600 80 520

Total actual contribution $000 19,500 10,140 4,680 624 4,056

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(d) 1.

The size of the variance – costs tend to fluctuate around a norm and therefore variances may be expected on most costs. The company will need to decide how large a variance must be before it is considered ‘abnormal’ and worthy of investigation.

2.

The likelihood of the variance being controllable – managers may know from experience that certain variances may not be controllable even if a lengthy investigation is undertaken to determine their cause. Managers may argue that a material price variance is less easily controlled than a material usage variance as it is determined by external factors. On the other hand a material price variance may be due to the efficiency of the purchasing department and this would only be apparent after further investigation.

3.

The likely cost versus the potential benefits of the investigation – the cost of the investigation would need to be weighed against the cost that would be incurred if the variance were allowed to continue in future periods.

Other acceptable factors could be: • •

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The interrelationship between variances The type of standard that was set

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Answer to Question Four

(a) Year 1 expected sales revenue = ($450m x 50%) + ($300m x 30%) + ($600m x 20%) = $435m Year 2 sales revenue = $435m +100m = $535m Year 3 sales revenue = $535m + 100m = $635m Year 4 sales revenue = $635m + 100 = $735m Contribution Year 1 = $435m x 60% = $261m Contribution Year 2 = $535m x 60% = $321m Contribution Year 3 = $635m x 60% = $381m Contribution Year 4 = $735m x 60% = $441m Fixed Costs Depreciation per annum ($600m - $400m) / 4 = $50m Fixed costs excluding depreciation = $150m - $50m = $100m Cash Flows

Contribution Fixed Costs Marketing Costs Net cash flows

Year 1 $m 261

Year 2 $m 321

Year 3 $m 381

Year 4 $m 441

(100) (50) 111

(100) (50) 171

(100) (50) 231

(100) (50) 291

Year 1 $m 111 (150)

Year 2 $m 171 (113)

Year 3 $m 231 (84)

Year 4 $m 291 147

(39) 12

58 (17)

147 (44)

438 (131)

Taxation

Net cash flows Tax Depreciation Taxable profit Taxation @ 30%

Net present value Year 0 $m Development (600) and fit out costs Working (60) capital Net cash flows Tax payment

Year 1 $m

Year 2 $m

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Year 4 $m 400

Year 5 $m

60 111

171

231

291

6

(9)

(22)

(66)

6

(8)

(22)

(65)

168

201

663

(65)

Tax payment Net cash flow (660) after tax Discount 1.000 factors @ 8% Present (660) value Net present value = $195m

Year 3 $m

117 0.926

0.857

108

144

10

0.794 160

0.735 487

0.681 (44)

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The net present value is positive therefore on this basis the company should go ahead with the project.

(b) (i)

Fixed costs Tax @ 30% Tax payment Net cash flow Discount Factor @ 8% Present value

Year 1 $m 100

Year 2 $m 100

Year 3 $m 100

Year 4 $m 100

30 (15)

30 (30)

30 (30)

30 (30)

(15)

85

70

70

70

(15)

0.926

79

0.857

0.794

60

56

0.735

51

Year 5 $m

Total $m

0.681

(10)

236

$195 / $236 = 82.6% If fixed costs increase by more than 82.6% the NPV of the project will be negative and the decision will be to reject the project. (ii) 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 value (NPV) reaches zero i.e. the indifference point. Alternatively, specific changes can be calculated to determine the effect on NPV.

(c) (i)

Net cash flows Cumulative cash flows

Year 0 $m (660)

Year 1 $m 117

Year 2 $m 168

Year 3 $m 201

(660)

(543)

(375)

(174)

Year 4 $m 663

Year 5 $m (65)

Payback period 3 yrs + (174 / 663) x 12 = 3 yr 3 months (ii) Projects which return their cash outlay quicker can be seen as less risky. Payback is therefore used by companies at an early stage to eliminate projects that have unacceptable risk and return characteristics. In this case there is uncertainty surrounding the potential of the market

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and the management may be concerned to ensure that the payback period is relatively short in the event that it becomes necessary to withdraw from the market. Alternatively, a long payback period may persuade management not to enter the market in the first place.

Payback is also seen as useful when funds are in short supply since early payback of funds allows investment in other profitable opportunities. Payback is also easy to use and is a simple way to communicate project acceptability to managers.

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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 B1(b) explain the purposes of budgeting, including planning, communication, co-ordination, motivation, authorisation, control and evaluation, and how these many conflict. It examines candidates’ ability to explain the behavioural consequences of budgeting and the difficulties and conflicts that can arise.

(b)

The question assesses learning outcome E2(a) identify sources of short-term funding.

It examines candidates’ ability to discuss the advantages and disadvantages of an overdraft as a method of short term finance.

(c)

The question assesses learning outcome D1(f) apply decision trees. It examines candidates’ ability to use decision trees to evaluate a decision where there is uncertainty regarding expected cash flows.

(d)

The question assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial considerations. It examines candidates’ ability to compare two alternatives investments that have unequal lives.

(e)

The question assesses learning outcome E2(b) identify alternatives for investment of short-term cash surpluses. It examines candidates’ ability to explain the risk factors that a company needs to consider when making short term investment decisions.

(f)

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 return per machine hour using a throughput accounting approach and calculate profit on a throughput accounting basis.

Section C – Questions Three and Four - Compulsory 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 sales mix and sales quantity variances. Part (b) assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines candidates’ ability to explain the meaning of the two variances calculated in part (a).Part (c) also assesses learning outcome A1(d) apply standard costing methods, within costing systems, including the reconciliation of budgeted and actual profit margins and examines candidates’ ability to reconcile the budgeted and actual contribution for one of the products. Part (d) also assesses learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines September 2011

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candidates’ ability to explain the factors that a company would use to determine whether a variance was significant and required investigation.

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 value of the project. Part (b) assesses learning outcome C1(f) apply sensitivity analysis to cash flow parameters to identify those to which net present value is particularly sensitive. It examines candidates’ ability to calculate the sensitivity of one variable and then to explain the benefits in carrying out sensitivity analysis.

Part (c) (i) also assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates’ ability to calculate the payback period of a project. Part (c)(ii) assesses learning outcome C2(b) compare and contrast the alternative techniques of investment appraisal. It examines the candidates’ ability to discuss why payback might be used in practice despite its theoretical disadvantages.

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