Case: Laurentian Bakeries Required: As a management consulting firm, prepare a report to Daniel Knowles of Laurentian Bakeries. Your firm has been hired to evaluate and make a recommendation concerning the Laurentian Bakeries $5.2 million expansion of the company?s Winnipeg frozen pizza plant. In your report include any quantitative and qualitative assessment of the proposed expansion. Do any sensitivity analysis you feel is appropriate. Ignore the impact of inflation. In your report highlight what quantitative information is relevant and what quantitative information is irrelevant, along with details as to any assumptions that you deem necessary. Report Specifications: ? Maximum length: 10 pages (excluding exhibits) Your exhibits must be in Word and form part of your completed report-use only one word file. ? Your cover page for your report must include the name of your consulting firm, the name of each member of your company, and the course number, instructor?s name and date of submission. ? Page specifications: Double spaced, 12 pt font, Times New Roman, 1? margins ? Software: Microsoft Word ? Professional report presentation (grammar, spelling, executive summary, table of contents, page numbers)

S w 906B27 LAURENTIAN BAKERIES (ABRIDGED) Mary Heisz revised this case (originally prepared by Rob Barbara under the supervision of Professors David Shaw and Steve Foerster) solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 1995, Ivey Management Services Version: (A) 2009-09-15 In late May, 2005, Danielle Knowles, vice-president of operations for Laurentian Bakeries Inc., was preparing a capital project expenditure proposal to expand the company's frozen pizza plant in Winnipeg, Manitoba. If the opportunity to expand into the U.S. frozen pizza market was taken, the company would need extra capacity. A detailed analysis, including a net present value calculation, was required by the company's Capital Allocation Policy for all capital expenditures in order to ensure that projects were both profitable and consistent with corporate strategies. COMPANY BACKGROUND Established in 1984, Laurentian Bakeries Inc. (Laurentian) manufactured a variety of frozen baked food products at plants in Winnipeg (pizzas), Toronto (cakes) and Montreal (pies). While each plant operated as a profit center, they shared a common sales force located at the company's head office in Montreal. Although the Toronto plant was responsible for over 40 per cent of corporate revenues in fiscal 2004, and the other two plants accounted for about 30 per cent each, all three divisions contributed equally to profits. The company enjoyed strong competitive positions in all three markets and it was the low cost producer in the pizza market. Income Statements and Balance Sheets for the 2003 to 2005 fiscal years are in Exhibits 1 and 2, respectively. Laurentian sold most of its products to large grocery chains, and in fact, supplying several Canadian grocery chains with their private label brand frozen pizzas generated much of the sales growth. Other sales were made to institutional food services. The company's success was, in part, the product of its management's philosophies. The cornerstone of Laurentian's operations included a commitment to continuous improvement; for example all employees were empowered to think about and make suggestions for ways of reducing waste. As Danielle Knowles saw it: \"Continuous improvement is a way of life at Laurentian.\" Also, the company was known for its above average consideration for the human resource and environmental impact of its business decisions. These philosophies drove all policy-making, including those policies governing capital allocation. Page 2 9B06B027 Danielle Knowles Danielle Knowles' career, which spanned 13 years in the food industry, had included positions in other functional areas such as marketing and finance. She had received an undergraduate degree in mechanical engineering from Queen's University in Kingston, Ontario, and a masters of business administration from the Ivey Business School. THE PIZZA INDUSTRY Major segments in the pizza market were frozen pizza, deli-fresh chilled pizza, restaurant pizza and takeout pizza. Of these four, restaurant and take-out were the largest. While these segments consisted of thousands of small, family-owned establishments, a few very large North American chains, which included Domino's, Pizza Hut and Little Caesar's, dominated. Although 12 firms manufactured frozen pizzas in Canada, the five largest firms, including Laurentian, accounted for 95 per cent of production. McCain Foods was the market leader with 44 per cent market share, while Laurentian had 21 per cent. Per capita consumption of frozen pizza products in Canada was one-third of the level in the United States where retail prices were lower. Sales of Canadian and America frozen and fresh pizza at Canada's grocery stores grew more than 410 per cent between 1997 and 2001 from $45 million to $230 million. By 2003, frozen pizza sales accounted for 17 per cent of total frozen prepared foods in Canada double the market share from 1997.1 LAURENTIAN'S PROJECT REVIEW PROCESS All capital projects at Laurentian were subject to review based on the company's Capital Allocation Policy. The latest policy, which had been developed in 1999 when the company began considering factors other than simply the calculated net present value for project evaluation, was strictly enforced and managers were evaluated each year partially by their division's return on investment. The purpose of the policy was to reinforce the management philosophies by achieving certain objectives: that all projects be consistent with business strategies, support continuous improvement, consider the human resource and environmental impact, and provide a sufficient return on investment. Prior to the approval of any capital allocation, each operating division was required to develop both a Strategic Plan and an Operating Plan. The Strategic Plan had to identify and quantify either inefficiencies or lost opportunities and establish targets for their elimination, include a three-year plan of capital requirements, link capital spending to business strategies and continuous improvement effort, and achieve the company-wide hurdle rates. The first year of the Strategic Plan became the Annual Operating Plan. This was supported by a detailed list of proposed capital projects which became the basis for capital allocation. In addition to meeting all Strategic Plan criteria, the Operating Plan had to identify major continuous improvement initiatives and budget for the associated benefits, as well as develop a training plan identifying specific training objectives for the year. These criteria were used by head office to keep the behaviour of divisional managers consistent with corporate objectives. For example, the requirement to develop a training plan as part of the operational plan 1 Canadian Restaurant and Food Services Association. Page 3 9B06B027 forced managers to be efficient with employee training and to keep continuous improvement as the ultimate objective. All proposed projects were submitted on an Authorization for Expenditure (AFE) form for review and approval (see Exhibit 3). The AFE had to present the project's linkage to the business strategies. In addition, it had to include specific details of economics and engineering, involvement and empowerment, human resource, and the environment. This requirement ensured that projects had been carefully thought through by forcing managers to list the items purchased, the employees involved in the project, the employees adversely affected by the project, and the effect of the project on the environment. Approval of a capital expenditure proposal was contingent on three requirements which are illustrated in Exhibit 4. The first of these requirements was the operating division's demonstrated commitment to continuous improvement (C.I.), the criteria of which are described in Exhibit 5. The second requirement was that all projects of more than $300,000 be included in the Strategic Plan. The final requirement was that for projects greater than $1 million, the operating division had to achieve its profit target. However, if a project failed to meet any of these requirements, there was a mechanism through which emergency funds might be allocated subject to the corporate executive committee's review and approval. If the project was less than $1 million and it met all three requirements, only divisional review and approval was necessary. Otherwise, approval was needed from the executive committee. The proposed Winnipeg plant project was considered a Class 2 project as the expenditures were meant to increase capacity for existing products or to establish a facility for new products. Capital projects could fall into one of three other classes: cost reduction (Class 1); equipment or facility replacement (Class 3); or other necessary expenditures for R&D, product improvement, quality control and concurrence with legal, government, health, safety or insurance requirements including pollution control (Class 4). A project spending audit was required for all expenditures; however, a savings audit was also needed if the project was considered either Class 1 or 2. Each class of project had a different hurdle rate reflecting different levels of risk. Class 1 projects were considered the most risky and had a hurdle rate of 20 per cent. Class 2 and Class 3 projects had hurdle rates of 18 per cent and 15 per cent, respectively. Knowles was responsible for developing the Winnipeg division's Capital Plan and completing all AFE forms. WINNIPEG PLANT'S EXPANSION OPTIONS Laurentian had manufactured frozen pizzas at the Toronto plant until 2002. However, after the company became the sole supplier of private-label frozen pizzas for a large grocery chain and was forced to secure additional capacity, it acquired the Winnipeg frozen pizza plant from a competitor. A program of regular maintenance and equipment replacement made the new plant the low cost producer in the industry, with an operating margin that averaged 15 per cent. The plant, with its proven commitment to continuous improvement, had successfully met its profit objective for the past three years. After the shortage of capacity had been identified as the plant's largest source of lost opportunity, management was eager to rectify this problem as targeted for in the Strategic Plan. Because the facility had also included the proposed plant expansion in its Strategic Plan, it met all three requirements for consideration of approval for a capital project. Page 4 9B06B027 Annual sales had matched plant capacity of 10.9 million frozen pizzas when Laurentian concluded that opportunities similar to those in Canada existed in the United States. An opportunity surfaced whereby Laurentian could have a four year exclusive arrangement to supply a large U.S.-based grocery chain with its private-label-brand frozen pizzas beginning in April, 2006. The contract would be renewable at the grocery chains option on a year-to-year basis following the initial four years. As a result of this arrangement, frozen pizza sales would increase rapidly, adding 2.2 million units in fiscal 2006, another 1.8 million units in fiscal 2007, and then 1.3 million additional units to reach a total of 5.3 million additional units by fiscal 2008. However, the terms of the agreement would only provide Laurentian with guaranteed sales of half this amount. Knowles expected that there was a 50 per cent chance that the grocery chain would order only the guaranteed amount. Laurentian sold frozen pizzas to its customers for $1.70 in 2005 and prices were expected to increase just enough to keep pace with inflation. Production costs were expected to increase at a similar rate. Laurentian had considered, but rejected, three other alternatives to increase its frozen pizza capacity. First, the acquisition of a competitor's facility in Canada had been rejected because the equipment would not satisfy the immediate capacity needs nor achieve the cost reduction possible with expansion of the Winnipeg plant. Second, the acquisition of a competitor in the United States had been rejected because the available plant would require a capital infusion double that required in Winnipeg. As well, there were risks that the product quality would be inferior. Last, the expansion of the Toronto cake plant had been rejected as it would require a capital outlay similar to that in the second alternative. The only remaining alternative was the expansion of the Winnipeg plant. By keeping the entire frozen pizza operation in Winnipeg, Laurentian could better exploit economies of scale and assure consistently high product quality. The Proposal The expansion proposal, which would require six months to complete, would recommend four main expenditures: expanding the existing building in Winnipeg by 60 per cent would cost $1.3 million; adding a spiral freezer, $2 million; installing a new high speed pizza processing line, $1.3 million; and acquiring additional warehouse space, $600,000. The equipment was expected to be useful for 10 years, at which point its salvage value would be zero. On-going maintenance expenditures, projected to be equal to annual straight-line depreciation, would be needed to keep the equipment up-to-date. The building and warehouse space was expected to be useful for 25 years for depreciation purposes but would have a salvage value of 10 per cent of the cost at the end of 10 years. Knowles understood that investments in buildings (including warehouse space) and equipment qualified for capital cost allowance (CCA) at the rates of five per cent and 30 per cent respectively. The land on which the Winnipeg plant was built was valued at $250,000 and no additional land would be necessary for the project. While the expansion would not require Laurentian to increase the size of the plant's administrative staff, Knowles wondered what portion, if any, of the $223,000 in fixed salaries should be included when evaluating the project. Likewise, she estimated that it cost Laurentian approximately $40,000 in sales staff time and expenses to secure the U.S. contract that had created the need for extra capacity. Last, net working capital needs would increase with additional sales. Working capital was the sum of inventory and accounts receivable less accounts payable, all of which were a function of sales. Knowles calculated new working capital for the 2005 year to be 40 days of revenues.2 She estimated, however, that the new high-speed line would allow the company to cut two days from average inventory age. 2 Forty days represents the net of days of A/R plus days of inventory less days of A/P. Page 5 9B06B027 Added to the benefit derived from increased sales, the project would reduce production costs in two ways. First, the new high-speed line would reduce plant-wide unit cost by $0.019, though only 70 per cent of this increased efficiency would be realized in the first year. There was an equal chance, however, that only 50 per cent of these savings could actually be achieved. Second, \"other\" savings totaling $138,000 per year would also result from the new line and would increase each year at the rate of inflation. Three areas of environmental concern had to be addressed in the proposal to ensure both conformity with Laurentian policy and compliance with regulatory bodies and local by-laws. First, design and installation of sanitary drain systems, including re-routing of existing drains, would improve sanitation practices of effluent/wastewater discharge. Second, the provision of water-flow recording meters would quantify water volumes consumed in manufacturing and help to reduce its usage. Last, the refrigeration plant would use ammonia as the coolant as opposed to chloro-fluro-carbons. These initiatives were considered sufficient to satisfy the criteria of the Capital Allocation Policy. THE DECISION Knowles believed that the project was consistent with the company's business strategy since it would ensure that the Winnipeg plant continued to be the low cost producer of frozen pizzas in Canada. However, she knew that her analysis must consider all factors, including the project's net present value. The plant's capital allocation review committee would be following the procedures set out in the company's Capital Allocation Policy as the basis for reviewing her recommendation. Knowles considered the implications if the project did not provide sufficient benefit to cover the Class 2 hurdle rate of 18 per cent. Entering the U.S. grocery chain market was a tremendous opportunity and she considered what other business could result from Laurentian's increased presence. Page 6 9B06B027 Exhibit 1 INCOME STATEMENT For The Year Ending March 31 ($ millions) 2003 Revenues 1 Cost of Goods Sold Gross Margin Operating Expenses Operating Income Interest Income Before Tax Income Tax at 38.5% Net Income 1 2 $ 91.2 27.4 63.8 95.8 28.7 67.1 101.5 30.5 71.0 52.7 14.4 55.8 15.2 0.9 12.8 2 2005 50.1 13.7 $ 2004 1.0 13.4 1.6 13.6 4.9 7.9 5.2 8.2 5.2 8.4 Includes raw material, direct labour and variable overhead. Includes administrative salaries and fixed overhead. Page 7 9B06B027 Exhibit 2 BALANCE SHEET For The Year Ending March 31 ($ millions) 2003 2004 2005 6.2 11.3 6.2 0.3 0.0 24.0 9.4 11.8 6.6 0.6 0.9 29.3 13.1 12.5 7.0 2.2 0.9 35.7 35.3 36.1 36.4 59.3 65.4 72.1 7.5 0.7 8.2 7.9 1.3 9.2 8.3 2.2 10.5 Long-Term Debt 16.8 20.4 24.3 Shareholders' Equity 34.3 35.8 37.3 59.3 65.4 72.1 Assets: Cash Accounts Receivable Inventory Prepaid Expenses Other Current Total Current $ Fixed Assets TOTAL $ Liabilities and Shareholders' Equity: Accounts Payable Other Current Total Current TOTAL $ Page 8 9B06B027 Exhibit 3 AUTHORIZATION FOR EXPENDITURE FORM Company Name: ____________________________ Business Segment: __________________________________ Project Title: __________________________________________________________________________________ Project Cost (AFE Amount): ____________________________ Project Cost (Gross Investment Amount): __________________ Net Present Value at ___________%: __________________ Internal Rate of Return: ________% Years Payback: _________ Brief Project Description: Approvals Estimated Completion Date: _________________________ Signature Date __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ _______________________ Name __________________ Project Contact Person: __________________ __________________ __________________ __________________ __________________ Phone: _________________ Fax: ___________________ Currency Used: CDN _______ US _______ Other __________________ Post Audit: Company: Yes _____ No_____ Corporate: Yes _____ No_____ Page 9 9B06B027 Exhibit 4 CAPITAL EXPENDITURE APPROVAL PROCESS Page 10 9B06B027 Exhibit 5 BUSINESS REVIEW CRITERIA Used To Assess Divisional Commitment To Continuous Improvement Safety Lost time accidents per 200,000 employee hours worked Product Quality Number of customer complaints Financial Return on Investment Lost Sales Market share % where data available Manufacturing Effectiveness People cost (total compensation $ including fringe) as a percentage of new sales Plant scrap (kg) as a percentage of total production (kg) Managerial Effectiveness/Employee Empowerment Employee Survey Training provided vs. training planned Number of employee grievances Sanitation Sanitation audit ratings Other Continuous Improvement Measurements Number of continuous improvement projects directed against identified piles of waste/lost opportunity completed and in-progress