QUESTION 10 (25 Marks)

The president of Rollway Transport received a letter from one of his major customers indicating that the customer was interested in changing the transportation arrangements for his product in the coming year. The product was a fine glassware that was transported to several locations throughout the province. The customer felt that the cost of transportation was becoming high relative to the desired selling price for the product. Currently, Rollway carries 3,000 loads of the product a year at a contract price of $810 per load. This contract had been held by Rollway for several years and there had been few complaints from the customer. Due to the fragile nature of the product and the handling of it at distribution points, Rollway was required to carry special breakage insurance on the loads. In the past several years, the premiums had exceeded $50,000 per year for this product alone. The management accountant had determined that the specialized handling of the glassware at the warehouses costs Rollway $675,000 per year in labour and materials.

The customer stated that his company had developed a new carrier that had the potential to carry over 50% more units of the product per load. In terms of the current volumes, the customer expected that Rollway would only have to carry 1,800 loads per year. He also reported that the tests on the carrier showed that the breakage factor was reduced to almost zero. As such, the customer felt that Rollway would save money on the insurance coverage for the product. Since the glassware was carried in a specialized container in the new carrier, conventional handling techniques such as those used for regular cargo could be used on the containers rather than the specialized handling that had been previously required. Unfortunately, the carriers were designed specifically for the customers product and as such were not suitable for carrying the products of other customers.

The customer proposed that Rollway consider the possibility of purchasing 50 of these new carriers at a cost of $65,000 each. The units were expected to have a useful life of at least 12 years. If Rollway did acquire the units, the customer was prepared to enter into a five year contract with Rollway to transport a volume of glassware no smaller than the current level for each year. The customer indicated that the Transportation Ministry, which regulates tariffs, indicated that Rollway could charge up to $1,228 per load if it used its own equipment. The new carriers would require the construction of special ramps at each of the distribution points used by Rollway. It was estimated that the ramps could be built at a total cost of $146,000.

From the tone of the letter, the president got the feeling that the customer was very strongly committed to this new carrier. He wondered if the customer might be considering whether to buy the equipment himself. If so, could Rollway simply provide the drivers and the warehousing facilities? A phone call to the Ministry of Transportation indicated that Rollway could charge up to $560 per load if they used the customers carriers rather than their own.

Currently, Rollway expected at least a 10% return after taxes on capital investment projects. With a tax rate of 46%, the president felt that any project would have to be very sound in order for the company to consider accepting it. Alternatively, if the customer were to buy the equipment, the president was very sure that the tax rate and the cost of borrowing for the customer would be essentially the same as for Rollway. The controller for Rollway informed the president that the allowable CCA rate for the new equipment would be 30% annually, while the CCA rate for the ramps would be 6% annually. Given the nature of the transportation business, the president was reluctant to consider any analysis covering a period exceeding five years. With specialized equipment such as this, he suspected that the salvage value at the end of five years would probably be equal to the cost of disposal of the equipment.

The president was very concerned about the implications of this proposal. He felt that the proposal would be a very significant investment for Rollway to make even for a major customer such as this one. The president also had serious concerns regarding how the truckers would react to this proposal. In the last few years, the workload and demand for services had been declining. With a new labour contract about to be negotiated with the union, the president was not certain whether the union would be responsive to the potential reduction in the number of loads to be carried and to the likely reduction of labour at the distribution points. Certainly, Rollway had no intention of keeping the specialized handling requirements in the warehouses if the new equipment did not require it.

REQUIRED:

Determine the net benefits to Rollway under each of the following:

1. Rollway buys the equipment, or

2. the customer buys the equipment.

Full justify your answer and make a recommendation.