Accounting for Shutdown Point

ShutdownShutdown 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. Mostly the company is facing problems when its total revenue is less than the total variable cost.

It will happen when the company meets the cash flow shortage and need to find a solution for a short time.

When Should We Shutdown?

The business expects to generate total revenue, which 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 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 pay even the production stop.  When the sale is bigger than variable cost, we will leave with some cash to pay for the fixed cost even we still running lose. 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

Company A produces product X and incurs the cost following

  • Raw material @ 5 per unit
  • Direct labor @ 10 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

We will calculate the shutdown process following

January

The variable cost is $ 15,000 [($5 + $10) *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.

February

The variable cost is $ 15,000

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 we are making a loss ($ 5,000), but we should continue our production because the revenue still higher than variable cost. If we stop production, our loss will be increased to $ 10,000 which is the fixed cost.

March

The variable cost is $ 15,000

The sale is $ 6,500 (5,000 units * 1.3)

The sale is now less than our variable cost. We are making loss of $ 18,500 (6,500 – 15,000 – 10,000).

We lose only $ 10,000 if we stop the production, we suggest to shutdown this product.

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 which 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  afraid that we will shutdown another product which will impact them. They may consider choosing a new supplier and reduce order quantity to reduce the risk if something 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.