Operational Level Paper

P1 Performance Operations
Examiners Answers
SECTION A
Answer to Question One
1.1 The correct answer is A.

1.2

(102 + 67 - 54) = 115 days The correct answer is B.

1.3

$19,615/$219,615 = 8.9% The correct answer is D.

1.4

If the maximin rule is applied, the highest of the worst profit for each of the three projects is $450,000 i.e. project C. The correct answer is C.

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1.5 Minimax Regret Table Market Conditions A Poor Average Good ($300,000) ($80,000) ($200,000) B 0 0 ($500,000) Projects C ($250,000) ($50,000) 0 D ($340,000) ($150,000) ($250,000)

The maximum regret for Project A is $300,000 The maximum regret for Project B is $500,000 The maximum regret for Project C is $250,000 The maximum regret for Project D is $340,000 Therefore if the company wants to minimise the maximum regret it will invest in project C. The correct answer is C.

1.6 July 36,000 Aug 38,000 Sept 40,000 Oct 42,000 Nov 44,000 Dec 46,000 Total 246,000

Credit sales

Cash Collected: Outstanding receivables June Credit sales Less receivables at 31 December 100% December credit sales 50% November credit sales 25% October credit sales Total cash collected (46,000) (22,000) (10,500) 232,500 $ 65,000 246,000 311,000

1.7 (i) The expected value of fixed costs is: ($80,000 x 0.40) + ($130,000 x 0.45) + ($160,000 x 0.15) = $114,500 The expected value of variable costs is: ($30,000 x 0.25) + ($40,000 x 0.35) + ($50,000 x 0.40) = $41,500 The expected value of total costs is therefore $114,500 + $41,500 = $156,000 P1 2 September 2010

(ii) $ 130,000 + 160,000 + 160,000 + 160,000 + $ 50,000 = 30,000 = 40,000 = 50,000 = $ 180,000 190,000 200,000 210,000

Joint probability is (0.45 x 0.40) = Joint probability is (0.15 x 0.25) = Joint probability is (0.15 x 0.35) = Joint probability is (0.15 x 0.40) =

0.1800 0.0375 0.0525 0.0600 0.3300

Alternatively: $130,000 + $50,000 = $180,000 Joint probability is (0.45 x 0.40) = At fixed costs of $160,000, total costs are all greater than $180,000 therefore probability is =

0.1800 0.1500 0.3300

The probability is 33%.

1.8

Yield to maturity of similar bonds is 8%, therefore use 8% as the discount rate. Cashflows $ 100 1,000 Discount rate @ 8% 3.993 0.681 PV of cashflows $ 399.30 681.00 1,080.30

Year 1-5 Year 5 PV

The expected market value of the bond is therefore $1,080.30

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SECTION B
Answer to Question Two

(a)
(i) Payment will be made 30 days earlier. Number of compounding periods = 365/30 = 12.167

1 + r = 1.361 The benefit from accepting the discount is 36.1% (ii) Examiners note: the question asks for two methods. Examples of methods that would be rewarded are given below. a) Factoring or invoice discounting b) Interest penalties for late payment c) Improved credit control procedures

(b)
EOQ
2 150,000 360 = 6,000 units 3.00

Total cost of inventory management using EOQ is: Cost of ordering inventory + cost of holding inventory
DCo ChQ 150,000 360 3.00 6,000 + = + 2 2 6,000 Q

= =

$9,000 + $9,000 $18,000

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(ii)

Total cost of inventory management using 10,000 units is:

DCo ChQ 150,000 360 3.00 10,000 + = + Q 2 10,000 2

= =

$5,400 + $15,000 $20,400

Additional inventory management cost if 10,000 components are purchased = $2,400 Value of the discount is (150,000 x $2.00) x 1% = $3,000 It is therefore worthwhile to purchase 10,000 components and take the quantity discount

(c)
Traditional cost accounting systems track the sequence of raw materials and components moving through production. Such systems are time consuming and expensive to operate as they require considerable documentation, such as material requisitions and time sheets, and detailed accounting in order to maintain the job cards and inventory records. Backflush costing delays the recording of costs until after production has been completed or even sold. Standard costs can then be used to work backwards to 'flush' out the manufacturing costs. The absence of inventory in a just-in-time purchasing and production system makes choices about inventory valuation methods unnecessary and the rapid conversion of direct materials costs into cost of goods sold simplifies the cost accounting system. Cost accounting is simplified in a backflush system. For example, inventory valuation is avoided. Also, all production labour is treated as an indirect cost and is included with the other overheads in conversion costs. This is because, in a JIT system, supplies of raw material and production activity are only required when there is sales demand and so production labour will be paid regardless of activity.

(d)
There are a number of advantages to the charity in the use of zero based budgeting (ZBB) as follows: (a) (b) It avoids the complacency inherent in the traditional incremental approach where it is assumed that future activities will be very similar to current ones. It encourages a questioning approach by focusing attention not only on the cost of the activity but on the benefits it provides. This will force the charity managers to articulate the benefits encouraging them to think clearly about the activities. Preparation of the decision packages will normally require the involvement of many employees. This involvement may produce useful ideas and promote job satisfaction.

(c)

There are, however, a number of potential disadvantages of zero based budgeting: (a) The creation of decision packages and their subsequent ranking by top management is very time consuming and costly. The charity will need to assess whether the benefits of the system outweigh the costs involved.

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(b)

(c)

The ranking process is inherently difficult as value judgements are inevitable. In an organisation like a charity, the decision packages are very disparate and difficult to compare. 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.

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(e)
(i) Product Q 80,000/5,000 = 16 4 64 Product R 120,000/4,000 = 30 2 60 124 $74,400 $74,400/124 = $600 Total

Number of batches Machine set ups per batch Total number of set ups Budgeted cost of set ups Budgeted cost per set up

Budgeted cost per unit of product Q: Total number of set ups = 64 Total budgeted set up costs = 64 x $600 = $38,400 Budgeted set up costs per unit = $38,400/80,000 units = $0.48 per unit (ii) Examiners note: the question asks for two benefits. Examples of points that would be rewarded are given below. (a) Activity based budgeting provides a clear framework for understanding the link between costs and the level of activity. Activity based budgeting allows the ranking of activities and the determination of how limited resources should be allocated across competing activities. Activity based budgeting is useful for the review of capacity utilisation. If it is known that the resources devoted to a particular activity are above those currently required then these resources can be reduced or redeployed. Activity based budgeting allows the identification of value added and non-value added activities and ensures that any budget cuts are made to non-value added activities.

(b)

(c)

(d)

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(f)
Decision tree: advertise programme or not

No Increase 35% Poor 60% Increase 65% No Increase 75% Good 40% Increase 25% Dont Advertise Poor 60% 40 students $115,000 Good 40%

40 students $100,000

$21,000

Advertise

50 students $150,000

$58,500

20 students $0

$0

25 students $25,000

$2,500

$82,000 $69,000

20 students $15,000

$6,000 $75,000

Therefore the programme should be advertised.

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SECTION C

Answer to Question Three

(a)
Reconciliation Statement for July $ 56,000 16,000 8,000 48,000 7,300 14,000 5,080 13,200 0 6,600 4,000 10,000 85,580

Budgeted gross profit Sales price variance Sales volume profit variance Budgeted gross profit from actual sales Material price variance Material usage variance Labour rate variance Labour efficiency variance Variable overhead expenditure variance Variable overhead efficiency variance Fixed overhead expenditure variance Fixed overhead volume variance Actual gross profit Workings Budgeted sales Budgeted cost of sales Budgeted profit

A F A F F F F A F

$350,000 $294,000 $56,000 (or (1,400 x ($250 - $210))

Sales price variance = ($250 - $240) x 1,600 = $16,000 A Sales volume profit variance = (1,600 1,400) x ($250 - $210) = $8,000 F Material price variance = (7,300 x $20) - $153,300 = $7,300A Material usage variance = ((1,600 x 5) - 7,300) x $20 = $14,000 F Labour rate variance = 5,080 x ($10 - $9) = $5,080 F Labour efficiency variance = (1600 x 4) 5,080)) x $10 = $13,200 F Variable overhead expenditure variance = (5,080 x $5) - $25,400 = 0 Variable overhead efficiency variance = ((1,600 x 4) 5,080) x $5 = $6,600 F Fixed overhead expenditure variance = $70,000 - $74,000 = $4,000A Fixed overhead volume variance = ((1,600 1,400) x $50) = $10,000F $ 384,000 (153,300) (45,720) (25,400) (74,000) 85,580

Actual sales revenue Material cost Labour cost Variable overhead Fixed overhead Actual gross profit

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(b)
Total material cost variance: Budgeted material cost Actual material cost Material cost variance (890 x 5kg) x $20 = 4,375kg x $21.60 = $89,000 $94,500 $ 5,500 A

This can be analysed into planning and operational variances as follows: Planning variance Material price variance ((890 x 5kg) x ($20 - $20.90)) Operational variances Material price variance (4,375kg x ($20.90 $21.60)) Material usage variance ((890 x 5kg) 4,375) x $20.90 $3,062.50 A $1,567.50 F $5,500.00 A $4,005 A

(c)
The advantages of a standard costing system that uses planning and operational variances are: The use of planning and operational variances enables 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). Less time is spent on investigating variances that are uncontrollable and the demotivational effect of staff being held responsible for factors that they cannot influence is avoided. Operational managers 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 is being judged by factors he cannot control. The use of planning variances allows management to assess how effective the companys planning process has been. Where a revision of standards is required due to 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)

Without gymnasium and spa: = (40 x 360) = 14,400 = 80% = 11,520 = $250 = $2,880,000

Number of available room nights per annum Occupancy rate Occupied room nights per annum Average room rate Total revenue With gymnasium and spa: Occupied room nights (14,400 x 82%) Average room rate Total Revenue Incremental Revenue Incremental Costs: Employees (4 x $30,000) Overheads Incremental cash flows in Year 1 Cash Flows Taxation Year 1 $ 57,600 37,500 20,100 6,030

= 11,808 = $262.50 = $3,099,600 = $219,600

= ($120,000) = ($42,000) = $57,600

Net cash flows Tax Depreciation Taxable profit Taxation @ 30%

Year 2 $ 59,904 28,125 31,779 9,534

Year 3 $ 62,300 21,094 41,206 12,362

Year 4 $ 64,792 48,281 16,511 4,953

Tax Depreciation Year 1 $ 150,000 37,500 Year 2 $ 112,500 28,125 Year 3 $ 84,375 21,094 Year 4 $ 63,281 (15,000) 48,281

Tax WDV Residual value Tax Depreciation

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Net present value Year 0 $ (150,000) Year 1 $ 57,600 Year 2 $ 59,904 Year 3 $ 62,300 Year 4 $ 64,792 15,000 (3,015) (4,767) (3,015) (150,000) 54,585 52,122 (6,181) (4,767) 51,352 (2,476) (6,181) 71,135 (2,476) (2,476) Year 5 $

Net cash flows Residual value Tax payment Tax payment Net cash flow after tax Discount factor Present value

1.000 (150,000)

0.893 48,744

0.797 41,541

0.712 36,563

0.636 45,242

0.567 (1,404)

Net present value = $20,686

(b)
The post tax money cost of capital at which the hotel will be indifferent between accepting / rejecting the project is where the net present value is equal to zero i.e. the IRR of the project. If cash flows are discounted at 20% Year 0 $ (150,000) Year 1 $ 54,585 Year 2 $ 52,122 Year 3 $ 51,352 Year 4 $ 71,135 Year 5 $ (2,476)

Net cash flow after tax Discount factor Present value

1.000 (150,000)

0.833 45,469

0.694 36,173

0.579 29,732

0.482 34,287

0.402 (995)

Net present value = -$5,334 By interpolation 12% + 8% (20,686/(20,686+5,334)) = 18.36%

(c)
An alternative approach would be to express the cash flows in todays value terms and to discount the cash flows at the real cost of capital. The post tax money cost of capital is 12% and inflation is 4%. The real cost of capital can be calculated as:

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In this case : 1.12 / 1.04 = 1.0769 -1 = 7.69% The cash flows would be discounted at 7.69%. There are problem however in taking this approach when there are taxation implications. If there are any tax implications the tax cash flows would need to be treated separately. Capital allowances are based on original cost, rather than on replacement cost and do not change in line with changing prices. Similarly the residual value of the equipment is stated at Year 4 values and would need to be adjusted to present day values.

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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) examines candidates ability to calculate the effective rate of interest of accepting a cash discount and paying an invoice early. It also examines the ability to identify other methods that a supplier could use to reduce the level of outstanding trade receivables. examines candidates ability to apply the EOQ formula and to calculate the cost of holding and ordering the suggested level of stock. The question then requires candidates to consider whether it is worth accepting a bulk quantity discount for ordering stock above the EOQ. examines candidates ability to explain the benefits of using backflush accounting compared to a traditional cost accounting system in a company that operates just in time production and purchasing. examines candidates ability to identify and explain the advantages and disadvantages of zero based budgeting. examines candidates ability to apply activity based budgeting to a service department. examines candidates ability to use decision trees to evaluate a decision where there is uncertainty regarding expected cash flows.

(b)

(c)

(d)

(e) (f)

Section C Questions Three and Four - Compulsory

Question Three examines candidates ability to calculate variances including both planning and operational variances and, using these variances, to prepare a statement reconciling the budget gross profit to the actual gross profit. The advantages of identifying both planning and operational variances are also examined. Question Four, in part (a) examines candidates ability to calculate the net present value of a project involving the identification of relevant costs and calculation of the effect of inflation and taxation. Part (b) of the question examines candidates ability to calculate the IRR of a project. Part (c) examines the candidates understanding of the treatment of inflation in investment appraisal.

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