Northfield Bakery: The Supermarket Contract
A wholesale bakery runs a single eight-hour night shift, 24 nights a month, baking 12,000 loaves. The ovens can produce 15,000 loaves a night, but the existing packing line handles only 13,200. Variable cost is USD 0.62 per loaf and the current wholesale price is USD 1.05.
A supermarket chain has offered a two-year contract for 3,000 loaves a night at USD 0.85, starting in six weeks. Meeting it would require 1.5 hours of overtime baking at USD 180 per hour. Packing must be solved first: a second packing line costs USD 95,000, takes 14 weeks to install and adds USD 300 a month in maintenance; alternatively, packing can be subcontracted at USD 0.05 per loaf. The current reject rate is 2.4%, and the technical manager warns that the ovens would then run at 100% of rated capacity with no buffer for breakdowns or product changeovers.
1. Calculate the nightly and monthly contribution of the contract under each packing option, and state the payback period for the second packing line.
Read the worked answer
Step 1 - unit contribution. Price USD 0.85 − variable cost USD 0.62 = USD 0.23 per loaf.
Step 2 - nightly contribution before packing and overtime. 3,000 × 0.23 = USD 690.
Step 3 - deduct incremental overtime. 1.5 hours × USD 180 = USD 270 per night, so net = 690 − 270 = USD 420 per night.
Note: only the overtime is incremental; the existing shift labour is not, so it must not be charged to the contract. This is the classic trap - charging absorbed fixed cost to the decision.
Option A - subcontract packing. Cost = 3,000 × 0.05 = USD 150 per night. Net = 420 − 150 = USD 270 per night = 270 × 24 = USD 6,480 per month.
Option B - second packing line. Net = USD 420 per night = USD 10,080 per month, less maintenance USD 300 = USD 9,780 per month.
Option C - the line cannot start on time. It takes 14 weeks but supply is needed in six, so weeks 1–14 must be subcontracted anyway.
Payback of the line. Incremental benefit over subcontracting = 420 − 270 = USD 150 per night = USD 3,600 per month (before maintenance; USD 3,300 after). Payback = 95,000 ÷ 3,300 ≈ 28.8 months of operation.
Interpretation. Against a two-year (24-month) contract, the line cannot repay itself inside the contract term. That is the decisive figure for the recommendation.
2. Recommend, with justification, whether Northfield should accept the contract and which packing solution it should choose.
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Accept or reject first. Total contribution over 24 months, if packing is subcontracted throughout: USD 270 × 24 nights × 24 months = USD 155,520. That is a large, positive contribution that also absorbs fixed overhead and improves full-cost per loaf on existing volume. Rejecting it leaves the bakery with a packing line already near its ceiling (12,000 of 13,200) and no growth.
Choosing between options.
- Subcontract throughout: USD 155,520 over the term, no capital, starts in six weeks.
- Line, after 14 weeks: rooms 1–14 weeks subcontracted (270 × 24 × 3.2 ≈ USD 20,700), then 420 × 24 × 20.8 ≈ USD 209,700, minus capital 95,000 and maintenance ≈ 6,200 → ≈ USD 108,800.
Subcontracting wins on cash over the contract term, because the line's payback (≈29 months) exceeds the two-year term. Recommendation: accept the contract and subcontract packing, while placing an option on the line.
The judgement should be contingent: if the supermarket extends to four years, or if a second customer lifts nightly volume beyond 14,000, the line becomes the cheaper route because the USD 150‑per‑night gap compounds. Northfield should therefore negotiate a renewal clause and re-tender the line when the price falls or the term lengthens. Subcontracting also preserves flexibility if the contract is terminated - the capital is not stranded.
Conditions to attach. (i) A minimum-volume or take-or-pay clause, because the USD 95,000 or the subcontract rate is committed against one buyer. (ii) A price-review clause tied to flour and energy, since USD 0.23 of contribution is thin. (iii) Written acceptance of a 2.4% reject allowance.
3. Assess the operational risks of running the ovens at 100% of rated capacity and explain how they affect the decision.
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What 100% utilisation means. Existing output 12,000 + contract 3,000 = 15,000 = the rated maximum. Rated capacity is not sustainable capacity: it assumes no breakdowns, no changeovers, no cleaning downtime and no quality losses. Once there is no buffer, every stoppage becomes a delivery failure, and supermarket supply contracts carry service-level penalties and delisting clauses.
Quality exposure. At a 2.4% reject rate, 15,000 loaves produces about 360 rejects a night. Those rejects must be re-made from capacity that does not exist, so shortfalls are passed straight to the customer - who measures fill rate in cases, not in goodwill. Reject rate typically rises when equipment is pushed: a plausible deterioration to 3.5% costs about 525 loaves a night, roughly one sixth of the contract volume.
Packing constraint. The existing line caps at 13,200. Even with the contract the bakery needs 15,000 packed, so subcontracting is not just a cost choice but a capacity necessity - 1,800 loaves have no route through the plant without it.
Effect on the decision.
- It strengthens the case for not buying the packing line immediately, because capital spent before the process is stable buys a bottleneck rather than capacity.
- It requires contingency before signing: a part-baked frozen buffer, a second-line maintenance contract, and a negotiated defect allowance rather than an absolute specification.
- It argues for a staged volume ramp - for example 1,500 loaves a night for the first eight weeks - which tests the process, protects the service level and gives the technical manager evidence for or against accepting full volume.
Conclusion. At 100% utilisation the risk is not that the bakery loses money on the contract, but that it loses the customer and damages its reputation with other wholesale accounts. Contingency capacity is a condition of acceptance, not an optional extra.