CANADA CABINETRY Suggested Time (60 minutes)

It is now early January 2018 and you, CPA, work for Bosch and Partners, Chartered Professional Accountants LLP. You have recently been introduced to Richard Maytag, the sole owner and operator of a kitchen cabinet manufacturing company, Canada Cabinetry Ltd. (CCL). In 2017, CCL manufactured and sold 500 sets of kitchen cabinets, its best year ever. As a result, Richard began to share with you his ideas about the future of his company. I have more space than I can use in our manufacturing facility right now. Therefore, I could immediately invest in new equipment and hire additional employees to increase our production capacity by 75 sets of kitchen cabinets per year. I am not sure whether I should make this investment or not. I spoke with my bank recently and they are willing to finance the entire equipment purchase at a fixed 5% annual interest rate, which is only 2% higher than the current prime lending rate. The loan would be secured by the equipment and repaid over a period of five years, consisting of blended annual principal and interest payments due at the end of each year. Alternatively, the bank said that they could provide me with a line of credit secured by the companys accounts receivable and inventory. The limit would be based on 75% of accounts receivable plus 50% of inventory, to be reviewed periodically. The interest rate would be prime plus 1% and it requires a minimum of annual interest-only payments. I am wondering whether I should consider the line of credit or the term loan to finance the investment in the new equipment. I would prefer not to have both funding sources in place at the same time since I am rather debt averse. To date, I think my main reason for success has been a focus on keeping tight control over the materials, labour, and overhead costs by reviewing them at the end of each quarter based solely on the results reported on the income statement. This helps me generate as high a profit as possible. Richard also mentioned that he has been approached by Kerr Homes Inc. (Kerr), a national manufacturer of modular housing, to supply approximately 300 kitchen cabinets per year for its line of Historic homes. To become a supplier, CCL would have to supply its standard costing for a set of kitchen cabinets and Kerr would then pay a modest fixed premium over the amount given the high volume of the contract. Richard has never used a standard costing system in the past and he wants to know what such a system would entail in his situation. Although he has limited knowledge, he has expressed some concerns with cost overruns and maintaining a safety profit margin. He would like your recommendation as to how he should respond to the proposal. You took notes during the meeting (Appendix I). You decide to draft a memo to address the issues Richard has raised.

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APPENDIX I

NOTES FROM MEETING WITH RICHARD MAYTAG

The new equipment will cost $750,000 and needs to be paid for up front. The useful life of the equipment is expected to be 10 years and the relevant capital cost allowance (CCA) rate is 30%. Four new part-time employees would need to be hired and each would be paid an annual salary of $40,000 per year plus 15% for benefits. Those new employees could be hired in stages, two of them immediately and two of them starting two years from now. The capacity increase will not be realized from a sales perspective immediately. It will increase evenly over the first three years, after which time it will remain stable for the remaining years. As a result of the new equipment, maintenance and utilities costs will increase on average by $20,000. Richard uses an after-tax rate of return of 8% as a benchmark when considering capital investments. CCLs tax rate is 16%. CCLs land and building had a net book value of $250,000 at December 31, 2017. The fair market value of these assets is currently $800,000 in excess of the net book value. There is currently a $100,000 mortgage on the land and building. When CCL purchased the land and building several years ago for $400,000, it obtained a mortgage at the same time for $300,000. CCLs accounts receivable and inventory balances were $500,000 and $225,000, respectively, as at December 31, 2017. Richard expressed some concern about the labour costs as a percentage of sales revenue (sales revenue of $5 million in 2017). We have focused so much on growth that we have not realized any economies of scale on the labour side. I know there is waste, but I have not been able to isolate the cause of the inefficiency. Also, the materials costs have remained steady in 2017 at 50% of revenues."