Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
General Comments
Performance on this paper was reasonable particularly bearing in mind the very high pass rate
achieved in November 2013. A number of candidates produced very weak papers however
there were also some fairly high scoring scripts.
Candidates scored well in the multiple choice questions and Question 1 as a whole was fairly
well done. Question 2 was reasonably well done although candidates once again struggled with
the narrative questions.
Question 3 was generally badly done, with a very low average mark compared to previous
sessions. This was mainly due to poor performance on the computational aspects of the
question. Part (a) consisted of basic variances yet many candidates were unable to calculate
these correctly. Many candidates scored well in part (b) but part (c) was very poorly answered
with many of the answers being irrelevant and not answering the question that was asked.
Question 4 presented some difficulties for candidates and the average mark was low compared
to previous sessions. There was a lack of understanding regarding the opportunity cost of the
project and candidates had obviously not read the question very carefully and failed to make
basic calculations such as multiplying the weekly gross profit by 52. Despite this candidates
could still achieve a reasonable mark for part (a) but part (b) was poorly answered and part (c)
was split between those who could do the question and scored well and those who did not
know what they were doing and scored badly.
There are still a number of recurring issues as follows:
•
Many candidates did not seem to know how to lay out answers with the result that the
task for markers was very difficult. In some cases even the candidates were not able
to follow their own workings and picked up the wrong figures. When the exam paper
gives candidates instructions to show workings in $millions, this is for the candidates’
benefit and the instruction should be followed. In question 4, many candidates were
unable to handle the large numbers and mixed $millions with $000s.
•
The narrative questions are still causing problems for some candidates who do not
address the question asked.
•
The performance in Question 3 was exceptionally poor despite the fact that only basic
variances were required. Candidates who are given exemption from the Certificate
level are advised to review the Certificate syllabi and ensure that any knowledge gaps
are filled.
 The Chartered Institute of Management Accountants 2014
Page 1
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
SECTION A – 20 MARKS
ANSWER ALL EIGHT SUB-QUESTIONS IN THIS SECTION
Question 1.1
1.1
AB is preparing its cash budget for the next quarter.
Which of the following items should NOT be included in the cash budget?
A
Payment of tax due on last year’s profits
B
Gain on the disposal of a piece of machinery
C
Repayment of the capital amount of a loan
D
Receipt of interest from short term investments
(2 marks)
The correct answer is B
Question 1.2
1.2
A company has a real cost of capital of 6% per annum and inflation is 3% per annum.
The company’s money cost of capital per annum is:
A
9.00%
B
2.91%
C
3.00%
D
9.18%
(2 marks)
The correct answer is D
Workings
(1 + r) x (1 + i) = (1 + m)
(1 + 0.06) x (1 + 0.03) = 1.0918
(1 + m) = 1.0918
m = 0.0918
m = 9.18%
 The Chartered Institute of Management Accountants 2014
Page 2
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
RS has recently introduced an activity based costing system. RS manufactures two products,
details of which are given below:
Budgeted production
per annum (units)
Batch size (units)
Machine set-ups per
batch
Processing time per
unit (minutes)
Product R
80,000
Product S
60,000
100
3
50
3
3
5
The budgeted annual costs for two activities are as follows:
Machine set-up
Processing
$180,000
$108,000
Question 1.3
The budgeted processing cost per unit of Product R is:
A
$0.20
B
$0.51
C
$0.60
D
$0.45
(2 marks)
The correct answer is C
Workings
Budgeted production
per annum (units)
Number of batches
Number of machine
set-ups
Total processing time
(minutes)
Product R
80,000
Product S
60,000
Total
140,000
800
2,400
1,200
3,600
2,000
6,000
240,000
300,000
540,000
Cost driver rate = $108,000 / 540,000 = $0.20
Total processing costs = $0.20 x 240,000 = $48,000
Processing costs per unit = $48,000 / 80,000 = $0.60
 The Chartered Institute of Management Accountants 2014
Page 3
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 1.4
The budgeted machine set-up cost per unit of Product S is:
A
$150
B
$1.80
C
$1.50
D
$30
(2 marks)
The correct answer is B
Workings
Cost driver rate = $180,000 / 6,000 = $30 per set up
Total set-up costs = $30 x 3,600 = $108,000
Set up cost per unit =$108,000 / 60,000 = $1.80
Question 1.5
An investment project requires an initial investment of $500,000 and has a residual value of $130,000 at
the end of five years. The net present value of the project is $140,500 after discounting at the company’s
cost of capital of 12% per annum.
The profitability index of the project is:
A
0.38
B
0.54
C
0.28
D
0.26
(2 marks)
The correct answer is C
Workings
The profitability index
= net present value of the investment / initial investment
= $140,500 / $500,000
= 0.281
 The Chartered Institute of Management Accountants 2014
Page 4
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 1.6
EF sells personal computers on which it gives a one year warranty. EF is estimating the cost of warranty
claims for next year.
If all products under warranty need minor repairs the total cost is estimated to be $2 million. If all products
under warranty need major repairs it would cost $6 million. If all products under warranty need to be
replaced it would cost $10 million.
Based on past experience EF has estimated that 80% of products under warranty will require no repairs,
15% will require minor repairs, 3% will require major repairs and 2% will need to be replaced.
Required:
Calculate the expected value of the cost of warranty claims for next year.
(3 marks)
Workings
The expected value of cost of the warranty claims is:
$2,000,000 x 15% =
$6,000,000 x 3% =
$10,000,000 x 2% =
$300,000
$180,000
$200,000
$680,000
Question 1.7
JK’s trade receivables outstanding at the end of this year are expected to be 55 days. Credit sales for this
year are expected to be $862,860 spread evenly throughout the year. JK is preparing the budget for next
year and estimates that credit sales will increase by 5%.
The trade receivables amount, in $, outstanding at the end of next year is estimated to be the same as at
the end of this year.
Required:
Calculate the budgeted trade receivable days at the end of next year. Your answer should be
rounded to two decimal places of a day.
(3 marks)
Workings
Trade receivable at the end of this year = $862,860 x 55/365 = $130,020
Credit sales for next year = $862,860 x 1.05 = $906,003
Trade receivable days at end of next year = $130,020 / $906,003 x 365 = 52.38 days
 The Chartered Institute of Management Accountants 2014
Page 5
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 1.8
A marketing manager is deciding which of four potential selling prices to charge for a new product. The
market for the product is uncertain and reaction from competitors may be strong, medium or weak. The
manager has prepared a payoff table showing the forecast profit for each of the possible outcomes.
Competitor
Reaction
Selling price
$80
$90
$100
$110
Strong
$70,000
$80,000
$70,000
$75,000
Medium
$50,000
$60,000
$70,000
$80,000
Weak
$90,000
$100,000
$90,000
$80,000
Required:
(i)
Identify the selling price that would be chosen if the manager applies the maximin criterion to
make the decision.
(ii)
Identify, using a regret matrix, the selling price that would be chosen if the manager applies
the minimax regret criterion to make the decision.
(4 marks)
Workings
(i)
The minimum profit at a selling price of $80 is $50,000
The minimum profit at a selling price of $90 is $60,000
The minimum profit at a selling price of $100 is $70,000
The minimum profit at a selling price of $110 is $75,000
Therefore if the manager wants to maximise the minimum profit a selling price of $110 would be chosen.
(ii)
A regret matrix can be produced as follows:
Competitor
Reaction
Selling price
$80
$90
$100
$110
Strong
$10,000
$0
$10,000
$5,000
Medium
$30,000
$20,000
$10,000
$0
Weak
$10,000
$0
$10,000
$20,000
Maximum regret
$30,000
$20,000
$10,000
$20,000
Therefore if the manager wants to minimise the maximum regret a selling price of $100 would be chosen.
 The Chartered Institute of Management Accountants 2014
Page 6
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
SECTION B – 30 MARKS
ANSWER ALL SIX SUB-QUESTIONS. YOU SHOULD SHOW YOUR WORKINGS AS
MARKS ARE AVAILABLE FOR THE METHOD YOU USE
Question 2(a)
(a)
“Public sector organisations are responsible for taxpayers’ money therefore they should no longer
be allowed to use incremental budgeting but should instead use a zero based budgeting system”.
Required:
Explain TWO advantages and ONE disadvantage of public sector organisations using zero based
budgeting.
(5 marks)
Rationale
The question assesses learning outcome B3(b) apply alternative approaches to budgeting. It examines
candidates’ ability to explain the advantages and disadvantages of zero based budgeting.
Suggested Approach
Candidates should clearly explain two advantages and one disadvantage of zero based budgeting in the
scenario described.
Marking Guide
• Explanation of advantages of zero based budgeting
• Explanation of disadvantage of zero based budgeting
Marks
1 mark per
valid point
Up to 2 marks
for each
advantage /
disadvantage
Maximum marks awarded
5 marks
Examiner’s comments
Most candidates could explain zero based budgeting (ZBB) and incremental budgeting. The main
difficulty was in explaining two distinct advantages of ZBB. Many candidates wrote about ZBB starting
from scratch which prevented inefficiencies being brought forward, thus avoiding the downside of
incremental budgeting. However, for the next point candidates often stated that under ZBB everything had
to be justified (or they repeated starting from scratch) thus reducing wastage. With the disadvantage, only
one was requested and most candidates stated that it was time consuming and expensive but did not
expand the point any further or instead they then cited a second disadvantage.
Common errors
• Failure to expand on the points made
• Failure to give two distinct advantages
 The Chartered Institute of Management Accountants 2014
Page 7
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 2(b)
(b)
A company has to decide which of three mutually exclusive projects to invest in next year. The
directors believe that the success of the projects will vary depending on economic conditions.
There is a 30% chance that conditions will be good, a 20% chance that conditions will be fair and a
50% chance that conditions will be poor. The company uses expected value to make this type of
decision.
The net present value for each of the possible outcomes is as follows:
Economic
Conditions
Project A
Project B
Project C
$000
$000
$000
Good
700
800
700
Fair
400
500
600
Poor
300
400
500
A firm of economic analysts believes it can provide perfect information on economic conditions.
Required:
Calculate the maximum amount that should be paid for the information from the firm of economic
analysts.
(5 marks)
Rationale
The question assesses learning outcome D1(e) calculate the value of 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 apply the probabilities for the economic conditions to calculate the expected
value of the net present value (NPV) for each of the projects without perfect information. They should
then select the best outcome for each of the possible economic conditions 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.
Marking Guide
Expected values without perfect information
Expected value with perfect information
Value of perfect information
Marks
1 ½ marks
2 ½ marks
1 mark
Maximum marks awarded
5 marks
 The Chartered Institute of Management Accountants 2014
Page 8
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Examiner’s comments
Most candidates either achieved 1 ½ marks or 5 marks as the majority of candidates could calculate the
expected values of projects A, B, and C. Unfortunately many candidates could not then calculate the
expected value with perfect information.
Common errors
• Calculating the expected value with perfect information using the expected values for the projects
rather than the net present values under each of the economic conditions
• Summing the expected values without perfect information and using this total to calculate the
value of perfect information
• Calculating the value of perfect information as the value of the project with the highest expected
value less the value of the project with the lowest expected value i.e. $580k - $440k = $140k
 The Chartered Institute of Management Accountants 2014
Page 9
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 2(c)
(c)
A company is concerned about its cash flow position. It has reviewed its trade receivable days and
is considering offering an early settlement discount. The company currently receives payments
from customers on average 65 days after the invoice date. The company’s current credit terms are
30 days after the invoice date. The company is considering offering a 2% early settlement discount
for payment within 20 days of the invoice date.
Required:
(i)
Calculate the effective annual interest rate of the early settlement discount. You should
use compound interest methodology and assume a 365 day year.
(3 marks)
(ii)
State TWO other methods that could be used to reduce the trade receivable days.
(2 marks)
(Total for sub-question (c) = 5 marks)
Rationale
Part (i) assesses learning outcome E1(e) analyse trade debtor and creditor information. It examines
candidates’ ability to calculate the effective annual interest rate of an early settlement discount. Part (ii)
assesses learning outcome E1(f) analyse the impacts of alternative debtor and creditor policies. It
examines candidates’ ability to identify methods that could be used to reduce a company’s trade
receivable days.
Suggested Approach
In part (i) candidates should calculate how many days early the payment will be received. They should
then divide 365 days by this to calculate the number of compounding periods. The discount rate should
then be compounded by the number of periods to calculate the effective annual interest rate. In part (ii)
candidates should clearly state two methods that could be used to reduce a company’s trade receivable
days.
Marking Guide
Part (i)
Number of compounding periods
1.00/0.98
Correct application
Part (ii)
Examples of methods that could be used to reduce trade receivable days
Maximum marks awarded
 The Chartered Institute of Management Accountants 2014
Marks
1 mark
1 mark
1 mark
1 mark each
method
Max 2 marks
5 marks
Page 10
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Examiner’s comments
In part (i) some candidates were confused over how to calculate the number of compounding periods with
365/65, 365/20 and 45/365 all used. Most candidates did use 1.00/0.98 correctly but some used 1.02,
without showing workings, and it was impossible to determine whether the figure had been derived
correctly or was just 1 plus the 2% settlement discount. Some candidates continue to struggle to convert
their answer into the correct percentage.
In part (ii) most candidates were able to state two methods and achieve two marks. Those who did not
generally failed to state two distinct methods i.e. send out chasing letters and phoning. Some candidates
also suggested discounts for early payment however this was included in the question and ‘other’
methods were required by the question.
Common errors
• Incorrect calculation of number of compounding periods
• Using 1.02 rather than 1.00/0.98
• Failure to correctly calculate a percentage rate
 The Chartered Institute of Management Accountants 2014
Page 11
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 2(d)
(d)
PR is a retailer of bicycles. The most popular children’s bicycle has an annual demand of 30,000
units. Demand is predictable and spread evenly throughout the year.
The bicycles are purchased by PR for $200 each. Ordering costs are $150 per order and the
annual cost of holding one bicycle in inventory is $25.
Required:
(i)
Calculate the economic order quantity (EOQ) for the children’s bicycle.
(2 marks)
(ii)
Calculate the total annual ordering and holding costs for the bicycle assuming the
company purchases the EOQ, does not hold any buffer inventory and the lead time is zero.
(3 marks)
(Total for sub-question (d) = 5 marks)
Rationale
The question assesses learning outcome E1(g) analyse the impacts of alternative policies for stock
management. Part (i) examines candidates’ ability to calculate the economic order quantity (EOQ) for a
product. Part (ii) requires candidates to calculate the total inventory holding and ordering costs if the
company uses the EOQ.
Suggested Approach
In part (i) candidates should apply the formula for the EOQ given in the question paper to the figures
given in the question in order to calculate the EOQ. In part (ii) candidates should firstly calculate the total
number of orders that would be required if the EOQ was used. This can then be multiplied by the ordering
costs per order to calculate the total ordering costs. In order to calculate the holding costs the EOQ
should be divided by two to calculate the average inventory held. This should then be multiplied by the
holding cost per unit to calculate the total holding costs. The total ordering cost and total holding costs
can then be added together.
Marking Guide
Part (i)
EOQ
2 marks
Part (ii)
Number of orders
Ordering costs
Holding costs
Total costs
½ mark
½ mark
1 mark
1 mark
Maximum marks awarded
5 marks
 The Chartered Institute of Management Accountants 2014
Marks
Page 12
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Examiner’s comments
In part (i) the majority of candidates achieved two marks for calculating the EOQ correctly. Most
candidates were then able to calculate the ordering cost correctly but the holding costs caused more
difficulty.
Common errors
• Calculating holding costs as 600 x $25
• Assuming that holding costs were zero
• Using 30,000 units to calculate holding and ordering costs
 The Chartered Institute of Management Accountants 2014
Page 13
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 2(e)
“Environmental costing is an important part of a company’s environmental management system.
Management needs to be aware of the extent of environmental costs if these are to be effectively managed”.
Required:
Explain THREE benefits that may arise for a company that uses an environmental costing system.
(5 marks)
Rationale
The question assesses learning outcome A3(a) apply principles of environmental costing in identifying
relevant internalised costs and externalised environmental impacts of the organisation’s activities. It
examines candidates’ ability to explain the benefits to a company from using an environmental costing
system.
Suggested Approach
Candidates should clearly explain three benefits that may arise for a company that uses an environmental
costing system.
Marking Guide
• Increased awareness of the impact of environment related activities on their
financial statements
• Cost control / reduction
• More accurate product costs / improved decision making
• Environmental risk management
Marks
1 mark per valid
point
Maximum marks awarded
5 marks
Up to 2 marks
per benefit
Examiner’s comments
In answering this question most candidates did not emphasise the management of environmental costs.
Instead they tended to discuss the benefits that would arise if a company was environmentally
friendly/aware. Most of the answers given were not linked to environmental costing, which was required in
the question.
Common errors
• Failure to answer the specific question
• Giving an answer relating to environmental management rather than to environmental costing
 The Chartered Institute of Management Accountants 2014
Page 14
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 2(f)
(f)
ST is considering investing in a bill of exchange which has a face value of $1,000 and 91 days to
maturity. The issue price of the bill is based on a discount yield of 6% per annum.
(i)
Calculate the issue price of the bill assuming a 365 day year.
(3 marks)
(ii)
State TWO ways in which an accepted bill of exchange can be used by the holder.
(2 marks)
(Total for sub-question (f) = 5 marks)
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(b) identify
alternatives for investment of short-term cash surpluses. Part (i) examines candidates’ ability to calculate
the issue price of a bill of exchange. Part (ii) requires candidates to state two ways in which an accepted
bill of exchange can be used by the holder.
Suggested Approach
In part (i) candidates should calculate the discount on the bill by multiplying the face value by the discount
yield for 91 days. The discount on the bill should then be subtracted from the face value to calculate the
issue price. In part (ii) candidates should clearly state two ways in which an accepted bill of exchange can
be used by the holder.
Marking Guide
Part (i)
Discount on the bill
Issue price of the bill
Marks
2 marks
1 mark
Part (ii)
Two ways in which an accepted bill of exchange can be used
1 mark each
Maximum marks awarded
5 marks
Examiner’s comments
Many candidates had no idea how to do part (i) of the question with many trying to work out a net present
value. In part (ii) candidates often did not provide sufficient detail to obtain full credit e.g. stating only that
the bill could be taken to the bank for immediate payment without mentioning that the face value would
not be achieved.
Common errors
• Calculating the price of the bill as $1,000 x 0.943 = $943
• Adding the discount to $1,000 rather than deducting the discount
• Calculating the discount for 365 days rather than 91 days
 The Chartered Institute of Management Accountants 2014
Page 15
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Please turn over the page for Section C
 The Chartered Institute of Management Accountants 2014
Page 16
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
SECTION C – 50 MARKS
ANSWER BOTH THE TWO QUESTIONS
Question 3
Required:
(a) Prepare a statement that reconciles the budgeted gross profit with the actual gross profit for
February. Your statement should show the variances in as much detail as possible.
(13 marks)
(b) Discuss, using the variances calculated in part (a), the effect on performance of the
decisions taken by the Production Director.
(6 marks)
(c)
Explain why a standard costing system may not be considered appropriate in a modern
manufacturing environment.
(6 marks)
(Total for Question Three = 25 marks)
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 enable the
reconciliation of budgeted and actual profit. Part (b) 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 discuss the reasons the variances may have
arisen and the possible interrelationship between the variances. Part (c) assesses learning outcome
A1(h) explain the impact of just-in-time manufacturing methods on cost accounting and the use of ‘backflush accounting’ when work in progress stock is minimal. It examines candidates’ ability to explain the
reasons why standard costing may not be considered useful in a modern manufacturing environment.
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 and production 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 discuss the effect that the Production Director’s decision has had on the
company performance as shown by the variances.
In part (c) candidates should clearly explain the reasons why standard costing may not be considered
useful in a modern manufacturing environment.
 The Chartered Institute of Management Accountants 2014
Page 17
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Marking Guide
Part (a)
Budgeted profit
Sales variances
Material variances
Labour variances
Variable overhead variances
Fixed overhead variances
Actual profit
Format of reconciliation statement
Marks
1 mark
2 marks
2 marks
2 marks
2 marks
2 marks
1 mark
1 mark
Total 13 marks
Part (b)
Discussion of the effect on performance of the decisions taken
by the production director
1 mark per
valid point
Max 6 marks
Part (c)
Explanation of why a standard costing system may not be
appropriate in a modern manufacturing environment
1 mark per
valid point
Max 6 marks
Maximum marks awarded
 The Chartered Institute of Management Accountants 2014
25 marks
Page 18
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Examiner’s comments
Candidate performance in part (a) was particularly disappointing with a typical candidate only calculating
the correct budgeted gross profit, sales price variance, material price and usage variances and labour
rate and efficiency variances.
Part (b) was not attempted by a number of candidates. Many candidates did not know how to answer this
type of question. Therefore rather than explaining the reasons for the variances based on the scenario
provided, they instead tried to make other suggestions as to what had caused the variances or they
stated that a further breakdown of the variances into planning and operational variances was required.
Candidates who did better at this question logically looked at the material variances then the labour
variances in turn and discussed each variance separately showing how they had been affected by the
details given in the scenario. Some candidates discussed material and labour variances but did not
discuss the sales price and sales volume variances even though the selling price and sales volume were
specifically mentioned in the scenario.
Part (c) was not particularly well done by many candidates. The main problem with candidates' answers
was that they tended to state that standard costing was outdated without explaining why. Many
candidates discussed activity based costing (ABC) and how using ABC would provide more accurate
costing information, which did not answer the question.
Common errors
Part (a)
• Calculating the sales volume profit variance using the budgeted sales price of $300 instead of the
budgeted gross profit of $60
• Calculating the material usage and labour efficiency variances based on the sales of 1,200 units
rather than on the production of 1,400 units
• Failure to calculate the overhead variances
• Calculating the total variable overhead variance of $9,000F as the expenditure variance
• Calculating the total fixed overhead variance as the expenditure variance
• Calculating the fixed overhead volume variance incorrectly as (6,800 - 7,000) x $3 = $600F
• Failure to adjust the actual gross profit figure for the increase in inventory of $48,000
• Poor presentation of the reconciliation statement
Part (b)
• Failure to interpret the variances based on the information given in the scenario
• Stating the amount of the variances without linking this to the scenario
• Failure to discuss the sales variances
Part (c)
• Failure to address the question
• Discussing the benefits of activity based costing
 The Chartered Institute of Management Accountants 2014
Page 19
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Question 4
Required:
(a)
Evaluate whether LM should go ahead with the proposal to establish an on-line shopping
service. You should use net present value as the basis of your evaluation. Your workings
should be rounded to the nearest $million.
(14 marks)
(b)
Explain TWO other factors that LM should consider before deciding whether to go ahead
with the contract.
(4 marks)
(c)
LM is concerned that replacing the delivery vehicles every five years will result in
breakdowns and customer complaints. It is therefore considering whether to replace the
vehicles on a one, two or three year cycle. The proposed contract with the online retailer
expires after five years however at the end of this period LM will continue to operate the
online business. The delivery vehicles will therefore require to be continually replaced.
Each vehicle costs $25,000. The operating costs per vehicle for each year and the resale
value at the end of each year are estimated as follows:
Operating costs
Resale value
Year 1
$
6,000
16,000
Year 2
$
8,000
10,000
Year 3
$
12,000
4,000
Required:
Calculate, using the annualised equivalent method, whether the vehicles should be
replaced on a one, two or three year cycle. You should assume that the initial investment
is incurred at the beginning of year 1 and that all other cash flows arise at the end of the
year. Ignore taxation and inflation and use a cost of capital of 12%.
(7 marks)
(Total for Question Four = 25 marks)
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(g) prepare decision support information for management, integrating financial and
non-financial considerations. It examines candidates’ ability to explain other factors that the company
would need to consider before deciding whether to go ahead with the project. Part (c) assesses learning
outcome C2(c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to
capital rationing. It examines candidates’ ability to determine the optimum replacement cycle for a
company’s non-current assets.
 The Chartered Institute of Management Accountants 2014
Page 20
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Suggested Approach
In part (a) candidates should firstly calculate the gross profit that would be earned in each year from the
online shopping service and deduct the lost profit from existing in-store sales. They should then deduct
the payments to PQ and the other operating costs and add on the lease income. The tax depreciation and
tax payments should then be calculated. The total cost of the investment, the residual value 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 clearly explain
two other factors that the company would need to consider before deciding whether to go ahead with the
project. In part (c) candidates should calculate the NPV of the cash flows under each of the three
alternatives. They should then divide the NPV by the appropriate annuity factor to calculate the
annualised equivalent cost. The optimum replacement cycle can then be selected as the alternative with
the lowest annualised equivalent cost.
Marking Guide
Part (a)
Year 1-5 gross profit
Lost gross profit on in-store sales
Other operating costs
Lease income
Fees to PQ
Tax depreciation
Tax payments
Initial investment/residual value
Discount factors
Present value of cash flows
Net present value of cash flows
Investment decision
Marks
2 ½ marks
1 mark
1 mark
½ mark
1 ½ marks
2 marks
2 marks
1 mark
½ mark
½ mark
½ mark
1 mark
Total 14
marks
Part (b)
Two other factors that the company would need to consider
Part (c)
Net present value after 1 year
Net present value after 2 years
Net present value after 3 years
Annualised equivalent cost
Decision
Up to 2 marks
for each
factor
1 mark
1 ½ marks
2 marks
1 ½ marks
1 mark
Total 7
marks
 The Chartered Institute of Management Accountants 2014
Page 21
Paper P1 – Performance Operations
Post Exam Guide
March 2014 Exam
Examiner’s comments
Part (a) of this question was reasonably well done. Most candidates are now very familiar with this type of
question and make a reasonable attempt at it. However there are many mistakes that are made through
either careless reading of the scenario or basic mathematical errors. Candidates seem to be better at
dealing with the tax depreciation with fewer candidates treating it as a cash flow however they still
struggle to calculate the balancing figure correctly. Some candidates still get confused about how to deal
with depreciation. Some candidates deducted it from the fixed costs even though the question specifically
stated that the costs were excluding the depreciation. Most candidates are now including a statement as
to whether or not the project should go ahead.
Many candidates found part (b) difficult as they needed to think of other factors, but unfortunately most
candidates could only question the figures provided in part (a).
Many candidates struggled with part (c) even though the net present value (NPV) calculations are
straightforward, and should provide some easy marks. For some reason candidates seem to struggle to
interpret the cash flows and often do not discount correctly.
Common errors
Part (a)
• Failure to multiply the gross profit by 52 weeks
• Making decimal place value errors on the costs
• Multiplying the sales revenue by 1.2 instead of by 0.2
• Deducting 20% from the sales revenue i.e. calculating the gross margin as 80%
• Applying the 1% fee to PQ to the net gross profit i.e. after the forgone gross profit from in-store
sales
• Including the lease income as a cost
•
Calculating tax depreciation on the warehouse costs even though the question stated specifically
that these costs would not be eligible for tax depreciation
Part (b)
• Failure to address the question
Part (c)
• Treating the cost of the vehicle as a Year 1 cash flow rather than a Year 0 cash flow
• Using the cumulative discount factors in the net present value calculation
• Failure to include the previous years’ operating costs in the net present value calculations
• Calculating the annualised equivalent cost by dividing by 1, 2 and 3 respectively
 The Chartered Institute of Management Accountants 2014
Page 22