Operational Level Paper

P1 – Performance Operations
March 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 April 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 (1 + r) x (1 + i) = (1 + m)

(1 + 0.06) x (1 + 0.03) = 1.0918

(1 + m) = 1.0918

m = 0.0918

m = 9.18%

The correct answer is D.

 The Chartered Institute of Management Accountants 2014

1.3

Product R Product S Total

Budgeted production 80,000 60,000 140,000
per annum (units)
Number of batches 800 1,200 2,000
Number of machine 2,400 3,600 6,000
set-ups
Total processing time 240,000 300,000 540,000
(minutes)

Cost driver rate = $108,000 / 540,000 = $0.20

Total processing costs = $0.20 x 240,000 = $48,000
Processing costs per unit = $48,000 / 80,000 = $0.60

The correct answer is C.

1.4

Cost driver rate = $180,000 / 6,000 = $30 per set up

Total set-up costs = $30 x 3,600 = $108,000
Set up cost per unit =$108,000 / 60,000 = $1.80

The correct answer is B.

1.5
The profitability index = net present value of the investment / initial investment
= $140,500 / $500,000
= 0.281

The correct answer is C.

1.6 The expected value of cost of the warranty claims is:

$2,000,000 x 15% = $300,000

$6,000,000 x 3% = $180,000
$10,000,000 x 2% = $200,000
$680,000

Performance Operations 2 March 2014

1.7 Trade receivable at the end of this year = $862,860 x 55/365 = $130,020
Credit sales for next year = $862,860 x 1.05 = $906,003
Trade receivable days at end of next year = $130,020 / $906,003 x 365 = 52.38 days

1.8

(i)

The minimum profit at a selling price of $80 is $50,000

The minimum profit at a selling price of $90 is $60,000
The minimum profit at a selling price of $100 is $70,000
The minimum profit at a selling price of $110 is $75,000

Therefore if the manager wants to maximise the minimum profit a selling price of $110 would
be chosen.

(ii)

A regret matrix can be produced as follows:

Competitor Selling price

Reaction
$80 $90 $100 $110

Strong $10,000 $0 $10,000 $5,000

Medium $30,000 $20,000 $10,000 $0

Weak $10,000 $0 $10,000 $20,000

Maximum regret $30,000 $20,000 $10,000 $20,000

Therefore if the manager wants to minimise the maximum regret a selling price of $100 would
be chosen.

March 2014 3 Performance Operations

SECTION B

Answer to Question Two

(a)

Rationale

The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It
examines candidates’ ability to explain the advantages and disadvantages of zero based
budgeting.

Suggested Approach

Candidates should clearly explain two advantages and one disadvantage of zero based
budgeting in the scenario described.

Examiner’s note: the question asks for two advantages and one disadvantage. Examples of
points that would be rewarded are given below.

Advantages
a) It avoids the complacency inherent in the traditional incremental approach where it is
assumed that future activities will be very similar to current ones.
b) It encourages a questioning approach by focusing attention not only on the cost of the
activity but on the benefits is provides. This will force the public sector managers to
articulate the benefits encouraging them to think clearly about the activities.
c) Preparation of decision packages will normally require the involvement of many
employees. This involvement may produce many ideas and promote job satisfaction.

Disadvantage
a) The creation of decision packages and their subsequent ranking is very time consuming
and costly. The public sector organisation will need to assess whether the benefits of
the system outweigh the costs involved.
b) The ranking process is very difficult and value judgements are inevitable. In a public
sector organisation the decision packages are very disparate and difficult to compare.
c) In applying ZBB ‘activities’ may continue to be identified with traditional functional
departments rather than cross functional activities and thus distract attention from the
real cost-reduction issues.

Performance Operations 4 March 2014

(b)

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 cash flows.

Suggested Approach

Candidates should firstly apply the probabilities for the economic conditions to calculate the
expected value of the net present value (NPV) for each of the projects without perfect
information. They should then select the best outcome for each of the possible economic
conditions 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.

Economic
Project A Project B Project C
Conditions
$000 $000 $000

Good (30%) 700 800 700

Fair (20%) 400 500 600

Poor (50%) 300 400 500

Expected values ($000)

Project A ($700 x 0.3) + ($400 x 0.2) + ($300 x 0.5) = $440

Project B ($800 x 0.3) + ($500 x 0.2) + ($400 x 0.5) = $540
Project C ($700 x 0.3) + ($600 x 0.2) + ($500 x 0.5) = $580

On the basis of expected value Project C would be chosen.

Expected value with perfect information ($000)

If good select Project B = ($800 x 0.3) = $240

If fair select Project C = ($600 x 0.2) = $120
If poor select Project C = ($500 x 0.5) = $250

Expected value with perfect information is $240 + $120 + $250 = $610

The maximum amount that should be paid is ($610k – $580k) = $30k

March 2014 5 Performance Operations

(c)

Rationale

Part (i) assesses learning outcome E1(e) analyse trade debtor and creditor information. It
examines candidates’ ability to calculate the effective annual interest rate of an early
settlement discount. Part (ii) assesses learning outcome E1(f) analyse the impacts of
alternative debtor and creditor policies. It examines candidates’ ability to identify methods that
could be used to reduce a company’s trade receivable days.

Suggested Approach

In part (i) candidates should calculate how many days early the payment will be received.
They should then divide 365 days by this to calculate the number of compounding periods.
The discount rate should then be compounded by the number of periods to calculate the
effective annual interest rate. In part (ii) candidates should clearly state two methods that
could be used to reduce a company’s trade receivable days.

(i)

Payment will be made 45 days early.

Number of compounding periods = 365/45= 8.111

8.111
1+ r = (1.00/0.98)

1+ r = 1.17805

The effective annual interest rate of the early settlement discount is 17.81%

(ii)

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

a) Interest penalties for late payment

b) Improved credit control procedures
c) Reduce the credit terms

Performance Operations 6 March 2014

(d)

Rationale

The question assesses learning outcome E1(g) analyse the impacts of alternative policies for
stock management. Part (i) examines candidates’ ability to calculate the economic order
quantity (EOQ) for a product. Part (ii) requires candidates to calculate the total inventory
holding and ordering costs if the company uses the EOQ.

Suggested Approach

In part (i) candidates should apply the formula for the EOQ given in the question paper to the
figures given in the question in order to calculate the EOQ. In part (ii) candidates should firstly
calculate the total number of orders that would be required if the EOQ was used. This can
then be multiplied by the ordering costs per order to calculate the total ordering costs. In
order to calculate the holding costs the EOQ should be divided by two to calculate the
average inventory held. This should then be multiplied by the holding cost per unit to
calculate the total holding costs. The total ordering cost and total holding costs can then be
added together.

2C o D
(i) EOQ =
Ch

Where:

Co (cost per order) = $150

D = (annual demand) = 30,000 units
Ch = (cost of holding one unit for one year) = $25

2 × 150 × 30, 000

EOQ = = 600 units
25

(ii)

Number of orders = 30,000 / 600 = 50 per year

Ordering costs = 50 x $150 = $7,500
Holding costs = 600 x 0.5 x $25 = $7,500
Total ordering and holding costs = $15,000

March 2014 7 Performance Operations

(e)

Rationale

The question assesses learning outcome A3(a) apply principles of environmental costing in
identifying relevant internalised costs and externalised environmental impacts of the
organisation’s activities. It examines candidates’ ability to explain the benefits to a company
from using an environmental costing system.

Suggested Approach

Candidates should clearly explain three benefits that may arise for a company that uses an
environmental costing system.

Examiner’s note: the question asks for three benefits. Examples of points that would be
rewarded are given below.

Increased awareness of the impact of environment related activities on their financial

statements
Organisations that use an environmental costing system will have greater awareness of the
impact of environment related activities on their financial statements. This is because
conventional management accounting systems tend to attribute many environmental costs to
general overhead accounts with the result that they are “hidden” from management.

Cost control / reduction

Organisations which adopt environmental cost management principles are more likely to
identify and take advantage of cost reduction and other improvement opportunities. Identifying
and monitoring the usage and cost of resources such as water, electricity and fuel will result
in better control of the cost of these resources and identification of potential for cost reduction.

More accurate product costs / improved decision making

A good environmental costing system will produce more accurate product costs. This will
reduce the chances of employing incorrect pricing of products and services and taking the
wrong options in terms of mix and development decisions. Lack of cost information can result
in the cross subsidisation of environmentally damaging products.

Environmental risk management

Improved environmental cost information will enable environmental considerations to form
part of investment decisions. The likelihood and impact of environmental risks can also be
assessed.

Performance Operations 8 March 2014

(f)

Rationale

Part (i) of the question assesses learning outcome E2(d) illustrate numerically the financial
impact of short-term funding and investment methods. Part (ii) assesses learning outcome
E2(b) identify alternatives for investment of short-term cash surpluses. Part (i) examines
candidates’ ability to calculate the issue price of a bill of exchange. Part (ii) requires
candidates to state two ways in which an accepted bill of exchange can be used by the
holder.

Suggested Approach

In part (i) candidates should calculate the discount on the bill by multiplying the face value by
the discount yield for 91 days. The discount on the bill should then be subtracted from the
face value to calculate the issue price. In part (ii) candidates should clearly state two ways in
which an accepted bill of exchange can be used by the holder.

(i)

If the discount yield is 6% then the discount on the bill will be:

$1,000 x 0.06 x 91/365 = $14.96

The issue price of the bill is therefore:

$1,000 - $14.96 = $985.04

(ii)

Examiner’s note: the question asks for two ways. Examples of points that would be rewarded
are given below.

The holder of an accepted bill of exchange can do one of the following:

(i) Hold the bill until the due date and collect the money

(ii) Discount the bill with the bank for immediate payment

(iii) Transfer the bill to a third party in settlement of an amount due.

March 2014 9 Performance Operations

SECTION C

Answer to Question Three

Rationale

The question assesses a number of learning outcomes. Part (a) assesses learning outcome
A1(d) apply standard costing methods, within costing systems, including the reconciliation of
budgeted and actual profit margins. It examines candidates’ ability to calculate appropriate
variances to enable the reconciliation of budgeted and actual profit. 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 discuss the reasons the variances may have arisen and the possible
interrelationship between the variances. Part (c) assesses learning outcome A1(h) explain
the impact of just-in-time manufacturing methods on cost accounting and the use of ‘back-
flush accounting’ when work in progress stock is minimal. It examines candidates’ ability to
explain the reasons why standard costing may not be considered useful in a modern
manufacturing environment.

Suggested Approach

In part (a) candidates should firstly calculate the budgeted profit and the actual profit for the
period. They should then calculate each of the variances for sales, material, labour and
production overheads. They should then prepare a reconciliation statement starting with the
budgeted profit and then showing each of the individual variances to reconcile the budgeted
profit to actual profit. In part (b) candidates should discuss the effect that the Production
Director’s decision has had on the company performance as shown by the variances.
In part (c) candidates should clearly explain the reasons why standard costing may not be
considered useful in a modern manufacturing environment.

Performance Operations 10 March 2014

(a) (i) Reconciliation statement for February

$ $
Budgeted gross profit
60,000
(1,000 units x $60)
Sales volume profit variance
12,000 F
(1,200 units - 1,000 units) x $60
Sales price variance
7,200 F
1,200 units x ($306 - $300)
Direct material price variance
66,000 A
22,000 mtrs x ($9 - $12)
Direct material usage variance
9,000 A
((1,400 x 15 mtrs) – 22,000 mtrs) x $9
Direct labour rate variance
20,400 A
6,800 hours x ($12 - $15)
Direct labour efficiency variance
2,400 F
((1,400 x 5 hrs) – 6,800) x $12
Variable overhead expenditure variance
7,800 F
(6,800 x $6) – $33,000
Variable overhead efficiency variance
1,200 F
((1,400 x 5 hrs) – 6,800) x $6
Fixed overhead expenditure variance
3,000 A
(1,000 x $15) - $18,000
Fixed overhead volume variance
6,000 F
((1,400 – 1,000 x 5 hrs) x $3)
Actual gross profit /(loss) (1,800)

Workings:

Actual gross profit for the period

$
Sales 1,200 units x $306 367,200
Direct materials 22,000 metres x $12 264,000
Direct labour 6,800 hours x $15 102,000
Variable production overheads 33,000
Fixed production overheads 18,000
Closing stock 200 units x $240 (48,000)
Actual gross profit (1,800)

(b)
The Production Director’s decision has resulted in a favourable sales volume variance of
$12,000 and a favourable sales price variance of $7,200 F which may at least partly be as a
result of the improved quality of the product. However, the favourable sales variances have
been achieved at a very high cost in terms of material and labour.

The Production Director’s decision has resulted in a total material cost variance of $75,000 A
and a total labour cost variance of $18,000 A. The material price variance is adverse due to
the purchase of higher quality materials. However, there is also an adverse material usage
variance which may be because the labour force was unfamiliar with handling the new
material. The decision to use higher skilled labour has resulted in an adverse labour rate
variance which has been only partially offset by a favourable labour efficiency variance.

March 2014 11 Performance Operations

(c)
In a JIT environment measuring standard costing variances may encourage dysfunctional
behaviour. A JIT production environment relies on producing small batch sizes economically
by reducing set up times. Performance measures that benefit from large batch sizes or
producing for inventory should therefore be avoided.

In an AMT environment the major costs are those related to the production facility rather than
production volume related costs such as materials and labour, which standard costing is
essentially designed to plan and control. Fixed overhead variances don’t necessarily reflect
under or overspending but may simply reflect differences in production volume. An activity
based cost management system may be more appropriate, focusing on the activities that
drive the cost.

In a total quality environment, standard costing variance measurement places an emphasis

on cost control to the detriment of quality. Cost control may be achieved at the expense of
quality and competitive advantage.

A continuous improvement environment requires a continual effort to do things better rather

than achieve an arbitrary standard based on prescribed or assumed conditions. In today’s
competitive environment cost is market driven and is subject to considerable downward
pressure. Cost management must consist of both cost maintenance and continuous cost
improvement.

In a JIT/AMT/TQM environment the workforce is usually organised into empowered, multi-

skilled teams controlling operations autonomously. The feedback they require is real time.
Periodic financial reports are neither meaningful nor timely enough to facilitate appropriate
control action.

Performance Operations 12 March 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) assesses learning outcome
C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject
to capital rationing. It examines candidates’ ability to determine the optimum replacement
cycle for a company’s non-current assets.

Suggested Approach

In part (a) candidates should firstly calculate the gross profit that would be earned in each
year from the online shopping service and deduct the lost profit from existing in-store sales.
They should then deduct the payments to PQ and the other operating costs and add on the
lease income. The tax depreciation and tax payments should then be calculated. The total
cost of the investment, the residual value 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 value (NPV) of the project. In part (b) candidates should clearly explain two other
factors that the company would need to consider before deciding whether to go ahead with
the project. In part (c) candidates should calculate the NPV of the cash flows under each of
the three alternatives. They should then divide the NPV by the appropriate annuity factor to
calculate the annualised equivalent cost. The optimum replacement cycle can then be
selected as the alternative with the lowest annualised equivalent cost.

(a)
Gross profit Years 1 – 5
Year 1: 100,000 customers x 52 weeks x $200 = $1,040m x 20% = $208m
Year 2: 120,000 customers x 52 weeks x $200 = $1,248m x 20% = $250m
Year 3: 150,000 customers x 52 weeks x $200 = $1,560m x 20% = $312m
Year 4: 160,000 customers x 52 weeks x $200 = $1,664m x 20% = $333m
Year 5: 170,000 customers x 52 weeks x $200 = $1,768m x 20% = $354m

Taxation
Year 1 Year 2 Year 3 Year 4 Year 5
$m $m $m $m $m
Gross profit 208 250 312 333 354
Lost profit from (62) (75) (94) (100) (106)
existing sales
Other operating (60) (65) (70) (75) (80)
costs
Lease income 20 20 20 20 20
Fee to PQ (30) (30) (30) (30) (30)
Fee to PQ (2) (3) (3) (3) (4)
Net cash flows 74 97 135 145 154
Tax depreciation (4) (3) (2) (2) (4)
Taxable profit 70 94 133 143 150
Taxation @ 30% 21 28 40 43 45

March 2014 13 Performance Operations

Net present value

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

$m $m $m $m $m $m $m
Investment (445) 350
/ residual
value
Net cash 74 97 135 145 154
flows
Tax (11) (14) (20) (22) (23)
payment
Tax (10) (14) (20) (21) (22)
payment
Net cash (445) 63 73 101 103 460 (22)
flow after
tax
Discount 1.000 0.893 0.797 0.712 0.636 0.567 0.507
factors @
12%
Present (445) 56 58 72 66 261 (11)
value
Net present value = $57m
The net present value is positive therefore the project should go ahead.

(b)
Two other factors that the company would need to consider are:

Quality/ reliability: can the online retailer provide the quality and reliability of service that LM’s
customers will expect?

Financial strength of PQ: LM is reliant on PQ being able to provide the IT technology and
delivery service to its customers for at least the five year period of the contract.

(c)

Replace after Year 1 Replace after Year 2 Replace after Year 3

Year Discount Cash Present Cash Present Cash Present
Factor flows value flows value flows value
@12% $ $ $ $ $ $
0 1.000 (25,000) (25,000) (25,000) (25,000) (25,000) (25,000)
1 0.893 10,000 8,930 (6,000) (5,358) (6,000) (5,358)
2 0.797 2,000 1,594 (8,000) (6,376)
3 0.712 (8,000) (5,696)
Net (16,070) (28,764) (42,430)
present
value
Cumulative 0.893 1.690 2.402
discount
factor
Annualised (17,996) (17,020) (17,664)
equivalent

The lowest annualised equivalent cost occurs if the vehicles are kept for two years. Therefore
the optimum replacement cycle is to replace the vehicles every two years.

Performance Operations 14 March 2014