Kōwhai Brewing: spare capacity or a cross-Tasman contract
Kōwhai Brewing is a Hawke's Bay craft brewery with annual capacity of 1,200,000 litres. It currently produces 936,000 litres for the New Zealand market. Domestic draught sales have fallen 6% in the past year as cost-of-living pressures hit hospitality, but packaged can sales are growing. Average domestic selling price is $6.80 per litre ex-works; variable cost is $3.20 per litre and fixed costs are $2.4 million a year. An Australian distributor has offered a three-year contract for 400,000 litres a year at $4.10 per litre ex-works. Kōwhai's bank covenant requires EBITDA of at least $900,000. The company has $600,000 cash. Adding a 500,000-litre tank and packaging line would cost $1.8 million. Alternatively, a large Auckland brewery has offered tolling capacity for up to 200,000 litres at $2.60 per litre, which would free up space at Kōwhai. The board must decide before the Australian offer expires in six weeks.
1. Calculate the contribution per litre for domestic and export sales, and assess the financial viability of accepting the full 400,000-litre contract using Kōwhai's current capacity. Show your reasoning.
Read the worked answer
Contribution and capacity
- Domestic contribution = $6.80 − $3.20 = $3.60 per litre.
- Export contribution = $4.10 − $3.20 = $0.90 per litre.
- Current production is 936,000 L, so spare capacity is 1,200,000 − 936,000 = 264,000 L.
- The full export contract needs 400,000 L, which is 136,000 L more than spare capacity. Accepting it means displacing 136,000 L of domestic sales.
Financial effect
Contribution with the full contract and displacement:
- Domestic: 800,000 × $3.60 = $2,880,000
- Export: 400,000 × $0.90 = $360,000
- Total contribution = $3,240,000
- Less fixed costs $2,400,000 = EBITDA $840,000
That is below the bank covenant of $900,000 and $129,600 worse than the current EBITDA of $969,600 (936,000 × $3.60 − $2,400,000). The export price is also below full cost per litre: at current volume, full cost is $3.20 + ($2,400,000 ÷ 936,000) = $5.76, so each export litre is sold below full cost. It is still above variable cost, so it contributes, but only if spare capacity exists. The judgement is that the full contract is not viable on current capacity; a reduced contract or extra capacity/tolling is needed.
2. Evaluate two options: (a) accept a reduced 264,000-litre contract using only spare capacity, or (b) toll-brew 200,000 litres in Auckland and accept the full 400,000-litre export contract. Recommend one, with conditions.
Read the worked answer
Option A: 264,000 L export using spare capacity
Contribution = 264,000 × $0.90 = $237,600. EBITDA rises to $969,600 + $237,600 = $1,207,200. There is no new fixed cost and no quality risk from another brewer, but it uses all spare capacity and leaves no buffer for domestic recovery. It also under-fills the distributor's request, which may weaken the relationship or invite a competitor.
Option B: toll 200,000 L and accept full 400,000 L
Tolling 200,000 L costs 200,000 × $2.60 = $520,000, compared with own variable cost of 200,000 × $3.20 = $640,000, a saving of $120,000. The export adds 400,000 × $0.90 = $360,000 contribution. Incremental EBITDA versus the status quo is $480,000, giving $1,449,600. In-house volume is 736,000 L domestic + 400,000 L export = 1,136,000 L, within the 1,200,000 L capacity.
Recommendation
Option B is financially stronger and meets the covenant, but only with conditions: a trial batch and quality audit of the tolling partner; confidentiality and brand-control clauses; a right to terminate; a price review clause with the Australian distributor; and retaining at least 64,000 L of spare capacity as a buffer. Without those protections, the brand and supply risk could outweigh the $242,400 advantage over Option A. If the tolling partner cannot meet quality standards, choose Option A.
3. The board is also worried about long-term brand positioning. Explain how accepting a low-price export contract could affect Kōwhai's domestic brand and bargaining power, and how this should influence the decision.
Read the worked answer
Accepting a low-price export contract can affect the domestic brand in three ways.
First, reference price and positioning. Kōwhai sells craft beer at $6.80/L domestically. A large volume at $4.10/L signals a lower-value product and may make domestic customers and distributors question the premium. If the export product is visibly the same brand, it can dilute the craft story.
Second, bargaining power and dependence. A three-year contract for 400,000 L gives the Australian distributor a large share of Kōwhai's volume. That buyer can later demand lower prices, longer terms or exclusivity. The domestic business then cross-subsidises the export, which is unstable if domestic margins fall.
Third, capacity lock-in and opportunity cost. The contract commits capacity for three years. If domestic packaged sales recover, Kōwhai may be unable to serve them without breaching the export contract. That is a real cost even if the export contribution is positive today.
The decision should therefore not be based only on contribution. The board should cap export at a share of capacity, insist on annual price reviews and a volume flex clause, and keep the export product clearly positioned or branded to protect domestic price. If the distributor will not accept those terms, a smaller contract is the better judgement.