A shutdown point is a concept in managerial economics that suggests that a business should at least temporarily stop production and close its doors because it is no longer profitable to sustain operations.

This theory arose from neoclassical models of perfect competition. Based on these models, a firm should never produce when it cannot cover all production and distribution costs in the long run.

In the short run, a firm’s willingness to produce should continue to the point where the marginal cost curve is no longer above average variable costs. The supply curve in a short-run perfect equilibrium model is the marginal cost curve above the average variable cost curve.

Determining the point of closing a business

Three main factors help determine the point of closing a business:

1. How much variable costs are involved in producing a good or service
2. The marginal revenue received from the production of that good or service
3. The types of goods or services provided by the company

For a single-product firm, stopping point occurs whenever marginal revenue falls below marginal variable cost. For a multiproduct firm, shutdown occurs when average marginal revenue falls below average variable costs.

A firm could reach the shutdown point for reasons ranging from standard diminishing marginal returns to falling market prices for its goods.

Under the perfect competition model, producers have a complete understanding of their marginal costs, future revenues, and opportunity costs. If the marginal variable cost of producing the 10,005th widget is $12, but the firm can only sell it for $11, then the firm is better off not producing more than the 10,004th widget until the market price rises or variable costs decrease.

Businesses do not have perfect information in the real world. A good company cost accounting can approximate average total cost of production and projected marginal costs.

The approach for multi-product firms

Perfect competition models show companies that produce only one type of product, and that product is indistinguishable from competitors’ products.

However, most manufacturers offer more than one good or service. Even if marginal revenue falls below variable costs for a product, the firm could still generate a product through the other offerings.

For the multiproduct firm, production can continue as long as average marginal revenue from its various products exceeds average variable costs. Even then, a shutdown must not occur, as only one product may need to be discontinued to regain profitability.

Impact of a shutdown

If prices and production were the only important factors, closing price theory might work as advertised. Unfortunately, a business has many more variables to consider.

For example, a temporary shutdown could have disastrous consequences for any professional relationships the business has built up. Its employees may be sent home without continued pay. Vendors, distributors and other third party partners may have to interrupt their normal business processes. For publicly traded companies, investor confidence would also likely be affected. All firms must practice well relationship management.

conclusion

The shutdown point is when a business can no longer cover its variable costs, making it unprofitable to continue operations temporarily. For single-product firms, shutdown occurs when marginal revenue falls below variable costs, while multi-product firms might continue if other products make up for the losses. Despite the financial rationale, the shutdown can strain relationships with employees, suppliers and investors.