Northgate Foods: peak capacity, defects and a subcontractor
Northgate Foods packs breakfast cereals for own-label retailers from a single plant. The line can produce 1,200,000 units a month on two shifts. Demand is 900,000 units a month from January to September but rises to 1,450,000 in October to December. Overtime can lift output to 1,350,000 units a month at an extra $0.04 per unit, but the shortfall in the peak is currently lost, costing $0.15 per unit of lost contribution and a $60,000 annual penalty for missed delivery. The defect rate is 4.8%, against a customer target of 2.0%; rework costs $0.03 per unit. A second line would cost $1.6m, take eight months to install and add $220,000 a year to fixed costs. Alternatively, a subcontractor has quoted $0.09 a unit for up to 300,000 units in the peak, with a five-week lead time and a 3% defect rate. A third option is an 8% off-peak discount, expected to shift 120,000 units from the peak quarter, costing $0.06 per unit in lost contribution.
1. Calculate the cost of the peak capacity shortfall under the current arrangement and compare it with subcontracting the shortfall.
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Current position in the peak.
- Demand: 1,450,000 units a month
- Maximum in-house output with overtime: 1,350,000 units
- Shortfall: 100,000 units a month
Costs:
- Lost contribution: 100,000 × $0.15 = $15,000
- Delivery penalty: $60,000 (annual)
- Overtime premium: 150,000 units × $0.04 = $6,000
- Total: $81,000
Subcontracting the 100,000-unit shortfall.
- Subcontract cost: 100,000 × $0.09 = $9,000
- Rework on 3% defects: 3,000 × $0.03 ≈ $90
- Overtime unchanged: $6,000
- Total: about $15,090
The saving is roughly $66,000 a year, and the $60,000 penalty is avoided entirely if the subcontract volume arrives in time.
Caveats. The five-week lead time means Northgate must commit before peak orders are certain; if demand disappoints, it may pay for units it does not need, although a framework agreement can reduce this. A 3% defect rate is better than Northgate's own 4.8% but still above the 2% customer target, so the subcontractor must be audited. There is also a quality-risk transfer problem: the retailer's brand is on the pack, so Northgate carries the reputational cost of the subcontractor's errors.
Judgement. Subcontracting is clearly better than losing sales, but it is a temporary fix. The underlying problem is that capacity is 1.2m against a 1.45m peak - a 21% gap - while the plant runs at 75% utilisation for nine months of the year. Northgate should combine subcontracting with demand smoothing rather than treating it as a permanent solution.
2. Evaluate whether Northgate should invest in the second line.
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Capacity effect. A second line adds 700,000 units a month, taking capacity to 1.9m. Against peak demand of 1.45m, that is 76% utilisation in the peak and 47% off-peak. The line therefore does not just solve the shortfall; it creates substantial idle capacity.
Financial test.
- Annual benefit: avoided lost contribution $15,000 + avoided penalty $60,000 + avoided subcontract $9,090 ≈ $84,090
- Added fixed costs: $220,000
- Net annual cost: about $136,000
To cover the extra fixed costs from contribution alone would require $220,000 ÷ $0.15 = 1.47m additional units a year - more than the entire peak shortfall. Payback on $1.6m at $84,000 a year is about 19 years, and even that ignores the eight-month installation, which means the line misses this year's peak.
Qualitative factors. The line gives security of supply, removes dependence on a subcontractor, and could win new contracts. Own-label contracts are won on reliability and price, and a second line could support a push into a new category. But the plant would carry high fixed costs through a nine-month trough, raising operational gearing and making profit fragile if a contract is lost.
Judgement. Reject the second line on current demand. The numbers only work if Northgate first wins a contract of at least 1.5m units a year, or if the line can be leased or bought second-hand to cut the capital outlay. The better sequence is: subcontract the peak now, fix the defect rate, use the off-peak discount to smooth demand, and revisit capacity when a named contract is signed.
3. Discuss how Northgate should address the 4.8% defect rate, and explain why it may matter more than the capacity decision.
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Scale of the problem. At 1.35m units a month, 4.8% means about 64,800 defective units. Direct rework at $0.03 is only about $1,944 a month - small enough to be ignored, which is exactly why the problem persists. The real cost is hidden: retailer rejections, chargebacks, emergency overtime, and the risk of losing a contract that represents a large share of revenue.
Why it matters more than capacity. Capacity failure costs about $81,000 a year and can be bought out through subcontracting. A quality failure can remove the customer entirely, and own-label customers audit factories and delist suppliers. Capacity is a constraint; quality is an existential risk.
Tools Northgate should use.
- Pareto analysis of defect types to find whether a few causes (for example, one filler head, or inconsistent recycled board) account for most faults.
- Statistical process control on fill weight and seal temperature, so the process is corrected before defects are made.
- Kaizen and operator training: the training budget is not given, but quality problems are often a symptom of rushed changeovers and untrained agency staff.
- Supplier quality agreements for packaging, since recycled board varies more than virgin board.
- Cost of quality accounting to show the board that prevention is cheaper than appraisal plus failure.
Judgement. Northgate should set a 12-month quality plan with a target of 2.5%, measure defects per million, and make the production manager accountable. Spending, say, $150,000 on inspection and process control is easier to justify than $1.6m on a second line, because it protects existing revenue rather than adding capacity that current demand cannot fill.