Say you are the manager of a perfectly competitive firm selling a product. Your
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Question
Say you are the manager of a perfectly competitive firm selling a product. Your business is making a loss because total revenue is less than total costs. What would you do--shut down or continue to operate? Use hypothetical numbers to explain. Information you need to provide include--state the product you are selling, the price of the product, the quantity of the product you produce, fixed costs, total cost, figure out total revenue, total and average variable costs. Then go ahead and make your decision. Explain carefully why it makes better sense to shut down rather than continue to operate or to continue to operate rather than shut down, as the case may be. How do fixed costs play a role in your analysis? What is the difference between shutting down and going out of business?Explanation / Answer
'Break-even point' and 'shut-down point' appear to sound as similar concepts, but these are concepts from two different topics. Break-even point is a concept for companies to take business decision based on relationship between product cost, price and volume. The concept of competition has no role to play in break-even analysis. Concept of shut-down point is from the field of economics. It is used to understanding the way companies decide on the level of their sales and production volume taking into consideration between production cost, sales price and customer demand under competitive conditions. Break-even Point Break-even point is defined the level of production and sales of product by a firm at which the sales revenue generated is exactly equal to the cost of production. The term break-even is used to mean that the company makes no profit and on loss - it breaks even. Typically the production cost for any product can be be divided in two components, a fixed cost component and a variable cost components. The same fixed cost is incurred by the company irrespective of the level of production. For example if a production facility is set up some costs will be incurred for the things like rent, depreciation and interest charges which are fixed for a period irrespective of production volume. The variable cost is directly proportional to the volume of production, and is incurred on things like raw material used, piece rate wages paid and other expenses related directly to the production. The company must typically fix a selling price that is more than the variable cost per piece. Unless this is so, more a company produces, more losses it will make. The excess of selling price over the variable cost is called "contribution to fixed cost and profits" or simply contribution. This total amount of contribution can be represented bu the following equation. Total contribution = Quantity x (Selling price - variable cost) And profit of the company = Total contribution - fixed cost At zero volume the company, the contribution is zero, and the company makes a loss equal to the fixed cost. AS the sales increases the contribution increase in direct proportion. As one point of sales volume called break-even point the contribution is exactly equal to fixed cost. At this point company makes no profit and no loss. Company makes losses below the break-even point, and profit above this point. The break-even analysis is generally used by the companies to take decision on new investments. Shut-down Point Shut-down point is the minimum market price at which a company would prefer to close down its operation rather than manufacture anything. In determining the shut-down price it is assumed that the variable cost per unit decreases with increasing volume up to a point. After this the the variable cost rises. As a result when a curve of quantity on x-axis and and average variable cost on y-axis is drawn it is a u-shaped curve. The shut down point for the company is the lowest point on this curve. The concept of shut-down point is used to understand and analyse and understand the way companies take decision on the product level under competitive conditions. It is not used by the companies themselves for their decision making. EX; lets call this the home market Sales of homes are 50,000 40,000 60,000 150,000 Variable costs are 30,000 25,000 35,000 90,000 Contribution 20,000 15,000 25,000 60,000 Fixed costs 17,000 18,000 20,000 55,000 Profit/loss 3,000 (3,000) 5,000 5,000 The company is concerned about its poor profit performance, and is considering whether or not to cease selling Cretes. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. Rs. 5,000 of the fixed costs of Cretes are attributable fixed costs which would be saved if production ceased. All other fixed costs would remain the same. Solution: a. By stopping production of Homes, the consequences would be 10,000 fall in profits. Loss of contribution (15,000) Savings in fixed costs 5,000 Incremental loss (10,000) b. Suppose, however, it were possible to use the resources realized by stopping production of Homes and switch to producing a new item,Boats, which would sell for 50,000 and incur variable costs of 30,000 and extra direct fixed costs of 6,000. A new decision is now required.