March 2012 1 P1

Operational Level Paper

P1 –Performance Operations Examiner’s Answers

SECTION A Answer to Question One 1.1 The correct answer is C. 1.2 Net Present Value of the project = $180,000

Present value of the annual cash outflow = $100,000 x 3.312 = $331,200

Sensitivity = $180,000/$331,200 = 54.3% The correct answer is A.

1.3 Regret Matrix Staffing mix Fee level Deluxe High Standard Low X $5,000 0 $2,500 $20,000 Y $15,000 $5,000 0 $5,000 Z $35,000 $20,000 $7,500 0 Maximum regret $35,000 $20,000 $7,500 $20,000 The Standard fee strategy minimises the maximum regret. The correct answer is C.

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1.4

EOQ = h

o

C

D2C

Where: Co = (cost per order) = $160 D = (annual demand) = 26,000 units Ch = (cost of holding one unit for one year) = $1.40

EOQ = 1.46

000,26 160 2 ××

The correct answer is A.

1.5 Number of orders = 26,000 / 2,600 = 10 per year

Ordering costs = 10 x $160 = $1,600 Holding costs = 2,600 x 0.5 x $1.40 = $1,820 Total ordering and holding costs = $3,420

The correct answer is D.

1.6 The holders 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. 1.7

Time Cash flow $

Discount factor 12% Present value $

0 1 - ∞

(50,000) 5,670

1.000 1 / 0.09 = 11.111

(50,000) 63,000

Net present value 13,000 The net present value of the project is $13,000

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1.8 The fixed costs will remain the same therefore the contribution has to exceed $2,880,000.

The possible outcomes and the probability of them occurring are given below: 100,000 x ($48 - $21) = $2,700,000 Joint probability is 0.40 x 0.25 = 0.10 100,000 x ($48 - $19) = $2,900,000 Joint probability is 0.40 x 0.75 = 0.30 120,000 x ($48 - $21) = $3,240,000 Joint probability is 0.60 x 0.25 = 0.15 120,000 x ($48 - $19) = $3,480,000 Joint probability is 0.60 x 0.75 =

0.45

1.00

The probability therefore that the contribution will exceed $2,880,000 is 90%.

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SECTION B Answer to Question Two (a)

Quarter 1 Quarter 2 Quarter 3

$ $ $

Receipts b/f trade receivables 125,000

20% cash sales 100,000 90,000 96,000 56% in same quarter 280,000 252,000 268,800 24% in quarter following sales 120,000 108,000 Total receipts 505,000 462,000 472,800

Payments b/f trade payables 60,000

Materials 50% in same Quarter 69,000 75,600 57,800 Materials 50% in next Quarter

69,000 75,600

Labour and overheads 284,000 284,000 284,000 Loan repayment

100,000

Total payments 413,000 428,600 517,400

Opening balance 49,400 141,400 174,800 Net cash flow 92,000 33,400 -44,600 Closing balance 141,400 174,800 130,200

(b) Project appraisal involves the estimation of cash flows over several years. As the cash flows can only be estimated with varying degrees of certainty it is useful to see the impact of changes in assumptions on project viability. 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 variables to ascertain by how much each variable would need to change before the net present value (NPV) reaches zero i.e. the indifference point. Alternatively, specific changes can be tested to determine the effect on NPV.

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(c) (i) The percentage cost of the discount = [(100/(100 – d)]365/t - 1 = [100/98]365/35 - 1 = 1.0204110.43 - 1 = 1.2346 – 1 = 23.5% (ii) Examiner’s note: the question asks for two methods. Examples of methods that would be rewarded are given below. Bank references - These may be provided by the prospective customer’s bank to indicate the customer’s financial standing. Financial statements - The most recent financial statements of the prospective customer can be obtained either direct from the customer, or for limited companies, from Companies House. Personal contact - A representative of TJ might visit the business premises of the prospective customer. (d) Environmental internal failure costs These are costs that are incurred after hazardous materials, waste and/or other contaminants have been produced. The costs are incurred in order to comply with both externally and internally imposed standards. Examples include treating and disposing of toxic materials and recycling costs. Environmental external failure costs These are incurred when there are failures of internal control and hazardous materials, waste or contaminants have been introduced into the environment. Examples of costs that an organisation has to pay include decontaminating land or cleaning a river after leakages. Organisations may also be subject to penalties imposed by the government for these external failures. These costs can give rise to adverse publicity. Some external failure costs may be caused by the organisation but ‘paid’ by society.

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(e) (i) January

$000 February

$000 Gross profit 568.40 705.60 Over/(under) absorption of fixed overheads (30) 28 Gross profit 538.40 733.60 Workings: January: Gross profit = 9,800 units x ($135 -$45 - $32) = $568,400 Under absorption of fixed overhead (10,000 units x $32) – $350,000 = $30,000 February: Gross profit = 11,200 units x ($140 - $45 - $32) = $705,600 Over absorption of fixed overhead (11,500 units x $32) - $340,000 = $28,000 (ii) Profit using absorption costing $538.40k Profit using marginal costing Difference

$532.00k

$ 6.40k

Increase in inventory in January = 200 units Absorbed fixed overheads included in inventory under absorption costing: 200 units x $32 = $6,400 (f) Cost driver rates Set up costs $200,000 / 800 = $250 per set up Inspection/quality costs $120,000 / 400 = $300 per test Stores receiving $252,000 / 1,800 = $140 per requisition Product W cost per unit Direct materials $2.50 Direct labour $0.54 Set up costs: 15,000/150 units = 100 batches x $250 = $25,000 / 15,000 units = $1.67 Inspection/ quality cost: quality tests 100/2 = 50 x $300 = $15,000 / 15,000 units = $1.00 Stores receiving costs: 80 x $140 = $11,200 / 15,000 units = $0.75 Total production costs = $2.50 + $0.54 + $1.67 + $1.00 + $0.75 = $6.46

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SECTION C Answer to Question Three (a) Reconciliation statement for February Standard material cost

78 x $210 $16,380

Material price variance – Raw material A

2,800 litres x ($1.40 - $1.50) $280 A

Material price variance – Raw material B

2,700 litres x ($1.20 - $1.30) $270 A

Material price variance - Raw material C

1,000 litres x ($3.65 - $4.00) $350 A

Material price variance - Raw material D

1,900 litres x ($2.60 - $2.50) $190 F

Material mix variance – Raw material A

See workings below $784 A

Material mix variance – Raw material B

See workings below $648 A

Material mix variance – Raw material C

See workings below $1,314 A

Material mix variance – Raw material D

See workings below $3,796 F

Material yield variance

See working below $420 A

Actual material cost

$16,460

Material mix variance Raw material Actual input @

standard mix litres

Actual input @ actual mix litres

Variance Litres

Standard cost $

Variance $

A 2,240 2,800 560 A 1.40 784A B 2,160 2,700 540 A 1.20 648A C 640 1,000 360 A 3.65 1,314A D 3,360 1,900 1,460 F 2.60 3,796F 8,400 8,400 1,050F Or alternatively: Material mix variance Raw material

Actual input @ standard mix

litres

Actual input @ actual mix litres

Variance Litres

Standard cost differences

$

Variance $

A 2,240 2,800 560 A (1.40 – 2.00) 336F B 2,160 2,700 540 A (1.20 – 2.00) 432F C 640 1,000 360 A (3.65 – 2.00) 594A D 3,360 1,900 1,460 F (2.60 – 2.00) 876F 8,400 8,400 1,050 F

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NB either method of calculating the individual mix variances would be acceptable Material yield variance Standard input per 100 litres = 105 litres 7,800 litres x 1.05 = 8,190 litres Actual usage = 8,400 litres Variance = 210 litres A Standard input cost per litre = $2.00 Variance = 210 A x $2.00 = $ 420 A Or alternatively: 8,400 litres input should produce 8,000 litres output Did produce 7,800 litres Yield variance = 200 litres A Standard output material cost per litre = $2.10 Yield variance = 200 A x $2.10 = $420 A (b) (i) The size of the variance (ii) The likelihood of the variance being controllable (iii) The likely cost versus the potential benefits of the investigation (iv) The interrelationship between variances (v) The type of standard that was set

(c) Direct labour rate planning variance (7,800 x 0.08 hours) x ($24 - $26) = $1,248 A Direct labour rate operational variance (640 x $26) - $16,500 = $140 F Direct labour efficiency operational variance [(7,800 x 0.08) – 640] x $26 = $416 A (d) The calculation of planning and operational variances is important for the following reasons: • The use of planning and operational variances will enable management to draw a

distinction between variances caused by factors extraneous to the business and planning errors (planning variances) and variances caused by factors that are within the control of management (operational variances).

• The manager’s 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 affected by factors that the manager cannot control. In part c) the labour rate variance was $1,108A however it can be clearly seen that $1,248A was a result of a planning error and was not within the control of the operational managers.

• 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

March 2012 9 P1

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.

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Answer to Question Four (a) (i) Expected value of increase in demand (1,000 x 0.30) + (700 x 0.50) + (500 x 0.2) = 750 members Contribution per member $800 x 55% = $440 Additional contribution Year 1 = $440 x 750 = $330k Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 $000 $000 $000 $000 $000

Contribution

330 343 357 371 386

Additional fixed costs

(120) (125) (130) (135) (140)

Net cash flows

210 218 227 236 246

Taxation Year 1 Year 2 Year 3 Year 4 Year 5 $000 $000 $000 $000 $000 Net cash flows

210 218 227 236 246

Tax depreciation

(150) (113) (84) (63) (160)

Taxable profit

60 105 143 173 86

Taxation @ 30%

18 32 43 52 26

Net present value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $000 $000 $000 $000 $000 $000 $000 Net cash flows

(600) 210 218 227 236 246 30

Tax payment

(9) (16) (21) (26) (13)

Tax payment

(9) (16) (22) (26) (13)

Net cash flow after tax

(600) 201 193 190 188 237 (13)

Discount factors @ 12%

1.000 0.893 0.797 0.712 0.636 0.567 0.507

Present value

(600) 179 154 135 120 134 (7)

Net present value = $115k The net present value is positive therefore on this basis the company should go ahead with the project.

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(ii) Two non-financials factors that could be considered are as follows: • The risk of the project. The cash flows used in the project appraisal are estimates and will

depend on a number of factors that are uncertain. The club will need to be aware of the risk involved in the project.

• The prospect of obtaining planning permission for the new facilities. The success of the

project will depend on the club obtaining planning permission for the new facilities. The planning conditions may also have an effect on the cost involved in the project.

(b)

Year 0 $000

Year 1 $000

Year 2 $000

Year 3 $000

Year 4 $000

Year 5 $000

Year 6 $000

Net cash flows

(600) 201 193 190 188 237 (13)

Discount factor @ 20%

1.000 0.833 0.694 0.579 0.482 0.402 0.335

Present value

(600) 167 134 110 91 95 (4)

Net present value = $(7)k IRR NPV at 12% = $115k NPV at 20% = $(7)k By interpolation 12% + (115/(115+7)) x 8% =19.5% (c) (i) The company’s real cost of capital

(ii) An alternative approach would be to express the cash flows in today’s value terms and to discount the cash flows at the real cost of capital. There are problems however in taking this approach when there are tax implications. If there are tax implications the tax cash flows would need to be treated separately. Capital allowances are based on original cost rather than replacement cost and do not change in line with changing prices. Each tax depreciation figure would have to be reduced by expected inflation over the relevant period to obtain a current value. Similarly the residual value of the equipment is stated at year 5 values and would need to be adjusted to present day values. 50% of the tax payable for any year will be a money cash flow in the following year. This second stage payment in each year would have to be reduced by one year’s inflation to determine its ‘real’ value in that year.

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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 learning outcome E1(c) analyse cash-flow forecasts over a twelve month period. It examines candidates’ ability to prepare a cash budget.

(b) The question assesses learning outcome D1(b) apply sensitivity analysis to both short

and long-run decisions models to identify variables that might have significant impacts on project outcomes. It requires candidates to explain why sensitivity analysis is useful when dealing with uncertainty in project appraisal.

(c) The question assesses learning outcome learning outcome E1(f) analyse the impacts

of alternative debtor and credit policies. Part (i) assesses candidates’ ability to calculate the effective annual interest rate of an early settlement discount offered to customers. Part (ii) examines candidates’ ability to identify potential sources of information that can be used when assessing a customer’s creditworthiness.

(d) The question assesses learning outcome 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 and give examples of environmental internal failure costs and environmental external failure costs.

(e) 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 two periods using absorption costing where the production volume and sales volume are different. Part (ii) requires candidates to explain why there is a difference in profit for the period using marginal and absorption costing.

(f) The question assesses learning outcome B3(b) apply alternative approaches to

budgeting. It examines candidates’ ability to calculate the budgeted cost per unit of a product using activity based costing.

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 material variances including material mix and yield 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 identify the factors that a company should consider before deciding whether to investigate variances. Part (c) also assesses learning outcome A1(f) interpret

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material, labour, variable overhead, fixed overhead and sales variances, distinguishing between planning and operational variances. It examines candidates’ ability to calculate planning and operational variances. 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 candidates’ ability to explain the importance of the planning and operational variances calculated in part (c). Question Four Part (a)(i) assesses learning outcomes C1(b) apply the principles of relevant cash flow analysis to long-run projects that continue for several years and C1(c) calculate project cash flows, accounting for tax and inflation, and apply perpetuities to derive ‘end of project’ value where appropriate and also 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 (a)(ii) assesses learning outcome C1(g) prepare decision support information for management, integrating financial and non-financial factors. It examines candidates’ ability to identify and explain non-financial factors that would need to be considered before a decision is made regarding the potential investment. Part (b) also assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It requires candidates to calculate the IRR of the project. Parts (c)(i) and (ii) also assess learning outcome C1(c) calculate project cash flows, accounting for tax and inflation, and apply perpetuities to derive ‘end of project’ value where appropriate. Part (c)(i) examines candidates’ ability to calculate the real cost of capital and part c(ii) requires candidates to explain how the real cost of capital can be used to calculate the net present value of a project where the cash flows are subject to inflation.