Operational Level Paper

P1 – Performance Operations
May 2012 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 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.

1.1 The correct answer is D.

1.2 The correct answer is A.

1.3
Variable costs per unit =($290,000 – $200,000) / (100,000 – 64,000)
= $2.50
Fixed costs =$290,000 – (100,000 x $2.50)
= $40,000

At an activity level of 85,000 units, distribution costs will therefore be:

(85,000 x $2.50) + $40,000 = $252,500

May 2012 1 P1
 The correct answer is A.

1.4
Accounts receivable days (10 /48) x 365 = 76.0

Inventory days (8/(48 x 0.6)) x 365 = 101.4

Accounts payable days (5/(48 x 0.6)) x 365 = (63.4)

114.0

The cash operating cycle is 114 days.

The correct answer is B.

1.5 Annual interest = ($250,000 x 80%) x 10% = $20,000

The correct answer is C.

1.6 Payment will be made 38 days early.

Number of compounding periods = 365/38 = 9.60526

9.60526
1+ r = (1.00/0.97)

1+ r = 1.3399

The effective annual interest rate of the early settlement discount is 34.0%

1.7 The abandonment decision should be based on future cash flows:

Year Cash flow Discount factor Present value

$ $
1 (90,000) 0.893 (80,370)
2 60,000 0.797 47,820
3 40,000 0.712 28,480
(4,070)

As the net present value of the future cash flows is negative the project should be
abandoned.

1.8

(i) The production budget for Product R for next year will be:

units
Closing inventory 6,000 x 0.90 5,400
Plus: sales 80,000
85,400
Less opening inventory (6,000)
Production required 79,400

P1 2 May 2012
(ii) The purchases budget for Material T for next year will be

kg
Closing inventory 75,000
Plus: production 79,400 units x 6 kg 476,400
551,400
Less opening inventory (60,000)
Purchases required 491,400

May 2012 3 P1
SECTION B

Answer to Question Two

(a)

Rationale
The question assesses learning outcome A1(f) interpret material, labour, variable overheads,
fixed overheads and sales variances, distinguishing between planning and operational
variances. It examines candidates’ ability to calculate material mix and material yield
variances.

Suggested Approach
In part (i) candidates should calculate the mix variance by comparing the actual quantity at
the standard mix with the actual quantity at the actual mix. The variance calculated in litres for
each of the chemicals should then by multiplied the standard cost per litre to calculate the
variance for each chemical. These should then be added together to calculate the total mix
variance. In part (ii) the standard litres of input per litre of output should be multiplied by the
actual output in litres. This should then be compared to the actual litres input. The resultant
variance in litres should be multiplied by the weighted average cost per litre of input to
calculate the yield variance.

(i)

Material mix variance

Actual input Actual input Variance Standard Variance
@standard @ actual mix (000 litres) cost $000
mix (000 litres) $
(000 litres)
Chemical A 1,791 2,144 353 A 0.60 211.8 A
Chemical B 1,074 824 250 F 1.40 350 F
Chemical C 895 792 103 F 1.00 103 F
3,760 3,760 241.2 F

Or alternatively:

Weighted average cost per litre of input

$0.97/1.05 litres = $0.9238

Material mix variance

Actual input Actual input @ Variance Standard cost Variance
@standard mix actual mix (000 litres) difference $000
(000 litres) (000 litres) $
Chemical A 1,791 2,144 353 (0.60 – 0.9238) 114.3 F
Chemical B 1,074 824 250 (1.40 – 0.9238) 119.1 F
Chemical C 895 792 103 (1.00 – 0.9238) 7.8 F
3,760 3,760 241.2 F

(ii)

P1 4 May 2012
Material yield variance
Standard litres of input per litre of output = 1.05 litres
3,300k litres output x 1.05 litres = 3,465k litres input
Actual usage = 3,760k litres
Variance = 295k litres A
Standard cost per litre = $0.9238
Variance = 295k litres x $0.9238 = $272.5k A

Or alternatively:
3,760k litres should yield 3,760/1.05 = 3,580.95k litres
Actual yield = 3,300k litres
Yield variance = 280.95k litres A
Standard material cost = $0.97
Yield variance = 280.95k litres x $0.97 = $272.5k A

(b)

Rationale
The question assesses learning outcome D1(b) apply sensitivity analysis to both short and
long run decision models to identify variables that might have significant impact on project
outcomes . It examines candidates’ ability to use calculate the sensitivity of the investment
decision to a change in a variable and to identify the benefits of using sensitivity analysis in
investment appraisal.

Suggested Approach
In part (i) candidates should calculate the net present value of the investment and then
express the net present value as a percentage of the present value of the fixed costs. In part
(ii) candidates should clearly state the potential benefits that arise as a result of the use of
sensitivity analysis in investment appraisal.

(i) If the present value of the fixed costs were to increase by more than $8,675 then the
project would cease to be viable. As a percentage increase this is:

$8,675 / $90,125 = 9.6%

(ii)

• Sensitivity analysis enables a company to determine the effect of changes to

variables on the planned outcome.
• Sensitivity analysis enables a company to assess the risk associated with a project.
• Sensitivity analysis enables identification of variables that are of special significance.
• Sensitivity analysis enables risk management strategies to be put in place to focus on
those variables of special significance.

May 2012 5 P1
(c)

Rationale
The question assesses learning outcome E1(g) analyse the impact of alternative policies for
stock management. It examines candidates’ ability to explain the benefits of a centralised
purchasing system.

Suggested Approach
Candidates should consider the potential benefits to a company of using a centralised
purchasing system compared to the current system in use and clearly explain what the
benefits are and why they arise under this system.

The advantages of a centralised purchasing system are as follows:

• A centralised buyer is able to order in larger quantities and may be able to negotiate
bulk buying discounts.
• A centralised buyer may have a wider network of suppliers than a local buyer and
should be able to ensure that the best available prices are identified.
• With centralised purchasing it is easier to enforce common quality standards for
purchased materials.
• Centralised purchasing should result in more efficient management of inventory. The
buyer should have access to information about the current inventory levels at all
locations in the organisation and where appropriate can arrange for inventory to be
transferred from one location to another to avoid purchasing additional quantities.
• In an organisation where the operating units are all within a small geographical area it
should also be possible to operate a single centralised stores location. It should be
easier to control inventory levels within a centralised store rather than with several
localised stores.
• The company should benefit from economies of scale and the reduction in
administration costs. As larger orders are being placed with suppliers it will also
reduce inventory ordering and handling costs.
• Centralised purchasing should enable closer relationships with suppliers and allow
the use of JIT inventory management techniques.

(d)

Rationale
The question assesses learning outcome B1(b) explain the purposes of budgets, including
planning, communication, co-ordination, motivation, authorisation, control and evaluation. It
examines candidates’ ability to explain the benefits and problem with managers’ participation
in setting budgets.

Suggested Approach
Candidates should first consider the benefit of management participation in terms of
motivation, optimisation of performance and reducing the information asymmetry gap. The
potential problems of management participation should then be considered and the conflicts
that can arise been management participation and the use of the budget as a control
mechanism.

P1 6 May 2012
The participation of managers in the budget setting process has several advantages.
Managers are more likely to be motivated to achieve the budget if they have participated in
the budget setting process. Participation can also reduce the information asymmetry gap that
can arise when targets are imposed by senior management and should result in more realistic
budgets. Imposed budgets are likely to make managers feel demotivated and alienated and
result in poor performance.

Participation however can cause problems; in particular, managers may attempt to negotiate
budgets that they feel are easy to achieve which gives rise to ‘budget padding’ or budgetary
slack. They may also be tempted to ‘empire build’ because they believe that the size of their
budget reflects their importance within the organisation. This can result in budgets that are
unsuitable for control purposes. Manager participation is only effective if it is true participation.
Pseudo participation can be worse for motivation than no involvement at all. The involvement
of managers in the budget setting process is time consuming and the benefits of participation
would need to weighed against the cost of the resources used.

(e)

Rationale
The question assesses learning outcome D1(e) calculate the value of perfect 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 calculate the expected value of the contribution from each package
without perfect information. They should then select the best outcome for each of the possible
customer reactions 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.

Expected values ($000)

Package A ($700 x 0.25) + ($600 x 0.4) + ($400 x 0.35) = $555

Package B ($900 x 0.25) + ($500 x 0.4) + ($300 x 0.35) = $530
Package C ($800 x 0.25) + ($400 x 0.4) + ($500 x 0.35) = $535

Expected value of perfect information ($000)

If good select Package B = ($900 x 0.25) = $225

If moderate select Package A = ($600 x 0.4) = $240
If poor select Package C = ($500 x 0.35) = $175

Expected value of perfect information is $225 + $240 + $175 = $640

The maximum amount that should be paid is ($640k – $555k) = $85k

May 2012 7 P1
(f)

Rationale
The question assesses learning outcome E2(b) identify alternatives for investment of short
term cash surpluses. It examines candidates’ ability to explain the factors that a company
should consider before deciding how to invest short term surplus funds.

Suggested Approach
Candidates should identify three factors that companies would need to consider when
deciding to invest short tern cash surpluses. They should define each of the factors and
clearly explain why these are important in the investment decision.

Three factors that would need to be considered when deciding how to invest short term cash
surpluses are:

Maturity
A short term investment will involve investing the money for a specified period of time and
receiving interest and the payment of the capital at a specified future date. The maturity date
of the investment should be no longer than the duration of the cash surplus. If the cash is
required before the maturity of the investment and the investment is ‘cashed in’ early, there
will be the risk of loss of interest or capital value.

Risk v Return
Risk refers to the possibility that the investment might fall in value or that there may be some
doubt about the eventual payment of interest or repayment of capital. Generally a higher risk
investment will offer a higher return.

Investing in equities is high risk since the value of the equities depends on the profitability and
future prospects of the company and stock market movements. Share prices can fall by a
large amount in a short period of time therefore equities are generally regarded as an
unsuitable form of short-term investment.

Liquidity
Liquidity refers to the ease with which an investment can be ‘cashed in’ without any significant
loss of value or interest. All short-term investments are less liquid than cash in a bank current
account but some are more liquid than others. For example, many savings accounts or
deposit accounts are reasonably liquid and a depositor can withdraw cash immediately
without penalty or for the loss of only several days’ interest.

P1 8 May 2012
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 reconcile budget and actual profit under a marginal costing system. Part (b)
assesses learning outcome A1(b) discuss a report which reconciles budget and actual profit
using absorption and/or marginal costing principles. It examines candidates’ ability to explain
why the variances are different under absorption and marginal costing systems. It also
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 the revised variances under an absorption costing system. Part (c)
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 explain the arguments for suing absorption costing for
inventory valuation and profit reporting purposes.

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, variable
overheads and fixed 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 clearly explain the difference that
arise when calculating variances using an absorption costing system compared to a marginal
costing system. In part (c) candidates should calculate the sales volume profit variance and
the fixed overhead volume variance. In part (d) candidates should clearly explain the reasons
why absorption costing is preferred to marginal costing for profit reporting and inventory
valuation.

May 2012 9 P1
(a)

$ $
Budgeted profit
466,000
Add back fixed production overheads
170,000
Budgeted contribution
636,000
Sales volume contribution variance
(9,000 units - 10,000 units) x $63.60 63,600 A

Standard contribution on actual sales volume

Other variances:
Selling price variance
9,000 units x ($184 - $180) 36,000 F

Cost variances:
Direct material price variance
74,000 kg x ($10.80 – $11.20) 29,600 A

Direct material usage variance

((9,000 x 8 kg) – 74,000 kg) x $10.80 21,600 A

Direct labour rate variance

10,800 x ($18.00 - $19.00) 10,800 A

Direct labour efficiency variance

((9,000 x 1.25) – 10,800) x $18.00 8,100 F

Variable overhead expenditure variance

(10,800 hours x $6) - $70,000 5,200 A

Variable overhead efficiency variance

((9,000 x 1.25) – 10,800) x $6.00 2,700 F

Fixed overhead expenditure variance

$170,000 - $168,000 2,000 F

Actual profit
384,000

Workings:
Budgeted profit for the period
$
Sales 10,000 units x $180 1,800,000
Direct materials 10,000 units x $86.40 864,000
Direct labour 10,000 units x $22.50 225,000
Variable production overheads 10,000 units x $7.50 75,000 (1,164,000)
Contribution 10,000 units x $63.60 636,000
Fixed production overheads (170,000)
Budgeted profit 466,000

P1 10 May 2012
Actual profit for the period
$
Sales 9,000 units x $184 1,656,000
Direct materials 74,000 kg @ $11.20 828,800
Direct labour 10,800 hours @ $19 205,200
Variable production overheads 70,000 (1,104,000)
Contribution 552,000
Fixed production overheads (168,000)
Actual profit 384,000

(b) (i)
In a standard marginal costing variance statement the sales volume contribution variance is
calculated using the standard contribution per unit. In a standard absorption costing variance
statement, standard contribution is replaced by the standard profit per unit which includes a
fixed overhead absorption rate. The difference in the variance is represented in the absorption
costing variance statement by the fixed production overhead volume variance which is
calculated as the difference in actual and budgeted volume x the fixed overhead absorption
rate. The fixed production overhead volume variance represents a part of the under absorbed
fixed overhead as a result of producing a lower volume than budgeted.

(b) (ii)

Sales volume profit variance

(9,000 units - 10,000 units) x $46.60 = $46,600 A

It would also be necessary to include a fixed production overhead volume variance as follows:

Fixed production overhead volume variance

(9,000 units – 10,000 units) x $17 = $17,000 A

(c)

The arguments used in favour of using absorption costing for profit reporting and inventory
valuation are as follows:

• Fixed production overheads can be a large proportion of total production costs. It is

therefore important that these costs are included in the measurement of product costs
as they have to be recovered to make a profit.
• Absorption costing follows the matching concept by carrying forward a proportion of
the fixed production overhead costs in the inventory valuation to be matched against
the sales revenue generated when the items are sold.
• It is necessary to include fixed production overheads in inventory valuations for
financial statements.
• It has been argued that in the longer term all costs are variable and it is appropriate
to try to identify overhead costs with the products or services that cause them.

May 2012 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 C1(c) calculate project cash flows,
accounting for tax and inflation, and apply perpetuities to derive ‘end of project’ value where
appropriate 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. It also
requires candidates to calculate the effect of tax and inflation on the cash flows. Part (b) also
assesses learning outcome C2(a) evaluate project proposals using the techniques of
investment appraisal. It examines candidates’ ability to calculate the IRR of a project. Part (c)
assesses learning outcome C1(e) explain the financial consequences of dealing with long-run
projects, in particular the importance of accounting for the ‘time value of money’. It examines
candidates’ ability to explain what determines the time value of money and its importance in
appraising investment projects.

Suggested Approach
In part (a) candidates should firstly calculate the expected value of the car parking charge
and inflate this by 5% to calculate the year 1 parking charge. They should then calculate the
number of car parking spaces available each week and multiply this by the charge per week x
52 weeks to get the Year 1 revenue. The revenue should then be multiplied by 80% to get
Year 1 contribution. The Year 1 contribution should then be inflated by 5% per annum for
each year of the project. Fixed costs excluding the lease cost should also be inflated by 4%
per annum. Once the relevant cash flows for each year of the project have been identified
they should then calculate the tax payments. The net cash flows after tax should be
discounted at a discount rate of 8% to calculate the NPV of the project. In part b) the same
cash flows should then be discounted at a higher discount rate and the IRR calculated using
interpolation. In part (c) candidates should explain the three elements that determine the time
value of money and clearly explain why the time value of money is important in investment
appraisal.

(a)

Year 1 car parking charges

($60 x 40%) + ($50 x 25%) + ($70 x 35%) = $61 x 1.05 = $64.05

Year 1 sales revenue

Year 1 sales revenue = (600 x 0.75) x $64.05 x 52 weeks = $1,499k

Year 1 contribution = $1,499k x 0.8 = $1,199k

Fixed Costs

Year 1 Staff costs = $350k x 1.04 = $364k

Year 1 Security system costs = $100k x 1.04 = $104k

P1 12 May 2012
Cash Flows
Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000
Contribution 1,199 1,259 1,322 1,388 1,457

Leasing (50) (50) (50) (50) (50)

costs
Staff costs (364) (379) (394) (409) (426)
Security (104) (108) (112) (117) (122)
system
costs
Net cash 681 722 766 812 859
flows

Taxation
Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000
Net cash 681 722 766 812 859
flows
Taxation @ (204) (217) (230) (244) (258)
30%

Net present value

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
$000 $000 $000 $000 $000 $000 $000
Land (8,000) 10,000
purchase
and
development
Net cash 681 722 766 812 859
flows
Tax payment (102) (108) (115) (122) (129)

Tax payment 0 (102) (109) (115) (122) (129)

Net cash (8,000) 579 512 542 575 10,608 (129)

flow after tax
Discount 1.000 0.926 0.857 0.794 0.735 0.681 0.630
factors @
8%
Present (8,000) 536 439 430 423 7,224 (81)
value
Net present value = $971k
The project has a positive net present value and therefore should be accepted

(b)

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

$000 $000 $000 $000 $000 $000 $000
Net cash flow after tax (8,000) 579 512 542 575 10,608 (129)

Discount factors @ 12% 1.000 0.893 0.797 0.712 0.636 0.567 0.507

Present value (8,000) 517 408 386 366 6,015 (65)

Net present value = -$373k

May 2012 13 P1
IRR = 8% + (($971k/($971k + $373k)) x (12% - 8%))
= 8% + 2.9%
= 10.9%

(c)
The time value of money relates to the return required by investors and has three main
elements:

Delayed Consumption
There is an opportunity cost involved with the investment of funds. Generally the value of
$1.00 now is greater than the value of $1.00 in one year’s time since investors have to give
up present consumption. An investor will give up present consumption for the potential of
higher future consumption i.e. they need to be rewarded for giving up certain current
consumption for certain future consumption.

Inflation
If there is inflation then investors also need to be compensated for the loss in purchasing
power as well as for time.

Risk
The promise of money in the future carries with it an element of risk. The payout may not take
place or the amount may be less than expected. An investor therefore needs to be
compensated for time, inflation and also risk.

The objective of investment within a company is to create value for its owners. Investors have
alternative uses for their funds and therefore have an opportunity cost if money is invested in
a corporate project. Investments therefore must generate enough cash for all investors to
receive their required returns. The use of net present value in investment appraisal
recognises the time value of money and discounts cash flows at the investors’ required rate of
return.

P1 14 May 2012