Northgate Components: Make-or-Buy Under Capacity Pressure
Northgate Components makes precision brackets for automotive customers. Its single plant runs at 88% of practical capacity of 120,000 units a year. A key customer offers a one-year contract for 25,000 extra units at £18 each. Current unit costs at 100,000 units are: direct materials £6.50, direct labour £4.20, variable overhead £1.80, fixed overhead £3.10 (absorbed on machine hours), and allocated central overhead £1.40. Total £17.00. Taking the order would require overtime on 15,000 units (labour at 1.5x) and would displace 8,000 units of existing business sold at £24 with the same variable cost base. A subcontractor has offered to supply 10,000 units at £15.50 each, but quality certification would take six weeks and the customer requires delivery in four.
1. Calculate the relevant cost of accepting the order and advise whether Northgate should take it.
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Capacity check. Practical capacity is 120,000; current output 100,000; spare capacity 20,000. The order needs 25,000, so 5,000 units must come from displaced business or overtime. The question says overtime applies to 15,000 units, implying 10,000 come from spare capacity and 15,000 from overtime/displacement.
Relevant costs (avoid absorption). Fixed and central overheads are not incremental, so exclude £3.10 and £1.40.
- Spare-capacity units (10,000): variable cost £6.50 + £4.20 + £1.80 = £12.50 → £125,000.
- Overtime units (15,000): labour premium 50% of £4.20 = £2.10 extra → £14.60 each → £219,000.
- Displacement: 8,000 units of £24 business lost. Contribution lost = 8,000 × (£24 − £12.50) = £92,000.
Total relevant cost = £125,000 + £219,000 + £92,000 = £436,000, i.e. £17.44 per unit. Revenue is 25,000 × £18 = £450,000. Net gain = £14,000 - marginally positive.
Subcontract option. At £15.50 for 10,000 units (£155,000) it replaces £125,000 of in-house spare-capacity cost, adding £30,000 - but the six-week certification exceeds the four-week deadline, so it is not feasible.
Advice. Accept only if the £14,000 margin survives risk; it is thin. Negotiate a higher price or defer displacement.
2. Identify the qualitative factors that could overturn the numerical recommendation.
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Strategic and commercial factors.
- Customer relationship. The order may secure future volume; refusing could lose a key account. Conversely, accepting a low-margin order sets a precedent that weakens future pricing.
- Displaced customers. Losing 8,000 units of £24 business may damage relationships that are worth more than £92,000 of contribution over multiple years.
- Quality and certification. Subcontracting is infeasible on timing, but the six-week certification signals that quality assurance is a real constraint; rushing overtime production risks defects and warranty claims.
- Workforce. Sustained overtime causes fatigue, error rates and industrial relations risk; the 1.5x premium may also become an expectation.
- Capacity learning. Running at 88% leaves little buffer for breakdowns; a machine failure could jeopardise both the new contract and existing deliveries, with penalty clauses.
- Cost behaviour. The £14,000 gain is within estimation error; a 3% materials increase erases it. Fixed costs may step up if overtime persists.
Recommendation. The numerical case is marginal. Northgate should accept only with a price increase to at least £18.60, a written volume commitment, and a contingency plan for capacity. Otherwise, decline and protect the higher-margin core business.