Operational Level Paper

P1 – Performance Operations
May 2014 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 A.

1.2
The discount for 91 days = $1,000 - $985.04 = $14.96

The annual discount = $14.96 / 91 x 365 = $60

$60 / $1,000 = 6%

The correct answer is C.

 The Chartered Institute of Management Accountants 2014

1.3 (10,000 units x 3 kg) x ($4 - $5) = $30,000 A

The correct answer is B.

1.4 32,000 kg x ($5 - $4.80) = $6,400 F

The correct answer is C.

1.5
If inflation is removed from the costs

$21,000 / 1.05 = $20,000

$26,780 / 1.03 = $26,000

The variable cost per unit = ($26,000 - $20,000) / (16,000 – 12,000) = $1.50

At an inflation index of 1.08 = $1.50 x 1.08 = $1.62

The correct answer is D.

1.6
Expected value of profit with marketing campaign

($300,000 x 0.90) + (-$80,000 x 0.1) = $262,000 - $50,000 = $212,000

Expected value of profit without marketing campaign

($300,000 x 0.75) + (-$80,000 x 0.25) = $205,000

It is therefore worthwhile for the company to undertake the marketing campaign as the
increase in the expected value of profit is $7,000

1.7
$60 - $20 = $40 Joint probability is 0.30 x 0.25 = 0.0750
$64 - $20 = $44 Joint probability is 0.25 x 0.25 = 0.0625
$64 - $24 = $40 Joint probability is 0.25 x 0.40 = 0.1000
$68 - $20 = $48 Joint probability is 0.45 x 0.25 = 0.1125
$68 - $24 = $44 Joint probability is 0.45 x 0.40 = 0.1800
$68 - $26 = $42 Joint probability is 0.45 x 0.35 = 0.1575
0.6875
Alternatively:-
$60 - $20 = $40 Joint probability is 0.30 x 0.25 = 0.0750
$64 - $20 = $44 Joint probability is 0.25 x 0.25 = 0.0625
$64 - $24 = $40 Joint probability is 0.25 x 0.40 = 0.1000
At a selling price of $68, the contribution per
unit under all three alternatives is greater than
$40 therefore probability is = 0.4500
0.6875

Performance Operations 2 May 2014

1.8
Net cash flows per annum = $101,000 - $30,000 - $5,000 = $66,000

PV of net cash flows = $66,000 x 3.605 = $237,930

Net present value = $237,930 - $150,000 = $87,930

The PV of the sales revenue = $101,000 x 3.605 = $364,105

The percentage change in the selling price that will result in the project being rejected is:

$87,930 / $364,105 = 24.15%

End of Section A. Section B begins on page 4

May 2014 3 Performance Operations

SECTION B

Answer to Question Two

(a)

Rationale

The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It
examines candidates’ ability to explain the advantages and disadvantages of a top-down
approach to budgeting.

Suggested Approach

Candidates should clearly explain one advantage and two disadvantages of a top-down
approach to budgeting.

Examiner’s note: the question asks for one advantage and two disadvantages. Examples that
would be rewarded are given below:

Advantages
• Top-down budgeting avoids the problem of managers attempting to negotiate budgets
that they feel are easy to achieve which gives rise to ‘budget padding’ or budgetary
slack.

• It also avoids the problem of managers trying 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.

• The involvement of managers in the budget setting process is time consuming. Top-
down budgets can be produced much more quickly.

• Top-down budgeting avoids pseudo-participation which can be especially demotivating

for managers.

Disadvantage

• Imposed targets are likely to make managers feel demotivated and alienated and result
in poor performance. Managers are more likely to be motivated to achieve the target if
they have participated in setting the target.

• Senior management are not involved in the day to day operation of the business.
Participation by managers can reduce the information asymmetry gap that can arise
when targets are imposed by senior management and should result in more realistic
budgets.

• The use of a top-down budgeting approach will result in the absence of communication
between managers at all levels throughout the organisation.

Performance Operations 4 May 2014

(b)

Rationale

The question assesses learning outcome D1(f) apply decision trees.

It examines candidates’ ability to use decision trees to evaluate a decision where there is
uncertainty regarding expected cash flows.

Suggested Approach

Candidates should firstly draw the decision tree and then using the profit/loss and
probabilities given for each branch of the tree work back to calculate the expected profit/loss
at each node. They should then clearly indicate the most profitable decision.

May 2014 5 Performance Operations

 $540,000
No action
20%

Similar
$223,000 $320,000
50%

Better
Product X 30%
($150,000)

$ 620,000
No action
20%

$254,000 Product Y $254,000

Similar
$ 380,000
50%

Better
No 30%
Product ($200,000)

No action $0
60%

($40,000)

New
product
40% ($100,000)

The company should launch Product Y

Performance Operations 6 May 2014

(c)

Rationale

The question assesses learning outcome E1(g) analyse the impacts of alternative policies for
stock management. It examines candidates’ ability to discuss the potential benefits for a
company from using a JIT purchasing system.

Suggested Approach

Candidates should explain how a JIT purchasing system operates and the potential benefits
that may arise from the use of the system. Candidates should also consider the pre-requisites
for achieving the benefits from a JIT purchasing system.

The successful operation of a JIT purchasing system relies on 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 allows the company to 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.

The use of a small number of suppliers should also reduce administrative costs for the
company and may result in greater quantity discounts.

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 result in a reduction in quality control costs for the company. Quality standards should
also improve resulting in lower wastage in the production process. However, close co-
operation with suppliers is essential thus suppliers are not selected on the basis of price
alone. Their performance in terms of quality and the ability to deliver as needed and their
commitment to JIT purchasing are also of vital importance.

May 2014 7 Performance Operations

(d)

Rationale

The question assesses learning outcome B3(a) prepare a budget for any account in the
master budget, based on projections/forecasts and managerial targets. It examines
candidates’ ability to prepare a cash budget based on information given about the timing of
cash flows.

Suggested Approach

Candidates should firstly prepare a format for the cash budget with months along the top and
receipts and payments down the side. They should then work out the timing of the cash flows
for each of the items. The cash receipts and cash payments should be totalled and the net
cash flow for each month should be calculated. The opening cash balance and closing cash
balance for each month can then be calculated.

July August September

$ $ $
Receipts
1/3 cash sales 30,000 60,000 75,000
2/3 credit sales 0 60,000 120,000
Total receipts 30,000 120,000 195,000

Payments
Purchases 0 60,000 120,000
Machinery 0 30,000 0
Expenses 20,000 20,000 20,000
Advertising 0 5,000 5,000
Total payments 20,000 115,000 145,000

Opening balance 0 10,000 15,000

Net cash flow 10,000 5,000 50,000
Closing balance 10,000 15,000 65,000

Performance Operations 8 May 2014

(e)

Rationale

Part (i) of the question assesses learning outcomes E1(a) explain the importance of cash flow
and working capital management. Part (ii) assesses learning outcome E1(d) discuss
measures to improve a cash forecast situation. Part (i) examines candidates’ ability to explain
why it is important for a business to prepare a cash budget. Part (ii) requires candidates to
state three ways of improving the cash flow position of a business.

Suggested Approach

In part (i) candidates should clearly explain the benefits to the company of cash budgeting. In
part (ii) candidates should state three methods that could be used to improve the cash flow
position of a business.

(i)
The objective of a cash budget is to ensure that sufficient cash is available to meet the level
of operations in the various functional and capital budgets. Cash deficits can be identified in
advance and steps taken to ensure that sources of finance will be available to cover any
deficits. Cash budgets can also help a company to avoid cash surpluses by enabling
management to take actions in advance to invest the surplus cash in short-term or long-term
investments as appropriate. The overall aim should be to manage the cash of the company to
ensure that cash is available when required and that the maximum benefit is gained from the
use of any idle funds.

(ii)

Examiner’s note: the question asks for three methods. Examples that would be rewarded are
given below:

• Using different forms of financing for capital expenditure e.g. leasing rather than
purchasing outright.
• Selling short-term investments.
• Postponing non-essential capital expenditure.
• Disposing of non-current assets that are no longer required.
• Reducing inventory levels by using, for example, JIT purchasing.
• Reducing the time taken to collect receivables by e.g. offering early settlement
discounts, reducing credit terms or factoring the debt.
• Delaying the payment of payables.

May 2014 9 Performance Operations

(f)

Rationale

Part (i) of the question assesses learning outcome E2(d) illustrate numerically the financial
impact of short-term funding and investment methods. Part (ii) assesses learning outcome
E2(a) identify sources of short-term funding. Part (i) examines candidates’ ability to calculate
the cost of two alternative methods of funding a company’s short-term borrowing requirement.
Part (ii) requires candidates to state two advantages of using an overdraft to fund short-term
cash deficits.

Suggested Approach

In part (i) candidates should calculate the cost of the overdraft based on the balance
outstanding each month. They should then calculate the annual interest cost of the loan net
of the interest receivable on the unused portion. In part (ii) candidates should clearly state two
advantages of using an overdraft to fund short-term cash deficits.

(i)

Interest on the overdraft

$370,000 x 3/12 x 0.12 = $11,100

$280,000 x 3/12 x 0.12 = $ 8,400
$400,000 x 3/12 x 0.12 = $12,000
$31,500

Interest on loan

$400,000 x 0.10 = $40,000

Less interest receivable

$400,000 x 3/12 x 0.04 = ($4,000)

$120,000 x 3/12 x 0.04 = ($1,200)
$30,000 x 3/12 x 0.04 = ($300)
$34,500

The overdraft is therefore the cheaper alternative.

(ii) Examiner’s note: the question asks for two advantages. Examples that would be
rewarded are given below:

• Flexibility: the bank will agree an overdraft limit or facility. The borrower may not require
the full facility immediately but may draw funds up to the limit as and when required. If
the funds are no longer required they can be repaid without suffering any penalty.
• Minimal documentation: legal documentation is fairly minimal when arranging an
overdraft. The documents will state the maximum overdraft limit, the interest payable
and the security required.
• An overdraft is seen as a relatively cheap source of finance. Banks usually charge
between 2% and 5% above base rate depending on the borrower’s creditworthiness
and security offered by the borrower. Savings come from the fact that interest is only
paid on the daily outstanding balance. Therefore a large cash inflow can offset the
balance outstanding and temporarily lower the interest payable, whilst still retaining the
ability to borrow up to the overdraft limit when required.

Performance Operations 10 May 2014

SECTION C

Answer to Question Three

Rationale

The question assesses a number of learning outcomes. Part (a) of the question 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 examines candidates’ ability to calculate the cost of a product
using both traditional absorption costing and activity based costing. Part (b) 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 a sales mix gross profit variance and a sales quantity gross profit variance. Part (c)
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 meaning of a sales mix gross profit variance and why it is
useful to calculate the variance.

Suggested Approach

In part (a)(i) candidates should identify the direct material costs for each product and then
calculate the overhead absorption rate. This rate can then be applied to each product and the
total overhead cost calculated. In part (a)(ii) candidates need to calculate a cost driver rate for
each of the activities and then apply this cost driver rate to calculate the overhead cost for
each activity per product. The gross profit for each product can then be recalculated. In part
(b)(i) candidates should calculate the sales mix gross profit variance by comparing the actual
sales quantity at the budgeted mix with the actual sales quantity at the actual mix. The
variance calculated in units for each of the products should then be multiplied by the standard
gross profit per unit to calculate the variance for each product. These should then be added
together to calculate the total mix variance. In part (b)(ii) the budgeted sales quantity should
be compared to the actual sales quantity at the budgeted mix. The resultant variance in units
should be multiplied by the standard gross profit per unit to calculate the sales quantity gross
profit variance for each product. These should then be added together to calculate the total
sales quantity gross profit variance. In part (c) candidates should clearly explain the meaning
of the sales mix gross profit variance and why it is useful for a company to calculate this
variance.

(a)

(i)

Fixed production overheads = $15,400,000

Budgeted material cost = $22,000,000
Fixed production overhead absorption rate = $15,400,000 / 22,000,000 = 70%

Anti-ageing Facial masks Collagen Total

cream fillers
$000 $000 $000 $000

Fixed production overhead 8,260 4,340 2,800 15,400

May 2014 11 Performance Operations

(ii)

Anti-ageing Facial Collagen

Cream Masks Fillers
Budgeted production per annum (units) 1,000,000 1,200,000 600,000
Batch size (units) 1,000 2,000 1,500
Number of batches 1,000 600 400
Number of machine set-ups 3,000 1,800 1,600
Number of purchase orders 2,000 1,200 400
Processing time (minutes) 2,000,000 3,600,000 2,400,000

Activity Activity cost Cost driver Cost driver rate

$000
Machine set up 3,600 Number of machine $3,600,000 / 6,400
set ups = $562.50 per set-up
Quality inspection 1,200 Number of quality $1,200,000 / 2,000
inspections = $600 per inspection
Processing 6,500 Processing time $6,500,000 / 8,000,000
= $0.8125 per minute
Purchasing 1,800 Number of $1,800,000 / 3,600
purchase orders = $500 per purchase order
Packaging 2,300 Number of units $2,300,000 / 2,800,000
= $0.821 per unit
15,400

Anti-ageing Facial Collagen Total

Cream Masks Fillers
$000 $000 $000 $000
Sales 60,000 38,000 22,000 120,000
Direct material 11,800 6,200 4,000 22,000
Direct labour 3,700 2,400 1,900 8,000
Machine set ups (3,000 x $562.50) (1,800 x $562.50) (1,600 x $562.50)
1,688 1,012 900 3,600
Quality (1,000 x $600) (600 x $600) (400 x $600)
inspections 600 360 240 1,200
Processing (2,000,000 x (3,600,000 x (2,400,000 x
$0.8125) $0.8125) $0.8125) 6,500
1,625 2,925 1,950
Purchasing (2,000 x $500) (1,200 x $500) (400 x $500)
1,000 600 200 1,800
Packaging (1,000,000 x $0.821) (1,200,000 x $0.821) (600,000 x $0.821)
821 986 493 2,300
Gross profit
38,766 23,517 12,317 74,600

Performance Operations 12 May 2014

(b)
(i)

Sales Mix Gross Profit Variance:

Actual Actual Difference Standard Variance

Sales Sales at (units) gross profit $
quantity budget mix $
(units) (units)
Anti-ageing cream 250,000 243,750 6,250 F 34.00 212,500 F
Facial masks 260,000 284,375 24,375 A 20.00 487,500 A
Collagen fillers 140,000 121,875 18,125 F 22.00 398,750 F
650,000 650,000 123,750 F

Or alternatively:

Budget Standard Total profit

sales gross profit $000
Quantity $
(units)
Anti-ageing cream 240,000 34 8,160
Facial masks 280,000 20 5,600
Collagen fillers 120,000 22 2,640
640,000 16,400

Weighted average gross profit = $16,400k / 640,000 = $25.625

Actual Actual Difference Variance from Variance

sales sales at (units) weighted $
quantity budget mix average gross
(units) (units) profit per unit
Anti-ageing cream 250,000 243,750 6,250 F ($34 - $25.625) 52,344 F
Facial masks 260,000 284,375 24,375 A ($20 - $25.625) 137,109 F
Collagen fillers 140,000 121,875 18,125 F ($22 - $25.625) 65,703 A
650,000 650,000 123,750 F

(ii)

Sales Quantity Gross Profit Variance

Budget Actual Difference Standard Variance

sales sales at (units) gross profit $
quantity budget mix $
(units) (units)
Anti-ageing cream 240,000 243,750 3,750 F 34 127,500 F
Facial masks 280,000 284,375 4,375 F 20 87,500 F
Collagen fillers 120,000 121,875 1,875 F 22 41,250 F
640,000 650,000 256,250 F

Or alternatively:

Sales quantity gross profit variance = (650,000 – 640,000) x $25.625 = $256,250 F

May 2014 13 Performance Operations

(c)
The sales mix gross profit variance identifies the effect on profit of a change in the mix of
product sales. It compares the actual quantity of products sold at the budgeted mix with the
actual mix of products sold. From the figures calculated in part (b) we can see that the change
in the sales mix has resulted in an increase in profit of $123,750. The change in the sales mix
has resulted in a relatively higher proportion of sales of the anti-ageing cream and collagen
fillers which are the products that earn the highest profit per unit and a lower proportion of
sales of facial masks which have a relatively lower profit per unit. This is important information
for future planning and pricing purposes. An overall increase in quantity of products sold may
not result in an increase in profits if the increased sales are from a lower margin product at
the expense of products with a higher profit margin.

Performance Operations 14 May 2014

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 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(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 why discounted cash flow
techniques should be used when evaluating a long-term investment project. Part (c)
assesses learning outcome C1(a) explain the processes involved in making long-term
decisions. It examines candidates’ ability to explain the benefits of carrying out a post-
completion audit of a long-term investment project.

Suggested Approach

In part (a) candidates should firstly calculate the number of units sold and the contribution
that would be earned from the product in each year. They should then deduct the fixed costs
after adjusting for depreciation. The tax depreciation and tax payments should then be
calculated. The total cost of the investment and the residual value should then 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 of the project. In part (b) candidates should
clearly explain why it is necessary to adjust cash flows to account for the time value of
money. In part (c) candidates should clearly explain the potential benefits to a company of
carrying out a post-completion audit of a long-term investment project.

(a)
Contribution Years 1 – 5
Year 1: 50 million x 20% x $20 = $200 million
Year 2: 50 million x 1.1 = 55 million x 25% x $20 = $275 million
Year 3: 55 million x 1.1 = 60.5 million x 30% x $20 = $363 million
Year 4: 60.5 million x 1.1 = 66.55 million x 30% x $20 = $399 million
Year 5: 66.55 million x 1.1 = 73.21 million x 35% x $20 = $512 million

Fixed Costs
Depreciation per annum = ($500m - $120m) / 5 = $76m

Fixed costs (excluding depreciation) per annum

= $200m - $76m = $124m

Taxation

Year 1 Year 2 Year 3 Year 4 Year 5

$m $m $m $m $m
Contribution 200 275 363 399 512
Fixed operating (124) (124) (124) (124) (124)
costs
Advertising (50) (50) (80) (80) (80)
Net cash flows 26 101 159 195 308
Tax depreciation (125) (94) (70) (53) (38)
Taxable profit (99) 7 89 142 270
Taxation @ 30% 30 (2) (27) (43) (81)

May 2014 15 Performance Operations

Net present value

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

$m $m $m $m $m $m $m
Investment (500) 120
/ residual
value
Working (30) 30
capital
Net cash 26 101 159 195 308
flows
Tax 15 (1) (13) (21) (40)
payment
Tax 15 (1) (14) (22) (41)
payment
Net cash (530) 41 115 145 160 396 (41)
flow after
tax
Discount 1.000 0.893 0.797 0.712 0.636 0.567 0.507
factors @
12%
Present (530) 37 92 103 102 225 (21)
value

Net present value = $8m

The net present value is positive therefore the project should go ahead.

(b)
Discounted cash flow techniques are used in investment appraisal in recognition of the fact
that money has a time value. It reflects the fact that the value of $1.00 now is greater than the
value of $1.00 in one year’s time. This is because if there is inflation then more can be
purchased now than at some time in the future. Alternatively the money can be invested to
gain interest or borrowings can be reduced. The rate of interest on the investment reflects
both inflation and the risk involved in the investment.

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. This means that future cash
flows are reduced in value in order to reflect their value if they were received today i.e. to
express them in present value terms.

(c)
Post completion audit has benefits in terms of the current project and future projects. In terms
of the current project, it enables changes to be made to over or under performing projects at
an early stage. This also makes it more likely that unsuccessful projects will be terminated.

In terms of future projects, it improves the quality of decision making as past experience is
made available to future decision makers. It encourages greater realism in predicting future
outcomes as past inaccuracies are made public. It highlights reasons for successful projects
which may be important in achieving greater benefits from future projects and in future project
selection.

Performance Operations 16 May 2014