May 2008 Examinations

Managerial Level

Paper P1 – Management Accounting – Performance Evaluation

Question Paper 2

Examiner’s Brief Guide to the Paper 21

Examiner’s Answers 22

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

is a Post Examination Guide for the paper which provides much valuable and complementary
material including indicative mark information.

© 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.
 P1 – Performance Evaluation
Management Accounting Pillar

Managerial Level Paper

P1 – Management Accounting –
Performance Evaluation
20 May 2008 – Tuesday 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 sub-
questions). The requirements for the questions in Section 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 17 sub-

questions and is on pages 2 to 8.

Answer ALL SIX compulsory sub-questions in Section B on pages 9 and 10.

Answer ONE of the two questions in Section C on pages 11 to 14.

Maths Tables and Formulae are provided on pages 15 to 19.

The list of verbs as published in the syllabus is given for reference on the
page 20.

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.

Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.

© The Chartered Institute of Management Accountants 2008

SECTION A – 40 MARKS
[the indicative time for answering this section is 72 minutes]
ANSWER ALL SEVENTEEN SUB-QUESTIONS

Instructions for answering Section A:

The answers to the seventeen sub-questions in Section A should ALL be written in
your answer book.

Your answers should be clearly numbered with the sub-question number 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 1.11 to 1.17 you should show your workings as marks are
available for the method you use to answer these sub-questions.

Question One

1.1 If inventory levels have increased during the period, the profit calculated using marginal
costing when compared with that calculated using absorption costing will be

A higher.
B lower.
C equal.
D impossible to answer without further information.
(2 marks)

1.2 Fixed production overheads will always be under-absorbed when

A actual output is lower than budgeted output.

B actual overheads incurred are lower than budgeted overheads.
C overheads absorbed are lower than those budgeted.
D overheads absorbed are lower than those incurred.

(2 marks)

P1 2 May 2008
 The following scenario is to be used for questions 1.3 and 1.4
A company manufactures three products: W, X and Y. The products use a series of different
machines, but there is a common machine that is a bottleneck.

The standard selling price and standard cost per unit for each product for the next period are as
follows:
W X Y
£ £ £
Selling price 180 150 150

Cost:
Direct material 41 20 30
Direct labour 30 20 50
Variable production overheads 24 16 20
Fixed production overheads 36 24 30
Profit 49 70 20
Time (minutes) on bottleneck machine 7 10 7

The company is trying to plan the best use of its resources.

1.3 Using a traditional limiting factor approach, the rank order (best first) of the products
would be

A W, X, Y
B W, Y, X
C X, W, Y
D Y, X, W
(2 marks)

1.4 Using a throughput accounting approach, the rank order (best first) of the products would
be

A W, X, Y
B W, Y, X
C X, W, Y
D Y, X, W

(2 marks)

Section A continues on the next page

May 2008 3 P1
1.5 A company’s summary budgeted operating statement is as follows:

$000
Revenue 400
Variable costs 240
Fixed costs 100
Profit 60

Assuming that the sales mix does not change, the percentage increase in sales volume that
would be needed to increase the profit to $100,000 is

A 10%
B 15%
C 25%
D 40%
(2 marks)

1.6 Which of the following statements are true?

(i) Enterprise Resource Planning (ERP) systems are accounting oriented information
systems which aid in identifying and planning the enterprise wide resources needed
to resource, make, account for and deliver customer orders.
(ii) Flexible Manufacturing Systems (FMS) are integrated, computer-controlled
production systems, capable of producing any of a range of parts and of switching
quickly and economically between them.
(iii) Just-In-Time (JIT) is a system whose objective is to produce, or to procure,
products or components as they are required.

A (i) and (ii) only

B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)
(2 marks)

1.7 Flexed budgets for the cost of medical supplies in a hospital, based on a percentage of
maximum bed occupancy, are shown below:

Bed occupancy 82% 94%

Medical supplies cost $410,000 $429,200

During the period, the actual bed occupancy was 87% and the total cost of the medical
supplies was $430,000.

The medical supplies expenditure variance was

A $5,000 adverse
B $12,000 adverse
C $5,000 favourable
D $12,000 favourable

(2 marks)

P1 4 May 2008
1.8 A company uses a standard absorption costing system. The fixed overhead absorption
rate is based on labour hours.

Extracts from the company’s records for last year were as follows:
Budget Actual
Fixed production overhead $450,000 $475,000
Output 50,000 units 60,000 units
Labour hours 900,000 930,000

The under- or over-absorbed fixed production overheads for the year were

A $10,000 under-absorbed
B $10,000 over-absorbed
C $15,000 over-absorbed
D $65,000 over-absorbed

(2 marks)

1.9 A flexible budget is a budget that

A is changed during the budget period according to changed circumstances.

B is continuously updated by adding a further accounting period when the earliest
accounting period has expired.
C results from the participation of budget holders.
D recognises different cost behaviour patterns and is designed to change as the volume of
activity changes.
(2 marks)

1.10 A company will forecast its quarterly sales units for a new product by using a formula to
predict the base sales units and then adjusting the figure by a seasonal index.
The formula is BU = 4000 + 80Q
Where BU = Base sales units and Q is the quarterly period number
The seasonal index values are:

Quarter 1 105%
Quarter 2 80%
Quarter 3 95%
Quarter 4 120%

The forecast increase in sales units from Quarter 3 to Quarter 4 is

A 25%
B 80 units
C 100 units
D 1,156 units
(2 marks)

Section A continues on the next page

May 2008 5 P1
1.11 Product XYZ is made by mixing three materials (X, Y and Z). There is an expected loss
of 20% of the total input.

The budgeted and actual results for Period 1 are shown below. There were no opening or
closing inventories of any materials or of the finished product.

Budget Actual
Output of XYZ 800 kg 960 kg
Material
X 500 kg @ $5⋅00 per kg 600 kg @ $4⋅70 per kg
Y 300 kg @ $6⋅00 per kg 380 kg @ $6⋅50 per kg
Z 200 kg @ $7⋅00 per kg 300 kg @ $7⋅10 per kg
Total input 1,000 kg 1,280 kg

Calculate for Period 1:

(i) the total materials mix variance;

(2 marks)
(ii) the total materials yield variance.
(2 marks)

(Total for sub-question 1.11 = 4 marks)

1.12 Extracts from a company’s year-end accounts are shown below:

$000
Revenue 9,456
Gross profit 5,872
Operating profit 2,981
Non-current assets 17,850
Inventory 950
Cash at bank 1,750
Short-term borrowings 1,225
Trade receivables 731
Trade payables 813

Calculate the following performance measures:

(i) Operating profit margin;

(ii) Return on capital employed;
(iii) Trade receivable days (debtors days);
(iv) Current ratio.
(4 marks)

P1 6 May 2008
 The following data are given for sub questions 1.13, 1.14 and 1.15
Premier Cycles has two divisions: the Frame Division and the Assembly Division. The Frame
Division produces bike frames. The frames can be sold directly to external customers as “frame
only” or the frames can be transferred to the Assembly Division where they are built up into
complete bikes by adding other components, such as wheels and handlebars.

Frame Division
Budgeted details for the forthcoming year for the Frame Division are:

Selling price per frame $852

Variable cost per frame $420
Annual fixed cost $4,000,000
Annual capacity 12,000 frames

The Division has orders for 5,000 frames from external customers for the forthcoming year.

Assembly Division
The Manager of the Assembly Division has just signed a contract to supply 8,000 bikes to a
sporting goods retailer next year. This will mean that the Division will be operating at full
capacity. Budgeted details are as follows:

Selling price per bike $1,600

Variable cost of assembly and components $500 (excluding frame)
Annual fixed cost $2,400,000
Annual capacity 8,000 bikes

Company Policy
It has been announced that Premier Cycles will be introducing a new performance appraisal
system. The Divisional Managers’ bonuses will only be payable if they earn a minimum annual
contribution of 108% of fixed costs.

1.13 Calculate the minimum number of frames the Frame Division must sell next year in order
for the Divisional Manager to earn a bonus if frames are sold for $852 each.
(2 marks)

1.14 Calculate the maximum price per frame that the Manager of the Assembly Division could
pay and still earn a bonus next year.
(2 marks)

1.15 Ignoring Premier Cycles’ performance appraisal system, explain how the Manager of the
Frame Division should calculate the transfer price of frames it supplies to the Assembly
division in order to maximise profits for Premier Cycles.

Note: NO calculations are required.

(2 marks)

Section A continues on the next page

May 2008 7 P1
1.16 State FOUR aims of a transfer-pricing system.
(2 marks)

1.17 Product GH passes through two consecutive processes: the output from Process 1 is
transferred to Process 2. Details of Process 1 for Period 3 were as follows:

There were 5,000 units of opening work-in-progress, which were valued as follows:

Materials $77,080
Labour $33,480
Production overheads $8,825

During the period, 14,000 units were added to the process and the following costs were
incurred:

Materials $230,000
Labour $101,000
Production overheads $40,000

At the end of Period 3, there were 6,000 units of closing work-in-progress. The degree of
completion for these units was:

Materials 100%
Labour 80%
Production overheads 65%

The expected normal loss is 10% of new units added to the process during the period.
These units and any other losses can be sold for $5 per unit.

11,000 units were transferred to Process 2 and there were losses of 2,000 units.

All losses occur at the end of the process.

Weighted average costing is used.

Calculate the total cost of the 11,000 units that were transferred to Process 2.
(4 marks)

(Total for Section A = 40 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.

P1 8 May 2008
SECTION B – 30 MARKS
[the indicative time for answering this section is 54 minutes]
ANSWER ALL SIX SUB-QUESTIONS. EACH SUB-QUESTION IS WORTH 5
MARKS

Question Two

(a) Describe THREE key features that are present in any organisation that is successfully
focused on Total Quality Management (TQM).
(5 marks)

(b) Explain THREE behavioural consequences that may result after the introduction of
participative budgeting.
(5 marks)

(c) Discuss the advantages and disadvantages of rolling budgets.

(5 marks)

May 2008 9 P1
 The following data relate to sub-questions (d), (e) and (f)
A multi-national company manufactures and sells a wide range of digital equipment. The
company is structured into three Divisions: Computers, Audio-visual and Photographic. The
Divisions operate as investment centres and the performance of the Divisional Managers is
evaluated by using Return on Investment (ROI).

The Manager of the Photographic Division was concerned that the Division was falling behind its
competitors in terms of financial returns and market share, and has implemented strategies to
improve the situation. An external benchmarking exercise was undertaken to try to establish the
position of the Division in relation to its competitors in a number of key areas. It has now been
suggested that the Division should also carry out an internal benchmarking exercise.

(d) The manager of the Photographic Division is considering introducing a Balanced

Scorecard to measure the success of the strategies. He has identified two perspectives
and two associated goals. They are:

Perspective Goal
Innovation Technology Leadership
Customer Support

(i) For the “Innovation Perspective” of the Division, recommend a performance measure and
briefly explain how the measure will reflect the achievement of the stated goal.
(3 marks)

(ii) For the “Customer Perspective” of the Division, state which data should be collected and
explain how this could be used to ensure the goal of “support’’ is met.
(2 marks)

(Total for (d) = 5 marks)

(e) Explain THREE reasons why internal benchmarking may provide information that is more
useful to the Manager of the Photographic Division, in terms of monitoring and improving
performance, than that provided by external benchmarking.
(5 marks)

(f) Explain THREE reasons why ROI may not be a good performance measure.
(5 marks)

(Total for Question Two = 30 marks)

(Total for Section B = 30 marks)

End of Section B

Section C starts on the next page

P1 10 May 2008
SECTION C – 30 MARKS
[the indicative time for answering this section is 54 minutes]
ANSWER ONE OF THE TWO QUESTIONS

Question Three

The newly-appointed Managing Director of FX has received the variance report for Month 6,
which is shown below:

Month 6 Variance Report

Output and Sales for Month 6. Budget: 1,000 units. Actual: 1,200 units.

£ £ £
Budgeted contribution 90,000
Budgeted fixed costs 70,000
Budgeted profit 20,000
Volume variance 18,000
Expected profit on actual sales 38,000
Sales price variance 12,000
Production variances Favourable Adverse
Materials price 6,300
Materials usage 6,000
Labour rate 5,040
Labour efficiency 2,400
Variable overhead expenditure - -
Variable overhead efficiency 1,200
Fixed overhead _____ 4,000
5,040 19,900 14,860
Actual profit 11,140

Background information (not seen by the Managing Director)

The report did not include any other information. Details relating to the company and the
product that it makes are given below:

FX produces one type of product. It operates a standard marginal costing system.

The standard unit cost and price of the product is as follows:

£ £
Selling price 250
Direct material (5 kg at £20) 100
Direct labour (4 hours at £10) 40
Variable overheads (4 hours at £5) 20 160
Contribution 90

The variable overhead absorption rate is based on direct labour hours.

The company has budgeted fixed overheads of £70,000 per month.

Budgeted sales and production levels are 1,000 units per month.

May 2008 11 P1
Month 6
The company has just completed Month 6 of its operations. Extracts from its records show:

1. 1,200 units were produced and sold.

2. The actual direct materials purchased and used was 6,300 kg costing £132,300
3. The actual direct labour hours worked were 5,040 hours.

Required:

(a) Prepare a report for the Managing Director of FX that explains and interprets the
Month 6 variance report. The Managing Director has recently joined the company
and has very little previous financial experience.
(17 marks)

The Managing Director was concerned about the Material Price variance and its cause.
He discovered that a shortage of materials had caused the market price to rise to £23 per
kg.

Required:

(b) In view of this additional information, calculate for Direct Materials:

• The total variance;

• The planning variance;
• The two operational variances.
(7 marks)

(c) Discuss the advantages and disadvantages of reporting planning and operational
variances. Your answer should refer, where appropriate, to the variances you
calculated in (b) above.
(6 marks)

(Total for Question Three = 30 marks)

Section C continues on the next page

P1 12 May 2008
Question Four

Q, a new company, is being established to manufacture and sell an electronic tracking device:
the Trackit. The owners are excited about the future profits that the business will generate.
They have forecast that sales will grow to 2,600 Trackits per month within five months and will
be at that level for the remainder of the first year.

The owners will invest a total of $250,000 in cash on the first day of operations (that is the first
day of Month 1). They will also transfer non-current assets into the company.

Extracts from the company’s business plan are shown below.

Sales
The forecast sales for the first five months are:

Month Trackits
(units)
1 1,000
2 1,500
3 2,000
4 2,400
5 2,600

The selling price has been set at $140 per Trackit.

Sales receipts
Sales will be mainly through large retail outlets. The pattern for the receipt of payment is
expected to be as follows:

Time of payment % of sales value

Immediately 15 *
One month later 25
Two months later 40
Three months later 15

The balance represents anticipated bad debts.

* A 4% discount will be given for immediate payment.

Production
The budget production volumes in units are:

Month 1 Month 2 Month 3 Month 4

1,450 1,650 2,120 2,460

Variable production cost

The budgeted variable production cost is $90 per unit, comprising:

$
Direct materials 60
Direct wages 10
Variable production overheads 20
Total variable cost 90

Direct materials: Payment for purchases will be made in the month following receipt. There will
be no opening inventory of materials in Month 1. It will be company policy to hold inventory at
the end of each month equal to 20% at of the following month’s production requirements. The
direct materials cost includes the cost of an essential component that will be bought in from a
specialist manufacturer.

May 2008 13 P1
Direct wages will be paid in the month in which the production occurs.

Variable production overheads: 65% will be paid in the month in which production occurs and
the remainder will be paid one month later.

Fixed overhead costs

Fixed overheads are estimated at $840,000 per annum and are expected to be incurred in equal
amounts each month. 60% of the fixed overhead costs will be paid in the month in which they
are incurred and 15% in the following month. The balance represents depreciation of non-
current assets.

Ignore VAT and Tax

Required

(a) Prepare a cash budget for each of the first three months and for that three-month
period in total.
(14 marks)

(b) There is some uncertainty about the cost of the specialist component (this is
included in the direct material cost). It is thought that the cost of the component
could range between $32 and $50 per Trackit. It is currently included in the cost
estimates at $40 per Trackit.

Calculate the budgeted total net cash flow for the three-month period in total if the
cost of the component was
(i) $32

(ii) $50
(6 marks)

(c) Prepare a report for the owners of Q that offers advice about the profitability of their
business and the situation revealed by the extracts from the business plan and
your answers to (a) and (b) above.
(10 marks)

Total for Question Four = 30 marks

(Total for Section C = 30 marks)

End of question paper

Maths Tables and Formulae are on pages 15 to 21

P1 14 May 2008
May 2008 15 P1
PRESENT VALUE TABLE

Present value of $1, that is (1+ r )

−n
where r = interest rate; n = number of periods until
payment or receipt.
Periods Interest rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

P1 16 May 2008
Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
1− (1+ r ) − n
years r

Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

May 2008 17 P1
 Formulae

PROBABILITY
A ∪ B = A or B. A ∩ B = A and B (overlap).
P(B A) = probability of B, given A.

Rules of Addition
If A and B are mutually exclusive: P(A ∪ B) = P(A) + P(B)
If A and B are not mutually exclusive: P(A ∪ B) = P(A) + P(B) – P(A ∩ B)

Rules of Multiplication
If A and B are independent: P(A ∩ B) = P(A) * P(B)
If A and B are not independent: P(A ∩ B) = P(A) * P(B | A)

E(X) = ∑ (probability * payoff)

Quadratic Equations
If aX2 + bX + c = 0 is the general quadratic equation, the two solutions (roots) are given
by:
− b ± b 2 − 4ac
X =
2a

DESCRIPTIVE STATISTICS
Arithmetic Mean
∑x ∑ fx
x = x= (frequency distribution)
n ∑f

Standard Deviation
∑( x − x ) 2 ∑ fx 2
SD = SD = − x 2 (frequency distribution)
n ∑f

INDEX NUMBERS
Price relative = 100 * P1/P0 Quantity relative = 100 * Q1/Q0

⎛P ⎞
∑ w ∗ ⎜⎜ 1 ⎟
⎟
⎝ Po ⎠
Price: x 100
∑w

⎛Q ⎞
∑ w ∗ ⎜⎜ 1 ⎟⎟
Quantity: ⎝ Qo ⎠ x 100
∑w

TIME SERIES
Additive Model
Series = Trend + Seasonal + Random

Multiplicative Model
Series = Trend * Seasonal * Random

P1 18 May 2008
LINEAR REGRESSION AND CORRELATION
The linear regression equation of Y on X is given by:

Y = a + bX or Y - Y = b(X – X)

where
Covariance ( XY) n ∑ XY − ( ∑ X)( ∑ Y )
b= =
Variance ( X) n ∑ X 2 − ( ∑ X) 2

and a = Y – bX

or solve
∑ Y = na + b ∑ X
∑ XY = a ∑ X + b∑X2

Coefficient of correlation

Covariance ( XY) n ∑ XY − ( ∑ X)( ∑ Y )

r= =
Var ( X).Var ( Y ) {n ∑ X 2 − ( ∑ X) 2 }{n ∑ Y 2 − ( ∑ Y ) 2 }

6∑d2
R(rank) = 1 -
n(n 2 − 1)

FINANCIAL MATHEMATICS

Compound Interest (Values and Sums)

Future Value S, of a sum of X, invested for n periods, compounded at r% interest
S = X[1 + r]n

Annuity
Present value of an annuity of £1 per annum receivable or payable for n years,
commencing in one year, discounted at r% per annum:

1⎡ 1 ⎤
PV = ⎢1 − ⎥
r ⎣⎢ [1 + r ] n ⎦⎥

Perpetuity
Present value of £1 per annum, payable or receivable in perpetuity, commencing in one
year, discounted at r% per annum:
1
PV =
r

May 2008 19 P1
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 VERBS USED DEFINITION
1 KNOWLEDGE
What you are expected to know. List Make a list of
State Express, fully or clearly, the details of/facts of
Define Give the exact meaning of

2 COMPREHENSION
What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something

3 APPLICATION
How you are expected to apply your knowledge. Apply To put to practical use
Calculate/compute To ascertain or reckon mathematically
Demonstrate To prove with certainty or to exhibit by
practical means
Prepare To make or get ready for use
Reconcile To make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table

4 ANALYSIS
How you are expected to analyse the detail of Analyse Examine in detail the structure of
what you have learned. Categorise Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct To build up or compile
Discuss To examine in detail by argument
Interpret To translate into intelligible or familiar terms
Produce To create or bring into existence

5 EVALUATION
How you are expected to use your learning to Advise To counsel, inform or notify
evaluate, make decisions or recommendations. Evaluate To appraise or assess the value of
Recommend To advise on a course of action

P1 20 May 2008
 The Examiner for Management Accounting – Performance Evaluation offers to
future candidates and to tutors using this booklet for study purposes, the
following background and guidance on the questions included in this
examination paper.

Section A – Question One – Compulsory

Question One consists of 17 objective test sub-questions. These are drawn from all sections of
the syllabus. They are designed to examine breadth across the syllabus and thus cover many
learning outcomes.

Section B – Question Two – Compulsory

Question Two has six sub-questions.
(a) covers learning outcome A(vii) - Explain the role of MRP and ERP systems in supporting
standard costing systems, calculating variances and facilitating the posting of ledger
entries.
(b) covers learning outcome C(xiii) - Evaluate the impact of budgetary control systems on
human behaviour.
(c) covers learning outcome C(vi) - Evaluate and apply alternative approaches to budgeting
(d) covers learning outcome B(v) – Prepare reports using a range of internal and external
benchmarks and interpret the results
(e) covers learning outcome D(iv) - Calculate and apply measures of performance for
investment centres (often ‘strategic business units’ or divisions of larger groups).
(f) covers learning outcome D(iv) - Calculate and apply measures of performance for
investment centres (often ‘strategic business units’ or divisions of larger groups).

Section C – answer one of two questions

Question Three has three parts.

(a) covers learning outcome B(iiii) - Prepare and discuss a report which reconciles budget
and actual profit using absorption and/or marginal costing principles
(b) covers learning outcome B(iv) - Calculate and explain planning and operational variances.
(c) covers learning outcome B(iv) - Calculate and explain planning and operational variances.

Question Four has three parts.

(a) covers learning outcome C(iii) - Calculate projected revenues and costs based on
product/service volumes, pricing strategies and cost structures.
(b) covers learning outcome C(vii) - Calculate the consequences of “what if” scenarios and
evaluate their impact on master profit and loss account and balance sheet.
(c) covers learning outcome C(iv)- Evaluate projected performance by calculating key metrics
including profitability, liquidity and asset turnover ratios.

May 2008 21 P1
 Managerial Level Paper

P1 – Management Accounting –

Performance Evaluation
Examiner’s Answers

SECTION A

Answer to Question One

1.1 The correct answer is B

1.2 The correct answer is D

1.3 The traditional limiting factor approach would view contribution per unit as the selling price
minus all variable costs

W X Y
Contribution per unit £ 85 94 50
Bottleneck minutes 7 10 7
Contribution per minute 12·1 9·4 7·1
Rank 1 2 3

The correct answer is A

1.4 A throughput accounting approach assumes that materials are the only variable costs.
Consequently the contribution is different to that calculated using the traditional method.

W X Y
Contribution per unit £ 139 130 120
Bottleneck minutes 7 10 7
Contribution per minute 19·9 13 17·1
Rank 1 3 2

The correct answer is B

P1 22 May 2008
1.5 Contribution to sales ratio = 160/400 = 40%

Extra profit required = $40,000. Fixed costs are constant and therefore extra contribution
will generate extra profit.

The revenue needed to generate contribution of $40,000 is $40,000/40% = $100,000.

The current revenue is $400,000 and therefore $100,000 is 25% of this.

The correct answer is C

1.6 The correct answer is D

1.7
% $
High 94 429,000
Low 82 410,000
Difference 12 19,200

Variable cost per % = $19,200/12 = $1,600

87% is 5% more than 82% and therefore the total cost for the flexed budget for a bed
occupancy of 87% is $410,000 + (1,600 * 5) = $418,000

The expenditure variance is $418,000 - $430,000 = $12,000 adverse

The correct answer is B

1.8 The under or over absorbed overhead is the difference between the actual overhead
spent and the overheads absorbed. Overheads are absorbed based on the standard
content of the actual output. Here we are told that the absorption rate is based on labour
hours.

The overhead absorption rate is $450,000/900,000hours = $0·50 per labour hour

Standard labour hours per unit = 900,000/50,000 = 18 hours per unit

The output was 60,000 units. This is 60,000 * 18 = 1,080,000 standard hours.

Overhead absorbed = $1,080,000 * 0·50 = $540,000

The actual over heads were $475,000 and therefore overheads were over absorbed by
$65,000.

The correct answer is D

1.9 The correct answer is D

1.10 Forecast for Q3 = {4,000 + (80 * 3)} * 95% = 4,028

Forecast for Q4 = {4,000 + (80 * 4)} * 120% = 5,184

This is an increase of 1,156 units.

The correct answer is D

May 2008 23 P1
1.11

(i) Mix variance = (actual inputs in the actual mix at standard prices) v (actual inputs in
standardised mix at standard prices)

Actual mix Standard mix

kg $ per kg $ kg $ per kg $
X 600 5 3,000 640 5 3,200
Y 380 6 2,280 384 6 2,304
Z 300 7 2,100 256 7 1,792
1,280 7,380 1,280 7,296

Mix variance = $7,380 v $7,296 = $84 adverse

(ii) Yield variance = (actual inputs in standardised mix at standard prices) v (standard input in
standardised mix at standard prices for the actual output).

The actual output of XYZ was 960 kg. The input required to achieve an output of 960 kg
is 1,200 kg (there is a 20% loss, therefore the input = 960/0⋅8).

Standardised input Standard input needed

kg $ per kg $ kg $ per kg $
X 640 5 3,200 600 5 3,000
Y 384 6 2,304 360 6 2,160
Z 256 7 1,792 240 7 1,680
1,280 7,296 1,200 6,840

Yield variance = $7,296 v $6,840 = $456 adverse

1.12

(i) Operating profit margin = 2,981,000/9,456,000 = 31⋅53%

(ii) Return on capital employed = 2,981 /(17,850 + 950 + 1,750 – 1,225 + 731 – 813) =
15·49%
(iii) Trade receivable days = (731,000/9,456,000) x 365 = 28⋅22 days
(iv) Current ratio = (950 + 1,750 + 731)/(1,225 + 813) = 1⋅68

1.13 Contribution per frame = $432

Return required = $4m x 1⋅08 = $4⋅32m
Minimum number of frames = $4⋅32m/$432 = 10,000 frames

1.14 Return required = $2⋅4m x 1⋅08 = $2⋅592m

Minimum contribution per frame = $2.592m/8,000 = $324
Contribution before charging for frame = $1,600 - $500 = $1,100
Therefore the maximum payment would be $1,100 - $324 = $776

1.15 The transfer price should be based on opportunity cost. If there is an external market for
the frames then the market price should be used. If there is not an external market, the
transfer price should be the marginal cost incurred.

P1 24 May 2008
1.16

The aims of a transfer-pricing system include:

• Promote goal congruence;

• Motivate managers;
• Facilitate performance evaluation;
• Retain divisional autonomy;
• Ensure optimal allocation of resources.

(Candidates only needed to state four aims)

1.17

Units Units
Opening W-i-P 5,000 Closing W-i-P 6,000
Input 14,000 Output 11,000
19,000 Normal loss 1,400
Abnormal loss 600
Total 19,000

The income from the sale of the normal loss (1,400 x $5) is used to reduce the cost of materials.

Costs Equivalent units

Opening Period Total Output Closing Abn Total Cost per
W-i-P W-i-P Loss EU
$ $ $ $
Materials 77,080 223,000 300,080 11,000 6,000 600 17,600 17⋅05
Labour 33,480 101,000 134,480 11,000 4,800 600 16,400 8⋅20
Prod o/h 8,825 40,000 48,825 11,000 3,900 600 15,500 3⋅15
28⋅40

Value of output = 11,000 units x $28⋅40 = $312,400

May 2008 25 P1
SECTION B

Answer to Question Two (a)

Three key features that can be found in any organisation that is focussed on Total Quality
Management include:

• Top priority is given to satisfying customers. The organisation will be structured in a way
to allow managers to facilitate this.
• People are considered to be the route to success. Management is visible and
accessible, and the decision making process is participative. There is only a short span
of control.
• Team working is encouraged to improve co-ordination through the organisation and the
development of skills.
• Change is embraced and the organisation is structured to allow change to happen.
• The organisation pursues continuous improvement with the aim of eliminating all
defects. Performance is measured against new benchmarks rather than against a
historic standard.
• The emphasis is on the prevention of problems rather than detection by inspection.

Answer to Question Two (b)

Three possible behavioural consequences that may result from the introduction of participative
budgeting include:

• greater acceptance of targets and thus improved motivation to achieve them;

• the attitude to the accounting system itself may improve, reducing the potential for
dysfunctional behaviour;
• improved communication within an organisation leading to better understanding and
resolution of issues, trade-offs and so on.

Against this:

• pseudo-participation (or only limited participation), with subsequent imposition of more

difficult targets in order to achieve the desired corporate budget, is likely to be counter-
productive;
• participation may result in budget “slack” – the understatement of budgeted revenues and
overstatement of budgeted costs with no incentive to improve on slack targets.

Answer to Question Two (c)

The advantages of rolling budgets include:

• rolling budgets are particularly useful when the environment is uncertain. This is because
the remainder of the current budget is reviewed when a new period is added;
• there is a focus on consistently planning twelve months ahead and consequently a
constant focus on any changes to the business outlook. This necessitates a continuous
review of the organisation’s strategy and tactical operations.
• control is likely to be more effective because budgets are less likely to be out-of-date;

P1 26 May 2008
The disadvantages of rolling budgets include:
• the continuous cycle of budgeting can be time-consuming and costly:
• managers may doubt the value of preparing frequent budgets at regular intervals and
might not take the planning process seriously.

Answer to Question Two (d)

(i) A performance measure for “Technology Leadership” could be the number of patents
registered each year. This would show how inventive the team had been. In a
technology-driven market it is essential for the Division to be constantly developing new
ideas and products. Alternative measures could be: time to develop new products; time
to introduce updates to products; new technologies introduced and so on.

(ii) A successful outcome for “Support” would be that customers are satisfied with the support
that they are given. One way of measuring this would be to log the number of support
requests received and the percentage of these requests that are closed to the satisfaction
of the customer. This should be easy to administer given a web-based approach to
product/customer support.

Note: Other answers to these questions were equally acceptable.

Answer to Question Two (e)

Three reasons why internal benchmarking might provide information that is more useful than
external benchmarking, to the manager of the Photographic Division, include:

• Competitive data is not readily available for external benchmarking whereas it should be
easier to gather internal data;
• Comparisons are more relevant with internal benchmarking since they relate specifically
to the business;
• Allows the setting of acceptable targets that are already being achieved by a part of the
organisation;
• Enables continuous improvement through the sharing of best practices between
managers;
• External data does not explain how performance could be improved. More details can be
obtained about the reasons for the differences between internal business units and this
enables improvements to be made;
• An external benchmarking system can be resource intensive in terms of time and money;
• Available data for external benchmarking may be inaccurate and out of date.

May 2008 27 P1
Answer to Question Two (f)

Three reasons why Return on Investment (ROI) might not be a good performance measure
include:

• Short term v long-term conflict: ROI can encourage managers not to invest in new
projects;
• Problems of comparison: differing business profiles and risk will merit a different return;
• Reliance on a single measure: no one measure can be suitable. It is preferable to use a
portfolio of measures to reflect the organisation’s strategy;
• ROI does not reflect the “size” of the organisation/project: it is a relative measure. Some
investors and managers will prefer an absolute measure (they want to know the monetary
size);
• ROI will be determined by asset values. There are many concerns in this area: current
value of assets as opposed to historical, comparison between divisions, easier to earn a
high return from aged (and therefore depreciated) assets and so on.

• Transfer pricing systems will affect the individual profits of any divisions and therefore will
also affect their ROI.

P1 28 May 2008
SECTION C

Answer to Question Three

(a)
Report

To: Managing Director, FX

From: Management Accountant

Date: 20 May 2008

Subject: Interpretation of Month 6 Variance Report

Overview
The company produced and sold 1,200 units. This was 200 units more than budgeted for and
should have resulted in additional profits of £18,000, and therefore total profits of £38,000.
However, a reduction in the selling price of £10 per unit and over-spending on materials and
fixed overheads resulted in an actual profit of £11,140.

Interpretation of the Month 6 Variance Report

The purpose of this report is to provide a commentary to accompany the Month 6 Variance
Report.

The variance report reconciles the budget profit and the actual profit for the month by listing the
financial deviation from standard (variances). The variances are shown individually so that
specific points of concern can be seen and areas of responsibility highlighted. This report will
provide a commentary on the variances and will follow the sequence of the variance statement.

Budgeted profit
This is the profit that would have been earned if the forecast level of sales and output had been
achieved and is based on all costs and revenues being as planned.

Volume variance
Given that output and sales were higher than forecast by 200 units it is to be expected that the
profits would be different from those stated in the budget. The company uses a marginal costing
system and consequently each unit sold is deemed to earn a contribution of £90 towards fixed
costs and profit. Fixed costs are not accounted for on a unit basis; they are charged to the profit
statement as a total figure.

Given that sales were 200 units higher than budget, it would be expected that profit would be
£18,000 higher (200 x £90).

This level of sales and output (1,200 units) then provides the level of performance that other
variances should be measured against.

Sales price variance

This is the difference due to selling the units at a price that is different from the standard
(expected) selling price. It can be worked out from the statement that the variance is adverse (I
appreciate that the statement would be more user-friendly if this was explicitly shown on the
statement). This means that we sold the units at a lower price than standard. Given that the
variance is £12,000, we must have sold each of the units for £10 less (on average) than the
standard price.

May 2008 29 P1
Materials price variance
The materials price variance relates to the actual quantity of materials that were purchased. We
purchased 6,300 kg for £132,300. The standard price of the materials was £20 per kg and
therefore we should have paid £126,000.

Materials usage variance

Each unit produced should have used 5 kg of material. We used 6,300 kg instead of 6,000 kg.
This over-usage of 300 kg is valued at the standard price of £20 per kg. The standard price is
used to quantify the variance in monetary terms because the price is not under the control of the
Production Manager. It is the responsibility of the Purchasing Department.

Labour rate variance

The labour force worked 5,040 hours and we have paid them £5,040 less than we expected to
do. We have paid them £1 per hour below the standard rate.

Labour efficiency variance

The adverse efficiency variance indicates that the labour force took longer to produce 1,200
units that they should have done. They should have taken 4,800 hours and this would be
valued at £48,000. The adverse variance of £2,400 shows that they have taken an additional
240 hours. (Check: £2,400 = 240 x £10).

Variable overhead expenditure variance

This variance indicates whether the spending on variable overheads is in line with standard
levels. Labour hours are being used for the absorption rate: this means that it is thought that the
variable overheads change proportionally with the labour hours worked. The rate of expenditure
was thought to be £5 per labour hour. Given that there is no variance it would appear that the
use of labour hours to predict the expenditure on these overheads is a good assumption.

Variable overhead efficiency variance

This is linked to the labour efficiency because labour hours are used as the base for the
absorption rate. We used 240 hours too many for the production achieved and now we will cost
them at £5 per hour. This gives the variance of £1,200 adverse.

Fixed overhead variance

The variance is the fixed overhead expenditure variance and shows by how much the
expenditure on fixed overheads differed from that budgeted. The company uses marginal
costing and therefore the fixed overheads are not attributed to individual units of production.
Consequently there is no need for a fixed overhead absorption rate. The fixed production
overheads are not broken down or absorbed into products or units under such a system.

The variance is £4,000 adverse and therefore we must have spent £74,000 on fixed overheads
during Month 6.

If you require any further details please do not hesitate to contact me.

(b)
Direct Materials Variances

Total variance = standard cost of actual output v actual cost

= £120,000 v £132,300
= £12,300 adverse

Planning variance = revised standard cost of output v original standard cost of output
= (5 kg @ £23 x 1,200) v £120,000
= £138,000 v £120,000
= £18,000 adverse

Operational variances (now use the revised standard price of £23 per kg)

P1 30 May 2008
Material price variance = standard cost of actual amount purchased v actual cost
= (£23 x 6,300) v £132,300
= £144,900 v £132,300
= £12,600 favourable
Material usage variance
= (standard usage for actual output v actual usage)@ £23 per kg
= ((1,200 x 5) v 6,300) @ £23
= £6,900 adverse

Check: total variance = planning variance + operational variances

£12,300 adverse = £18,000 adverse + £12,600 favourable + £6,900 adverse

(c)
The revision of the standard provides a more up to date, and therefore realistic, benchmark
against which to measure performance.

For example in the scenario above, it originally looked as if the Purchasing Department had paid
far too much (£6,300) for the materials. However, it was then realised that the market price had
increased. This is an uncontrollable factor and it would be unfair to judge the performance of
the Purchasing Department against a standard that cannot be achieved. The uncontrollable
element of the total variance is separated out into a “planning variance” and then appropriate
control action can be taken based on a relevant standard. The variance that the Purchasing
Department should be held responsible for is calculated using the revised standard. This now
gives a price variance of £12,600 favourable. This gives an entirely different view of the work of
the Purchasing Department.

The operational usage variance will now be valued at £23 per kg and thus reflects the current
purchase price of the extra materials used.

A further advantage is that highlighting the planning variances helps to identify any errors in
forecasts so that the planning process can be continually refined.

The disadvantages of calculating these variances are the often subjective way of determining
the revised standard and the additional time and cost incurred.

May 2008 31 P1
Answer to Question Four

Sales receipts ($)

Month 1 Month 2 Month 3

Sales 140,000 210,000 280,000
Receipts
15% less discount 20,160 30,240 40,320
+ 1 month, 25% 35,000 52,500
+ 2 months, 40% - - 56,000
Total 20,160 65,240 148,820

Material purchases ($)

Month 1 Month 2 Month 3 Month 4

Material used 87,000 99,000 127,200 147,600
Closing inventory + 19,800 25,440 29,520
Opening inventory - - 19,800 25,440
Purchases 106,800 104,640 131,280
Paid 106,800 104,640

Cash budget
Month 1 Month 2 Month 3 Total
$ $ $ $
Material 106,800 104,640 211,440
Labour 14,500 16,500 21,200 52,200
Variable overheads 18,850 31,600 39,110 89,560
Fixed overheads 42,000 52,500 52,500 147,000
Total payments 75,350 207,400 217,450 500,200
Receipts 20,160 65,240 148,820 234,220
Net cash flow -55,190 -142,160 -68,630 -265,980
Opening balance 250,000 194,810 52,650 250,000
Closing balance 194,810 52,650 -15,980 -15,980

(b)
Total cash outflow for materials during the period = $211,440. This is based on a unit cost of
$60 of which $40 is for the component. Therefore, the budgeted cash paid for the component is
$140,960.

(i) If the price of the component falls to $32 the total paid for components during the period
will be $112,768 (calculated as $140,960 x 32/40).

This will result in a cash saving of $28,192 and, therefore, the total net cash flow over the
three-month period will be an outflow of $237,788.

(ii) If the price of the component rises to $50, the total cash paid for components will rise to
$176,200.

This will mean that the cash outflow will rise by $35,240 and, therefore, the total net cash
flow over the three-month period will be an outflow of $301,220.

P1 32 May 2008
(c)
Workings:

Forecast sales for the first year = 27,700 units.

“What if” analysis:

Component price $32 $40 $50

Contribution per Trackit $58 $50 $40
Total contribution $1,606,600 $1,385,000 $1,108,000
Profit $766,600 $545,000 $268,000
Break-even (Trackits) 14,483 16,800 21,000
Margin of safety 47⋅7% 39⋅4% 24⋅2%

Report

To: Owners of Q

From: Management Accountant

Date: 20 May 2008

Review of business prospects

Terms of reference
This report will provide a brief review of the profitability and the prospects for the business as
revealed by your business plan.

Profitability
Based on the original estimates of a sales volume of 27,700 Trackits and $40 per component,
the forecast profit for the year is $545,000. Sales could fall by 39⋅4% before the business
started to makes losses – this is a good margin of safety. However, you have expressed
uncertainty about the price of the component.

The best and worst case scenarios are as follows:

Best: component price falls to $32. This gives a total profit of $766,600 and a margin of safety
of 47⋅7%.

Worst: component price rises to $50. This gives a total profit of $268,000 and a margin of
safety of 24⋅2%.

However, even though the business is profitable, it does not generate net cash inflows in the
short term.

Cash flow
Based on the original estimates and an opening cash balance of $250,000, the company will
need an overdraft of almost $16,000 to cover the cash deficit that will arise in Month 3.

If the component cost falls to $32 per unit, there will be sufficient funds available to cover the net
outflow for the three month period of $237,788.

However, if the component cost rises to $50 per unit, the net cash outflow rises to $301,220.
The company will need an overdraft of $51,220 to cover this, or there will be need to inject
further cash into the business.

May 2008 33 P1
Component cost
It is appreciated that any business plan is an estimate, but you have expressed uncertainty
about the cost of the outsourced component. The variability of the cost of this component has
an impact on the profitability of the business but, even at the highest forecast price, the business
is profitable.

A more critical impact of the price variability is on cash flow: you need to be aware of the
possible need to invest more cash into the business or arrange for an overdraft. However, this
will only be short-term; the business is profitable and will eventually generate net cash inflows.

The component is an essential part of the Trackit. Consequently, you should explore the
possibilities of forging a close relationship with the supplier and entering into a mutually
advantageous arrangement with them. You should try to secure a guaranteed supply at a
guaranteed price.

Note: The answer is based on using the ‘unadjusted’ contribution. If allowances are made for
the cash discount and bad debts the contribution per Trackit will be reduced by $0.84
(calculated as $140 x 15% x 4%) and $7 (calculated as $140 x 5%) respectively. The ‘what if’
analysis figures would then be:

“What if” analysis:

Component price $32 $40 $50

Contribution per Trackit $50.16 $42.16 $32.16
Total contribution $1,389,432 $1,167,832 $890,832
Profit $549,432 $327,832 $50,823
Break-even (Trackits) 16,746 19,924 26,119
Margin of safety 39.5% 28.1% 5.7%

Candidates would be rewarded for writing their report based on either of these two approaches.

P1 34 May 2008