Table Of Content

CIMA S T U D Y T E X T OPERATIONAL PAPER P1 PERFORMANCE OPERATIONS SUITABLE FOR EXAMS UP TO SEPTEMBER 2014 Our text is designed to help you study effectively and efficiently. In this edition we: • Highlight the most important elements in the syllabus and the key skills you will need • Signpost how each chapter links to the syllabus and the learning outcomes • Provide lots of exam alerts explaining how what you're learning may be tested • Include examples and questions to help you apply what you've learnt • Emphasise key points in section summaries • Test your knowledge of what you've studied in quick quizzes • Examine your understanding in our exam question bank • Reference all the important topics in the full index ii First edition 2009 Fifth edition June 2013 ISBN 9781 4453 7132 0 (Previous ISBN 9781 4453 9608 8) e-ISBN 9781 4453 7177 1 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA www.bpp.com/learningmedia Printed in the United Kingdom by Polestar Wheatons Hennock Road Marsh Barton Exeter EX2 8RP Your learning materials, published by BPP Learning Media Ltd, are printed on paper sourced from sustainable, managed forests. 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If they act illegally and unethically in one area, can you really trust them? iii Contents Page Introduction How our Study Text can help you pass iv Features in our Study Text v Streamlined studying vi Syllabus and learning outcomes vii Studying P1 xiii The exam paper xvii Part A Managing short-term finance 1 Working capital and the operating cycle 3 2 Cash flow forecasts 23 3 Cash management 53 4 Receivables and payables 83 5 Managing inventory 119 Part B Cost accounting systems 6a Basic management accounting techniques 133 6b Absorption and marginal costing 159 7a Standard costing 173 7b Variance analysis 193 7c Interpretation of variances 217 8 Further variance analysis 239 9 The modern business environment 279 10 Modern costing techniques – throughput and backflush accounting 307 11 Modern costing techniques – activity based costing 323 12 Environmental costing 341 Part C Forecasting and budgeting techniques 13 Budgeting 355 14 Preparing forecasts 391 Part D Project appraisal 15 Investment decision making 425 16 DCF techniques of investment appraisal 439 17 Taking account of taxation and inflation 471 18 Further aspects of investment decision making 487 Part E Dealing with uncertainty in analysis 19 Risk and uncertainty in decision making 519 Objective test question bank 567 Objective test answer bank 571 Exam question bank 579 Exam answer bank 595 Appendix: Mathematical tables and exam formulae 639 Index 645 Review form iv INTRODUCTION How our Study Text can help you pass Streamlined studying • We show you the best ways to study efficiently • Our Text has been designed to ensure you can easily and quickly navigate through it • The different features in our Text emphasise important knowledge and techniques Exam expertise • Studying P1 on page xiii introduces the key themes of the syllabus and summarises how to pass • We highlight throughout our Text how topics may be tested and what you’ll have to do in the exam • We help you see the complete picture of the syllabus, so that you can answer questions that range across the whole syllabus • Our Text covers the syllabus content – no more, no less Regular review • We frequently summarise the key knowledge you need • We test what you’ve learnt by providing questions and quizzes throughout our Text Our other products BPP Learning Media also offers these products for the P1 exam: Practice and Revision Kit Providing lots more question practice and helpful guidance on how to pass the exam Passcards Summarising what you should know in visual, easy to remember, form Success CDs Covering the vital elements of the P1 syllabus in less than 90 minutes and also containing exam hints to help you fine tune your strategy i-Pass Providing computer-based testing in a variety of formats, ideal for self-assessment Interactive Passcards Allowing you to learn actively with a clear visual format summarising what you must know Strategic case study kit Providing question practice with specially written questions, based on the preseen issued by CIMA You can purchase these products by visiting www.bpp.com/cimamaterials CIMA Distance Learning BPP's distance learning packages provide flexibility and convenience, allowing you to study effectively, at a pace that suits you, where and when you choose. There are four great distance learning packages available. Online classroom live Through live interactive online sessions it provides you with the traditional structure and support of classroom learning, but with the convenience of attending classes wherever you are Online classroom Through pre-recorded online lectures it provides you with the classroom experience via the web with the tutor guidance and support you’d expect from a face to face classroom Basics Plus A guided self study package containing a wealth of rich e-learning and physical content Basics Online A guided self study package containing a wealth of rich e-learning content You can find out more about these packages by visiting www.bpp.com/cimadistancelearning INTRODUCTION v Features in our Study Text Section Introductions explain how the section fits into the chapter Key Terms are the core vocabulary you need to learn Key Points are points that you have to know, ideas or calculations that will be the foundations of your answers Exam Alerts show you how subjects are likely to be tested Exam Skills are the key skills you will need to demonstrate in the exam, linked to question requirements Formulae To Learn are formulae you must remember in the exam Exam Formulae are formulae you will be given in the exam Examples show how theory is put into practice Questions give you the practice you need to test your understanding of what you’ve learnt Case Studies link what you’ve learnt with the real-world business environment Links show how the syllabus overlaps with other parts of the qualification, including Knowledge Brought Forward that you need to remember from previous exams Website References link to material that will enhance your understanding of what you’re studying Further Reading will give you a wider perspective on the subjects you’re covering Section Summaries allow you to review each section KEY POINT CASE STUDY KEY TERM vi INTRODUCTION Streamlined studying What you should do In order to Read the Chapter and Section Introductions See why topics need to be studied and map your way through the chapter Go quickly through the explanations Gain the depth of knowledge and understanding that you'll need Highlight the Key Points, Key Terms and Formulae To Learn Make sure you know the basics that you can't do without in the exam Focus on the Exam Skills and Exam Alerts Know how you'll be tested and what you'll have to do Work through the Examples and Case Studies See how what you've learnt applies in practice Prepare Answers to the Questions See if you can apply what you've learnt in practice Revisit the Section Summaries in the Chapter Roundup Remind you of, and reinforce, what you've learnt Answer the Quick Quiz Find out if there are any gaps in your knowledge Answer the Question(s) in the Exam Question Bank Practise what you've learnt in depth Should I take notes? Brief notes may help you remember what you’re learning. You should use the notes format that’s most helpful to you (lists, diagrams, mindmaps). Further help BPP Learning Media’s Learning to Learn Accountancy provides lots more helpful guidance on studying. It is designed to be used both at the outset of your CIMA studies and throughout the process of learning accountancy. It can help you focus your studies on the subject and exam, enabling you to acquire knowledge, practise and revise efficiently and effectively. INTRODUCTION vii Syllabus and learning outcomes Paper P1 Performance Operations The syllabus comprises: Topic and Study Weighting % A Cost Accounting Systems 30 B Forecasting and Budgeting Techniques 10 C Project Appraisal 25 D Dealing with Uncertainty in Analysis 15 E Managing Short-Term Finance 20 Learning Outcomes Lead Component Syllabus content A Cost accounting systems 1 Discuss costing methods and their results (a) compare and contrast marginal (or variable), throughput and absorption accounting methods in respect of profit reporting and stock valuation; (b) discuss a report which reconciles budget and actual profit using absorption and/or marginal costing principles; (c) discuss activity-based costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting; (d) apply standard costing methods, within costing systems, including the reconciliation of budgeted and actual profit margins; (e) explain why and how standards are set in manufacturing and in service industries with particular reference to the maximisation of efficiency and minimisation of waste; (f) interpret material, labour, variable overhead, fixed overhead and sales • Marginal (or variable), throughput and absorption accounting systems of profit reporting and stock valuation. • Activity-based costing as a system of profit reporting and stock valuation. • Criticisms of standard costing in general and in advanced manufacturing environments in particular. • Integration of standard costing with marginal cost accounting, absorption cost accounting and throughput accounting. • Manufacturing standards for material, labour, variable overhead and fixed overhead. • Price/rate and usage/efficiency variances for materials, labour and variable overhead. • Further subdivision of total usage/efficiency variances into mix and yield components. (Note: The calculation of mix variances on both individual and average valuation bases is required.) • Fixed overhead expenditure and volume variances. (Note: the subdivision of fixed overhead volume variance into capacity and efficiency elements will not be examined.) viii INTRODUCTION Learning Outcomes Lead Component Syllabus content variances, distinguishing between planning and operational variances; (g) prepare reports using a range of internal and external benchmarks and interpret the results; (h) explain the impact of just- in-time manufacturing methods on cost accounting and the use of ‘back-flush accounting’ when work in progress stock is minimal. • Planning and operational variances. • Standards and variances in service industries (including the phenomenon of ‘McDonaldization’), public services (eg Health), (including the use of ‘diagnostic related’ or ‘reference’ groups), and the professions (eg labour mix variances in audit work). • Sales price and sales revenue/margin volume variances (calculation of the latter on a unit basis related to revenue, gross margin and contribution margin). Application of these variances to all sectors, including professional services and retail analysis. • Interpretation of variances: interrelationship, significance. • Benchmarking. • Back-flush accounting in just-in- time production environments. The benefits of just-in-time production, total quality management and theory of constraints and the possible impacts of these methods on cost accounting and performance measurement. 2 Explain the role of MRP and ERP systems (a) explain the role of MRP and ERP systems in supporting standard costing systems, calculating variances and facilitating the posting of ledger entries. • MRP and ERP systems for resource planning and the integration of accounting functions with other systems, such as purchase ordering and production planning. 3 Apply principles of environmental costing (a) apply principles of environmental costing in identifying relevant internalised costs and externalised environmental impacts of the organisation’s activities. • Types of internalised costs relating to the environment (eg emissions permits, taxes, waste disposal costs) and key externalised environmental impacts, especially carbon, energy and water usage. Principles for associating such costs and impacts with activities and output. INTRODUCTION ix Learning Outcomes Lead Component Syllabus content B Forecasting and budgeting techniques 1 Explain the purposes of forecasts, plans and budgets. (a) explain why organisations prepare forecasts and plans; (b) explain the purposes of budgets, including planning, communication, co-ordination, motivation, authorisation, control and evaluation, and how these may conflict. • The role of forecasts and plans in resource allocation, performance evaluation and control. • The purposes of budgets and the budgeting process, and conflicts that can arise (eg between budgets for realistic planning and budgets based on ‘hard to achieve’ targets for motivation). 2 Prepare forecasts of financial results. (a) calculate projected product/service volumes employing appropriate forecasting techniques; (b) calculate projected revenues and costs based on product/service volumes, pricing strategies and cost structures. • Time series analysis including moving totals and averages, treatment of seasonality, trend analysis using regression analysis and the application of these techniques in forecasting product and service volumes. • Fixed, variable, semi-variable and activity based categorisations of cost and their application in projecting financial results. 3 Prepare budgets based on forecasts. (a) prepare a budget for any account in the master budget, based on projections/forecasts and managerial targets; (b) apply alternative approaches to budgeting. • Mechanics of budget construction: limiting factors, component budgets and the master budget, and their interaction. • Alternative approaches to budget creation, including incremental approaches, zero-based budgeting and activity-based budgets. C Project appraisal 1 Prepare information to support project appraisal (a) explain the processes involved in making long- term decisions; (b) apply the principles of relevant cash flow analysis to long-run projects that continue for several years; (c) calculate project cash flows, accounting for tax and inflation, and apply perpetuities to derive ‘end of project’ value where appropriate; • The process of investment decision making, including origination of proposals, creation of capital budgets, go/no go decisions on individual projects (where judgements on qualitative issues interact with financial analysis), and post audit of completed projects. • Identification and calculation of relevant project cash flows taking account of inflation, tax, and ‘final’ project value where appropriate. x INTRODUCTION Learning Outcomes Lead Component Syllabus content (d) apply activity-based costing techniques to derive approximate ‘long- run’ product or service costs appropriate for use in strategic decision making; (e) explain the financial consequences of dealing with long-run projects, in particular the importance of accounting for the ‘time value of money’; (f) apply sensitivity analysis to cash flow parameters to identify those to which net present value is particularly sensitive; (g) prepare decision support information for management, integrating financial and non-financial considerations. • Activity-based costing to derive approximate ‘long-run’ costs appropriate for use in strategic decision making. • Need for and method of discounting. • Sensitivity analysis to identify the input variables that most affect the chosen measure of project worth (payback, ARR, NPV or IRR). • Identifying and integrating non- financial factors in long-term decisions. • Methods of dealing with particular problems: the use of annuities in comparing projects with unequal lives and the profitability index in capital rationing situations. 2 Evaluate project proposals (a) evaluate project proposals using the techniques of investment appraisal; (b) compare and contrast the alternative techniques of investment appraisal; (c) prioritise projects that are mutually exclusive, involve unequal lives and/or are subject to capital rationing. • The techniques of investment appraisal: payback, discounted payback, accounting rate of return, net present value and internal rate of return. • Application of the techniques of investment appraisal to project cash flows and evaluation of the strengths and weaknesses of the techniques. D Dealing with uncertainty in analysis 1 Analyse information to assess the impact on decisions of variables with uncertain values (a) analyse the impact of uncertainty and risk on decision models that may be based on relevant cash flows, learning curves, discounting techniques etc; (b) apply sensitivity analysis to both short and long-run decision models to identify variables that might have significant impacts on project outcomes; • The nature of risk and uncertainty. • Sensitivity analysis in decision modelling and the use of computer software for “what if” analysis. • Assignment of probabilities to key variables in decision models. • Analysis of probabilistic models and interpretation of distributions of project outcomes. • Expected value tables and the value of information. • Decision trees for multi-stage decision problems. INTRODUCTION xi Learning Outcomes Lead Component Syllabus content (c) analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms; (d) prepare expected value tables; (e) calculate the value of information; (f) apply decision trees. E Managing short-term finance 1 Analyse the working capital position and identify areas for improvement (a) explain the importance of cash flow and working capital management; (b) interpret working capital ratios for business sectors; (c) analyse cash-flow forecasts over a twelve- month period; (d) discuss measures to improve a cash forecast situation; (e) analyse trade debtor and creditor information; (f) analyse the impacts of alternative debtor and creditor policies; (g) analyse the impacts of alternative policies for stock management • The link between cash, profit and the balance sheet. • The credit cycle from receipt of customer order to cash receipt and the payment cycle from agreeing the order to making payment. • Working capital ratios (eg debtor days, stock days, creditor days, current ratio, quick ratio) and the working capital cycle. • Working capital characteristics of different businesses (eg supermarkets being heavily funded by creditors) and the importance of industry comparisons. • Cash-flow forecasts, use of spreadsheets to assist in this in terms of changing variables (eg interest rates, inflation) and in consolidating forecasts. • Variables that are most easily changed, delayed or brought forward in a forecast. • Methods for evaluating payment terms and settlement discounts. • Preparation and interpretation of age analyses of debtors and creditors. • Establishing collection targets on an appropriate basis (eg motivational issues in managing credit control). • Centralised versus decentralised purchasing. xii INTRODUCTION Learning Outcomes Lead Component Syllabus content • The relationship between purchasing and stock control. • Principles of the economic order quantity (EOQ) model and criticisms thereof. 2 Identify short- term funding and investment opportunities (a) identify sources of short- term funding; (b) identify alternatives for investment of short-term cash surpluses; (c) identify appropriate methods of finance for trading internationally. (d) illustrate numerically the financial impact of short- term funding and investment methods. • Use and abuse of trade creditors as a source of finance. • Types and features of short-term finance: trade creditors, overdrafts, short-term loans and debt factoring. • The principles of investing short term (ie maturity, return, security, liquidity and diversification). • Types of investments (eg interest- bearing bank accounts, negotiable instruments including certificates of deposit, short-term treasury bills, and securities). • The difference between the coupon on debt and the yield to maturity. • Export finance (eg documentary credits, bills of exchange, export factoring, forfeiting). INTRODUCTION xiii Studying P1 1 What's P1 about? 1.1 Current performance evaluation and future projections P1 looks at how information is obtained, evaluated and used to control and predict business performance. For example, budgets are used along side cost accounting systems to evaluate business performance. Cash projections are used to evaluate individual projects and predict their performance. Cash flow forecasts are used to control working capital. All of these examples use estimated (and therefore uncertain) information and P1 looks at measuring the risk associated with this uncertainty. There is assumed prior knowledge of Certificate level papers, particularly C1 Fundamentals of Management Accounting and C3 Fundamentals of Business Maths. 1.2 Managing short-term finance This element of the syllabus concentrates on what’s required for the business’s day-to-day operations and short-term financing requirements including its working capital of inventory, receivables, payables and cash. P1 covers how working capital is measured and managed, how an organisation determines its short-term financing requirements and where it can invest surplus cash. 1.3 Cost accounting systems There are different ways of carrying out costing. These include traditional management accounting techniques and new alternatives which may be more appropriate for the modern business environment. The various costing methods impact upon the business’s inventory valuation and profitability. 1.4 Standard costing A standard cost is the planned unit of cost of a product or service. Without this, producing a budget would be very difficult. Standard costing and variance analysis act as a control mechanism by establishing standards and highlighting activities that do not conform to plan. 1.5 Forecasting and budgeting A budget is a plan of what the organisation is aiming to achieve and what it has set as a target. There are several different techniques used to produce a budget but they are all produced to ensure that objectives are achieved. It is important that results are measured regularly and compared to budget so that management can try to take corrective action if areas of the business are not performing well. 1.6 Project appraisal You are expected to understand and apply techniques for evaluating long-term proposals. This includes identifying relevant cash flows, using investment appraisal techniques (including DCF and ARR) and factoring in inflation and taxation, ranking the projects and applying sensitivity analysis. 1.7 Dealing with uncertainty in analysis This part of the syllabus looks at techniques for measuring risk and evaluating uncertainty. These techniques include expected values, sensitivity analysis and decision trees. You need to be familiar with the techniques and their application across a variety of decision making tools such as relevant cash flows, DCF and CVP analysis. xiv INTRODUCTION 2 What's required 2.1 Explanation As well as testing your knowledge and understanding, you are asked to demonstrate the skill of explaining key ideas, techniques or approaches. Explaining means providing simple definitions and covering the reasons why these approaches have been developed. You’ll gain higher marks if your explanations are clearly focused on the question and you can supplement your explanations with examples. You could try using the PEA approach. Point, Explain, Apply. Make your point in a sentence. Explain that point in another sentence by answering the reader's 'so what?' or 'why?'. Then apply it to the scenario so that your point relates to the organisation or specific situation in the question. 2.2 Interpretation and recommendation You will probably have to interpret the results of any calculations that you carry out. You must understand that interpretation isn’t just saying figures have increased or decreased. It means explaining why figures have changed and also the consequences of the changes. You will also have to provide recommendations. For example, you may be given some details or working capital ratios and then asked to explain how that particular business could improve its day-to-day working capital management and what sources of short-term finance it will need. 2.3 What the examiner means The table below has been prepared by CIMA to help you interpret the syllabus and learning outcomes and the meaning of exam questions. You will see that there are 5 levels of Learning objective, ranging from Knowledge to Evaluation, reflecting the level of skill you will be expected to demonstrate. CIMA Certificate subjects were constrained to levels 1 to 3, but in CIMA’s Professional qualification the entire hierarchy will be used. At the start of each chapter in your study text is a topic list relating the coverage in the chapter to the level of skill you may be called on to demonstrate in the exam. Learning objectives Verbs used Definition 1 Knowledge What are you expected to know • List • State • Define • Make a list of • Express, fully or clearly, the details of/facts of • Give the exact meaning of 2 Comprehension What you are expected to understand • Describe • Distinguish • Explain • Identify • Illustrate • Communicate the key features of • 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