Operational Level Paper

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

1.2

$40,000 x 3.791 = $151,640 $50,000 / $151,640 = 0.3297 = 33.0% The correct answer is C.

1.3

$10,500 / 1.05 = $10,000 $13,390 / 1.03 = $13,000 Using the high-low method ($13,000 $10,000) / (8,000 6,000) = $ 1.50 per unit At inflation index of 1.06 = $1.50 x 1.06 = $1.59 The correct answer is B.

1.4

The sales price variance is: ($6.60 $6.00) x 15,750 = $9,450 Favourable The correct answer is B.

1.5

The sales volume contribution variance is: (15,750 15,000) x $2.00 = $1,500 Favourable Budgeted sales were 15,750/1.05 = 15,000 units The correct answer is A.

November 2010

P1

1.6

Materials Usage 12,000 units x 4kg = 48,000kg Opening inventory = 3,000kg Closing inventory = 12,000/12 x 4kg x 1.1 = 4,400kg

Material Purchases Budget (kg) Material usage Plus closing inventory Less opening inventory 48,000kg 4,400kg (3,000)kg 49,400kg

Material Purchases Budget ($) 49,000kg x $8 = $392,000 400kg x $7.50 = $3,000 Total $395,000

1.7

Yield to maturity of similar bonds is 3%, therefore use 3% as the discount rate.

Year(s) 1-4 4 0

Description Interest Redemption Market value

Cash flow $ 6 100

Discount Factor (3%) 3.717 0.888

Present Value $ 22.3 88.8 111.1

The current expected market value of the bond is therefore $111.10

P1

November 2010

1.8 Probability Project A $000 Preferences 1 Preferences 2 Preferences 3 Expected Value 0.3 0.2 0.5 400 500 700 570 Project B $000 800 300 200 400 Project C $000 500 600 400 470

Project A is the best choice (without the benefit of perfect information) as it has the highest expected value (EV) of the NPV of $570k. With perfect information: If market research say preferences 1: select B and earn $800k probability 0.3 If market research say preferences 2: select C and earn $600k probability 0.2 If market research say preferences 3: select A and earn $700k probability 0.5 EV (with perfect information) = ($800k x 0.3) + ($600k x 0.2) + ($700k x 0.5) = $710k Value of perfect information is $710k $570k = $140,000

November 2010

P1

SECTION B
Answer to Question Two

(a)
There are three main stages in the budget setting process in a zero based budgeting system: Description of activities in decision packages The activities that are being proposed are described in a decision package. There will often be more than one decision package proposed e.g. one based on providing services at a minimum level and others at incremental levels above the minimum. Some of these packages will be mutually exclusive and will require management to select the best solution to the issue involved. For example options for debt collection could be in-house or outsourced solutions and a decision package will be needed for each. Evaluation and ranking Each decision package is evaluated. Its costs are compared to its benefits and net present values or other measures calculated. The non-financial aspects are also considered as some packages might have legal obligations attached e.g. updating accounting systems. Management will rank each package based on the benefits to the organisation. They may decide to reject packages even though the activity was undertaken last year. In this way the organisation is said to be starting from a zero base with each package given due consideration. Allocation of resources Once management decide which packages to accept a budget can be prepared for the resources required. This should include costs, revenues and other resource allocations necessary.

(b)
(i) If AP applied the maximin decision criterion it would order at the medium level. The worst result is a profit of $300 and this is the best worst result.

(ii)

If AP applied the maximax decision criterion it would order at the high level, since the maximum return of $600 is to be gained at this level.

P1

November 2010

(iii) Minimax Regret Table Demand level High Good Average Poor 0 $200 $400 Level of order Medium $300 0 0 Low $500 $300 $100

The maximum regret if AP orders at the high level is $400 The maximum regret if AP orders at the medium level is $300 The maximum regret if AP orders at the low level is $500 Therefore if AP wants to minimise the maximum regret it will order at the medium level.

(c)
(i) Expected values represent a long-run average outcome but decisions should not be made solely on expected values as they do not take account of the attitude to risk. In addition to expected value decision makers should consider measures of dispersion and the probability distribution of the outcomes of the various courses of action. A risk neutral decision maker will tend to ignore risk and choose the course of action that gives the highest expected value. A risk seeker is a decision maker that is interested in the best possible outcomes no matter how unlikely they are to occur. They are not put off with the low probability of an outcome but choose to focus on potential large returns instead. A risk seeker faced with a choice between two alternatives with identical expected values will choose the riskier investment with the highest possible outcome and ignore the downside risk. These decision makers are often viewed as optimistic. A risk averse decision maker is one that focuses on the poor results and seeks to avoid high degrees of risk. A risk averse decision maker, faced with a choice between two alternatives with identical expected values will choose the less risky alternative. These decision makers are often viewed as pessimistic.

(ii)

(d)
(i) Trade receivable at end of the year = $492,750 / 365 x 60 = $81,000 Bad debts = ($492,750 $81,000) x 5% = $20,587.50 Cash collected = $83,000 + $492,750 - $81,000 - $20,587.50 = $474,162.50

November 2010

P1

(ii) Examiners note: the question asks for two methods. Examples of methods that would be rewarded are given below. To reduce the incidence of bad debts RX could: Ensure that all new customers have a full credit rating check before the granting of credit. This can be achieved by the use of credit rating organisations or by the taking of references from the prospective customer. Carry out routine credit ratings checks on existing customers, in particular the slow payers. Ensure that debt collection procedures are efficient in chasing up late payers. Charge penalties for late payment or offer discounts to encourage customers to pay early. Ensure that credit limits are allocated to customers and enforced by the credit control department. No sales should be allowed if credit limits have been exceeded, effectively putting the account on stop should this happen.

(e)
The returns given are over different time periods. We need to calculate an annual rate to enable the investments to be compared. The annual return on the deposit account is (1.011) = 1.044731 or 4.47% per annum. The annual return on the bond is 2.5% x 2 = 5% per annum. The deposit account has two main types of risk. Firstly, the interest rate could change and this will introduce variability in the return, although this is likely to reflect market rates. Secondly, after the world banking crisis in 2008/2009 it is now conceivable for a bank to fail. This introduces another, albeit small, element of risk in that there is liquidation risk of the bank itself. A government bond is generally considered to be risk free. However the bonds are fixed dated and cannot be cashed in early. Therefore the bonds lack flexibility. Although the return is fixed, market interest rates may rise with the result that the return on the bond is below market rates. If they are a tradable item, the bonds could be sold to another investor through a broker. However this would incur sales costs and expose the company to price movements which will reflect the change in market interest rates. The choice of investment will depend on the companys attitude to risk and whether they prefer to have a fixed return. The bond currently offers a higher return but may not continue to do so in the future. It also offers less risk as the return is guaranteed.
4

P1

November 2010

(f)

The number of days for each component of the working capital cycle is as follows: Calculation 85/915 x 365 90/1215 x 365 185/(0.80 x 1,400) x 365 125/(0.95 x 915) x 365 Days 33.9 27.0 60.3 -52.5 68.7

Component Raw material inventory days Finished goods inventory days Receivable days Payables days Working capital cycle

The working capital cycle is therefore 68.7 days.

November 2010

P1

SECTION C

Answer to Question Three

(a)
Hip $ Fee charged to patient Surgeons fee Fee for follow-up consultations Medical supplies Overhead cost Profit per procedure Follow-up consultations working: Hip - $300 per consultation x 8% = $24 Knee - $300 per consultation x 5% = $15 Shoulder - $300 per consultation x 10% = $30 Overhead cost workings: Hip $ Sales revenue Overheads Overheads / sales revenue Cost per procedure $8,000 x 600 = $4,800,000 Knee $ $10,000 x 800 = $8,000,000 Shoulder $ $6,000 x 400 = $2,400,000 Total $ $15,200,000 $9,880,000 65% $8,000 x 65% $5,200 $10,000 x 65% $6,500 $6,000 x 65% $3,900 8,000 (1,200) (24) (400) (5,200) 1,176 Knee $ 10,000 (1,800) (15) (200) (6,500) 1,485 Shoulder $ 6,000 (1,500) (30) (300) (3,900) 270

P1

November 2010

(b)
Activity Theatre preparation for each session Operating theatre usage Nursing and ancillary services Administration Cost Driver Number of theatre preparations Procedure time In-patient days Sales revenue Number of procedures Overheads $000 864 No. of cost drivers (600/2 + 800/1 + 400/4) = 1,200 Cost per driver $ $720 per theatre preparation

1,449

5,428

1,216

(600 x 2hrs) + (800 x 1.2hrs) + (400 x 1.5hrs) = 2,760 (600 x 3) + (800 x 2) +(400 x 1) = 3,800 15,200,000

$525 per hour

$1,428 per day

Other overheads

923

(600 + 800 + 400) = 1,800

$0.08 per $ sales revenue $513 per procedure

Overhead cost per procedure Theatre preparation for each session Operating theatre usage Nursing and ancillary services Administration Other overheads Total overhead cost per procedure

Hip $720/2 = $360 ($525 x 2) = $1,050 ($1,428 x 3) =$4,284 (8,000 x $0.08) = $640 $513 $6,847

Knee $720/1 = $720 ($525 x 1.2) =$630 ($1,428 x 2) =$2,856 (10,000 x $0.08) = $800 $513 $5,519

Shoulder $720/4 = $180 ($525 x 1.5) = $788 ($1,428 x 1) =$1,428 (6,000 x$ 0.08) = $480 $513 $3,389

Hip $ Profit per procedure per (a) above Add back overhead cost per (a) above Less overhead cost using ABC Profit per procedure using ABC 1,176 5,200 (6,847) (471)

Knee $ 1,485 6,500 (5,519) 2,466

Shoulder $ 270 3,900 (3,389) 781

(c)

Under an activity based costing (ABC) system the various support activities that are involved in the process of making products or providing services are identified. The cost drivers that cause a change to the cost of these activities are also identified and used as the basis to attach activity costs to a particular product or service. Through the tracing of costs to product in this way ABC establishes more accurate costs for the product or service.

November 2010

P1

The identification of cost drivers provides information to management to enable them to take actions to improve the overall profitability of the company. Cost driver analysis will provide information to management on how costs can be controlled and managed. Variance analysis will be more useful as it is based on more accurate costs. The establishment of more accurate procedure costs should also help hospital managers to assess procedure profitability and make better decisions concerning pricing and procedure mix decisions. In the above example, the use of an ABC system has resulted in different levels of profit for each of the procedures. It is apparent that the knee replacement procedure and the shoulder replacement procedure are more profitable than was thought under the absorption costing system. The shoulder replacement procedure however is making a significantly lower margin that the knee replacement procedure. The hip replacement procedure is now shown to be loss making. This additional information will enable management to make important decisions regarding pricing of the procedures. The price of the knee replacement procedure could potentially be reduced to make it more competitive and increase volumes. The price of both the hip replacement and shoulder replacement procedures could be increased to make these procedures more profitable. Before making any decision regarding pricing however they would need to review market prices and consider the effect any adjustment would have on the companys market position. If market conditions would not allow an increase in price of both hip and shoulder replacement procedures they could look at ways to reduce the costs of these procedures. ABC gives more detailed information about how costs are incurred and the potential for cost reduction by reducing activity levels. Alternatively they may want to consider whether to discontinue the hip replacement procedures altogether and replace them with a more profitable use of resources. This decision may not be appropriate however if part of the marketing strategy is for the company to provide a range of complementary procedures. An activity based costing system can be extended beyond product and service costing to a range of cost management applications known as activity based management. These include the identification of value added and non value added activities and performance management in terms of measuring efficiency through cost driver rates.

P1

10

November 2010

Answer to Question Four

(a)

Project 1 Internal Failure Cost Savings: Current Expected Value ($300k x 0.5) + ($500k x 0.3) + ($700k x 0.2) = $440k Expected Savings Year 1 = $440k x 80% x 1.04 =$366k External Failure Cost Savings: Current Expected Value ($1,300k x 0.6) + ($1,900k x 0.3) + ($3,000k x 0.1) = $1,650k Expected Savings Year 1 = $1,650k x 80% x 1.04 = $1,373k Raw Material Cost: Expected savings Year 1 = 50,000 x $62 x 1.04 =$3,224k Net cash flows Year 1 $366,080 + $1,372,800 + $3,224,000 = $4,963k

(b)
(i)

Project 2 Component Costs: Expected savings Year 1 = 50,000 x $110 x 1.04 =$5,720k Depreciation per annum = $15,000,000 / 5 = $3,000k Additional fixed costs (excluding depreciation) per annum = $5,000k - $3,000k $2,000k

Net Present Value Year 0 $000 Initial (15,000) Investment Working (1,000) capital Cost savings Fixed costs Net cash flows Discount Factor @ 8% Present value (16,000) 1.000

Year 1 $000

Year 2 $000

Year 3 $000

Year 4 $000

Year 5 $000

1,000 5,720 (2,000) 3,720 0.926 5,949 (2,000) 3,949 0.857 6,187 (2,000) 4,187 0.794 6,434 (2,000) 4,434 0.735 6,691 (2,000) 5,691 0.681

(16,000)

3,445

3,384

3,324

3,259

3,876

Net present value = $1,288k

November 2010

11

P1

(ii) Year 0 $000 (16,000) 1.000 Year 1 $000 3,720 0.893 Year 2 $000 3,949 0.797 Year 3 $000 4,187 0.712 Year 4 $000 4,434 0.636 Year 5 $000 5,691 0.567

Net cash flows Discount Factor @ 12% Present value

(16,000)

3,322

3,147

2,981

2,820

3,227

Net present value = - $503k

IRR NPV at 8% = $1,288k NPV at 12% = -$503k By interpolation 8% + (1,288/(1,288 + 503)) x 4% =10.9%

(c)
The general rule in discount cash flow analysis where projects are mutually exclusive is that the project with the highest net present value should be selected. In this case project 1 has a NPV of $1,338K and project 2 has a NPV of $1,288K. Therefore on the basis on NPV alone project 1 should be selected. Project 2 requires an investment of $16m while project 1 requires an investment of $20m. While project 2 has a marginally lower NPV than alternative 1, if the additional $4m of funds can be invested in other projects with NPVs in excess of this difference, it would be worthwhile investing in project 2. The company directors will also have to consider the risk of the two projects and other nonfinancial factors.

(d)
The IRR measures the project return as a percentage whereas NPV measures the absolute amount. This can result in a problem if the IRR is used to select projects where the projects are mutually exclusive. Decisions based on IRR may result in the selection of a project with a lower investment and a higher return, when it may be preferable to invest a greater sum which generates a lower percentage return but produces a greater absolute amount. Where projects are mutually exclusive NPV should be used to select projects. Even if mutually exclusive projects have the same initial investment, NPV and IRR can give conflicting results due to the assumption regarding the reinvestment of surplus cash flows generated by an investment. The assumption if the NPV method is adopted is that the cash flows generated by an investment will be reinvested at the cost of capital. The IRR method assumes that cash flows generated by the investment will be reinvested at the IRR of the original project. IRR may favour an investment with high early cash flows, reinvested at the IRR, while NPV may prefer a different project with later cash flows. The NPV ranking of the projects depends on the discount rates used. When the discount rate exceeds a certain level the choice of projects will change and the conflict will no longer exist.

P1

12

November 2010

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 B3(b) apply alternative approaches to budgeting. It examines the candidates ability to explain the different stages in a budget setting process for a company that uses zero based budgeting. The question 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 apply various decision making criterion to a particular decision. The question 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 effect that a decision makers attitude to risk will have on the chosen decision. The question assesses learning outcome E1(e) analyse trade debtor and creditor information. Part (i) of the question examines candidates ability to calculate expected cash receipts from credit customers given information relating to bad debts and trade receivable days. Part (ii) of the question examines candidates ability to describe methods that a company could use to reduce the occurrence of bad debts. The question assesses learning outcome E2(b) identify alternatives for investment of short-term cash surpluses. It examines candidates ability to compare two potential short term Investment opportunities and explain the advantages and disadvantages of each. The question assesses learning outcome E1(b) interpret working capital ratios for business sectors. It examines candidates ability to calculate working capital ratios and the working capital cycle.

(b)

(c)

(d)

(e)

(f)

Section C Questions Three and Four - Compulsory

Question Three Part (a) of 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 cost of a service using a traditional method of overhead absorption. Part (b) assesses learning outcome A1(c) discuss activity-based costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting. It requires candidates to be able to apply activity based costing to the calculation of a service costs. Part (c) assesses learning outcome A1(c) discuss activitybased costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting. It

November 2010

13

P1

examines candidates ability to explain the potential benefits of the information for management decision making.

Question Four Parts (a) and (b) of the question assess learning outcomes C1(a) explain the processes involved in making long-term decisions and C2(a) evaluate project proposals using the techniques of investment appraisal. They examine candidates ability to identify relevant costs and calculate the net present value and IRR of a project. Part (c) of the question assesses learning outcome C2(a) evaluate project proposals using the techniques of investment appraisal. It examines candidates ability to evaluate two investment projects based on their NPV and IRR. Part d) of the question assesses learning outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. It requires candidates to discuss the reasons why conflicts arise between the ranking of projects based on their IRR and NPV.

P1

14

November 2010