May 2007 Examinations
Managerial Level
Paper P2 – Management Accounting – Decision
Management
Question Paper
2
Examiner’s Brief Guide to the Paper
20
Examiner’s Answers
21
The answers published here have been written by the Examiner and should provide a helpful
guide for both tutors and students.
Published separately on the CIMA website (www.cimaglobal.com/students) from mid-September
2007 is a Post Examination Guide for this paper, which provides much valuable and
complementary material including indicative mark information.
 2007 The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recorded or otherwise, without the written permission of the publisher.
Managerial Level Paper
P2 – Management Accounting Decision Management
23 May 2007 – Wednesday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper.
You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, highlight
and/or make notes on the question paper. However, you will not be allowed,
under any circumstances, to open the answer book and start writing or use
your calculator during the reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is, all parts and/or subquestions). The requirements for the questions in Sections B and C are
contained in a dotted box.
ALL answers must be written in the answer book. Answers or notes written
on the question paper will not be submitted for marking.
Answer the ONE compulsory question in Section A. This has eight subquestions and is on pages 3 to 5.
Answer ALL THREE compulsory questions in Section B on pages 6 to 9.
Answer TWO of the three questions in Section C on pages 10 to 15.
Maths Tables and Formulae are provided on pages 16 to 18.
The list of verbs as published in the syllabus is given for reference on the
inside back cover of this question paper.
Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.
P2 – Decision Management
Management Accounting Pillar
Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.
P2
2
May 2007
SECTION A – 20 MARKS
[the indicative time for answering this section is 36 minutes]
ANSWER ALL EIGHT SUB-QUESTIONS
Instructions for answering Section A:
The answers to the eight sub-questions in Section A should ALL be written in your
answer book.
Your answers should be clearly numbered with the sub-question number and then
ruled off, so that the markers know which sub-question you are answering. For
multiple choice questions, you need only write the sub-question number and
the letter of the answer option you have chosen. You do not need to start a
new page for each sub-question.
For sub-questions 1.6, 1.7 and 1.8 you should show your workings as marks are
available for the method you use to answer these sub-questions.
Question One
1.1
An investment project that requires an initial investment of $500,000 has a residual value
of $130,000 at the end of five years. The project’s cash flows have been discounted at the
company’s cost of capital of 12% and the resulting net present value is $140,500. The
profitability index of the project is closest to:
A
0·02
B
0·54
C
0·28
D
0·26
(2 marks)
1.2
A project has a net present value of $320,000.
The sales revenues for the project have a total pre-discounted value of $900,000 and a
total present value of $630,000 after tax.
The sensitivity of the investment to changes in the value of sales is closest to:
A
$310,000
B
$580,000
C
51%
D
36%
(2 marks)
May 2007
3
P2
1.3
A company provides a number of different services to its customers from a single office.
The fixed costs of the office, including staff costs, are absorbed into the company’s
service costs using an absorption rate of $25 per consulting hour based on a budgeted
activity level of 100,000 hours each period.
Fee income and variable costs are different depending on the services provided, but the
average contribution to sales ratio is 35%. The breakeven fee income each period is
closest to:
A
$1,400,000
B
$11,500,000
C
$875,000
D
$7,143,000
(2 marks)
1.4
A company has recently completed the production of the first unit of a new product. The
time taken for this was 12 minutes. The company expects that there will be a 75%
learning rate for this product.
Calculate the total time expected to produce the first four units.
(2 marks)
The following data are given for sub-questions 1.5 and 1.6 below
An investment project with no residual value has a net present value of $87,980 when it is
discounted using a cost of capital of 10%. The annual cash flows are as follows:
Year
0
1
2
3
4
5
$
(200,000)
80,000
90,000
100,000
60,000
40,000
1.5
Calculate the Accounting Rate of Return of the project using the average investment
value basis.
(2 marks)
1.6
Calculate the Internal Rate of Return of the project.
(3 marks)
P2
4
May 2007
1.7
A company manufactures three products. Each of these products use the same type of
material but in different quantities. The unit selling prices, cost and profit details are as
follows:
Product
X
$/unit
Selling price
Y
$/unit
Z
$/unit
23
26
28
Direct materials
Direct labour
Variable overhead
Fixed overhead
6
8
2
4
8
6
3
5
6
8
3
6
Profit
3
4
5
The direct material used on all three products costs $10 per kg. The material available is
expected to be limited to 600 kgs for the next accounting period. The maximum demand
for each of the products during the next accounting period is expected to be as follows:
X
240 units
Y
600 units
Z
400 units
No inventories of finished products are held.
Calculate the optimum product mix for the next accounting period.
(3 marks)
1.8
A company is launching a new product. Market research shows that if the selling price of
the product is $100 then demand will be 1,200 units, but for every $10 increase in selling
price there will be a corresponding decrease in demand of 200 units and for every $10
decrease in selling price there will be a corresponding increase in demand of 200 units.
The estimated variable costs of the product are $30 per unit. There are no specific fixed
costs but general fixed costs are absorbed using an absorption rate of $8 per unit.
Calculate the selling price at which profit is maximised.
Note: When Price = a-bx then Marginal Revenue = a-2bx
(4 marks)
(Total for Section A = 20 marks)
Reminder
All answers to Section A must be written in your answer book.
Answers to Section A written on the question paper will not be
submitted for marking.
End of Section A
Section B starts on page 6
May 2007
5
P2
SECTION B – 30 MARKS
[the indicative time for answering this section is 54 minutes]
ANSWER ALL THREE QUESTIONS
Question Two
A company is planning to launch a new product. It has already carried out market research at a
cost of $50,000 and as a result has discovered that the market price for the product should be
$50 per unit. The company estimates that 80,000 units of the product could be sold at this price
before one of the company’s competitors enters the market with a superior product. At this time
any unsold units of the company’s product would be of no value.
The company has estimated the costs of the initial batch of the product as follows:
Direct materials
Direct labour ($10 per hour)
Other direct costs
$000
200
250
100
Production was planned to occur in batches of 10,000 units and it was expected that an 80%
learning curve would apply to the direct labour until the fourth batch was complete. Thereafter
the direct labour cost per batch was expected to be constant. No changes to the direct labour
rate per hour were expected.
The company introduced the product at the price stated above, with production occurring in
batches of 10,000 units. Direct labour was paid using the expected hourly rate of $10 and the
company is now reviewing the profitability of the product. The following schedule shows the
actual direct labour cost recorded:
Cumulative number of batches
Actual cumulative direct labour cost
$000
280
476
809
1,376
1
2
4
8
Required:
(i)
Calculate the revised expected cumulative direct labour costs for the four levels
of output given the actual cost of $280,000 for the first batch.
(ii)
Calculate the actual learning rate exhibited at each level of output.
(iii)
Discuss the implications of your answers to (i) and (ii) for the managers of the
company.
(10 marks)
(Total for Question Two = 10 marks)
Section B continues on the opposite page
P2
6
May 2007
Question Three
A company operates a fleet of three canal boats that provide cruises for tourists around the
canals of a city. The company seeks your advice as to whether it is better to replace its boats
every year, every two years or every three years. The company has provided the following data:
Annual sales revenue from operating each boat
Purchase cost of each boat
$
800,000
400,000
Operating costs, which include maintenance, servicing, and similar costs are paid at the end of
each year. Operating costs and end of year trade-in values vary depending on the age of the
boat and are as follows for each year of the boat’s life:
Year
1
2
3
Operating Costs
$
300,000
400,000
600,000
Trade-in values
$
240,000
150,000
80,000
These costs do not include depreciation or any other fixed costs of providing the tourist service.
These other fixed costs are a constant $100,000 per year regardless of the age of the boat.
The company uses an 8% cost of capital for its investment decisions.
Required:
(a)
Produce calculations to determine the optimum replacement cycle of the
boats and state clearly your recommendations. Ignore taxation.
(6 marks)
The same company is also considering investing in one of three marketing campaigns to
increase its profitability. All three marketing campaigns have a life of five years, require the
same initial investment and have no residual value. The company has already evaluated the
marketing campaigns taking into consideration the range of possible outcomes that could result
from the investment. A summary of the calculations is shown below:
Marketing Campaign
Expected Net Present Value
Standard Deviation of Net Present Value
J
K
L
$400,000
$800,000
$400,000
$35,000
$105,000
$105,000
Required:
(b)
(i)
Explain the meaning of the data shown above; and
(ii)
Briefly explain how the data may be used by the company when choosing
between alternative investments.
(4 marks)
(Total for Question Three = 10 marks)
May 2007
7
P2
Question Four
Z is one of a number of companies that produce three products for an external market. The
three products, R, S and T may be bought or sold in this market.
The common process account of Z for March 2007 is shown below:
Inputs:
Material A
Material B
Material C
Direct labour
Variable overhead
Fixed cost
Totals
Kg
$
1,000
2,000
1,500
3,500
2,000
3,000
6,000
2,000
1,000
4,500
17,500
Kg
Normal loss
Outputs:
Product R
Product S
Product T
$
500
0
800
2,000
1,200
3,500
8,750
5,250
4,500
17,500
Z can sell products R, S or T after this common process or they can be individually further
processed and sold as RZ, SZ and TZ respectively. The market prices for the products at the
intermediate stage and after further processing are:
Market prices per kg:
R
S
T
RZ
SZ
TZ
$
3·00
5·00
3·50
6·00
5·75
6·75
The specific costs of the three individual further processes are:
Process R to RZ
Process S to SZ
Process T to TZ
variable cost of $1·40 per kg, no fixed costs
variable cost of $0·90 per kg, no fixed costs
variable cost of $1·00 per kg, fixed cost of $600 per month
The question requirement is on the opposite page
P2
8
May 2007
Required:
(a)
Produce calculations to determine whether any of the intermediate products
should be further processed before being sold. Clearly state your
recommendations together with any relevant assumptions that you have
made.
(3 marks)
(b)
Produce calculations to assess the viability of the common process:
(i)
assuming that there is an external market for products R,S and T; and
(ii)
assuming that there is not an external market for products R,S and T.
State clearly your recommendations.
(7 marks)
(Total for Question Four =10 marks)
(Total for Section B = 30 marks)
End of Section B
Section C starts on page 10
May 2007
9
P2
SECTION C – 50 MARKS
[the indicative time for answering this section is 90 minutes]
ANSWER TWO QUESTIONS OUT OF THREE
Question Five
X operates in an economy that has almost zero inflation. Management ignores inflation
when evaluating investment projects because it is so low as to be considered insignificant. X
is evaluating a number of similar, alternative investments. The company uses an after tax
cost of capital of 6% and has already completed the evaluation of two investments. The third
investment is a new product that would be produced on a just-in-time basis and which is
expected to have a life of three years. This investment requires an immediate cash outflow of
$200,000, which does not qualify for tax depreciation. The expected residual value at the end
of the project’s life is $50,000. A draft financial statement showing the values that are specific
to this third investment for the three years is as follows:
Year 1
$
Year 2
$
Year 3
$
230,000
350,000
270,000
54,000
60,000
80,000
102,000
80,000
90,000
66,000
70,000
80,000
Profit
36,000
78,000
54,000
Closing receivables
Closing payables
20,000
6,000
30,000
9,000
25,000
8,000
Sales
Production costs:
Materials
Labour
Other*
*Other production costs shown above include depreciation calculated using the straight line
method.
The company is liable to pay corporation tax at a rate of 30% of its profits. One half of this is
payable in the same year as the profit is earned, the remainder is payable in the following year.
Required:
(a)
Calculate the net present value of the above investment proposal.
(10 marks)
(b)
P2
Explain how the above investment project would be appraised if there were
to be a change in the rate of inflation so that it became too significant to be
ignored.
(5 marks)
10
May 2007
The evaluations of the other two investments are shown below:
Investment
W
Y
Initial investment
$
300,000
100,000
Net Present Value
$
75,000
27,000
The company only has $400,000 of funds available. All of the investment proposals are nondivisible. None of the investments may be repeated.
Required:
(c)
Recommend, with supporting calculations, which of the three investment
proposals should be accepted.
(3 marks)
(d)
(i)
Briefly explain gain sharing arrangements.
(3 marks)
(ii)
Explain the reasons why X might not want to overcome its investment funding
limitations by using a gain sharing arrangement.
(4 marks)
(Total for Question Five = 25 marks)
Section C continues on the next page
May 2007
11
P2
Question Six
H, a printing company, uses traditional absorption costing to report its monthly profits.
It is seeking to increase its business by winning work from new customers. It now has the
opportunity to prepare a quotation for a large organisation that currently requires a new
catalogue of its services.
A technical report on the resource requirements for the catalogues has been completed at a
cost of $1,000 and its details are summarised below:
Production period
It is expected that the total time required to print and despatch the catalogue will be one week.
Material A
10,000 sheets of special printing paper will be required. This is a paper that is in regular use by
H and the company has 3,400 sheets in inventory. These originally cost $1·40 per sheet but the
current market price is $1·50 per sheet. The resale price of the sheets held in inventory is $1·20
per sheet.
Material B
This is a special ink that H will need to purchase at a cost of $8 per litre. 200 litres will be
required for this catalogue but the supplier has a minimum order size of 250 litres. H does not
foresee any other use for this ink, but will hold the surplus in inventory. H’s inventory policy is to
review slow moving items regularly. The cost of any inventory item that has not been used for
more than 6 months is accounted for as an expense of the period in which that review occurs.
Direct labour
Sufficient people are already employed by H to print the catalogue, but some of the printing will
require overtime working due to the availability of a particular machine that is used on other
work. The employees are normally paid $8 per hour, the order will require 150 hours of work and
50 of these hours will be in excess of the employees’ normal working week. A rate of $10 per
hour is paid for these overtime hours. Employees are paid using an hourly rate with a
guaranteed minimum wage for their normal working week.
Supervision
An existing supervisor will take responsibility for the catalogue in addition to her existing duties.
She is not currently fully employed and receives a salary of $500 per week.
Machinery
Two different types of machine will be required:
Machine A will print the catalogues. This is expected to take 20 hours of machine time. The
running cost of machine A is $5 per hour. There is currently 30 hours of unused time on
machine A per week that is being sold to other printers for $12 per hour.
Machine B will be used to cut and bind the catalogues. This machine is being used to full
capacity in the normal working week and this is why there is a need to work overtime. The
catalogue will require 25 machine hours and these have a running cost of $4 per hour.
Despatch
There will be a delivery cost of $400 to transport the catalogues to the customer.
Fixed overhead costs
H uses a traditional absorption costing system to attribute fixed overhead costs to its work. The
absorption rate that it uses is $20 per direct labour hour.
Profit mark-up
H applies a 30% mark-up to its costs to determine its selling prices.
P2
12
May 2007
Required:
(a)
In order to assist the management of H in preparing its quotation, prepare a
schedule showing the relevant costs for the production of the catalogues.
State clearly your reason for including or excluding each value that has been
provided in the above scenario.
(15 marks)
(b)
Explain how the use of relevant costs as the basis of setting a selling price
may be appropriate for short-term pricing decisions but may be inappropriate
for long-term pricing decisions. Your answer should also discuss the conflict
between reporting profitability within a traditional absorption costing system
and the use of relevant cost based pricing.
(10 marks)
(Total for Question Six = 25 marks)
Section C continues on the next page
May 2007
13
P2
Question Seven
D provides a motorist rescue service to its members. At present all members pay a basic fee of
$100 per year but D is considering the introduction of different fees for members depending on
the data they provide when joining the service. The number of members, and therefore the fee
income of D, is uncertain but the following estimates have been made:
Number of members
20,000
30,000
40,000
Probability
0·3
0·5
0·2
Required:
(a)
Calculate the expected annual fee income of D.
(2 marks)
The operating costs to be incurred by D have been analysed between call-out costs and
administration costs. These operating costs have been assumed to vary in relation to the
number of members and consequently the average costs per member for next year are
expected to be:
Call-out cost per member for the year
Administration cost per member for the year
$50
$10
Each of these operating costs may vary by plus or minus 20%. There is equal probability of
these costs being as expected, 20% higher, or 20% lower. In addition D expects to incur annual
fixed costs of $1,100,000.
Required:
(b)
Using Expected Values, calculate the breakeven number of members.
(3 marks)
(c)
Prepare a two-way data table that shows the nine possible profit values.
(6 marks)
(d)
Explain the meaning of table that you have produced in (c) above and, by
including appropriate probability values, how it may be used by management.
(4 marks)
Now that you have presented your calculations and explanations to the Management Team of D
they have questioned the validity of the assumption that costs are caused by and therefore vary
in relation to the number of members. They referred to the activities that are performed by the
company:
•
•
•
•
•
P2
Processing applications for membership;
Operating the call centre that deals with logging and scheduling rescues;
Providing patrol vehicles and mechanics for breakdown assistance;
Recording details of the time taken to respond to members’ rescues;
Recording details of the costs incurred in carrying out each rescue.
14
May 2007
The Management Team collectively agreed that your assumption that operating costs are driven
by the number of members was too simplistic and that in future the Administration department
should request the following information from members:
•
•
•
•
•
•
Member’s date of birth;
Member’s address;
Number of years the member has been a qualified driver;
Age of vehicle;
Make and model of vehicle;
Average annual mileage.
Required:
(e)
Explain how and why the collection of this data from members might improve the
information that would be available to the Management Team.
(10 marks)
(Total for Question Seven = 25 marks)
(Total for Section C = 50 marks)
End of question paper
Maths Tables and Formulae are on pages 16 to 18
May 2007
15
P2
PRESENT VALUE TABLE
Present value of $1, that is (1+ r )
payment or receipt.
−n
where r = interest rate; n = number of periods until
Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
1%
0.990
0.980
0.971
0.961
0.951
0.942
0.933
0.923
0.914
0.905
0.896
0.887
0.879
0.870
0.861
0.853
0.844
0.836
0.828
0.820
2%
0.980
0.961
0.942
0.924
0.906
0.888
0.871
0.853
0.837
0.820
0.804
0.788
0.773
0.758
0.743
0.728
0.714
0.700
0.686
0.673
3%
0.971
0.943
0.915
0.888
0.863
0.837
0.813
0.789
0.766
0.744
0.722
0.701
0.681
0.661
0.642
0.623
0.605
0.587
0.570
0.554
4%
0.962
0.925
0.889
0.855
0.822
0.790
0.760
0.731
0.703
0.676
0.650
0.625
0.601
0.577
0.555
0.534
0.513
0.494
0.475
0.456
Interest rates (r)
5%
6%
0.952
0.943
0.907
0.890
0.864
0.840
0.823
0.792
0.784
0.747
0.746
0705
0.711
0.665
0.677
0.627
0.645
0.592
0.614
0.558
0.585
0.527
0.557
0.497
0.530
0.469
0.505
0.442
0.481
0.417
0.458
0.394
0.436
0.371
0.416
0.350
0.396
0.331
0.377
0.312
7%
0.935
0.873
0.816
0.763
0.713
0.666
0.623
0.582
0.544
0.508
0.475
0.444
0.415
0.388
0.362
0.339
0.317
0.296
0.277
0.258
8%
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215
9%
0.917
0.842
0.772
0.708
0.650
0.596
0.547
0.502
0.460
0.422
0.388
0.356
0.326
0.299
0.275
0.252
0.231
0.212
0.194
0.178
10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
0.467
0.424
0.386
0.350
0.319
0.290
0.263
0.239
0.218
0.198
0.180
0.164
0.149
Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
11%
0.901
0.812
0.731
0.659
0.593
0.535
0.482
0.434
0.391
0.352
0.317
0.286
0.258
0.232
0.209
0.188
0.170
0.153
0.138
0.124
12%
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322
0.287
0.257
0.229
0.205
0.183
0.163
0.146
0.130
0.116
0.104
13%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
0.376
0.333
0.295
0.261
0.231
0.204
0.181
0.160
0.141
0.125
0.111
0.098
0.087
14%
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270
0.237
0.208
0.182
0.160
0.140
0.123
0.108
0.095
0.083
0.073
Interest rates (r)
15%
16%
0.870
0.862
0.756
0.743
0.658
0.641
0.572
0.552
0.497
0.476
0.432
0.410
0.376
0.354
0.327
0.305
0.284
0.263
0.247
0.227
0.215
0.195
0.187
0.168
0.163
0.145
0.141
0.125
0.123
0.108
0.107
0.093
0.093
0.080
0.081
0.069
0.070
0.060
0.061
0.051
17%
0.855
0.731
0.624
0.534
0.456
0.390
0.333
0.285
0.243
0.208
0.178
0.152
0.130
0.111
0.095
0.081
0.069
0.059
0.051
0.043
18%
0.847
0.718
0.609
0.516
0.437
0.370
0.314
0.266
0.225
0.191
0.162
0.137
0.116
0.099
0.084
0.071
0.060
0.051
0.043
0.037
19%
0.840
0.706
0.593
0.499
0.419
0.352
0.296
0.249
0.209
0.176
0.148
0.124
0.104
0.088
0.079
0.062
0.052
0.044
0.037
0.031
20%
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
0.135
0.112
0.093
0.078
0.065
0.054
0.045
0.038
0.031
0.026
P2
16
May 2007
Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
years
1− (1+ r ) − n
r
Periods
(n)
1
2
3
4
5
1%
0.990
1.970
2.941
3.902
4.853
2%
0.980
1.942
2.884
3.808
4.713
3%
0.971
1.913
2.829
3.717
4.580
4%
0.962
1.886
2.775
3.630
4.452
Interest rates (r)
5%
6%
0.952
0.943
1.859
1.833
2.723
2.673
3.546
3.465
4.329
4.212
7%
0.935
1.808
2.624
3.387
4.100
8%
0.926
1.783
2.577
3.312
3.993
9%
0.917
1.759
2.531
3.240
3.890
10%
0.909
1.736
2.487
3.170
3.791
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
4.868
5.335
5.759
6.145
11
12
13
14
15
10.368
11.255
12.134
13.004
13.865
9.787
10.575
11.348
12.106
12.849
9.253
9.954
10.635
11.296
11.938
8.760
9.385
9.986
10.563
11.118
8.306
8.863
9.394
9.899
10.380
7.887
8.384
8.853
9.295
9.712
7.499
7.943
8.358
8.745
9.108
7.139
7.536
7.904
8.244
8.559
6.805
7.161
7.487
7.786
8.061
6.495
6.814
7.103
7.367
7.606
16
17
18
19
20
14.718
15.562
16.398
17.226
18.046
13.578
14.292
14.992
15.679
16.351
12.561
13.166
13.754
14.324
14.878
11.652
12.166
12.659
13.134
13.590
10.838
11.274
11.690
12.085
12.462
10.106
10.477
10.828
11.158
11.470
9.447
9.763
10.059
10.336
10.594
8.851
9.122
9.372
9.604
9.818
8.313
8.544
8.756
8.950
9.129
7.824
8.022
8.201
8.365
8.514
Periods
(n)
1
2
3
4
5
11%
0.901
1.713
2.444
3.102
3.696
12%
0.893
1.690
2.402
3.037
3.605
13%
0.885
1.668
2.361
2.974
3.517
14%
0.877
1.647
2.322
2.914
3.433
Interest rates (r)
15%
16%
0.870
0.862
1.626
1.605
2.283
2.246
2.855
2.798
3.352
3.274
17%
0.855
1.585
2.210
2.743
3.199
18%
0.847
1.566
2.174
2.690
3.127
19%
0.840
1.547
2.140
2.639
3.058
20%
0.833
1.528
2.106
2.589
2.991
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
3.605
3.837
4.031
4.192
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.988
5.118
5.229
5.324
4.656
7.793
4.910
5.008
5.092
4.486
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
16
17
18
19
20
7.379
7.549
7.702
7.839
7.963
6.974
7.120
7.250
7.366
7.469
6.604
6.729
6.840
6.938
7.025
6.265
6.373
6.467
6.550
6.623
5.954
6.047
6.128
6.198
6.259
5.668
5.749
5.818
5.877
5.929
5.405
5.475
5.534
5.584
5.628
5.162
5.222
5.273
5.316
5.353
4.938
4.990
5.033
5.070
5.101
4.730
4.775
4.812
4.843
4.870
May 2007
17
P2
FORMULAE
Time series
Additive model:
Series = Trend + Seasonal + Random
Multiplicative model:
Series = Trend*Seasonal*Random
Regression analysis
The linear regression equation of Y on X is given by:
Y = a + bX
or Y – Y = b(X – X ),
where:
b=
Covariance ( XY )
Variance ( X )
=
n ∑ XY − ( ∑ X )( ∑ Y )
2
n ∑ X − (∑ X )
2
a= Y –bX
and
or solve
∑ Y = na + b ∑ X
∑ XY = a ∑ X + b ∑ X2
Exponential
Geometric
Y = abx
Y = aXb
Learning curve
Yx = aXb
where:
Yx = the cumulative average time per unit to produce X units;
a = the time required to produce the first unit of output;
X = the cumulative number of units;
b = the index of learning.
The exponent b is defined as the log of the learning curve improvement rate divided by log 2.
P2
18
May 2007
LIST OF VERBS USED IN THE QUESTION REQUIREMENTS
A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for
each question in this paper.
It is important that you answer the question according to the definition of the verb.
LEARNING OBJECTIVE
1 KNOWLEDGE
What you are expected to know.
2 COMPREHENSION
What you are expected to understand.
VERBS USED
DEFINITION
List
State
Define
Make a list of
Express, fully or clearly, the details of/facts of
Give the exact meaning of
Describe
Distinguish
Explain
Identify
Communicate the key features
Highlight the differences between
Make clear or intelligible/State the meaning of
Recognise, establish or select after
consideration
Use an example to describe or explain
something
Illustrate
3 APPLICATION
How you are expected to apply your knowledge.
Apply
Calculate/compute
Demonstrate
Prepare
Reconcile
Solve
Tabulate
4 ANALYSIS
How are you expected to analyse the detail of
what you have learned.
Analyse
Categorise
Compare and contrast
5 EVALUATION
How are you expected to use your learning to
evaluate, make decisions or recommendations.
May 2007
19
To put to practical use
To ascertain or reckon mathematically
To prove with certainty or to exhibit by
practical means
To make or get ready for use
To make or prove consistent/compatible
Find an answer to
Arrange in a table
Construct
Discuss
Interpret
Produce
Examine in detail the structure of
Place into a defined class or division
Show the similarities and/or differences
between
To build up or compile
To examine in detail by argument
To translate into intelligible or familiar terms
To create or bring into existence
Advise
Evaluate
Recommend
To counsel, inform or notify
To appraise or assess the value of
To advise on a course of action
P2
The Examiner for Management Accounting – Decision Management 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 comprises eight sub questions in objective testing format. Some of the questions provide a
choice of answers of which only one is correct while others require solution by the candidate. This question
covers a number of syllabus areas and learning outcomes and is designed to complement the syllabus
coverage of the remaining questions on the paper.
Section B – Questions Two, Three and Four – Compulsory
Question Two This question tests candidates’ understanding of the learning curve and the effect of
differences between the expected and actual initial unit/time cost, the learning rate and the length of the
learning period on the eventual time/cost of units produced. This question addresses the learning outcome:
Explain and apply learning and experience curves to estimate time and cost for new products and services.
Question Three This question tests candidates’ knowledge of two specific areas of long term decision
making. In part (a) candidates are required to prepare calculations to determine the optimum asset
replacement cycle for a company. In part (b) candidates are required to explain the data provided and how
it may be used to choose between alternative investments. This question addresses the learning outcome:
Evaluate and rank projects that might be mutually exclusive, involve unequal lives and/or be subject to
capital rationing.
Question Four This question tests candidates’ ability to interpret a process account and with the other
data provided to determine the viability of the process. This question addresses the learning outcome:
Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is
unhelpful when decisions concerning process and product viability have to be taken.
Section C – answer two of three questions
Question Five This question tests candidates’ ability in part (a) to calculate the net present value of an
investment proposal from the data provided and in part (b) to discuss how their appraisal would change if
inflation were at a significant level. Part (c) of the question requires candidates to choose between
alternative investment opportunities, and part (d) requires candidates to explain gain sharing arrangements
and why they may not be a solution to a limitation in investment funding. This question addresses the
learning outcomes: Calculate project cash flows, accounting for tax and inflation, and apply perpetuities to
derive “end of project” value where appropriate; and Evaluate and rank projects that might be mutually
exclusive, involve unequal lives and/or be subject to capital rationing and Discuss gain sharing
arrangements whereby contractors and customers benefit if contract targets for cost, delivery etc are
beaten.
Question Six This question tests candidates’ ability in part (a) to interpret relevant cost data to determine
the relevant cost of printing a brochure and in part (b) to explain the appropriateness of using relevant
costs as the basis of pricing and the conflict that can arise when reporting profitability if a relevant cost
based pricing method is used. This question addresses the learning outcomes: Discuss the principles of
decision making including the identification of relevant cash flows and their use alongside non-quantifiable
factors in making rounded judgements; and Explain the possible conflicts between cost accounting for
profit reporting and stock valuation and the convenient availability of information for decision making; and
Explain the particular issues that arise in pricing decisions and the conflict between “marginal cost”
principles and the need for full recovery of all costs incurred.
Question Seven This question tests candidates’ ability to analyse data to determine the expected value
and range of possible profit values that could arise for a company that provides a motorist rescue service
and then to explain how the use of activity based costing might improve the information available to the
Management Team. This question addresses the learning outcomes: Evaluate the impact of uncertainty
and risk on decision models that may be based on CVP analysis, relevant cash flows, learning curves,
discounting techniques etc; and Apply activity based costing ideas to analyse direct customer profitability
and extend this analysis to distribution channel profitability.
P2
20
May 2007
Managerial Level Paper
P2 – Management Accounting – Decision
Management
Examiner’s Answers
SECTION A
Answer to Question One
1.1
Profitability Index = $140,500 / $500,000 = 0·28
The correct answer is C.
1.2
Sensitivity = $320,000 / $630,000 = 51%
The correct answer is C.
1.3
Breakeven sales value = Fixed cost / Contribution to sales ratio
= $2,500,000/ 0·35
= $7,142,857
The correct answer is D.
1.4
Units
1
2
4
Average Time/unit (minutes)
12·00
9·00
6·75
1.5
Lifetime cash flows
Lifetime depreciation
Lifetime profit
Average annual profit
Total time (minutes)
12·00
18·00
27·00
$
370,000
200,000
170,000
34,000
ARR = Average annual profit / Average investment value
= $34,000 / $100,000
= 34%
May 2007
21
P2
1.6
Discounting the cash flows using 20% gives:
Year
0
1
2
3
4
5
Cash flow
$
(200,000)
80,000
90,000
100,000
60,000
40,000
DF
PV
$
(200,000)
66,640
62,460
57,900
28,920
16,080
32,000
1·000
0·833
0·694
0·579
0·482
0·402
IRR (%) = 20 + (32,000/55,980 x 10) = 26%
1.7
Product
Contribution / unit
X
$7
Y
$9
Z
$11
Materials / unit (kg)
0·6
0·8
0·6
$11·67
$11·25
$18·33
Ranking
2nd
3rd
1st
Produce (units)
240
270
400
Uses (kgs)
144
216
240
Contribution / kg
1.8
P = $160 – 0·05q
MR = 160 – 0·1q
MC = 30
Profit is maximised when MC = MR so
30 = 160 – 0·1q
130 = 0·1q
q = 1,300
P = $160 – 0·05q
Therefore P = $160 – (0·05 x 1,300) = $95
P2
22
May 2007
SECTION B
Answer to Question Two
(i)
The company expected that the first batch of units would have a labour cost of $250
whereas the actual labour cost of the first batch was $280.
The company expected that there would be an 80% learning curve for the first four
batches, if this applied to the actual time taken for the first batch, the expected labour cost
for the first four levels would have been as follows:
Cumulative number of
batches
1
2
4
8
(ii)
Average direct labour cost
$
280
224
179·2
153·1
Cumulative direct labour cost
$
280
448
716·80
1224·85
The average actual direct labour costs per batch and their comparison with previous
averages can be calculated from the data provided as follows:
Cumulative number of
batches
1
2
4
8
Average direct labour cost
per batch
$
280
238
202·25
172
Average as % of previous
average
85%
85%
85%
The learning period did not end after four batches.
(iii)
It can be seen that there were differences in the initial time, the rate of learning and the
length of the learning period compared to those expected. As a consequence there will be
an impact on the profitability of the company or its pricing strategy depending upon the
basis of pricing being used. Further this may impact of the pricing of similar items in the
future.
May 2007
23
P2
Answer to Question Three
Requirement (a)
The sales revenue and fixed costs are the same regardless of the age of the boat and are
therefore not relevant to the decision. Depreciation is irrelevant because it is not a cash cost.
The solution is found by comparing the equivalent annual costs of each replacement cycle.
One year cycle
Year 1
Description
Cash flow
DF
PV
0
Purchase cost
$400,000
1·000
$400,000
1
Operating costs
Trade in value
$300,000
($240,000)
$ 60,000
0·926
$55,560
$455,560
Annualised equivalent
$455,560/0·926
$491,965
Two year cycle
Year 1
Description
Cash flow
DF
PV
0
Purchase cost
$400,000
1·000
$400,000
1
Operating costs
$300,000
0·926
$277,800
2
Operating costs
Trade in value
$400,000
($150,000)
$250,000
0·857
$214,250
1·783
$892,050
Annualised equivalent
$892,050/1·783
$500,308
Three year cycle
Year 1
Description
Cash flow
DF
PV
0
Purchase cost
$400,000
1·000
$400,000
1
Operating costs
$300,000
0·926
$277,800
2
Operating costs
$400,000
0·857
$342,800
3
Operating costs
Trade in value
$600,000
($80,000)
$520,000
0·794
$412,880
2·578
$1,433,480
Annualised equivalent
$1,433,480/2·578
$556,043
The lowest annualised cost is given by the one year cycle so this should be chosen.
P2
24
May 2007
Requirement (b)
(i)
The expected net present value of the campaigns is an average value based upon the
probability associated with each possible outcome. Its use as a management tool can
therefore be misleading because it does not provide any indication of the range of values
that may result. The standard deviation is a measure of the range of values that could
occur. The higher the standard deviation, the greater is the range of possible values and
therefore the more risky is the campaign.
(ii)
In the example provided campaigns J and L have the same expected net present value
but the standard deviation of campaign J is much lower. Thus campaign J is more
acceptable to a risk averse manager than campaign L because the expected return is the
same but for lower risk. Campaign K has the highest expected net present value but has
the same standard deviation (risk) as campaign L. Clearly therefore campaign K is
preferable to campaign L because it has higher return for the same risk. The selection of
campaign J rather than campaign K or vice versa will depend on the risk attitude of the
company. One campaign (J) is low risk but with a relatively low average return whereas
the other (K) is high risk with a high average return.
Answer to Question Four
Requirement (a)
Product
RZ
SZ
TZ
Incremental revenue per kg
$3·00
$0·75
$3·25
Incremental cost per kg
$1·40
$0·90
$1·00*
*excludes specific fixed cost of further process.
On financial grounds, it can clearly be seen that product R should be processed into RZ before it
is sold because the incremental revenue exceeds the incremental cost of further processing.
However, the opposite is true in respect of product S.
For product T the average further processing fixed cost per kg is $0·50 and thus this too should
be further processed provided the output shown from the earlier process of 1,200 kg is
representative of expected future output levels.
However, before making any final decisions the company must consider any non-financial
factors which might affect the decision such as the marketing effect of not supplying SZ and
whether this will affect the demand for RZ and TZ.
Requirement (b) (i)
The sales value of the output from the common process can be calculated as follows:
Product
R
S
T
Selling price/kg
$3·00
$5·00
$3·50
Kgs
800
2,000
1,200
Sales value
$ 2,400
$10,000
$ 4,200
$16,600
The costs of the common process during March 2007 were $17,500 and thus exceeded the
sales values of the products produced. The common process is not financially viable.
May 2007
25
P2
Requirement (b) (ii)
If there is no intermediate market then the further processing benefits also accrue to the
common process when assessing its financial viability since without the common process the
further processing profits cannot be earned. Therefore:
Benefits from further processing products R, S and T:
Product
RZ
SZ
TZ
Incremental
Revenue per kg
$3·00
$0·75
$3·25
Incremental cost
per kg
$1·40
$0·90
$1·00*
Incremental
contribution per kg
$1·60
($0·15)
$2·25
Total
$1,280
($300)
$2,700
$3,680
Summary
Deficit from common process
Incremental contribution (above)
Incremental fixed costs
$
(900)
3,680
(600)
Net surplus
2,180
On this basis the common process is financially viable.
Alternatively,
Revenue:
RZ 800 x $6·00
SZ 2,000 x $5·75
TZ 1,200 x $6·75
$
4,800
11,500
8,100
Common costs
17,500
Further costs:
RÆRZ 800 x $1·40
SÆSZ 2,000 x $0·90
TÆTZ 1,200 x $1·00
Fixed
P2
24,400
1,120
1,800
1,200
600
1,800
26
4,720
22,220
2,180
May 2007
SECTION C
Answer to Question Five
Requirement (a)
Depreciation has been included in “other costs” but since it is not a cash flow it must be
removed. Annual depreciation using the straight line method is $50,000 {($200,000 - $50,000) /
3 years}.
Revenues and costs need to be further adjusted using the values of receivables and payables to
convert them into cash flows.
Calculations follow below:
Year
Investment
0
$
Product costs
Less closing payables
Add opening payables
(200,000)
Taxation
Less c/fwd
Add b/fwd
Post-tax net cash flow
Discount Factor
PV
2
$
(200,000)
Sales
Less closing receivables
Add opening receivables
Pre-tax net cash flow
1
$
(200,000)
1·000
(200,000)
3
$
4
$
50,000
230,000
(20,000)
0
210,000
350,000
(30,000)
20,000
340,000
270,000
(25,000)
30,000
275,000
25,000
25,000
(144,000)
6,000
0
(138,000)
(222,000)
9,000
(6,000)
(219,000)
(166,000)
8,000
(9,000)
(167,000)
(8,000)
(8,000)
72,000
121,000
158,000
17,000
(25,800)
12,900
0
(12,900)
(38,400)
19,200
12,900
(32,100)
(31,200)
15,600
19,200
(34,800)
15,600
(15,600)
59,100
88,900
123,200
1,400
0·943
55,731
0·890
79,121
0·840
103,488
0·792
1,109
NPV = $39,449
Requirement (b)
If inflation were to become relevant then each of the underlying elements of the project (that is
sales and product costs) would need to be inflated by their own respective inflation rates. This
may require product costs to be analysed in more detail if different rates of inflation apply.
These would then be converted into cash flows for each year, taking care to ensure that where
receipts and payments relate to previous years sales and costs then these are at the money
values of the year in which they arose.
May 2007
27
P2
The net cash flows of each year would then be discounted using the money cost of capital (that
is a rate that includes an allowance for the effects of inflation). This can be calculated as follows:
(1 + real rate) x (1 + inflation rate) = (1 + money rate).
For example, if the real rate is 6% and if inflation is 4% then the money rate is approximately
10%.
Requirement (c)
As the projects are non-divisible then in a capital rationing situation it is necessary to identify the
combinations of projects/investments that are possible within the funding limitations and
maximise the total NPV.
Possible project combinations are:
W&Y
Y & Product
Investment required
$400,000
$300,000
NPV
$102,000
$66,449
Thus it is recommended that investments W & Y are undertaken because they yield a higher
total NPV.
Requirement (d) (i)
A gain sharing arrangement is a contractual arrangement between two parties whereby they
seek to make a profit which is shared between them in accordance with their arrangement. A
simple example of this is an employee bonus scheme based upon time saved whereby the
value of the time saved is shared between the employer and the employee. The employee
receives a bonus payment and the employer has reduced costs/increased saleable output. In
the context of this question X has insufficient capital available to invest in all three projects/
investments even though they are all worthwhile (they all have a positive NPV). In order to carry
out all of the projects/investments X could enter into a gain sharing arrangement with another
organisation who would invest in one or more of the projects up to a total of $200,000 (the
funding deficit), and who would then share in the profit yielded from the projects.
Requirement (d) (ii)
A gain sharing partner would expect to have some control over the use of their capital and would
probably expect to influence the projects in which they were investing. This would mean that X
would be answerable to them for their actions and may even be prevented from running the
project in the way that they would normally. Furthermore this involvement may mean that the
gain sharing partner learns more about X than X would want. Such an arrangement may mean
that the reasons why X is successful become known to one of its competitors with the obvious
damage that this may cause to X in the future. For this reason there will be a reluctance within X
to share any information.
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May 2007
Answer to Question Six
Requirement (a)
$
Technical report
Material A
Material B
Direct labour
Supervisor
Machine A
Machine B
Despatch
Overhead
Profit mark-up
0
15,000
2,000
500
0
240
100
400
0
0
Total
18,240
Technical report
Material A
Material B
Direct labour
Supervisor
Machine A
Machine B
Despatch
Overhead
Profit mark-up
This is a sunk cost and is therefore irrelevant
This material is in regular use, therefore its replacement cost is relevant
This is the full purchase cost because there is no certainty that the
remaining inventory will have any future value
The only relevant cost is that of the overtime hours because the
employees are guaranteed a minimum wage
The supervisor’s salary is unchanged by the decision so the relevant
cost is zero
The opportunity cost of the lost income is relevant to the cost of the
catalogues
The additional running cost of the machine is relevant
This is a future cost caused by the work
Absorbed overhead is not relevant because it is not specific to this work
Profit is not a relevant cost
Requirement (b)
When selling prices are based on relevant costs in order to win a one-off contract it is clear from
a decision making point of view that the work is worthwhile at that moment in time because there
is no better alternative available. However, the difficulty is that such a pricing policy cannot be
sustained in the longer term because it does not provide for the costs that are incurred by the
organisation in providing the facilities for the work to be carried out. These costs will be incurred
whether the work is carried out or not. Further difficulties thus arise when a repeat order is
received if the organisation is going to try to move towards a price that reflects these additional
facility costs.
With respect to the routine reporting of profit, the traditional absorption costing system will
attribute costs based on inventory values, time taken and agreed overhead absorption rates.
For example the cost of Material A that is recorded against this work will depend on whether the
company uses an AVCO, LIFO or FIFO basis of valuing materials issued from inventory and
also the quantity that is ordered from the supplier in order to complete the work. If the order
quantity is 6,600 sheets (thus leaving zero inventory when the work is done) the cost attributed
to the work will be:
Existing inventory
Purchases
May 2007
3,400 sheets x $1·40 =
6,600 sheets x $1·50 =
29
$4,760
$9,990
$14,660
P2
The cost recorded for material B will be only the cost relating to the quantity used. The
remainder will be held in inventory for up to six months and then if the material remains unused
its cost will be expensed.
The direct labour cost would be attributed to the work on the basis of hours worked. This is likely
to $1,200 (150 hours x $8 per hour) as the overtime is not being worked at the request of the
customer and so would probably be regarded as an overhead cost by H.
The overhead costs attributed to the work would be 150 hours x $20 per hour = $3,000 even
though these costs will not be affected by the acceptance of the work.
As a consequence it is likely that the special order contract will be reported as making a loss.
The manager accepting this contract must be prepared to justify his or her acceptance of the
work to the remainder of the management team.
Answer to Question Seven
Requirement (a)
Expected number of members:
20,000 x 0·3
30,000 x 0·5
40,000 x 0·2
6,000
15,000
8.000
29,000
paying $100 each = $2,900,000
Requirement (b)
Since these costs are equally distributed their expected values will equal the values given.
Expected contribution per member =
Annual fixed costs
Breakeven number of members =
$100 - $50 - $10 =
$1,100,000 / $40 =
$40
$1,100,000
27,500 members
Requirement (c)
20,000
Number of members
30,000
40,000
$28
($540,000)
($260,000)
$20,000
$40
($300,000)
$100,000
$500,000
$52
($60,000)
$460,000
$980,000
Contribution per member
Requirement (d)
The two-way data table shows management the possible values of profit or loss that could occur
based upon the data provided. Depending upon the risk attitude of the management they can
decide whether their business model is viable based upon this data. For example the most likely
number of members is 30,000 and the most likely values of cost cause the result of a profit of
$100,000, but the table shows that the business could make a loss of $540,000 or a profit of
$980,000 depending upon the number of members and the level of costs.
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May 2007
Further analysis incorporating the probabilities shows the following:
Result
Loss $540,000
Loss $300,000
Loss $ 60,000
Loss $260,000
Probability
0·10
0·10
0·10
0·17
Total 47%
Profit $100,000
Profit $460,000
Profit $ 20,000
Profit $500,000
Profit $980,000
0·17
0·17
0·06
0·06
0·07
Total 53%
This shows that there is a high likelihood of making a loss (47%) so if the management are risk
averse they may wish to re-consider their business strategy.
Requirement (e)
The assertion by the Management Team that the assumption that costs are caused by the
number of members is too simplistic is a criticism that has been accepted by a number of
organisations in recent years and has led to the development of Activity Based Costing (ABC).
ABC recognises that there are many causes of costs being incurred rather than simply the
number of units of activity (or members as in this case).
The proposed collection of the additional data will enable D to analyse the cause of its costs by
recording the costs incurred in respect of each member and then cross referencing these costs
to the other data provided. For example:
•
the age of the member may indicate the type of motoring that is being done by the
member. If they are of retirement age this would imply that their driving is outside of the
rush hour which may result in less breakdowns as a result of the engine overheating;
•
the age of the vehicle may be an indicator of its reliability. The older the vehicle the more
likely it is to break down;
•
the number of miles driven may also indicate the likelihood of a breakdown occurring.
The more miles the more likely is a breakdown;
•
the make and model of the vehicle may be an indicator of the cost associated with
repairing the vehicle as a result of a breakdown. Also some makes and models of vehicle
may be more reliable than others.
By collecting this data and cross referencing it to the costs being collected it will be possible to
identify the key causes of costs and consider applying this new knowledge to the pricing
strategy adopted by D. A better understanding of costs will also lead to improved cost planning
and control.
May 2007
31
P2