Zao Foods: A Special Order, Spare Capacity and a Cost Shock
Zao Foods processes mangoes on a single shift. Capacity is 50,000 kg a month; output is 40,000 kg, sold at KSh 120/kg to traders who pay cash. Variable cost is KSh 78/kg and fixed cost is KSh 1,440,000 a month. A supermarket chain offers to buy 12,000 kg a month for a year at KSh 92/kg, on 90-day payment terms. Zao funds its overdraft at 16% a year. The mango supplier has warned that variable cost will rise 12% from next quarter. The owner wants to accept at once: 'anything above cost is profit, and the chain's name will raise our profile.'
1. Compute Zao's break-even volume and margin of safety, then assess the chain's offer at 12,000 kg with and without displacing existing sales.
Read the worked answer
Current position Contribution per kg = 120 − 78 = KSh 42 Break-even = 1,440,000 ÷ 42 = 34,286 kg Margin of safety = (40,000 − 34,286) ÷ 40,000 = 14.3% Monthly profit = 40,000 × 42 − 1,440,000 = KSh 240,000
The offer Contribution per kg = 92 − 78 = KSh 14 Spare capacity = 50,000 − 40,000 = 10,000 kg
| Volume taken | Working | Incremental profit |
|---|---|---|
| First 10,000 kg (spare capacity) | 10,000 × 14 | +140,000 |
| Next 2,000 kg (displaces regular sales) | 2,000 × (14 − 42) | −56,000 |
| Whole 12,000 kg | 140,000 − 56,000 | +84,000 |
Verdict: taking all 12,000 kg adds KSh 84,000 a month; taking only 10,000 kg adds KSh 140,000. The owner's 'anything above cost is profit' is wrong twice over: the KSh 14 contribution must first cover the KSh 42 given up on the units it displaces, and it must cover the fixed cost that the 40,000 kg already absorbs.
2. Quantify the working-capital cost of the chain's 90-day terms and recommend what Zao should do.
Read the worked answer
Financing cost Receivable tied up = one month's sales × 3 months
- At 10,000 kg: 10,000 × 92 = 920,000 per month → 2,760,000 tied up → 16% = KSh 441,600 a year (KSh 36,800 a month)
- At 12,000 kg: 1,104,000 per month → 3,312,000 tied up → 16% = KSh 529,920 a year (KSh 44,160 a month)
Net benefit
- 10,000 kg: 140,000 − 36,800 = KSh 103,200 a month
- 12,000 kg: 84,000 − 44,160 = KSh 39,840 a month
The 90-day terms consume 26% of the contribution at 10,000 kg - a slow, unsecured debtor funded on overdraft is the classic way a profitable order becomes a cash problem.
Recommendation: accept, but capped.
- Take 10,000 kg, not 12,000 kg; never exceed spare capacity for a KSh 14 margin.
- Seek KSh 96–100/kg, or 60-day terms - at 96/kg the 10,000 kg contribution rises to KSh 180,000.
- Require a written contract, monthly payment on account, and a first-order prepayment to test their payment behaviour before committing volume.
- Do not lock a one-year fixed price while input costs are moving - see the next task.
3. Variable cost rises 12% next quarter as warned. Recompute the position and revise your advice on the chain contract.
Read the worked answer
New variable cost = 78 × 1.12 = KSh 87.36/kg
Regular business Contribution = 120 − 87.36 = KSh 32.64/kg Break-even = 1,440,000 ÷ 32.64 = 44,118 kg - above current output of 40,000 kg Profit at 40,000 kg = (40,000 × 32.64) − 1,440,000 = loss of KSh 134,400 a month
Chain order Contribution = 92 − 87.36 = KSh 4.64/kg Full 10,000 kg on spare capacity adds 10,000 × 4.64 = KSh 46,400 Result: −134,400 + 46,400 = loss of KSh 88,000 a month
Revised advice
- Do not sign a one-year fixed price at KSh 92. It converts a manageable KSh 134,400 shortfall into a smaller but locked-in loss and removes Zao's ability to pass cost through. The margin at 92/kg (4.64) is roughly a tenth of the regular margin and will not survive a smaller second cost rise.
- The real problem is the regular business: to restore the KSh 42 contribution, price must rise to 87.36 + 42 = KSh 129.36/kg, or fixed cost must fall, or yield/utilisation must improve. That is where management attention belongs.
- If the chain order is taken at all, take it only with a price-review clause tied to the mango price, or as a short trial while Zao re-prices to traders.
- Test to apply: a contract that locks margin is only safe when input cost is stable. Here it is not, so flexibility is worth more than the KSh 46,400.