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Royal Design Inc. (RDI) Royal Design Inc. (RDI) is a private corporation that designs, manufactures and installs custom kitchens, bathrooms and other cabinetry. RDI is owned 100% by Larry Rossi, the company's founder and Chief Executive Officer. Larry is a carpenter by trade and started RDI as a custom cabinet manufacturer. Over the years, RDI has evolved to provide a full range of design services. In June 2016, Larry approached RDI's bank to renew its line of credit agreement. The bank expressed concern over RDI's declining profitability, but agreed to renew the line of credit if certain conditions were met. Specifically, RDI was required to hire a qualified controller with a professional accounting designation and submit unqualified audited financial statements to the bank 60 days after each year end beginning with the October 31, 2016 year end. In addition, the bank requires RDI to establish a board of directors on which the bank would be allowed to appoint one seat. It is now July 3, 2016 and you, CPA, have recently been hired as the controller of RDI. In your first meeting with Larry, he expressed concern over RDI's performance. He doesn't understand how RDI's net income could be decreasing despite increasing revenue. He provided you with a copy of the draft financial statements for the six- m o n t h period ended April 30, 2016 (Exhibit I) together with a description of the accounting policies used (Exhibit II) and some background information on RDI's operations (Exhibit III). Larry has asked you to analyze the reasons for the decline in profitability and recommend a course of action. Larry would also like to understand what financial and non-financial key performance indicators he should consider tracking to ensure that the business is operating effectively. Finally, at the end of the meeting Larry mentioned that he is concerned about having to answer to a board of directors. He is used to being in charge and isn't sure how the board will change his ability to make decisions as the sole shareholder and CEO of RDI. He would like your advice on how to select the members of the new board of directors and on the role that the board should play, given that RDI is an owner-managed company. Required: Prepare the report to Larry addressing his concerns. Copyright 2009 ICAO School of Accountancy (Heavily Adapted) EXHIBIT I ROYAL DESIGN INC. BALANCE SHEET As at (in thousands of dollars) April 30 2016 (draft) October 31 2015 (unaudited) Capital assets $1,274 1,345 58 2,677 1,750 $1,008 1,430 49 2,487 1,870 Total assets $4,427 $4,357 $ 919 1,149 100 2,168 400 2,568 $ 820 1,022 100 1,942 500 2,442 100 1,759 2,659 $4,427 100 1,815 1,915 $4,357 Assets Current assets Accounts receivable Inventory Other assets Liabilities Current liabilities Bank indebtedness Accounts payable and accruals Current portion of long-term debt Long-term debt Shareholder's equity Common shares Retained earnings Total liabilities and equity EXHIBIT I (continued) ROYAL DESIGN INC. INCOME STATEMENT For the period ended (in thousands of dollars) April 30 2016 (draft) October 31 2015 (unaudited) $ 10,506 $ 18,700 Cost of sales 9,245 16,082 Gross margin 1,261 2,618 237 19 131 120 629 145 47 1,328 355 37 202 234 1,189 165 97 2,279 Revenue Shop operating costs Utilities Property taxes Maintenance Supervisory salaries Selling, general and administrative Amortization Interest Net income (loss) for the period (67) 339 Income tax expense (recovery) (11) 57 Net income (loss) after tax $ (56) $ 282 EXHIBIT II SIGNIFICANT ACCOUNTING POLICIES Inventory Inventory consists of raw materials (primarily lumber), work-in-progress and finished goods. Raw materials are recorded at the purchase price including any delivery charges. Work-inprogress includes the cost of raw materials and labour coded to any partially completed projects. Finished goods include the cost of raw materials and labour coded to any completed projects awaiting installation. EXHIBIT III (continued) BACKGROUND INFORMATION ON RDI'S OPERATIONS Design Process The first step in the design process is the creation of a customized design plan. RDI charges customers a flat fee of $1,500 to prepare this design plan. The design fee is not refundable, however, if the customer proceeds with the project, the full amount of the design fee is credited against the final invoice. There is no time limit on the credit, so even if the customer decides to proceed with the project at a later date, the credit can still be applied. RDI pays a designer $40 per hour to prepare the design plans. The average plan takes about 10 hours to complete. The design plan is created using RDI's customized software which interfaces with RDI's automated machinery. All of the specifications can be read by the computerized machinery directly from the design plans. RDI retains the design plan, however, if a customer decides not to use RDI to do the work, they can purchase a copy of the plan at any time for an additional $500. Approximately 75% of customers proceed with the project immediately after the design plan is created. Another 15% proceed with the project at a later date. Of the customers that do not proceed with the project, about half pay the additional $500 fee to obtain a copy of the design plan. Pricing Once a design plan is completed, a bill of materials is created. The bill of materials is a listing of everything that needs to be purchased for the project including lumber, paint, granite, tile, hardware and fixtures. Once complete, the bill of materials is sent to Larry to prepare a quote. Larry has always insisted that he be the one to quote jobs since there is a certain amount of judgment involved. Typically, Larry calculates the total material cost and multiples it by a factor of 2.5 to arrive at the quote. The mark-up has to cover all of the cutting, milling and customization of the cabinets and trim, which is performed in-house. The mark-up also has to cover labour costs to install the cabinets, flooring, counters, backsplashes and provide RDI with a reasonable margin. Sometimes Larry adjusts the price up or down based on his experience. EXHIBIT III (continued) BACKGROUND INFORMATION ON RDI'S OPERATIONS Operations The extent of custom woodworking varies by project depending on the style of cabinetry and trim, the type of wood, and the type of finish. More ornate designs use more machine time and labour and require the use of highly skilled production workers. Similarly, certain woods are more difficult to work with and therefore require more machine time and labour than others. RDI employs twenty-four full-time employees and three supervisors in its shop. The employees' hourly rate depends on their experience and skill level. Highly skilled employees are needed to do the more intricate woodworking and operate some of the specialized machinery. Larry estimates that the ratio of machine hours to employee labour hours is about two to one for the average project. Shop employees are required to scan their time card and enter a unique project code each time they switch from one project to another. Employees are assigned to one of three groupings based on their skill level, with A1 being the highest skill level and A3 being the lowest. The data from the time tracking system is automatically transmitted to the accounting system to calculate work- inprogress and finished goods inventory values. The system uses a standard labour rate for each of the three skill groupings: $15/hour for A3, $30/hour for A2 and $45/hour for A1. Shop supervisors are responsible for complicated machine set-ups and quality control on all projects. Supervisors, maintenance workers, and office staff do not code time to specific projects although they tend to spend more time on the highly customized labour-intensive projects because they are more complicated. The shop is currently operating near its capacity of about 75,000 machine hours per year. The cost of maintenance and utilities are directly proportional to the number of machine hours. Recently Completed Projects The following is a sample of recently completed projects which are considered to be representative of RDI's typical business. Job Number Material Cost Quoted Price Labour hours coded to project A3 A2 A1 1236 1245 1246 $16,799 $16,010 $15,566 $41,998 $40,025 $38,915 301 56 21 100 35 96 23 22 291 Job 1236 is a standard-size, traditional-style kitchen with milled cabinets, crown mouldings and granite counters. Job 1245 is a very large modern-style kitchen with a basic cabinet design and large granite counters and backsplashes. Job 1246 is a small old world European-style kitchen with elaborately carved exotic wood cabinets and mouldings