The first and primary benefit of a business stopping operations after crossing a shutdown point is it won't run the risk of losing money during ongoing production. It also gives management time to re-evaluate future business prospects and current company procedures. There are negatives, however, including the prospect of negative press coverage or loss of investor confidence. Businesses also have to consider client relationships, employee pay, and any perishable resources.
Understanding the Shutdown Point
In managerial economics, a shutdown point is reached as soon as a business no longer has sufficient revenue to cover its variable costs. The essential idea is that the firm will actually save money — or rather, lose less — by shutting down production. This is not the same as going out of business, it is a temporary cessation of activity while assessing other options.
The shutdown point is the minimum price at which a producer would financially prefer to stop operations rather than continue. This isn't very different from a store deciding to close at 6 p.m. instead of 9 p.m. because it expects revenue will fall below the cost of keeping the store open an additional three hours.
- There are significant differences between shutting down and going out of business.
- One advantage of a shutdown is it is temporary.
- A temporary closure can result in negative press, which could hurt the business.
Marginal Revenue and Average Variable Costs
If the business only cares about making economically efficient decisions, it should cease production as soon as marginal revenue equals variable costs. Any units produced beyond this point result in a net loss and no longer help to recoup fixed costs or produce a profit.
Marginal revenue is the amount of net income a business receives from producing one additional good. Variable costs depend on production volume, such as the costs of raw materials or wages paid to certain workers. A variable cost is distinguished from a fixed cost, such as rent or insurance.
Suppose a firm incurs $12 worth of expenses when creating its product. It wouldn't make sense to churn out any units with a market value of $11 since the firm would lose $1 per unit. Instead, the firm can decide to close temporarily after its shutdown point and attempt to find a way to reduce its variable costs.
Not all businesses receive a lot of press attention, but consider the potential fallout if a large corporate brand like Nike or Purina decided to institute a temporary closure. Investors and customers would likely lose faith in the company, and it could reasonably be expected that sales would not resume at pre-closure levels once the doors reopened.
In an integrated, specialized and global business environment, a lot of professional relationships could be affected by a decision to temporarily stop operations.
Employees might have to be sent home for extended time periods. Vendors, distributors and other third parties would have to scramble to find new partners. In short, the decision probably incorporates long-term effects that aren't included in a limited cost-benefit analysis.
Some businesses may also have perishable inventory or other short-lived assets. The businesses would have to account for these assets before executing a temporary closure.
(For related reading, see "What Factors Go into Determining a Business's Shutdown Point?")