What Is Shutdown Point?
A shutdown point is a level of operations at which a company experiences no benefit for continuing operations and therefore decides to shut down temporarily (or in some cases permanently). It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs. The shutdown point denotes the exact moment when a company’s (marginal) revenue is equal to its variable (marginal) costs - in other words, it occurs when the marginal profit becomes negative.
At this point, there is no economic benefit to continuing production. If an additional loss occurs, either through a rise in variable costs or a fall in revenue, the cost of operating will outweigh the revenue. At that point, shutting down operations is more practical than continuing, even if the company continues to experience losses in other areas, such as fixed costs. If the reverse occurs, continuing production is more practical.
If a company can produce revenues greater or equal to its total variable costs, it can use the additional revenues to pay down its fixed costs, assuming fixed costs, such as lease contracts or other lengthy obligations, will still be incurred when the firm shuts down. When a company can earn a positive contribution margin, it should remain in operations despite an overall marginal loss.
Understanding Shutdown Point
The shutdown point does not include an analysis of fixed costs in its determination. It is based entirely on determining at what point the marginal costs associated with operation exceed the revenue being generated by those operations.
Certain seasonal businesses, such as Christmas tree farmers, may shut down almost entirely during the off-season. While fixed costs remain during the shutdown, variable costs can be eliminated.
[Important: A shutdown point can apply to all of the operations a business participates in or just a portion of its operations.]
Other businesses may experience fluctuations or produce some goods year-round, while others are only produced seasonally. For example, Cadbury chocolate bars are produced year-round, while Cadbury Cream Eggs are considered a seasonal product. The main operations, focused on the chocolate bars, may remain operational year-round while the cream egg operations may go through periods of shutdown during the off-season.
The length of a shutdown may be temporary or permanent, depending on the nature of the economic conditions leading to the shutdown. For non-seasonal goods, an economic recession may reduce demand from consumers, forcing a temporary shutdown (in full or in part) until the economy recovers. Other times, demand dries up completely due to changing consumer preferences or technological change. For instance, nobody produces cathode-ray tube (CRT) televisions or computer monitors any longer, and it would be a losing prospect to open a factory these days to produce them.
Fixed costs are the costs that remain regardless of what operations are taking place. This can include payments to maintain the rights to the facility, such as rent or mortgage payments, along with any minimum utilities that must be maintained. Minimum staffing costs are considered fixed if a certain number of employees must be maintained even when operations cease.
Variable costs are more closely tied to actual operations. This can include but is not limited to, employee wages for those whose positions are tied directly to production, certain utility costs or the cost of the materials required for production.
- A shutdown point is a level of operations at which a company experiences no benefit for continuing operations and therefore decides to shut down temporarily (or in some cases permanently).
- A shutdown point results from the combination of output and price where the company earns just enough revenue to cover its total variable costs.
- Shutdown point is based entirely on determining at what point the marginal costs associated with operation exceed the revenue being generated by those operations.