Accounting for Shutdown Point
Shutdown point is the business decision in which the manager decides to close down a product, department, or whole operation due to the continuous loss or insufficient cash flow. It is the point that company decides to stop as it cannot continue the operation sustainably.
The company may not make a profit. But if the revenue can cover some part of the fixed cost, they may decide to continue the business. Even if the company is making a loss but the loss will be higher when the operation stop. In a short time, the company will continue the operation as long as the sale can cover the total variable cost.
Mostly the company is facing problems when its total revenue is less than the total variable cost. It means that the company will make more losses when they operate the business. Their loss is the total between fixed cost and negative gross margin. They will lose only the total fixed cost if they just stop the operation.
It will happen when the company meets the cash flow shortage and need to find a solution for a short time. It is very common when the company cannot find enough cash flow to settle its obligation. Many companies still making a profit, but they are bankrupt due to lacking cash flow to settle with suppliers.
Shutdown point does not only apply to the shutdown of the whole company, but it is also applies to the pause of some products, branches, or divisions.
When Should We Shutdown?
The business expects to generate total revenue, which is more than the total cost in order to make a profit. However, it does not mean that we need to close down our business when we are making losses. Before deciding to shut down, we need to take a look at a few steps, such as:
| Determine the shutdown point | |
|---|---|
| Calculate the variable cost | The company needs to figure out the total variable cost of product or segment. The variable cost includes direct material and direct labor, this cost will incur only when we produce goods. There is a fixed cost which always incurs even we do not make production. It includes depreciation, admin expense, staff salary, and other committed expenses. It can be called sunk cost or not relevant cost, and we need to pay them even if we stop the production. |
| Marginal revenue from the product | The company can shutdown product, segment, or region, so it is important to know both revenue and cost of each product, region, or country. |
| Compare the variable cost with Revenue | The products with revenue less than variable cost should be shut down, and it also applies to the segment or regional subsidiary. We compare only the variable cost because the fixed cost will keep getting paid even if the production stop. When the sale is bigger than the variable cost, we will leave with some cash to pay for the fixed cost even if we still run loss. If we stop, the loss will be higher as it is equal to the fixed cost. |
This can apply for the short-term decision as the fixed cost will not be fixed forever. The rental contract will end, depreciation will finish after a fixed asset’s useful life.
Shutdown Example
ABC is a production Company, that produces multiple products. During the year, the company is considering reducing the number of products to save some costs. The production manager recommends stopping the production of product X.
Based on the team, Product X incurs the following cost:
- Raw material @ $ 0.5 per unit
- Direct labor @ $ 1.0 per unit
- Fixed cost $ 10,000 per month
Suppose we have three months of revenue as follows:
- January, Sale 10,000 units @ $2.8 per unit
- February, Sale 10,000 units @ $ 2.0 per unit
- March, Sale 5,000 units @ $ 1.3 per unit
Please help to determine the shutdown point for the company. It is necessary to stop the production.
We will calculate the shutdown process below:
January
The variable cost is $ 15,000 [($0.5 + $1.0) *10,000 units]
The sale is $ 28,000 (10,000 units * $2.8)
The sale is greater than the variable cost, and we still can make $ 13,000 of gross profit. The net income is $3,000 (28,000 – 15,000 – 10,000) after we deduct the fixed cost.
The company is doing well with positive profit, and there is no indication of a shutdown in this month.
February
The variable cost is $ 15,000 ($ 15 * 10,000 units)
The sale is $ 20,000 (10,000 units * $ 2.0)
The sale is still more than the variable cost, and we can make $ 5,000 of gross profit. We will incur a loss of $ 5,000 after deducting the fixed cost.
Even though we are making a loss ($ 5,000), we should continue our production because the revenue is still higher than the variable cost. If we stop production, our loss will be increased to $ 10,000 which is the fixed cost.
March
The variable cost is $ 7,500 ($ 15 * 5,000 units)
The sale is $ 6,500 (5,000 units * 1.3)
The sale is now less than our variable cost. We are making loss of $ 11,000 (6,500 – 7,500 – 10,000).
In March, the company made a loss of $ 11,000. They will make a loss of only $ 10,000 if they do not produce this product. It should be the shutting point for product X. However, they need to look for other information before ceasing production.
It will be a problem when we stop the production while the loss is only in March. It can happen due to the fluctuation of seasonal sales. It will not make sense when the product is not making a profit for one month and we stop the production. We just want to illustrate an example that is easy to understand.
What are the impacts of Shutdown?
The shutdown of one product or business unit means that the whole company still operates. We may keep produce and selling other products to the customer. So the decision to shutdown may have some qualitative impact as the following:
| Negative Impacts of Shutdown | |
|---|---|
| Impact on Employee | In theory, direct labor should be zero as we stop production, but it is not that straightforward. For the workers, we need to arrange their work on other products. If we do not need them, we must go through the process of layoff. It is a complicated and costly process that the company needs to go through. It also impacts our reputation in public perception, which leads to a decrease in other products’ sales. The layoff will reduce a large number of skilled workers, and it will be a high cost if we need them later. We will spend time and money on hiring and training. Based on the research, the company will recruit more workers within 18 months after a layoff. |
| Impact on Customer | The retail customers will decrease buying from other products due to the bad reputation during the layoff. There may be protests or boycott again the company. For the business who rely on our products, they may reconsider as they are afraid that we will shut down another product that will impact them. They may consider choosing a new supplier and reduce order quantity to reduce the risk if something is wrong with our products. |
| Impact on Supplier | The suppliers will keep an eye on us after the shutdown of one or two products. What if next time we are closing the whole company, they will be in trouble. So they may consider reducing our credit term as well as the credit limit. |
| Impact on the competitor | The competitors will increase their competition as our product has gone. Moreover, they may try to compete with our remaining products in order to move us out of the market entirely. |
Conclusion
The shutdown point is just one of the tools that management can use to evaluate the company or any product performance. It is not absolute to follow the suggestion from this tool.
In a short term, the company may be willing to lose in order to get a profit in the long term. It depends on the product quality, market, and many other factors. So it is not compulsory to end production when the sale is less than the variable cost. However, management needs to find a solution to this issue. We cannot sell the product at lower than the variable cost. It is fine if the product sells during the promotional period.