Operational Level Paper

P1 – Performance Operations
May 2013 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 August 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
$
Cash received from previous period 460,000
Sales for this budget period 5,400,000
5,860,000
Credit sales not paid until next period
($5,400,000 x 80% x 1/12) (360,000)
Total cash received 5,500,000

The correct answer is C.

 The Chartered Institute of Management Accountants 2013

1.2 Year 2, quarter 3 is period 7

Trend sales = 22,000 + 800 (7)

= 27,600 units

Adjusted for seasonal variations = 27,600 x 1.30 = 35,880 units

The correct answer is A.

1.3
Trend sales for quarter 2 year 1 = 22,000 x 800(2)
= 23,600 units

Actual sales for quarter 2 year 1 = 23,600 x 90%

= 21,240 units

Seasonal variation using additive model = 21,240 – 23,600

= - 2,360

The correct answer is B.

1.4 The correct answer is C.

1.5
80% of invoiced sales = $2,190,000 x 80% = $1,752,000
Outstanding trade receivables = $1,752,000 x 50/365
= $240,000
Interest at 12% per annum = $240,000 x 12%
= $28,800

The correct answer is A.

1.6
Deviation from
Squared Weighted
NPV Probability expected
deviation amounts
value
$m $m $m $m
2 30% -1.2 1.44 0.432,
3 20% -0.2 0.04 0.008
4 50% 0.8 0.64 0.320
0.760

The standard deviation is √0.760 = 0.871780 i.e. $871,780

P1 2 May 2013
1.7
Project Investment Net present Profitability Ranking
value index
$ million $ million
A 10.0 4.20 0.4200 2
B 40.0 6.10 0.1525 6
C 20.0 8.50 0.4250 1
D 40.0 13.70 0.3425 3
E 50.0 3.80 0.0760 7
F 20.0 4.90 0.2450 4
G 20.0 4.33 0.2165 5

Project Investment Net present Ranking

value
$ million $ million
C 20.0 8.50 1
A 10.0 4.20 2
D 40.0 13.70 3
F 10.0 2.45 4
80.0 28.85

The maximum net present value is $28.85million

1.8
(i) If operated for 3 years

Year Cash flow Discount factors Present value

$ $
0 (40,000) 1.000 (40,000)
1 16,800 0.893 15,002
2 18,000 0.797 14,346
3 24,000 0.712 17,088
NPV 6,436

(ii) If abandoned after 2 years

Year Cash flow Discount factors Present value

$ $
0 (40,000) 1.000 (40,000)
1 16,800 0.893 15,002
2 34,000 0.797 27,098
NPV 2,100

(iii) If abandoned after 1 year

Year Cash flow Discount factors Present value

$ $
0 (40,000) 1.000 (40,000)
1 41,600 0.893 37,149
NPV (2,851)

May 2013 3 P1
SECTION B

Answer to Question Two

(a)

Rationale
The question assesses learning outcome E1(a) explain the importance of cash flow and
working capital management. It examines candidates’ ability to explain the meaning of an
aggressive policy in respect of the investment in and financing of working capital.

Suggested Approach
Candidates should clearly explain what is meant by an aggressive policy for both the
investment in and the financing of working capital.

Investment in working capital is normally in inventory, accounts receivable and cash or highly
liquid, short-term assets. These are partly financed by accounts payable and overdraft. In
conditions of uncertainty, companies must hold some minimum level of cash and inventory.
With an aggressive working capital investment policy, a company would hold minimal safety
inventories. Such a policy would minimise costs but it could reduce sales as the company
could not respond rapidly to changes in demand. Generally, the expected return is higher
under an aggressive policy but the risks are also greater. In cash management, an aggressive
policy involves holding low levels of cash which would expose the company to the risk that
they could not meet payments when they become due. In the case of accounts receivable
and account payable, an aggressive policy would mean low levels of receivables in relation to
sales and high levels of accounts payable.

Working capital financing policy decisions involve the determination of the mix of long-term
versus short-term debt. Since the yield curve is usually upward sloping, short-term debt
typically costs less than long-term debt. With an aggressive working capital financing policy,
the company finances part of its permanent asset base with short term debt. This policy
generally provides the highest expected return but it is very risky due to the frequent need to
refinance or if the company relied on an overdraft, the risk of withdrawal of that facility at short
notice.

(b)

Rationale
The question assesses learning outcome E1(g) analyse the impact of alternative policies for
stock management. It examines candidates’ ability to compare and contrast the economic
order quantity model and a JIT approach to inventory management.

Suggested Approach
Candidates should clearly explain how both systems operate and highlight the differences
between the two approaches.

The economic order quantity (EOQ) is based on the assumption that demand for the period is
known and constant. Therefore the optimum order quantity will be determined by the costs
that are affected by either the quantity of inventory held or the numbers of orders placed. A

P1 4 May 2013
higher quantity ordered each time will mean fewer orders each year and therefore a reduction
in ordering costs. However, this will also result in higher average inventory levels which
results in an increase in holding costs. The EOQ therefore is a trade-off between the cost of
carrying high inventory against the cost of placing more orders. The optimum order size is the
quantity that will result in the total of the ordering and holding costs being minimised.

In contrast, a just in time (JIT) inventory management system is based on actual demand
rather than an estimated demand level. It seeks to ensure the delivery of materials
immediately before their use. By ensuring that production and purchases are timed to
coincide with demand the determination of economic order quantities and re-order points is
no longer required. JIT purchasing involves having an arrangement with a small number of
key suppliers where the supplier is able to provide raw materials or components on demand
or with a very short lead time. This means that the company can hold zero or very little
inventory thus reducing the costs involved with holding inventory including storage costs,
insurance costs and obsolescence costs. The costs involved with ordering inventory may
however increase since JIT results in more frequent deliveries from suppliers. This contrasts
with an EOQ system where the amount of inventory held is determined by the EOQ formula
which aims to balance the costs of holding and ordering inventory. The use of a small number
of suppliers however should also reduce administrative costs for the company and may result
in greater quantity discounts. The successful operation of a JIT purchasing system involves
the company working together with their suppliers to ensure that they can rely on receiving
supplies at the right time and at the required quality level. This should also result in a
reduction in quality control costs for the company. Quality standards should also improve
resulting in lower wastage in the production process and hence reduced wastage costs.

(c)

Rationale
The question assesses learning outcome D1(c) analyse risk and uncertainty by calculating
expected values and standard deviations together with probability tables and histograms. It
examines candidates’ ability to calculate the expected values of possible outcomes using joint
probabilities.

Suggested Approach
Candidates should firstly calculate the profit for each of the combinations of number of units
sold, contribution and fixed costs. They should then calculate the joint probability of these
outcomes and multiply the profit by the joint probability to calculate the expected value. In
part (ii) they should sum the probabilities of the outcomes which give a profit, loss and break-
even.

May 2013 5 P1
 (i)

Number of Contribution Fixed Profit Joint Probability Expected

units per unit costs $ value
sold $ $
100,000 $7 400,000 300,000 0.06 18,000
(0.4 x 0.5 x 0.3)
100,000 $7 500,000 200,000 0.14 28,000
(0.4 x 0.5 x 0.7)
100,000 $5 400,000 100,000 0.06 6,000
(0.4 x 0.5 x 0.3)
100,000 $5 500,000 0 0.14 0
(0.4 x 0.5 x 0.7)
80,000 $7 400,000 160,000 0.09 14,400
(0.6 x 0.5 x 0.3)
80,000 $7 500,000 60,000 0.21 12,600
(0.6 x 0.5 x 0.7)
80,000 $5 400,000 0 0.09 0
(0.6 x 0.5 x 0.3)
80,000 $5 500,000 (100,000) 0.21 (21,000)
(0.6 x 0.5 x 0.7)
1.00 58,000

(ii)

The probability of a profit is 56% ((0.06 + 0.14 + 0.06 + 0.09 + 0.21) x 100%)
The probability of a loss is 21% (0.21 x 100%)
The probability of break-even is 23% ((0.14 + 0.09) x 100%)

(d)

Rationale
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 a period using absorption costing where the
production volume and sales volume are different. Part (ii) requires candidates to reconcile
the difference in profit for the period using marginal and absorption costing.

Suggested Approach
(i) Candidates should firstly calculate the gross profit per unit based on the budgeted fixed
overhead absorption rate. This should then be multiplied by the number of units sold.
The under/over absorption should then be calculated based on the number of units
produced multiplied by the fixed overhead absorption rate, less the actual overhead
incurred. Overheads under absorbed should be deducted from the gross profit and over
absorbed overhead should be added back to the gross profit.
(ii) Candidates should calculate the difference between the absorption costing profit for
April calculated in (i) and the marginal costing profit. The difference should then be
reconciled by taking the movement in inventory multiplied by the budgeted fixed
overhead absorption rate.

P1 6 May 2013
(i) Absorption costing profit:

$
21,000 units x $3.50 per unit 73,500
Plus: over absorption of fixed overheads
(23,000 units x $2.50) – ($52,000) 5,500
79,000

(ii) Marginal costing profit:

$
Contribution (21,000 units x $6) 126,000
Fixed production overheads 52,000
74,000

Difference in profit is $5,000

Opening inventory 1,000 units

Closing inventory 3,000 units
Inventory increase 2,000 units

Fixed overhead absorption rate = $2.50 per unit

Difference in profit = 2,000 units x $2.50 = $5,000

Inventory increased, therefore the absorption costing profit is $5,000 higher than the marginal
costing profit.

(e)

Rationale
The question assesses learning outcome E2(d) illustrate numerically the financial impact of
short-term funding and investment methods. It examines candidates’ ability to calculate the
yield to maturity on a bond given the current market value and the coupon rate of the bond.

Suggested Approach
Candidates should identify the cash flows if the bond was purchased today and then held
until maturity. They should then discount the cash flow using two different discount rates to
derive a positive and a negative net present value. Candidates should then use interpolation
to calculate the internal rate of return of the cash flows.

Year(s) Description Cash flow Discount Present Discount Present

factor value factor Value
$ (6%) $ (8%) $
0 Purchase (106) 1.000 (106.00) 1.000 (106.00)
1-5 Interest 8 4.212 33.70 3.993 31.94
5 Redemption 100 0.747 74.70 0.681 68.10
NPV 2.40 (5.96)

By interpolation

6% + (($2.40 /($2.40 + $5.96)) x 2) = 6.57%

The bond’s yield to maturity is 6.57%

May 2013 7 P1
(f)

Rationale
The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It
examines candidates’ ability to explain the potential benefits of using an activity-based
budgeting system rather than an incremental budgeting system.

Suggested Approach
Candidates should clearly explain how each of the budgeting systems operates highlighting
the potential benefits of using an activity-based budgeting system.

Incremental budgeting is based on what has happened in the past therefore the allocation of
resources to specific activities is not justified. It is assumed that activities will continue merely
because they were undertaken in the previous year. The result of this is that excessive costs
included in the previous budget will be carried forward into the next budget.

Under an activity based budgeting system, resource allocation is linked to the strategic plan
and is prepared after considering alternative strategies. This approach ensures that new
activities that are required to meet the company’s strategic objectives are included in the
budget.

Activity based techniques, including activity based budgeting, focus on the outputs of a
process rather than the inputs to the process. In contrast an incremental budgeting system
focuses on the inputs to the process. An activity based approach provides a clear framework
for understanding the link between costs and the level of activity. It allows the ranking of
activities and the determination of how limited resources should be allocated over competing
activities.

The focus on activities and the drivers of the cost of these activities enables a more informed
and accurate budget to be set. Variance analysis will also be more useful and therefore it will
ensure greater control of overhead costs which are an increasingly large proportion of total
product costs.

Activity based budgeting allows the identification of value added and non-value added
activities and ensures that cuts are made to non-value added activities. Under an incremental
budget the tendency is to make cuts across the board. Activity based budgeting is also useful
for the review of capacity utilisation. If it is known that the resources devoted to a particular
activity are greater than those currently required then these resources can be reduced or
redeployed.

P1 8 May 2013
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 variances to
enable the reconciliation of budgeted and actual contribution. Part (b), (c) and (d) assess
learning outcome A1(f) interpret material, labour, variable overhead, fixed overhead and
sales variances, distinguishing between planning and operational variances. Part (b)
examines candidates’ ability to separate variances into their planning and operational
elements. Part (c) examines candidates’ ability to explain the importance of planning and
operational variances. Part (d) examines candidates’ ability to interpret variances,
considering factors such as their possible interrelationship and significance.

Suggested Approach
In part (a) candidates should firstly calculate the budgeted contribution and the actual
contribution for the period. They should then calculate each of the variances for sales,
material and labour. They should then prepare a reconciliation statement starting with the
budgeted contribution and adding the favourable sales volume contribution variance to
calculate a revised standard contribution. They should then show each of the individual
variances to reconcile this standard contribution to the actual contribution. In part (b)
candidates should calculate the material usage planning variance and the material usage
operational variance. In part (c) candidates should clearly explain why calculating planning
and operational variances gives better information for planning and control purposes. In part
(d) candidates should explain two factors that should be taken into account before beginning
the process of investigating a variance.

(a)
Statement to reconcile budget and actual contribution for April
$ $

Budgeted contribution 390,000

Sales volume contribution variance

54,600 F
(2,850 units - 2,500 units) x $156

Standard contribution on actual sales volume 444,600

Other variances:
Selling price variance
42,750 A
2,850 units x ($385 - $400)
Cost variances:
Direct material price variance
49,800 F
24,900 kg x ($20.00 – $18.00)
Direct material usage variance
42,000 A
((2,850 x 8 kg) – 24,900 kg) x $20.00
Direct labour rate variance
28,200 A
18,800 x ($14.00 - $15.50)
Direct labour efficiency variance
23,800 A
((2,850 x 6hr) – 18,800) x $14.00
Actual contribution
357,650

May 2013 9 P1
Workings:

Budgeted contribution for the period

$
Budgeted Contribution 2,500 units x $156 390,000

Actual contribution for the period

$ $
Sales 2,850 units x $385 1,097,250
Direct materials 24,900 kg @ $18 448,200
Direct labour 18,800 hours @ $15.50 291,400
Actual Contribution 357,650

(b)

$ $
Direct material usage planning variance
71,250 A
(2,850 x (8kg – 9.25kg)) x $20
Direct material usage operational variance
29,250 F
((2,850 x 9.25 kg) – 24,900 kg) x $20.00

Total direct material usage variance 42,000 A

(c)
The calculation of planning and operational variances is useful for the following reasons:

• The use of planning and operational variances will enable management to draw a
distinction between variances caused by factors uncontrollable by the business and
planning errors (planning variances) and variances caused by factors that are within
the control of management (operational variances). In this case they can separate the
materials usage variance caused by the substitute material (planning variance) and
the variance as a result of efficient or inefficient production.

• The 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 performance is being judged according to factors
outside the manager’s control.

• 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 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.

• The information used in setting the ex-post standards can be used in future budget
periods. The planning variances may also indicate problems in the standard setting
process and the reasons for this can be identified and improvement made to the
process.

P1 10 May 2013
(d)
The size of the variance
It is not possible to budget with complete accuracy therefore a company will need to decide
how large a variance needs to be before it is considered abnormal and worthy of
investigation.

The likelihood of the variance being controllable

Some variances particularly those that arise as a result of external factors may be
uncontrollable and therefore the costs of the investigation would result in no benefit to the
company.

The likely cost versus the potential benefits of the investigation

The company will need to weigh up the costs of the investigation versus the benefit from
avoiding the variance occurring in the future.

The interrelationship between variances

A favourable variance in one area may result in an adverse variance in another area. For
example, the decision to use lower quality material may result in a favourable material price
variance but an adverse material usage variance.

May 2013 11 P1
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 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 net
present value to a change in passenger numbers. Part (c) 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 benefits of using sensitivity analysis in project appraisal.

Suggested Approach
In part (a) candidates should firstly calculate the passenger numbers for each year and the
passenger fare for each year after applying the inflation rate. These can then be multiplied
together to derive the total cash inflow each year. They should then deduct the payment to
the government and the other fixed costs after adjusting these for inflation. The tax
depreciation and tax payments should then be calculated. The total cost of the investment,
the residual value and the working capital cash outflows and inflows 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 take
the cash inflows from passenger fares and adjust these for tax. The cash inflows after tax
should then be discounted at the discount rate of 12% to calculate the present value of the
passenger revenue. The sensitivity of the net present value to a change in passenger
numbers can then be calculated by dividing the NPV of the project by the present value of the
passenger revenue. In part (c) candidates should clearly explain the benefits of carrying out a
sensitivity analysis before making investment decisions.

(a)
Cash inflows years 1-6
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Passenger 170.0 175.1 180.4 185.8 191.3 197.1
numbers
(millions)
Passenger $10 $10.40 $10.82 $11.25 $11.70 $12.17
fares
Total cash $1,700m $1,821m $1,952m $2,090m $2,238m $2,399m
inflow

Cash flows
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
$m $m $m $m $m $m
Total cash 1,700 1,821 1,952 2,090 2,238 2,399
inflow
Payment to (1,000) (1,000) (1,000) (1,000) (1,000) (1,000)
government
Other fixed (720) (749) (779) (810) (842) (876)
costs
Net cash flow (20) 72 173 280 396 523

P1 12 May 2013
Taxation Depreciation
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
$m $m $m $m $m $m
Tax written down 400 300 225 469 352 264
value
Tax depreciation (100) (75) (56) (117) (88) (164)

Taxation
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
$m $m $m $m $m $m
Net cash flows (20) 72 173 280 396 523
Tax (100) (75) (56) (117) (88) (164)
Depreciation
Taxable profit (120) (3) 117 163 308 359
Taxation @ 36 1 (35) (49) (92) (108)
30%

Net present value

Year 0 Year 1 Year 2 Year Year 4 Year Year Year
3 5 6 7
$m $m $m $m $m $m $m $m
Investment / (400) (300) 100
residual
value
Working (80) 80
capital
Net cash 0 (20) 72 173 280 396 523
flows
Tax 0 18 1 (18) (25) (46) (54)
payment
Tax 0 0 18 0 (17) (24) (46) (54)
payment
Net cash (480) (2) 91 (145) 238 326 603 (54)
flow after
tax
Discount 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452
factors @
12%
Present (480) (2) 73 (103) 151 185 306 (24)
value

Net present value = $106m

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

May 2013 13 P1
(b)

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

$m $m $m $m $m $m $m
Total cash 1,700 1,821 1,952 2,090 2,238 2,399
flow from
passenger
revenue
Taxation (510) (546) (586) (627) (671) (720)
@30%
Tax (255) (273) (293) (314) (336) (360)
payment
Tax (255) (273) (293) (313) (335) (360)
payment
Net cash 1,445 1,293 1,386 1,483 1,589 1,704 (360)
flow after
taxation
Discount 0.893 0.797 0.712 0.636 0.567 0.507 0.452
factor
Present 1,290 1,031 987 943 901 864 (163)
value

Present value of revenue = $5,853

Sensitivity of the proposed investment to a change in passenger numbers is therefore:

$106m / $5,853m = 1.8%

(c)
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. In this case the project is
highly sensitive to a change in passenger numbers. A 1.8% change in the passenger
numbers would result in the project no longer being viable. The company may decide that this
is too high a risk to take and not tender for the franchise.

P1 14 May 2013