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Very often it becomes necessary for a firm to temporarily close down the factory due to trade recession with a view to reopening it in the future. In such cases, the decision should be based on the marginal cost analysis. If the products are making a contribution towards fixed expenses or in other words if selling price is above the marginal cost, it is preferable to continue because the losses are minimized. By suspending the manufacture, certain fixed expenses can be avoided and certain extra fixed expenses may be incurred depending up on the nature of the industry, say, for example, extra cost incurred in protecting the machinery.
So the decision is based on as to whether the contribution is more than the difference between the fixed expenses incurred in normal operation and the fixed expenses incurred when the plant is shut down. In other words, the shut down point is calculated by using the formula:
Decision Making in Relation to Shut Down
1. Shut down point = {(Total fixed cost – Shut down costs) ÷ Contribution per unit} Decision Making in Relation to Shut Down Vs. Continue
In case of decision rendering closure or shut down we consider the following points:
1. Current profit situation has to be maintained, So by analyzing the proposal of shut down or outsourcing if the current income is reduced then shut down will not be allowed unless the product or factory has reached at the end of its life cycle.
2. In case of outsourcing proposal we can also apply the differential cost concept i.e. saving in cost must be greater than or equal to out-sourcing fees payment. Here saving in cost i.e. cash inflow is computed from the concept of relevant cost i.e. by closing down we are saving variable cost of production, and discretionary fixed cost or shut down cost.
This cash inflow further may be classified into two parts:
1. Saving in variable cost per time period i.e. CIF per annum.
2. One time cash inflow following shut down i.e. sale of machine, sale of current stock of material etc.
1. Saving in variable cost per time period i.e. CIF per annum.
2. One time cash inflow following shut down i.e. sale of machine, sale of current stock of material etc.
Thus, Total CIF or saving following shut down = one time CIF + CIF p.a. × life span of the proposal of outsourcing.
If this total is greater than total outsourcing fees then shutdown will take place other production will be continue.
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