NotesPaper P2 Ignore ratios at your peril p42

S t u d y

The ASAP approach (analyse requirements, source syllabus knowledge, analyse sce-nario, plan answer) to tackling exam questions is a systematic method that helps to ensure that candidates use the scenario information properly and apply

their knowledge effectively. Examiners rate these as key abilities for successful P3 students, but this is no less true for those sitting other papers.

Let’s tackle question 7 from May 2011’s P2 exam to see how ASAP works in this case. The full paper can be downloaded from bit.ly/P2May2011.

A: Analyse the question’s requirementsThe requirements are as follows:A. Prepare an analysis of the sales made by division E that shows clearly, in units and in dollars, the internal and external sales made during the year (three marks).B. Discuss the effect of possible changes in external demand on the profits of division E, assuming that the current transfer pricing policy continues (six marks). C. Assuming that the current transfer pricing policy continues (ignoring taxation and inflation): (i) Evaluate the investment from the perspective of the manager of division E (six marks).(ii) Evaluate the investment from the perspective of the DE company (four marks).

Paper P2

ManagementPerformance

By Ian Blackmore, BPP Learning Media

An article in November’s Study Notes used the ASAP approach to tackle a P3 paper. But this method works equally well in any paper requiring the application of knowledge to a scenario

In association with

D. Explain two factors that should be considered when designing divisional performance measures (six marks).

First, you need to note the key verbs used in the requirement: “prepare” in part A, “discuss” in part B, “evaluate” in part C and “explain” in part D. CIMA’s list of verbs contains these definitions:l Prepare: make or get ready to use.l Discuss: examine in detail by argument.l Evaluate: appraise or assess the value of.l Explain: make clear or intelligible, and/or state the meaning or purpose of.

The key phrase in part A is “analysis of sales”. You’ll need to prepare a table summarising the sales of the selling division. Assume that you will obtain one mark for sales units, one for sales volumes and one for making a clear distinction between internal and exter-nal sales.

Part B requires you to discuss – i.e. examine in detail by argument – the effect of possible changes in exter-nal demand on the profits of division E under the cur-rent transfer pricing policy. Your discussion should consider the effect of external demand on the transfer price and the effect on profit at different transfer prices. If you assume that each relevant point, well explained, will be worth up to two marks, you should be looking to make and explain three relevant points.

The requirements in part C are linked. You’ll need to evaluate the investment from two different perspec-tives. Your answer should include workings and all figures should be explained. In part (i), aim to provide two well-explained points (up to two marks each) and supporting calculations (up to two marks), for a max-imum of six marks. In part (ii), make use of your cal-culations for part (i) and provide two well-explained points (up to two marks each).

Your answer to part D should focus on two factors that need to be considered when divisional perfor-mance measures are being designed, rather than simply explaining the role of these performance meas-ures. Assume that there are three marks available for each factor you cover.

The guidance given here on mark allocation is an oversimplification of the marking process, but the over-

‘First, you need to note the key verbs used in the requirement’

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riding message – ensure that your answer for each part reflects the number of marks on offer for it – is important.

S: Source the syllabus knowledgeWhen reading the DE company scenario, you should be thinking about the knowledge that you will apply to answer the requirements. Possible areas include:l Performance statements.l Revenue and cost information for profit and invest-ment centre managers.l Transfer pricing and divisional decision-making.l Transfer prices. The scenario states that the current policy is for internal sales to be transferred at their opportunity cost (some at market price; some at vari-able cost).l Net present value investment (NPV) appraisal. Division E is considering an investment in new equip-ment that would reduce its unit variable costs by 20 per cent and increase capacity by 10 per cent for each of the next five years.l Measuring performance in businesses with a divi-sionalised structure.

A: Analyse the scenarioAt this stage, you need to underline or highlight key points in the scenario and make annotations in the margin. You are permitted to do this during your 20 minutes of reading time.

Look for information in the scenario that you can use to help answer the requirements. For example, we are told:l Division E operated at its full capacity of 140,000 units (second paragraph of the scenario).l Division E transferred 70,000 units to division D (second paragraph).l The current market price per unit of the component is $1,550 (second paragraph).l Internal sales are transferred at their opportunity cost (third paragraph).l The proposed investment would cost $120m and the equipment would have no value after five years (fourth paragraph).l Investments are evaluated using a cost of capital of eight per cent (fourth paragraph).l The external annual demand for components for the next five years will be 112,000 units at $1,550 each (fifth paragraph).l Internal annual demand of 70,000 units must be sat-isfied (fifth paragraph).

To answer part A, identify the quantities being sold internally and externally by division E and construct your table using the sales data given in the first two paragraphs of the scenario.

To answer part B you need to discuss the effect of possible changes in external demand on the profits of division E under the current transfer pricing policy, whereby internal sales are transferred at opportunity cost. Restrict yourself to discussing the impact on profit – the question is not asking for a series of statements showing profits and losses for changes in external demand.

Part C requires you to evaluate the investment from the perspective of division E’s manager and then from that of the DE company. Your answer should use NPV to show the costs and benefits to both the division and the company of investing in the new equipment. Ensure that you make an appropriate recommenda-tion for each party.

Part D requires you to describe two factors to con-sider when designing divisional performance meas-ures. You could pick two factors from the Smart mnemonic (specific, measurable, achievable, realistic and time-bound). Include examples that are relevant to the company.

P: Plan your answerAn effective answer plan will give structure to your answer and ensure that it covers all the points you want it to. It need not be detailed – it could simply be a number of bullet points featuring key headings and calculations. Use your plan as a reminder of these points once you start writing your answer.

To aid your understanding, the points included in the following example are more detailed than those that you would include in your plan.A: Analysis of sales made by division E during the year (three marks):l Table.l Internal sales: 70,000 units; $93.1m.l External sales: 70,000 units; $108.5m.B. Effects of possible changes in external demand on profits of division E (six marks):l Components have been sold to division D at variable cost (division E has not derived any financial benefit).l If these had been sold at market price, the cost to divi-sion D would have been $15.4m greater than under the current transfer price.l A fall in external demand would mean that more components would be supplied to division D at

‘When reading the scenario, you should be thinking about the knowledge that you will apply to answer the requirements’

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Paper P2Performance Managementvariable cost, reducing division E’s profits.l A rise in external demand would have the opposite effect until all of the internal transfers are being made at the external selling price.C(i). Evaluate the investment from the perspec-tive of the manager of division E (six marks):l A ten per cent increase in division E capacity will increase external sales.l Reduction in volume of external sales foregone by selling to division D.l No financial benefit to division E.l Variable cost of items sold at market value: $112m a year (cost saving of $22.4m a year).l Present value (8 per cent annuity): $89.4432m.l Cost of investment: $120m.l The investment is not financially viable from the per-spective of division E’s manager.C(ii). Evaluate the investment from the perspec-tive of the DE company (four marks):l Consider the benefits to division D.l 42,000 components at revised cost less 20 per cent = $33.6m.l 28,000 components at market value: $43.4m.l Division D saving: $16.1m a year.l Total cost saving per year to the DE company: $22.4m + $16.1m = $38.5m.

l Present value: $153.73m.l The investment is worthwhile from the DE compa-ny’s perspective.D. Two factors that should be considered when designing divisional performance measures (six marks):l They need to be easy to calculate and understand.l Include only items that are within the divisional man-ager’s control.l Link each factor to the DE company, supported by a brief example.

Once you’ve made your plan, you’re ready to start writing the answer. When you do this, use another mne-monic acronym – Pert – which was first highlighted in a Velocity article in June 2011 (bit.ly/VelocityASAP). Pert stands for: point, explain, relate and time:l Point. Make your points in a concise sentence and use this as a heading to a short paragraph.l Explain. Make the meaning of your point clear by using “because” or “owing to”. Markers can mark only what you explicitly say, not what you might have meant.l Relate. Your points must relate to the scenario. l Time. Don’t exceed your allocation.

Above all, remember that your points will earn marks only if they are relevant to the question.

‘Your answer plan need not be detailed – it could simply be a number of bullet points featuring key headings and calculations’

Paper P2Ignore ratios at your peril

By Norwood Whittle, FCMA, CGMACIMA course leader at the University of Northampton

Many candidates struggle with the ratio analysis question. Simple examples and an understanding of common errors can, however, help to illuminate this vital part of the syllabus

When reviewing the examination scripts for the P2 paper in the November sitting it was quickly apparent that most candidates encountered problems when tackling the ratio analysis ques-

tion. This situation is difficult to understand as ratio analysis is one of the most important items in the syllabus. Is this topic not fully understood, or did candidates ignore it when preparing for the exam? The aim of this article is to:a Discuss the fundamentals of this area of the syllabus by working through a simple example.b Closely examine the parts of the question that generated so many problems.c Describe some of the most common errors.

Let’s look at the requirements of a question (Q7 Part A) in the November 11 exam paper. The most important aspect centred on the relation-ship between the three requirements.

Study notes