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MODULE 1, ASSIGNMENT 3

September 14, 2010

Livoria Sandwiches Inc.

It was 2:00 a.m. and Paul Livoria sat in the corner stall of his restaurant staring out the window into the parking lot. His brother Sam was in the kitchen cleaning up after a very long day. Paul felt very restless, partially because of the seven cups of coffee he had had, but mostly because he was feeling very overwhelmed. He thought to himself, Running these two restaurants shouldnt be so complicated. At age 46, maybe it was time for a change. The Birth of Livoria Sandwiches Inc. Brothers Paul and Sam Livoria founded Livoria Sandwiches Inc. as a Canadian Controlled Private Corporation (CCPC) in December 1999, but began operations in January 2000. Both brothers had worked for Link Motor Company in the City of Dawkins (a major city of 275 sq. km) in one of its manufacturing plants. Paul was a truck production supervisor and Sam was an automobile line worker. Unfortunately, in 1999, both brothers were laid off as there was a huge decline in the automotive sector. With the severance packages they received, Paul and Sam opened up their first store. Both of them have no formal business training and many decisions have been made through trial and error. After five years of positive growth, Paul and Sam decided to open up a second location in a high-traffic area in Zone 1 (five kilometres away from each other) in Dawkins. Below is a map of the city:

2010 The Society of Management Accountants of Canada. All rights reserved. / Registered Trade-Marks/Trade-Marks are owned by The Society of Management Accountants of Canada. No part of this document may be reproduced in any form without the permission of the copyright holder.

Livoria Sandwiches Inc.

Food Terminal
Airport

R1 Restaurant Location 1 R2 Restaurant Location 2 The brothers hired a management consultant two years ago to help them develop the following vision and mission statements: Vision Statement Livoria will be the first choice of Dawkins residents who are seeking a variety of highquality fresh sandwiches at reasonable prices. Mission Statement We are the highest-quality sandwich shop in Dawkins because of our legendary sandwich-making processes and our commitment to using the highest-quality ingredients. A History of Tradition Paul and Sam are first generation Canadian-Italians, and learned to make quality sandwiches from their mother and grandparents. The Livoria brand is well known for its traditional custom-made sandwiches. All ingredients are sourced locally from the Food Terminal (located only three kilometres from each location) and the stores keep minimal (if any) inventory on hand. As a result, there is no waste and demand is very strong. The menu boasts the highest-quality cuts of meats and produce. As a result, the company has developed a loyal customer base. Livoria is best known for its veal and chicken sandwiches, but also offers other sandwich choices. See Appendix A for more detailed information on the sandwiches. The employees of Livoria are fully trained to use all the machines, and there has never been a workplace accident to date.

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Livoria Sandwiches Inc.

The locations maintain a very simple concept and floor layout. Both locations are approximately 1,600 square feet, or approximately 150 square meters. Customers enter the store through one door, order at the counter, pick up their order at the other end of the counter and then sit down in the seating area. The dcor is very modern, yet traditionally Italian with green, white and red accents (the colours of the Italian flag) throughout the restaurants. Pictures from the brothers parents hometowns in Italy adorn the walls. Customers have commented that they appreciate the layout of the restaurant because many other fast food restaurants in the area are either very cluttered (when lining up) or the lineups sometimes extend out the door. As with other fast food restaurants, there are no receivables or payables as customers pay by cash or debit at point of sale, and suppliers are paid daily when deliveries occur. The stores have very committed employees and turnover is very low. The culture is very family-oriented. Information on the employees is located below:
Direct Labour Detail PT Employee 1 PT Employee 2 PT Employee 3 PT Employee 4 PT Employee 5 PT Employee 6 Hrs 25.0 25.0 20.0 20.5 5.0 Weeks 52 52 52 52 50 50 2011 1,300 1,300 1,040 1,066 250 4,956 Hrs 30.0 30.0 20.0 20.5 5.0 Weeks 52 52 52 52 52 50 2012 1,560 1,560 1,040 1,066 260 5,486 Hrs 30.0 30.0 20.0 20.5 10.0 5.0 Weeks 52 52 52 52 52 50 2013 1,560 1,560 1,040 1,066 520 250 5,996

While staff are scheduled to work (and are paid for) the hours outlined above, only 90% of worked hours are productive hours. The other 10% of hours are for cleanup, preparation, paid breaks, etc. No further staff can be added at this time due to space constraints in the stores. The shops are open 354 days a year (every day except 11 statutory holidays) between 10 a.m. and 12 a.m. The stores do not offer a breakfast menu and the brothers will not consider this as an option. The Fast Food Restaurant Industry Between 2009 and 2010, the fast food restaurant industry in Dawkins reported a growth of 1.2 per cent, and analysts suggest that growth could possibly hit 2 per cent for 2011. In 2004, the City introduced mandatory quarterly health audits for all restaurant locations, and many restaurant owners have complained that 2010 was the strictest year ever. Many locations were forced to close down because of minor violations. Appendix B outlines the fast food restaurants in Dawkins. Sources of Inputs The brothers have sourced all food inputs (poultry, meats, dairy products, bread and vegetables) from the local Food Terminal. This is common practice for most restaurants

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Livoria Sandwiches Inc.

in Dawkins, as the Food Terminal has the best quality and is very reliable for on-time deliveries and product availability. However, in November 2010, a large fire damaged the buildings that serviced all wheat-based products (breads) and vegetables. The damage is estimated to be well over $2 million and arson is suspected. Consequently, this area of the Food Terminal is expected to be out of commission for an indefinite period of time (possibly 18 months or longer). As a result, all restaurants and food service companies must source their breads and vegetables from alternate suppliers. Paul and Sam were very concerned about where they were going to buy their bread and vegetables. There was always the option of buying from local supermarkets, but the cost of these inputs was significantly higher (nearly 6 per cent more) than what they were currently paying. After numerous frantic phone calls, Sam was able to source bread and vegetables from an alternate supplier (Canadiana Food Products) for only 0.5 per cent more than what Livoria was previously paying. The reason for this discount was twofold: volumes were significant and Sam and John (from Canadiana) are childhood friends. See Appendix A for cost information of the sandwiches. Other Information Concerning Dawkins Dawkins is an economically prosperous Canadian city, with a population of over 600,000. The municipal office keeps very accurate records on census household income information. Appendix C shows average household incomes from 2009 and 2010. Over the last three years, four large residential subdivisions, eight new office buildings and two luxury hotels have been constructed in Zone 1. No other zones have experienced such explosive growth. In addition, the office buildings are close to the airport and are home to many head offices of prominent Canadian corporations. Customers in the area have also indicated that they would like to see enhancements to Livorias menu. See Appendix D for potential menu options and pricing. Finally, in a recent study published in the Canadian Journal of Well-Being (CJWB), Dawkins was ranked as having the fastest-growing number of vegetarians in the country. Dr. Rupert Felder stated, There is mounting evidence that a vegetarian lifestyle acts as a preventive measure for numerous diseases including heart disease, diabetes and cancer. A vegetarian diet is said to increase energy and improve mental health while lowering bad cholesterol levels. The CJWB is read by over three million Canadians monthly and about 25% of the Dawkins residents. A Crisis for the Livoria Brothers In January 2010, a customer in Location 2 slipped on the floor and fell down the stairs on his way to the bathroom. He hit his head extremely hard and sustained serious injuries. He was subsequently hospitalized for three months, and during this time doctors determined that his short-term memory had been permanently impaired by the accident. By the end of 2010, the family of the injured young man brought legal action against Livoria Sandwiches Inc. and won a decision in court. The decision was that

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Livoria Sandwiches Inc.

Livoria was to pay $750,000 in damages, of which only $250,000 would be covered by the general liability insurance policy. The contingent liability was booked in 2010, but the judge ordered that full compensation be paid by May 2013. Even though sales were not adversely affected, the brothers took this very seriously and took corrective action immediately by hiring a safety contractor who coated the floor with a thin, non-skid floor treatment which would greatly reduce the likelihood of this happening again. The brothers had to take a pay cut just to keep cash flow moving, as their preference is not to borrow from the open line of credit they have access to at the bank. Finally, in 2010, Livoria Sandwiches Inc. was audited and found to still owe $22,500 in back taxes. This amount is due in the first quarter of 2011. The next day, Paul and Sam had a heated discussion about the business: Paul: Sam, we need to do something to shake things up around here. Sam: Why? Were profitable. We had the lawsuit, and while well be paying that out in instalments over the next three years, it hasnt affected our reputation. Customers keep coming back and they like our custom-made sandwiches. I think we have a good thing going here and any changes should be minimal. Paul: Sam, the area is building up and soon there will be much in the way of competition. We need to be realistic and realize we may lose some of our market share. We need to consider growth. After all, we need to start thinking about our retirement. Sam: Our retirement? Thats still 16 years away for me. Im not ready to sell yet! Paul: Im not suggesting selling the business. Instead, have you ever considered franchising? This way we can have someone else prepare the sandwiches and well get a percentage of the sales. I looked into this, and I feel that we could franchise out the name for $50,000 up front, charge 4.5 per cent on gross sales, and pay about 2.5 per cent for advertising. I estimate that we could do three stores for each of the next three years, with $500,000 in sales per storewed make a fortune! Sam: I worry about losing control over our brand if someone else besides ourselves manages the business. Customers will see us as a mass producer of sandwiches without the attention to detail that were famous for. How do we know our franchisees will actually uphold the same level of quality were famous for? Or for that matter, not report all their earnings in an effort to avoid paying us the royalty? We should focus on expanding our menu. Youve heard our clients tell us that we need to enhance our vegetarian line. More and more people are concerned about cholesterol and bad fats. A menu diversification has less risk and theres no additional capital investment. Paul: Sam, I think we should think more in terms of growth. Besides, people like our menu just the way it is.

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Livoria Sandwiches Inc.

Financial Information The 2010 income statement is provided in Appendix E. Livoria generated 53% contribution margins, but profitability was depressed because of the $500,000 contingent liability booked in 2010. Refer to Appendix F for the brothers forecast of the operating expenses for the next three years.

REQUIRED: To help the brothers decide on a course of action, they have retained the services of Dev Das, CMA. They have asked Das to review their options and come up with a recommendation on which option they should go with. Dass recommendation should also consist of at least three years of annual income statements (in contribution margin format) and cash flows for 2011, 2012 and 2013. The brothers have indicated that they would like to achieve $1.1 million in net income by 2013. Das is aware of the impending legal payment that must be met by May 2013.

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Livoria Sandwiches Inc.

Appendix A Menu Choices and Sales Forecasts for 2011-2013 Current Menu Options (for 2011) Selling Price per Unit $9.00 $9.00 $9.00 $8.00 $8.00 DM Cost per Unit 4.351 4.151 4.551 3.975 1.831 DL Cost per Unit 0.275 0.264 0.242 0.286 0.198

Sandwich Veal Cutlet Chicken Cutlet Sirloin Steak Meatball Eggplant

1. For 2012 and 2013, there will be a $0.15 price increase for all sandwiches and a $0.05 increase for drinks. 2. For 2012, direct material (drinks included) and direct labour costs will increase by 1.5% (over 2011 figures). 3. For 2013, direct material (drinks included) and direct labour costs will increase by 2.5% (over 2012 figures). Estimated Demand (Units) for 2011-2013 2011 Demand 86,333 98,962 32,031 28,775 25,131 2012 Demand 87,283 101,140 32,128 28,919 32,621 2013 Demand 88,069 102,607 32,161 28,919 112,416

Sandwich Veal Cutlet Chicken Cutlet Sirloin Steak Meatball Eggplant Sandwich Veal Sandwich Chicken Sandwich Sirloin Sandwich Meatball Sandwich Eggplant Sandwich

Time Required 1.25 min 1.20 min 1.10 min 1.30 min 0.90 min

Other Important Facts 1. 2. 3. 4. Canned soft drink sales are expected to be 55% of total sandwich sales. Bottled water sales are expected to be 30% of total sandwich sales. Bottled juice sales are expected to be 5% of total sandwich sales. Milk sales are expected to be 3% of total sandwich sales. For 2011, each beverage carries a unit sale price of $1.50 and a unit cost of $0.40.

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Livoria Sandwiches Inc.

Appendix B Fast Food Restaurants in Dawkins*


Establishment Public/Private Number of Locations 2010 Revenue CM % Operating Income % Sales Growth % Franchised? Format Chucks Burgers Private 12 $17,158,452 40.80% 15.68% -0.6% Yes Beef burgers, fries, soft drinks Livoria Sandwiches Private 2 $2,100,689 52.93% 0.29% 5.4% No Custom-made Italian sandwiches 1 Roccos Pizza Private 2 $1,462,134 45.20% 21.90% 3.2% No Sit-down style pizzeria, basic choices, pasta, salads 2 The Sub Place Private 8 $5,268,976 46.10% 20.55% 2.0% Yes Subs, pre-packaged sandwiches and pitas 3, 5, 7 Mama Janes Private 4 $3,407,876 43.50% 17.73% -0.4% No Sit-down style BBQ ribs, chicken 5, 8 Pablos Grill Private 6 $4,775,388 39.20% 16.42% -1.4% Yes Beef burgers, fries, soft drinks, alcoholic beverages 2, 6, 8

Zone(s)

2, 4, 6, 9

Establishment Public/Private Number of Locations 2010 Revenue CM % Operating Income % Sales Growth % Franchised? Format

Wok in China Private 14 $10,636,388 44.90% 19.88% 1.6% Yes Chinese buffet format (over 50 menu items)

Souvlaki Odyssey Private 8 $5,306,000 45.40% 19.26% 1.8% Yes Greek, souvlaki dinners, sit-down and takeout 1, 2, 7

Zone(s)

All

Caravan Private 26 $18,027,126 49.80% 20.44% 2.9% Yes Upscale Chinese cuisine, menu ordering only, sit-down style All

Della Private 9 $7,426,791 38.10% 18.10% -1.4% Yes Beef burgers, fries, soft drinks

Dawkins Industry Both 125 $92,969,500 44.70% 18.02% 1.2%

5, 6, 7, 8, 9

*Industry information from 2010

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Livoria Sandwiches Inc.

Appendix C Census Family Income Distribution City of Dawkins


60.0%

50.0%

40.0%

30.0%
2009 2010

20.0%

10.0%

0.0%

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Livoria Sandwiches Inc.

Appendix D Prospective Menu Options (for 2011) Selling Price per Unit $ 9.00 $10.50 $10.00 $ 9.00 DM Cost per Unit 2.7400 2.9450 3.0123 2.4820 DL Cost per Unit 0.1870 0.2068 0.1892 0.1980

Sandwich Avocado Grilled Tofu Hummus Grilled Veggies

1. For 2012 and 2013, there will be a $0.05 price increase for all sandwiches. 2. For 2012, direct material and direct labour costs will increase by 1.5% (over 2011 figures). 3. For 2013, direct material and direct labour costs will increase by 2.5% (over 2012 figures). Estimated Demand (Units) for 2011-2013 2011 Demand 2,478 1,269 1,844 2,608 2012 Demand 3,282 1,627 2,608 5,807 2013 Demand 13,844 8,567 21,421 53,709

Sandwich Avocado Grilled Tofu Hummus Grilled Veggies Sandwich Avocado Grilled Tofu Hummus Grilled Veggies

Time Required 0.85 min 0.94 min 0.86 min 0.90 min

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Livoria Sandwiches Inc.

Appendix E (Unaudited) Income Statement for 2010 2010 Revenue Sandwich sales Drink sales Total Revenue Variable Cost of Sales Material costs sandwiches Material costs drinks Direct labour costs Total Variable Costs Contribution Margin Fixed Manufacturing Costs Rent Property taxes Business insurance Utilities Security monitoring Waste management and maintenance Amortization Total Fixed Manufacturing Costs Operating Expenses Office expenses Legal Accounting Management salaries Sales and marketing costs Litigation Total Fixed Operating Expenses Total Fixed Costs Operating Income Income Tax Expense Net Income $1,819,003 281,686 $2,100,689

$852,404 80,482 55,907 $988,793 $1,111,896

$ 66,000 20,000 25,000 55,000 4,500 26,750 25,000 $222,250

$ 13,650 145,000 15,000 180,000 30,000 500,000 $883,650 $1,105,900 $5,996 1,199 $4,797

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Livoria Sandwiches Inc.

Appendix F 2011 Operating Expenses Total Fixed Manufacturing Overhead Costs Rent Property taxes Business insurance Utilities Security monitoring Waste management and maintenance Amortization Fixed Operating Expenses Office expenses Legal Accounting Management salaries Sales and marketing costs 78,000 25,000 30,000 65,000 5,000 30,000 25,000

15,000 25,000 20,000 350,000 40,000

For 2012 and 2013, all fixed costs (except amortization) are expected to increase by 2% over the previous year. Other Information 1. Direct labour costs include food preparers and staff who serve customers directly. 2. No capital purchases are expected for the next three years (2011-2013). 3. Income tax expense is 20%, and any amount owing arising from one fiscal year (year-end is December 31) is due on March 31 of the following year. 4. Livoria has an open line of credit with its bank. The closing cash balance at December 31, 2010, was $274,125. Interest charged on the line of credit is six per cent per annum. The bank requires a minimum cash balance of $20,000 on hand at any given time. The company pays back any amounts outstanding if it has excess cash at the end of the quarter. 5. Dividends of $100,000 will be declared and paid in each quarter of each year.

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