CIMA P1 Performance Operations Study Text 2013

CIMA

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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

First edition 2009 Fifth edition June 2013 ISBN 9781 4453 7132 0

(Previous ISBN 9781 4453 9608 8) e-ISBN 9781 4453 7177 1

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is available from the British Library Published by

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We are grateful to the Chartered Institute of Management Accountants for permission to reproduce past examination questions. The suggested solutions in the exam answer bank have been prepared by BPP Learning Media Ltd. ©

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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

Objective test answer bank

Exam question bank

Exam answer bank

Appendix: Mathematical tables and exam formulae

Index

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.

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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

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

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.

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.)

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.

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.

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.

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.

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).

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.

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

Learning objectives Verbs used Definition 3 Application

How you are expected to apply your knowledge

• Apply • Calculate/ compute • Demonstrate • Prepare • Reconcile • Solve • Tabulate

• Put to practical use

• Ascertain or reckon mathematically

• Prove with certainty or to exhibit by practical means

• Make or get ready for use

• Make or prove consistent/compatible • Find an answer to

• Arrange in a table 4 Analysis

How you are expected to analyse the detail of what you have learned

• Analyse • Categorise • Compare and contrast • Construct • Discuss • Interpret • Prioritise • Produce

• Examine in detail the structure of • Place into a defined class or division • Show the similarities and/or differences between

• Build up or compile

• Examine in detail by argument

• Translate into intelligible or familiar terms • Place in order of priority or sequence for action • Create or bring into existence

5 Evaluation

How you are expected to use your learning to evaluate, make decisions or recommendations

• Advise • Evaluate • Recommend

• Counsel, inform or notify • Appraise or assess the value of • Propose a course of action

3

How

to

pass

3.1 Study the whole syllabus

You need to be comfortable with all areas of the syllabus, as questions, particularly the objective testing questions in Section A, will often span a number of syllabus areas. Remember that all questions in paper P1 are compulsory.

3.2 Lots of question practice

You can develop application skills by attempting questions in the Exam Question Bank and later on questions in the BPP Practice and Revision Kit.

3.3 Exam technique

The following points of exam technique are particularly relevant to this paper.

• You should consider in advance how you are going to use the 20 minutes' reading time. It gives you a great opportunity to read through the paper and consider your answers. You can use it to analyse the Section B question, or read carefully through the Section C questions.

• Read the question carefully. You must make sure that you answer the actual question set rather than what you would like the question to say! It is easy to write all that you know about a topic but you must remember to stick to the actual requirement of the question.

• Make sure that you develop time management skills. You have 1.8 minutes per mark so Section A, for example, must be completed in 36 minutes. You should not go over on time on any question. If you have not finished the question, move on and come back to it if you have time at the end.

• Practise your writing skills. You need to be able to write short paragraphs which answer the question.

4 Brought forward knowledge

You may be tested on knowledge or techniques you've learnt at lower levels. CIMA C1 Fundamentals of

Management Accounting and C3 Fundamentals of Business Maths are particularly important for this

paper.

5 Links with other exams

Some of the topics in the P1 paper will be covered in more detail in later exams so it is important to keep your books and notes. For example, knowledge of budgeting, relevant costing, sensitivity analysis and modern philosophies such as JIT and TQM will all be needed for the P2 exam. Knowledge of project appraisal will be required for the F3 exam.

The exam paper

Format of the paper

Number of marks Section A: A variety of multiple choice and other objective test questions, 2-4

marks each 20

Section B: 6 compulsory questions, 5 marks each 30

Section C: 2 questions, 25 marks each 50

100 Time allowed: 3 hours, plus 20 minutes reading time

Numerical content

The paper is likely to have a mixture of numerical and written parts and the percentage of numerical questions is likely to vary with each exam sitting. You are probably unlikely to get a Section B or Section C question which is entirely numerical or entirely written. Section A questions will probably contain some multiple choice questions which refer to the meanings of terms. So, you cannot expect Section A to be entirely numerical either.

Breadth of question coverage

Questions may cover more than one syllabus area.

May 2013 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Aggressive working capital policy (b) Economic order quantity and just-in-time (c) Probability and expected values

(d) Absorption costing and marginal costing profit reconciliation (e) Yield to maturity calculation

(f) Activity based budgeting vs incremental budgeting

Section C

3 Operating statement, planning and operational variances, variance investigation 4 NPV, sensitivity analysis

March 2013 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Treasury bills and bank deposit accounts (b) Sensitivity of cost of capital

(c) Material mix and yield variance (d) Recovering overdue debts

(e) Expected values

(f) Zero-based budgeting

Section C

3 Absorption costing and activity-based costing

4 NPV, probability analysis, sensitivity analysis, optimum replacement cycle

November 2012 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Aged debt analysis

(b) Certificates of deposit and bills of exchange (c) Sales mix and quantity variances

(d) Zero-based budgeting

(e) Decision tree

(f) Expected value and its limitations

Section C

3 Absorption costing and activity-based costing 4 NPV, payback and environmental issues

September 2012 resit exam paper

Section A

Section B

2 (a) Purchasing versus leasing (b) Regret matrix and risk (c) Centralised purchasing (d) Incremental budgeting

(e) Effective annual interest rate

(f) Debt factoring advantages and disadvantages

Section C

3 Variances and operating statement, standard costing in a modern environment 4 NPV, IRR, payback, real and money cost of capital

May 2012 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Mix and yield variances (b) Sensitivity analysis (c) Centralised purchasing (d) Participation budgeting (e) Perfect information

(f) Short-term cash surplus

Section C

3 Operating statement and arguments for absorption costing 4 NPV, IRR and time value of money

March 2012 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Cash budget preparation (b) Sensitivity analysis

(c) EAR calculation and credit worthiness

(d) Environmental internal and external failure costs (e) Absorption profit and marginal profit reconciliation (f) ABC calculation

Section C

3 Operating statement, mix, yield, planning and operational variances, 4 NPV, IRR, non-financial factors and real cost of capital

November 2011 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Cash budget preparation

(b) Decision tree and value of perfect information (c) Credit limits for customers

(d) Benefits of environmental costing (e) Probability and expected value

(f) Benefits of budgetary planning and control systems

Section C

3 Operating statement, planning and operational variances, JIT purchasing 4 Annualised equivalent calculation, sensitivity analysis, tax depreciation

September 2011 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Budgets and management participation (b) Advantages and disadvantages of overdrafts

(c) Decision tree

(d) Annualised equivalent calculation (e) Default risk and interest rate risk (f) Throughput accounting

Section C

3 Sales mix and quantity variance, operating statement, investigating variances 4 NPV, sensitivity analysis, payback period

May 2011 exam paper

Section A

Section B

2 (a) Budgets as performance targets (b) Perfect information

(c) Optimum replacement cycle

(d) Factoring

(e) Export finance

(f) Yield to maturity

Section C

3 Budgeting and variances

4 NPV, IRR, discounted payback, post completion audit

March 2011 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Zero-based budgeting (b) Perfect information

(c) Attitudes to risk

(d) Factoring

(e) Investments

(f) Coupon rate and yield to maturity

Section C

3 Activity-based costing 4 NPV, IRR and sensitivity analysis

November 2010 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Zero-based budgeting

(b) Maximin, maximax and minimax regret criteria (c) Attitudes to risk

(d) Expected receipts and bad debts

(e) Investments

Section C

3 Activity-based costing

4 Relevant cash flows, NPV and IRR calculation and comparison

September 2010 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Trade receivables

(b) EOQ

(c) Backflush accounting

(d) ZBB

(e) ABC, ABB

(f) Decision tree

Section C

3 Operating statement, planning and operational variances

4 NPV, IRR

May 2010 exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Preparation of age analysis of trade receivables (b) EOQ and cost of holding and ordering inventory (c) Manufacturing resource planning

(d) Benefits of an activity based budgeting system (e) Production budget preparation

(f) Decision tree preparation

Section C

3 Operating statement, variances and standard costing

Specimen exam paper

Section A

1 Seven objective test questions

Section B

2 (a) Debtor days and debt factoring (b) Non-financial factors of debt factoring

(c) Decision tree

(d) Regression analysis and forecasting (e) Budgets – motivation vs control (f) Environmental failure costs

Section C

3 NPV and ARR 4 Variance analysis

1

Part A

MANAGING SHORT-TERM

3

1

topic list learning outcomes syllabus references ability required

1 Working capital E1(a) E1(ii) comprehension

2 Working capital ratios E1(b), (e) E1(iii) analysis

3 Working capital requirements E1(a) E1(ii) comprehension

WORKING CAPITAL AND THE

OPERATING CYCLE

In this chapter we consider functions of the management accountant relating to the management of working capital in general

terms, including how much working capital the business requires and the impact on working capital of changes in the business.

1 Working capital

1.1 What is working capital?

Introduction

Every business needs adequate liquid resources to maintain day-to-day cash flow. It needs enough to pay wages and salaries as they fall due and enough to pay suppliers if it is to keep its workforce and ensure its supplies. Maintaining adequate working capital is not just important in the short term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long term as well. Even a profitable company may fail if it does not have adequate cash flow to meet its liabilities as they fall due.

WORKING CAPITAL is the capital available for conducting the day-to-day operations of an organisation; normally the excess of current assets over current liabilities. (CIMA Official Terminology)

1.2 Working capital characteristics of different businesses

Different businesses will have different working capital characteristics. There are three main aspects to these differences.

(a) Holding inventories (from their purchase from external suppliers, through the production and warehousing of finished goods, up to the time of sale)

(b) Taking time to pay suppliers and other payables (c) Allowing customers (receivables) time to pay

The current assets of a business can be subdivided into permanent current assets (the core levels of inventory and receivables) and fluctuating current assets, which vary from period to period.

1.3 Examples

(a) Supermarkets and other retailers receive much of their sales in cash or by credit card or debit card. However, they typically buy from suppliers on credit. They may therefore have the advantage of significant cash holdings, which they may choose to invest.

(b) A company which supplies to other companies, such as a wholesaler, is likely to be selling and buying mainly on credit. Co-ordinating the flow of cash may be quite a problem. Such a company may make use of short-term borrowings (such as an overdraft) to manage its cash.

(c) Smaller companies with a limited trading record may face particularly severe problems. Lacking a long track record, such companies may find it difficult to obtain credit from suppliers. At the same time, customers will expect to receive the length of credit period that is normal for the particular business concerned. The firm may find itself squeezed in its management of cash.

1.4 What is working capital management?

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Ensuring that sufficient liquid resources are maintained is a matter of working capital management. This involves achieving a balance between the requirement to minimise the risk of insolvency and the requirement to maximise the return on assets (or profit). Efficient working capital management is vital if the organisation is to stay in business. Profitable businesses can go under very quickly if liquidity is not maintained. The business must decide what level of cash and inventories are to be maintained and how they are to be funded.

A business pursuing an aggressive working capital policy will hold minimal cash and inventories and use short-term financing to fund both permanent and fluctuating current assets. This policy carries the highest risk of insolvency and the highest level of financial return.

A business pursuing a conservative policy will hold large levels of ready cash and safety inventory and use long-term funding for both non-current and most current assets. This is the least risky option but results in the lowest expected return.

An excessively conservative approach to working capital management resulting in high levels of cash holdings will harm profits because the opportunity to make a return on the assets tied up as cash will have been missed.

A moderate policy will match short-term finance to fluctuating current assets and non-fluctuating current (and non-current) assets will be matched by long-term funding.

1.5 The working capital cycle

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WORKING CAPITAL CYCLE is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser.

(CIMA Official Terminology) The connection between investment in working capital and cash flow may be illustrated by means of the working capital cycle (also called the cash cycle, operating cycle or trading cycle).

The working capital cycle in a manufacturing business equals:

The average time that raw materials remain in inventory X

Less the period of credit taken from suppliers (X)

Plus the time taken to produce the goods X

Plus the time finished goods remain in inventory after production is completed X

Plus the time taken by customers to pay for the goods X

X If the turnover periods for inventories and receivables lengthen, or the payment period to payables shortens, then the operating cycle will lengthen and the investment in working capital will increase.

Wines Co buys raw materials from suppliers that allow Wines 2.5 months credit. The raw materials remain in inventory for 1 month, and it takes Wines 2 months to produce the goods. The goods are sold within a couple of days of production being completed and customers take on average 1.5 months to pay.

Required

Calculate Wines's working capital cycle.

We can ignore the time finished goods are in inventory as it is no more than a couple of days.

Months

The average time that raw materials remain in inventory 1.0

Less: The time taken to pay suppliers (2.5)

The time taken to produce the goods 2.0

The time taken by customers to pay for the goods 1.5

2.0

Solution

Example: working capital cycle

The company's working capital cycle is 2 months. This can be illustrated diagrammatically as follows.

0 2.5 3 4.5

Goods Goods

purchased sold to customers

Suppliers Cash received

paid from customers

Working capital cycle

2 months

The working capital cycle is the period between the suppliers being paid and the cash being received from the customers.

1.6 Managing the cycle

A longer working capital cycle requires more financial resource, so management will seek whenever possible to reduce the length of the cycle. Their possible options are as follows.

(a) Reduce levels of raw materials inventory. This may be done by the introduction of some type of just-in-time system, which will necessitate more efficient links with suppliers. Production delays due to running out of inventory must be avoided.

(b) Reduce work in progress by reducing production volume or improving techniques and efficiency. (c) Reduce finished goods inventory, perhaps by improving distribution. This may lead to delays in

fulfilling customer orders.

(d) Delay payments to suppliers. This can lead to loss of discounts and of supplier goodwill. (e) Reduce period of credit given to customers. This may mean offering discounts and more

aggressive credit control may lead to loss of customers.

1.7 Cash flow planning

Since a company must have adequate cash inflows to survive, management should plan and control cash flows as well as profitability. Cash budgeting is an important element in short-term cash flow planning. The purpose of cash budgets is to make sure that the organisation will have enough cash inflows to meet its cash outflows. If a budget reveals that a short-term cash shortage can be expected, steps will be taken to meet the problem and avoid the cash crisis (perhaps by arranging a bigger bank overdraft facility). Cash budgets and cash flow forecasts on their own do not give full protection against a cash shortage and enforced liquidation of the business. There may be unexpected changes in cash flow patterns. When unforeseen events have an adverse effect on cash inflows, a company will only survive if it can maintain adequate cash inflows despite the setbacks.

Learning outcome E1(a)

Give examples of unforeseen changes which may affect cash flow patterns.

Section

summary

The amount tied up in working capital is equal to the value of all inventory and receivables less payables. This amount directly affects the liquidity of the organisation.

Working capital cycle is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser.

(CIMA Official Terminology)

2 Working capital ratios

Introduction

Working capital ratios may help to indicate whether a company has too much working capital (over-capitalised) or too little (overtrading).

2.1 The current ratio and the quick ratio

The standard test of liquidity is the current ratio. It can be obtained from the statement of financial position. CURRENT RATIO = s liabilitie Current assets Current

A company should have enough current assets that give a promise of 'cash to come' to meet its

commitments to pay its current liabilities. Obviously, a ratio in excess of 1 should be expected; an ideal is probably about 2. Otherwise, there would be the prospect that the company might be unable to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is 'comfortable' varies between different types of businesses.

Some manufacturing companies might hold large quantities of raw material inventories, which must be used in production to create finished goods. Finished goods might be warehoused for a long time, or sold on lengthy credit. In such businesses, where inventory turnover is slow, most inventories are not very easy to turn into liquid assets, because the cash cycle is so long. For these reasons, we calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.

QUICK RATIO, or ACID TEST RATIO=

s liabilitie Current s inventorie less assets Current

This ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash flow difficulties.

The current ratio and the quick ratio are known as liquidity ratios.

Question 1.1

KEY TERM

2.2 The receivables collection period

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RECEIVABLE DAYS RATIO =

terms credit on sales daily Average s receivable trade

Average _{(CIMA Official Terminology)}

An equivalent measure is the receivables turnover period.

RECEIVABLES TURNOVER PERIOD =

year the for sales Credit s receivable trade Average × 365 days

The trade receivables are not the total figure for receivables in the statement of financial position, which includes prepayments and non-trade receivables. The trade receivables figure will be itemised in an analysis of the total receivables, in a note to the accounts.

The estimate of receivables days is only approximate.

(a) The statement of financial position value might be used instead of the average. However, don't forget that the statement of financial position value of receivables might be abnormally high or low compared with the 'normal' level the company usually has.

(b) Sales revenue in the income statement excludes sales tax, but the receivables figure in the

statement of financial position includes sales tax. We are not strictly comparing like with like. If the figures are too distorted by sales tax, adjustment will be needed.

(c) Average receivables may not be representative of year-end sales if sales are growing rapidly.

2.3 The payables payment period

The payables payment period indicates the average time taken, in calendar days, to pay for supplies received on credit.

PAYABLES DAYS RATIO =

terms credit on purchases daily Average payables trade

Average _{(CIMA Official Terminology)}

PAYABLES PAYMENT PERIOD, or PAYABLES TURNOVER PERIOD =

year for terms oncredit Purchases payables trade Average × 365 days

If the credit purchases information is not readily available, cost of sales can be used instead. Don't forget however that some elements of cost of sales (for example, labour costs) are not relevant to trade

payables. Note also that credit purchases in the income statement do not include sales tax.

2.4 The inventory turnover period

The inventory turnover period shows how long goods are being kept in inventory.

Another ratio worth calculating is the inventory turnover period. This is another estimated figure, obtainable from published accounts, which indicates the average number of days that items of inventory are held for. As with the average receivable collection period, it is only an approximate figure; there may be distortions caused by seasonal variations in inventory levels. However it should be reliable enough for finding changes over time.

KEY TERMS KEY TERMS

INVENTORY TURNOVER = period in sales of cost daily Average Inventory _or sales of Cost inventory Average

The inventory turnover period can also be calculated:

INVENTORY TURNOVER PERIOD =

sales of Cost

Inventory _{× 365 days}

A lengthening inventory turnover period indicates: (a) A slowdown in trading, or

(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is becoming excessive

Where a business is manufacturing goods for resale, inventory turnover will have three components: Raw materials: materials raw of purchases inventory materials average × 365 WIP: cost ing manufactur progress in work average × 365 Finished goods: sales of cost goods finished average × 365

Where average values are not available, closing values can be used. Where no breakdown of inventories is supplied, just use the overall ratio:

sales of cost

inventory average

If we add together the inventory days and the receivable days, this should give us an indication of how soon inventory is convertible into cash, thereby giving a further indication of the company's liquidity. All the ratios calculated above will vary industry by industry; hence comparisons of ratios calculated with other similar companies in the same industry are important. There are organisations which specialise in inter-firm comparison. A company submits its figures to one of these organisations and receives an analysis of the average ratios for its industry. It can then compare its own performance to that of the industry as a whole.

The receivables turnover period, payables turnover period and inventory turnover period are known as efficiency ratios.

The working capital cycle (covered in Section 1) can be calculated using the following formulae.

Days purchases materials Raw inventory materials Raw × 365 = _X cost ing Manufactur progress in Work × 365 = _X sales of Cost goods Finished × 365 = X Sales s receivable Trade × 365 = X Purchases payables Trade × 365 = (X) __ X KEY TERMS

Note that if you are provided with the statement of financial position figures for the start and end of a year (top line in each formula), you should calculate the average for the year. You add the two figures together and divide by two.

Exam skills

Remember that exam questions will probably ask you to discuss the results of any ratios that you calculate.

Another term you may come across is capital employed. This usually means non-current assets + current assets – current liabilities.

Section

summary

Working capital ratios may help to indicate whether a company has too much working capital (over-capitalised) or too little (overtrading).

Current ratio = s liabilitie Current assets Current Quick ratio = s liabilitie Current s inventorie less assets Current

Receivable days ratio=

terms credit on sales daily Average s receivable trade Average

(CIMA Official Terminology)

Receivables turnover period = Average trade receivables

Credit sales for the year × 365 days

Payables days ratio = Average trade payables

Average daily purchases on credit terms (CIMA Official Terminology)

Payables payment period, or payables turnover period = Average trade payables Purchases on credit

terms for year

× 365 days

Inventory turnover = Inventory

Average daily cost of sales in period or

Average inventory Cost of sales

3 Working capital requirements

Introduction

Current assets may be financed either by long-term funds or by current liabilities.

Liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds that it is unable to renew its short-term liabilities (for example, if the bank suspends its overdraft facilities, or suppliers start to demand earlier payment), there will be a danger of insolvency unless the company is able to turn enough of its current assets into cash quickly.

3.1 The need for funds for investment in current assets

Current liabilities are often a cheap method of finance (trade payables do not usually carry an interest cost) and companies may therefore consider that, in the interest of higher profits, it is worth accepting some risk of insolvency by increasing current liabilities, taking the maximum credit possible from suppliers.

3.2 The volume of current assets required

The volume of current assets required will depend on the nature of the company's business. For example, a manufacturing company may require more inventories than a company in a service industry. As the volume of output by a company increases, the volume of current assets required will also increase. Even assuming efficient inventory holding, receivable collection procedures and cash management, there is still a certain degree of choice in the total volume of current assets required to meet output

requirements. Policies of low inventory-holding levels, tight credit and minimum cash holdings may be contrasted with policies of high inventories (to allow for safety or buffer inventories) easier credit and sizeable cash holdings (for precautionary reasons).

3.3 Over-capitalisation and working capital

If there are excessive inventories, receivables and cash, and very few payables, there will be an over-investment by the company in current assets. Working capital will be excessive and the company will be in this respect over-capitalised. The return on investment will be lower than it should be, and long-term funds will be unnecessarily tied up when they could be invested elsewhere to earn profits.

Over-capitalisation with respect to working capital should not exist if there is good management, but the warning signs of excessive working capital would be unfavourable accounting ratios, including the following. (a) Sales/working capital

The volume of sales as a multiple of the working capital investment should indicate whether, in comparison with previous years or with similar companies, the total volume of working capital is too high.

(b) Liquidity ratios

A current ratio greatly in excess of 2:1 or a quick ratio much in excess of 1:1 may indicate over-investment in working capital.

(c) Turnover periods

Excessive turnover periods for inventories and receivables, or a short period of credit taken from suppliers, might indicate that the volume of inventories or receivables is unnecessarily high, or the volume of payables too low.

Calculate liquidity and working capital ratios from the following accounts of a manufacturer of products for the construction industry, and comment on the ratios.

20X8 20X7

$m $m

Sales revenue 2,065.0 1,788.7

Cost of sales 1,478.6 1,304.0

Gross profit 586.4 484.7

20X8 20X7 $m $m Current assets Inventories 119.0 109.0 Receivables (note 1) 400.9 347.4 Short-term investments 4.2 18.8

Cash at bank and in hand 48.2 48.0

572.3 523.2

Payables: amounts falling due within one year

Loans and overdrafts 49.1 35.3

Income taxes 62.0 46.7

Dividend 19.2 14.3

Payables (note 2) 370.7 324.0

501.0 420.3

Net current assets 71.3 102.9

Notes

20X8 20X7

$m $m

1 Trade _{receivables 329.8 285.4}

2 Trade _{payables 236.2 210.8}

3 We are not given a breakdown of inventories

20X8 20X7 Current ratio 572.3 501.0 = 1.14 523.2 420.3 = 1.24 Quick ratio 453.3 501.0 = 0.90 420.3 414.2 _{= 0.99} Receivables' turnover period 329.8

2,065.0 × 365 = 58 days 1,788.7

285.4 _{× 365 = 58 days} Inventory turnover period 119.0

1,478.6 × 365 = 29 days

109.0

1,304.0 × 365 = 31 days Payables turnover period 236.2

1,478.6 × 365 = 58 days

210.8

1,304.0 × 365 = 59 days The company is a manufacturing group serving the construction industry, and so would be expected to have a comparatively lengthy receivables turnover period, because of the relatively poor cash flow in the construction industry. It is clear that the company compensates for this by ensuring that they do not pay for raw materials and other costs before they have sold their inventories of finished goods (hence the similarity of receivables and payables turnover periods).

The company's current ratio is a little lower than average but its quick ratio is better than average and very little less than the current ratio. This suggests that inventory levels are strictly controlled, which is reinforced by the low inventory turnover period. It would seem that working capital is tightly managed, to avoid the poor liquidity which could be caused by a high receivables turnover period and comparatively high payables.

3.4 Overtrading

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OVERTRADING is the condition of a business which enters into commitments in excess of its available short-term resources. This can arise even if the company is trading profitably, and is typically caused by financing strains imposed by a lengthy operating cycle or production cycle. (CIMA Official Terminology) In contrast with over-capitalisation, overtrading happens when a business tries to do too much too quickly with too little long-term capital, so that it is trying to support too large a volume of trade with the capital resources at its disposal.

Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is short of money. Such liquidity troubles stem from the fact that it does not have enough capital to provide the cash to pay its debts as they fall due.

Great Ambition appoints a new managing director who has great plans to expand the company. He wants to increase revenue by 100% within two years, and to do this he employs extra sales staff. He recognises that customers do not want to have to wait for deliveries, and so he decides that the company must build up its inventory levels. There is a substantial increase in the company's inventories. These are held in additional warehouse space which is now rented. The company also buys new cars for its extra sales representatives.

The managing director's policies are immediately successful in boosting sales, which double in just over one year. Inventory levels are now much higher, but the company takes longer credit from its suppliers, even though some suppliers have expressed their annoyance at the length of time they must wait for payment. Credit terms for receivables are unchanged, and so the volume of receivables, like the volume of sales, rises by 100%.

In spite of taking longer credit, the company still needs to increase its overdraft facilities with the bank, which are raised from a limit of $40,000 to one of $80,000. The company is profitable, and retains some profits in the business, but profit margins have fallen. Gross profit margins are lower because some prices have been reduced to obtain extra sales. Net profit margins are lower because overhead costs are higher. These include sales representatives' wages, car expenses and depreciation on cars, warehouse rent and additional losses from having to write off out-of-date and slow-moving inventory items. The statement of financial position of the company changed over time from (A) to (B).

Statement of Statement of

financial position (A) financial position (B)

$ $ $ $ Non-current assets 160,000 210,000 Current assets Inventory 60,000 _150,000 Receivables 64,000 _135,000 Cash 1,000 _– 125,000 285,000 Total assets 285,000 495,000 Current liabilities Bank 25,000 _80,000 Payables 50,000 200,000 75,000 280,000 Share capital 10,000 _10,000 Retained earnings 200,000 _205,000 210,000 215,000 Total equity/liabilities 285,000 495,000

Example: overtrading