Every business sets a shutdown point. It is the point where a company cannot sustain its operations. The point can be about a product, a department, or a company.
Several factors contribute to the shutdown decisions. The most prominent factor is profitability. A business must also consider broader factors.
Let us discuss what are shutdown decisions for products and departments with the help of examples.
What is Shutdown Decision?
A shutdown decision is a decision to temporarily close a department, stop production of a product, or discontinue service by an entity.
A business may take such decisions due to several reasons. The main reason for a shutdown decision remains profitability for commercial entities. However, other considerations also compel an entity to take such decisions.
A business should look for quantifiable and non-quantifiable (qualitative) factors before taking the final decision.
Shutdown Point
Many businesses set a shutdown point for their products or a line of products. It is the point when a business cannot cover its variable costs through sales.
At this point, the company does not make any profit. Instead, it starts bearing losses beyond the break-even point. It may result due to operating inefficiencies, higher competition, lower selling prices, or a combination of these factors.
A business can continue operations as long as it can cover variable costs. The business anticipates covering fixed costs through additional sales. However, once the profitability falls below the marginal revenue, a business cannot sustain operations for long.
Understanding Shutdown Decisions – Product, Department, or Company
A business may take a shutdown decision for a product, department, or about the company itself.
Every business can set its shutdown point differently. It largely depends on the nature of business, industry, and size of the company.
For example, a travels and tours company can shut down its operations during snow season altogether. Similarly, a company producing multiple products such as apparel can discontinue a few selective items or produce more with seasonality issues.
The shutdown decision depends on several factors. In many cases, a business continues producing loss-making products to support the product mix. These supporting products only generate a small proportion of sales but help a business sell other products.
Why Companies opt for Shutdowns?
Once a product or a department starts making losses, a business needs to evaluate different options. The shutdown is one likely decision about the future operations of a department or the continuation of a product.
A few common reasons why businesses opt for shutdowns include:
- Diminishing profitability of a product or a department
- Cash flow problems
- Inefficient operations
- Outdated technology that cannot generate competitive products
- External market competition
- Higher taxation costs
- Economic conditions such as recessions
- Supplier relations or other raw material problems
Sometimes a line of product or a customized product may be too costly for a business to produce. The business can discontinue producing such products as well even if these products remain profitable.
Shutdown decisions can save operating costs for a business for several reasons. Similarly, it can save fixed costs as well.
Another key factor that many businesses consider is the production capacity. A business may decide to temporarily shut down a less profitable product line in the product mix. It would dedicate scarce resources to products with higher profitability.
Short Term Shutdown Decisions
Shutdown decisions consider different factors for the short and long-term. A business may continue producing a product in the short term even if it does not make profits.
If a business can continue to cover its average variable costs, it should continue a particular product. The reason is that the product will generate sufficient revenue that can cover fixed costs in the long run.
When marginal revenue is equal to marginal cost, it can continue with the operations. At this point, the company will break even. The average variable costs can be covered by average margins.
An important point to remember here is about the fixed costs. A business analyzing the short-term shutdown decisions does not consider fixed costs.
Long Term Shutdown Decisions
The long-term shutdown decisions consider several factors. The most important one is to consider whether the business can cover the total costs in the long run.
If a business can generate sufficient revenues that can cover the total costs of production, it can continue operations. However, the business should also consider admin, selling, taxation, and other costs.
A long-term decision is different from a short-term shutdown decision. If a business can compete after increasing prices or lowering inputs costs (lower quality), it can continue operations. However, in many cases, raising selling prices result in the loss of the market share.
A common scenario with shutdown decisions is that a business may decide the temporary closure of a product or a department. Seasonal businesses are a prime example of such decisions.
Important Considerations with Shutdown Decisions
A business should consider several factors before making the shutdown decisions. For instance, an economic recession means all businesses are affected and it cannot be a justification for such a decision.
Similarly, a business may face regulatory changes. For example, a government may impose a ban on the import of raw materials from a particular country. It can temporarily affect the productions levels of a company.
Seasonal businesses must plan proactively. A lower sales figure for a particular product or a loss-making department cannot be closed due to seasonal sales results.
A business can avoid a shutdown point by either decreasing costs or increasing prices. Operational efficiency is an internal factor that a business can control internally. However, increasing selling prices may result in a stern competition.
Impact of Shutdown Decisions
When a business makes a shutdown decision about a product, a department, or a company, it affects several stakeholders.
- Employees and skilled workers would need additional work. Else, it will end in a layoff decision for them.
- Customers may not like a shutdown decision about a particular product.
- Similarly, supplier relations can be compromised as well.
- A shutdown decision may also affect the market competition.
Example – Product Shutdown Decision
Suppose ABC company produces a product P1. The production costs and other details are given below.
| Description | Amount/Details |
| Units Produced | 1,000 |
| Selling Price Per Unit | $ 30 |
| Fixed Costs | $ 20,000 |
| Variable Costs (Per Unit) | $ 15 |
Let us calculate the profitability of product P1 and evaluate whether the company should continue with the production of P1.
| Description | Amount/Details |
| Sales (1,000 × 30) | $ 30,000 |
| Less: Fixed Costs | ($ 20,000) |
| Less: Variable Costs | ($ 15,000) |
| Profit/Loss | ($ 5,000) |
Analysis
The product P1 makes a loss of $ 5,000. However, if we evaluate the situation closely, it will be a bigger loss for ABC company if it makes a shutdown decision.
ABC company generates revenue of $ 30,000 through the product P1. It has to incur fixed costs of $ 20,000 regardless of the product shutdown. Thus, if it continues with the production, it can cover the fixed costs plus a portion of variable costs.
If ABC shuts down P1, its losses will be $ 20,000 per month. Thus, in the short term, it is advised to continue with the product P1. However, if the selling price of P1 falls below the variable cost per unit ($15), it will not be a sustainable product even in the short term.
Example – Department Shutdown Decision
Suppose Serenity Group runs a company with three departments. It has the following data available and it wants to decide on the shutdown decision about one of its departments.
| Details | D1 | D2 | D3 | Total |
| Sales (Units) | 6,000 | 5,000 | 2,000 | 13,000 |
| Revenues ($) | 130,000 | 210,000 | 28,000 | 368,000 |
| COGS | ||||
| Direct Material | 65,000 | 135,000 | 14,000 | 214,000 |
| Direct Labor | 22,000 | 30,000 | 8,000 | 60,000 |
| Overhead Costs | 5,200 | 6,100 | 3,300 | 14,600 |
| Other Expenses | 10,500 | 16,400 | 5,000 | 31,900 |
| Net Profit | 27,300 | 22,500 | (2,300) | 47,500 |
Solution:
Visibly the Serenity group should shut down the department D3. However, the management accountant has offered some valuable details that can help the management make the decision.
- Only 50% of the overheads can be allocated to three departments in a 2:2:1 ratio.
- Similarly, only 60% of other expenses can be allocated in a 3: 3: 2 ratio.
- Direct labor cannot be identified accurately, only 25% of the labor costs can be allocated on the basis of sales volume.
Now the profitability of each department can be adjusted as below.
| Details | D1 | D2 | D3 | Total |
| Sales (Units) | 6,000 | 5,000 | 2,000 | 13,000 |
| Revenues ($) | 130,000 | 210,000 | 28,000 | 368,000 |
| COGS | ||||
| Direct Material | 65,000 | 135,000 | 14,000 | 214,000 |
| Direct Labor (25% only) | 6,923 | 5,770 | 2,307 | 15,000 |
| Overhead Costs (50%, 2: 2: 1) | 2,920 | 2,920 | 1,460 | 7,300 |
| Other Expenses (60%, 3: 3: 2) | 7,177.5 | 7,177.5 | 4,785 | 19,140 |
| Contribution | 47,979.5 | 59,132.5 | 5,448 | 112,560 |
| Direct Labor (75%) | 45,000 | |||
| Overhead (50%) | 7,300 | |||
| Other Expenses (40%) | 12,760 | |||
| Net Profit | 47,500 |
Analysis
Department D3 of Serenity Group was showing losses from the outset. However, uneven cost allocations and indirect expenses made look D3 unprofitable. In reality, when we assigned relevant costs appropriately and calculated contribution margins for each department, D3 becomes profitable.
The total profitability of the group remains the same. Detailed analysis shows that a shutdown decision for D3 would have resulted in the loss of revenue for the group.
