Middleton Steel Company is considering whether to temporarily close one of its m
ID: 1188859 • Letter: M
Question
Middleton Steel Company is considering whether to temporarily close one of its manufacturing plants. If it does close the plant, it faces the costs of shutting down and then starting back up, the costs of criticism from the city in which the plant is located, and the costs of customer abandonment as some customers purchase products elsewhere. If it does not close the plant, it will experience substantial losses because revenues will not cover variable costs
a. what would a net present value analysis say about the decision?
b. What other strategies might be used?
Explanation / Answer
(a) The NPV analysis will find the sum of discounted present value of all explicit costs and benefits, and then if the NPV is less than zero, will suggest the temporary shutdown as the best choice of action. If NPV > 0, the criterion will suggest continuation of the plant.
(b) However, the NPV method only uses the explicit costs relevant for the analysis, but neither the implicit costs, nor the costs of externalities. Here, we can identify 3 implicit costs and externalities:
1. Cost of shutdown and future re-start, which is an estimated future expense whose likelihood or magnitude being uncertain currently, will be ignored by NPV analysis.
2. Cost of resident criticism will decrease the company's brand valuation in market, an implicit cost that has negative externality (for example, unemployment in the city caused by this shutdown decision) will be ignored by NPV analysis, and finally
3. The future customer value lost by losing customers who will switch to other brands, which, being an opportunity cost, will be ignored by NPV analysis.
Therefore, an alternative measure could be by Social Cost-Benefit analysis where these 3 social costs of shutdown will be included as Social Cost, and then the cost-benefit analysis will be undertaken.