Knead Bread Ltd. (KBL) is located in Winnipeg and produces specialty breads and buns. It is equally owned by brothers, Lawrence and David Sears, and a third shareholder, Amy Young.

It is now December 14, 2020. You, CPA, are an associate articling with the firm of Kelly & Ruzak Chartered Professional Accountants. Gary Ruzak, a partner at the firm, has just assigned you to assist him with a consulting engagement for KBL. Lawrence, David, and Amy are meeting with you and Gary to discuss their concerns.

Lawrence: KBL has been struggling to maintain profitability. Here is some information related to our two products (Appendix I). We seem to be operating at full capacity these days, so we want to determine a production schedule that will optimize our profit in our current operations. As well, we would like to know how long it would take to recover the costs of purchasing a new oven given our existing demand.

David: In addition, we have recently been asked to supply buns to the Winnipeg Arena for the upcoming hockey season and ongoing events for the next five years (Appendix II). I would like to know the financial implications of this deal, as it will require a significant investment in some specialized equipment. As well, can you outline the qualitative factors that we should consider regarding this potential contract?

Amy: I have been involved with KBL for over 20 years and would now like to reduce my involvement in the business. I want to retain 10% ownership of the company for sentimental reasons and retain the prospect of receiving future dividends. Here is some information about my finances (Appendix III). I would appreciate your advice on whether or not I can afford to retire now, as well as any suggestions you may have for me if my financial resources are not sufficient at this point. I am skeptical about government programs and want to ensure I can retire based on my funds alone.

Lawrence: David and I want to keep KBL in our family, so we will buy any shares Amy is willing to sell. For now, don't worry about the actual sale or any tax consequences just focus on Amy's request.

Appendix I

Bread and bun product lines

KBL is famous for its rye bread. Both our rye bread and white bun recipes use specialized bases, to which flour, yeast, and water are added.

Baking process

It takes approximately 15 minutes to prepare batch of rye bread (40 loaves), and 30 minutes to prepare batch of white buns (45 dozen).

The baking time for a batch of rye bread is 40 minutes, and for a batch of white buns it's 15 minutes. Our oven can hold three batches of rye bread or one batch of white buns at a time. As required under health and safety legislation, the oven only operates 16 hours per day, 365 days a year. Right now, we seem to be operating our oven at full capacity and we are still having trouble keeping up with demand.

Batch components and yield

Rye bread White buns

Variable cost per batch $33.41 $38.75

Selling price $3.29 per loaf $3.09 per dozen

Demand

Daily demand for our products is currently 2,400 loaves of rye bread and 900 dozen white buns. Given the growing demand for our products, some of our customers are being shorted on their orders. Some of these customers have voiced their concerns about the impact this is having on their businesses and have threatened to take their business to a competitor if we cannot service them effectively.

Oven

A new oven has been priced out at $300,000 and will have capacity identical to that of the existing oven. The model we are considering has recently been in the news as a number of parts have been recalled. Replacement parts for this model of oven are not available locally, but the supplier assures us the issue resulting in the recall has been addressed.

Appendix II

Proposed Winnipeg Arena deal

The Winnipeg Arena has approached KBL to supply white buns for all events hosted at the arena for a period of five years. The deal requires 50 dozen white buns per day, every day, at a discounted rate of $2.99 per dozen for the entire five-year period. If this level of service is not met, KBL would be subject to a penalty.

As part of the agreement, KBL will be required to use Bouquet flour, a key sponsor of the Winnipeg Arena. Bouquet is a local flour mill that is known for late delivery and quantity discrepancy on its orders.

Given our existing capacity constraints, we would need to invest in the additional oven and a "Rex machine," a specialized piece of equipment that shapes the buns. A Rex machine will cost $100,000 and requires annual recalibration at a cost of $5,000 per year.

The Rex machine can produce 60 dozen buns per hour. With the Rex machine, it would only take 12 minutes to shape a batch of buns, which would reduce the variable cost per batch of buns to $34.25 due to decreased labour costs. This machine comes from Switzerland, and we would have to bring over one of their technicians if it ever required repair.

KBL uses a 12% weighted average cost of capital when evaluating these types of investments. The tax impact can be ignored for the purpose of this calculation.

Appendix III

Retirement questions from Amy

I am currently 54 years of age and would like to ensure that I have sufficient retirement income to last 35 years. I estimate that I currently spend $6,200 per month on personal living expenses, and I anticipate that these expenses will drop by 20% upon retirement. If I can afford it, I would like to retire immediately.

I presently have an RRSP worth $400,000, a non-registered investment account with $115,000 in it, and a TFSA worth $26,000. All money is presented as after tax, so you can ignore tax for the purpose of your calculations. I have concerns about my investment strategy and the rate of return I am earning. Lately, my average rate of return is 3% per year with my current investment portfolio. Would a more aggressive investment strategy be advantageous?

I own my home, which has an approximate value of $460,000 and has no mortgages against it. This house has served my family well for the last 18 years. I now live alone and, although the house is large, I have no plans to move or sell at the moment, as I would like to leave this to family as an inheritance.

I have discussed the value of my one-third equity stake in KBL with Lawrence and David, and we agreed that my share is worth $450,000. I would like to retain a 10% equity stake in the company and estimate that I will receive an annual dividend of $10,000.