Printer Friendly

Performance management: candidates should perform a series of checks before and after answering each question to satisfy themselves that they will achieve the maximum score warranted by their technical know-how.

Recent articles in FM and Velocity have explained that candidates very often have the technical knowledge to answer a question, but fail because they don't approach it systematically. The post-exam guides also identify common errors that are often not technical. When tackling a paper, and each individual question within it, candidates need to follow a strict routine. Before you put pen to paper, you should ask yourself the following questions:

* Do I understand what is required? What is the examiner actually looking for?

* Do I understand the verbs that are being used in the question?

* Is there more than one element to each part of the question?

* Have I drawn up a plan?

* Have I allotted the suggested time (one minute and 48 seconds per mark) to answering each part of the question or the question in total? Bear in mind that effective time management is vital. Taking a few extra moments on each question could leave you without enough time to answer the last one that you attempt.

Lastly, remind yourself that you must not write in red ink or in pencil.

Let's now tackle a question that appeared in September 2012's P2 exam. Its requirements were relatively straightforward, but many candidates failed to follow the principles I have listed and their answers were poor as a result.

HJ and KL are two companies that operate in the same industry. Details for the two companies for the year ended 31 December 2011 are as follows:
                                HJ        KL

                             ($000)   ($000)

Revenue                       1,600      990

Cost of sales:

Variable production costs       400      400

Fixed production costs          800      390
(including depreciation
--see note 3)

                              1,200      790

Gross profit                    400      200

Administration costs (fixed)    120       80

Operating profit                280      120

Non-current assets:

Cost                          2,000    1,800

Depreciation (see notes below)  400    1,230

                              1,600      570

Net current assets              200      150

Capital employed              1,800      720

Performance measures

Return on capital employed   15.56%   16.67%

Operating profit margin      17.50%   12.12%

Asset turnover                 0.89     1.38


Answering part (a)

Note first that the main verb used in the requirement is "calculate"--ie, ascertain mathematically. Step one is to establish the age of KL's noncurrent assets as follows:
                                         $000

Cost                                    1,800

Depreciation at 25% in year one           450

                                        1,350

Depreciation at 25% in year two           337

                                        1,013

Depreciation at 25% in year three         253

                                          760

Depreciation at 25% in year four          190

End of year four (as shown in question)   570


Step two is to apply a depreciation rate of 25 per cent on a reducing-balance basis to HJ's noncurrent assets over the four-year period. The depreciation charge will be:
Cost                           2,000

Less 25%, year one               500

                               1,500

Less 25%, year two               375

                               1,125

Less 25%, year three             281

                                 844

Less 25%, year four (required)   211

End of year four                 633


The cumulative depreciation charge in $000s is therefore $500 + $375 + $281 + $211 = $1,367. Step three is to redraft HJ's P&L statement:
                                   $000

Revenue                           1,600

Cost of sales:

Variable production costs   400

Fixed production costs     400 *

New depreciation            211   1,011

Gross profit                        589

Administration costs                120

Operating profit                    469

* The original $800, less the previous depreciation of $400.


Step four is to redraft the balance sheet extract for HJ as follows:
                           $000

Non-current assets:

Cost                      2,000

Cumulative depreciation   1,367

                            633

Net current assets          200

Capital employed            833


Step five is to recalculate the ratios using the new figures identified for return (operating profit), capital employed and turnover:

* Return on capital employed: 469 / 833 = 56.3%.

* Operating profit margin: 469 / 1,600 = 29.3%.

* Asset turnover: 1,600 / 833 = 1.92 times.

Return on capital employed equals the operating profit margin multiplied by the asset turnover figure. This equation offers a useful check (albeit one that earns no marks) that can quickly be made to verify the accuracy of the three ratio calculations. In this case, 29.3% x 1.92 = 56.3%.

Note that you need to use the same profit figures in the two ratios that include the profit. You should also ensure that you use the same capital employed figure in the two ratios that include the capital employed.

Answering part (b)

Once again, the verb used in the requirement is "calculate". Step one is to calculate KL's contribution-to-sales (C/S) ratio that won't change in 2013: C/S ratio: 590 / 990 = 59.6%.

Step two is to establish KL's current fixed costs (excluding depreciation) as follows:
                                   $000

Fixed production costs: 390-190     200

Fixed administration costs           80

                                    280


Step three is to calculate the depreciation charge for 2013. If KL uses the same depreciation method--reducing-balance--in 2012 and 2013, its depreciation charge will be as follows:
                                               $

Non-current assets at 31 December 2011   570,000

Depreciation in 2012 (25%)               142,500

31 December 2012                         427,500

Depreciation in 2013 (25%)               106,875

31 December 2013                         320,625


Step four is to calculate the new figure for fixed costs, including depreciation, as follows:
                                                    $

Original fixed costs excluding depreciation   280,000

Depreciation in 2013                          106,875

                                              386,875


The final step is to calculate the break-even sales value in 2013 by dividing the fixed costs by the C/S ratio: $386,875 / 59.6% = $649,119.

Do check that your answer is sensible and in context--and don't forget the currency sign.

Answering part (c)(i)

Note that the verb in the requirement this time is "recommend"--i.e. advise on a course of action. Step one is to quantify the changes identified in the question as follows:

* Fixed costs, excluding depreciation, are to increase by 30 per cent. This change equates to ($390,000-$190,000) x 30% = $60,000.

* The variable production cost per unit is to decrease by 20 per cent. This change equates to $400,000 x 20% = $80,000.

The net cash inflow from the above changes is therefore a cost saving of $20,000.

Step two is to construct the following investment appraisal summary to establish whether or not KL should replace its non-current assets:
Year                    0         1       2      3        4          5

Capital cost  (1,200,000)
($)

Trade-in ($)      427,500

Net savings                20,000 *  20,000  20,000  20,000     20,000
($)

Resale value                                                   285,000
($)

                (772,500)    20,000  20,000  20,000  20,000    305,000

Discount at          1.00     0.909   0.826   0.751   0.683      0.621
10%

NPV ($)         (772,500)    18,180  16,520  15,020  13,660    189,410

Overall                                                      (519,710)
impact ($)

* Only the incremental figure is required.


Step three is to draw a conclusion. In this case, it's that the investment has an overall negative net present value of $519,710, which means that KL would not wish to replace its equipment.

Answering part (c)(ii)

The verb used in the requirement is "discuss"--i.e. examine in detail by argument. Remember that the discussion must be supported by relevant figures.

Step one is to establish the position. In this case, if KL were to replace its noncurrent assets with new equipment at a cost of $1.2m, this would cause a significant increase in the depreciation charge for the year.

Step two is to calculate the new depreciation figure for 2013. In this case the charge would be $1,200,000 x 25% = $300,000.

Step three is to calculate the new fixed cost for 2013 as follows:
                                                        $000

Original fixed production costs                          200

Administration costs                                      80

Additional fixed costs ([pounds sterling]60,000 a year)   60

New depreciation                                         300

Total fixed cost                                         640


Step four is to calculate the new C/S ratio. The existing C/S ratio in this case is 590 / 990 = 59.6%, which we calculated in step one of answering part (b). We need to repeat this calculation to help us understand the change that gives rise to the new C/S ratio. Because the variable production costs are expected to fall by $80,000 a year, the new C/S ratio will be (590 + 80) / 990 = 67.677%.

Step five is to calculate the new break-even sales value by dividing the new total fixed cost by the new C/S ratio: $640,000 / 67.677% = $945,668.

Step six is to establish the difference in breakeven sales values. Without the investment, the break-even sales value is $649,119. With the investment, it's $945,668, revealing an increase of $296,549--a 45.7 per cent rise.

When you have finished your answer, you should ask yourself the following questions:

* Have I written clearly? Will a marker be able to read my answer easily?

* Are all the figures clearly labelled?

* Are my calculations legible? Are my workings referred to clearly?

* Is the answer sensible--i.e. does it fit the context of the question?

* Have I used the units specified in the question--e.g. dollars or pounds?

* Have I answered the question, as opposed to answering the question I'd like to have seen?

Further reading Adrian Sims, "ASAP: helping you to pass quickly", Velocity, June 2011 (bit.ly/VelocityASAP). Norwood Whittle, "Exam dos and don'ts: a marker's advice", Velocity, December 2011 (bit.ly/VelocityMarker).

Notes

(1.) Assume that the non-current assets of both companies are all used in their manufacturing processes.

(2.) The two companies use different depreciation policies: HJ depreciates its noncurrent assets using straight-line depreciation at the rate of 20 per cent of cost with no residual value; KL uses the reducing-balance method at 25 per cent per annum.

(3.) Included in the fixed costs of the year ended 31 December 2011 is depreciation of $400,000 for HJ and $190,000 for KL.

(4.) Each company purchased all of its noncurrent assets in the month the company was formed. Neither has purchased or disposed of any noncurrent assets since their original purchase.

HJ has undertaken a benchmarking exercise. The managing director of HJ has been asked to explain the company's results compared with those of KL. The managing director says that the differences are because of HJ's depreciation policy and the age of the company's assets.

You are required to:

(a.) Calculate the three revised performance ratios of HJ after adjusting its results to align the age of its assets and its depreciation policy with KL's (nine marks).

(b.) Calculate, for KL only, the break-even sales value in 2013, assuming that there are no changes to its cost and selling price structure or to its mix of sales; that there are no purchases or disposals of non-current assets; and that the existing depreciation policy continues to be applied (four marks).

The directors of KL are now considering replacing its non-current assets with new equipment that will be fully operational from 1 January 2013. The manufacturer of the new equipment has offered to accept the company's old equipment as a trade-in at its net book value at 31 December 2012 of $427,500. If this offer is not accepted, KL does not expect to be able to dispose of the old equipment for any value at any time in the future.

The new equipment:

* Has a cost of $1.2m before any trade-in value is deducted.

* Increases the fixed production cost (excluding depreciation) by 30 per cent per annum.

* Reduces the variable production cost per unit by 20 per cent.

* Has a life of five years and a residual value after five years of $285,000. It is to be depreciated using the same method that's currently being used for the existing equipment.

Assume that:

* There is no change to the unit selling price or demand for KL's product.

* KL's cost of capital for this type of investment is 10 per cent per annum.

You are required to:

(c)(i) Recommend, based on net present value, whether or not KL should replace its noncurrent assets. Ignore taxation and inflation (six marks).

(c)(ii) Discuss the effect on the break-even sales value in 2013 of investing in the new equipment (six marks).

By Norwood Whittle FCMA

CIMA course leader at the University of Northampton and lead marker for P2
COPYRIGHT 2013 Chartered Institute of Management Accountants (CIMA)
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2013 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:Paper P2
Author:Whittle, Norwood
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Feb 1, 2013
Words:2009
Previous Article:8 ways to ... succeed with an M&A: because there are so many ways in which merger deals can go wrong, it pays to prepare well and consider both the...
Next Article:Fundamentals of Financial Accounting: as with many topics, you would be well advised to practise a methodical approach to answering questions about...
Topics:

Terms of use | Privacy policy | Copyright © 2022 Farlex, Inc. | Feedback | For webmasters |