PLEASE ONLY ANSWER QUESTION 3 FINANCING PROPOSALS

You, CPA, work for Mercer Consulting Ltd. It is now February 12, 2019, and your boss, Patricia Mercer, has just returned from a meeting with Adam Burke of Burke Entertainment Ltd. (BEL).

Patricia says, "BEL manufactures only one product and it's become the latest craze in kids' toys. It's called B.R.B. a doll that comes wrapped in multiple layers and requires children to unpack the layers to reveal the doll and all the accessories. The product has taken off as a result of the new 'unboxing' trend."

Now that the results for 2018 are in, Adam is looking for some advice. Sales and cost of sales were much higher than expected there was no way to predict just how popular this toy was going to be. However, Adam has noticed that BEL's margin is not in line with the prior year or industry standards.

Industry average 2018 2017

Gross margin 65% 53% 64%

Adam has been extremely busy trying to keep up with the increase in demand for B.R.B. As a result, he has not had the time to analyze the reason for the variance, although he does find it surprising. During the year, Adam switched polymer providers to a company that approached him with a lower price than his standard. Polymer is the material that makes up the body of the dolls as well as its accessories. Given the volume of sales, Adam thought that saving on the most significant raw material would be advantageous. With these cost savings, he expected margins to increase.

He has asked your firm to look into the margin variance and help him understand the cause of the decline.

In addition, Adam is proactively looking for ways to address the lower margin, and he would like your thoughts on a piece of equipment he is considering. He noted that the employees have complained that the new polymer is more easily damaged, and as such, they have had to discard more dolls. Adam thinks automating some of the process should help with this.

Task #1

Calculate the rate and efficiency variances for both the direct material and direct labour for the dolls. Explain the results. Your analysis should focus on the polymer material.

BEL produced and sold 167,000 dolls in 2018.

The standard costs on a per-unit basis for 2018 are as follows:

direct material: 50 grams per doll $0.08/gram

direct labour: 3 minutes per doll $15 per hour

You are also given the actual cost breakdown as follows:

direct materials: $623,000 (8,900,000 grams)

direct labour: $172,500 (11,500 hours)

Task #2

BEL has been considering purchasing a new piece of equipment to manufacture B.R.B. that may be the answer to its declining margins. The Toy Machine 3000 (TM 3000) is new on the market, and it uses the latest technology in toy manufacturing. The TM 3000's producer, which is based in China, has an excellent reputation, and the equipment is said to reduce the production time by 20%; therefore, BEL would expect a decrease in direct labour and variable overhead of 20%. Adam feels that the actual 2018 labour costs were an anomaly and expects these savings to be based on the 2018 standard costs of labour. Variable overhead is currently added at a rate of $0.93 per unit. The TM 3000 can be accommodated in the space that BEL already has, and includes a five-year warranty.

The equipment costs are as follows:

purchase cost: $100,000, with an associated tax shield of $10,600

maintenance: $2,000 per year

The equipment comes with free online training and support for the warranty period. However, the training and support are provided in Mandarin, so BEL will rely on one of its employees to translate. The equipment requires BEL to use a different glue than it currently uses, which will increase the direct material cost by $0.11 per doll.

The selling price of B.R.B will also remain unchanged at $15 per doll. Adam thinks the sales of B.R.B peaked in 2018, and he expects sales for this toy to be constant for the next five years. However, with changing trends, the company is not sure what will happen after that. The equipment can be resold for $40,000 at the end of year 5, and would result in a lost tax shield amount of $1,080. The tax rate is 25%, and BEL uses an 8% weighted average cost of capital when evaluating this type of investment.

Analyze whether or not BEL should purchase the equipment. In addition, document the qualitative factors BEL should consider before making a decision.

Task #3

BEL will need to determine how to finance the TM 3000 if the company decides to purchase it. Adam has requested that you analyze the financing proposals presented in the Appendix. In addition, document the qualitative factors BEL should consider before making a decision.

Appendix

Financing proposals

1. Line of credit

BEL can acquire a line of credit from the bank. The loan bears interest at prime plus 2.8%. The prime lending rate is currently 3.5%, and BEL would pay interest only on the amount actually borrowed. The total maximum amount available on this line of credit is $200,000. The line of credit is callable on demand at the bank's option. The line of credit would be secured by the company's property, plant, and equipment.

2. Five-year term loan

The bank is also prepared to offer a $150,000 long-term loan secured by the company's new equipment purchase (the TM 3000). The term loan would be for five years and bear interest at 5.3%. Interest only is payable monthly, with the principal due at maturity in March 2024.

3. Loan from friend

Adam's friend, Harold Ryan, is willing to lend the company $100,000 interest-free in exchange for 0.5% of BEL's sales for five years. The principal is due at the end of five years.