Question

LAST WORD If a firm's current revenues are less than its current variable costs, when should it shut down? If the firm decides to shut down, should we expect that decision to be final? Explain using an example that is not in the book.

Short answer

A firm should temporarily shut down if revenues are less than current variable costs, but this decision need not be final. For example, a seasonal ice cream shop might close in winter but reopen in summer.

Step-by-step solution

Understand Firm's Decision to Shut Down

When a firm's current revenues are less than its current variable costs, it means that for every unit produced, the firm loses money. This situation suggests that the firm is suffering a loss by continuing operations, as not even the variable costs are covered. Under these circumstances, the firm should consider shutting down temporarily to minimize its losses.

Consider Fixed Costs

Fixed costs, such as rent and salaries of permanent employees, will continue to accrue whether the firm operates or not. Therefore, if the firm shuts down, it will still have to pay these fixed costs but can avoid incurring additional variable costs related to production.

Temporary vs. Permanent Closure

The decision to shut down should be considered a temporary measure, often referred to as a 'shutdown point.' The firm should reassess its market conditions regularly to determine if it can reopen when the revenues cover the variable and possibly some fixed costs or when market conditions improve.

Real-world Example

Consider a seasonal ice cream shop which finds that during the winter months, the revenue from selling ice cream is less than the cost of ingredients, electricity for freezers, and wages for workers. The shop may choose to close during the winter to avoid these variable costs, but plans to reopen in the summer when sales will likely increase. Thus, the decision to close is not final but rather a strategic one to minimize losses.

Key concepts

Variable Costs

Variable costs are the expenses directly tied to the production of goods or services. They fluctuate based on the level of output. For example, the more units a firm produces, the higher the total variable costs will be. These can include expenses such as

• raw materials
• packaging
• hourly wages

Variable costs are essential for firms to consider because they impact profitability with each item produced. If the total income from sales doesn't meet or exceed these costs, the firm risks operating at a loss. In such cases, assessing these costs helps determine whether continuing operations is financially viable.

Fixed Costs

Fixed costs remain constant, regardless of how much a firm produces. They are expenses that a company incurs even if it doesn't manufacture any products. Examples of fixed costs include

• rent
• insurance
• salaries of permanent staff

These costs are unavoidable and do not fluctuate with production levels. When a firm considers shutting down, it can't avoid these fixed costs. The decision to stop production temporarily does not eliminate these expenses. Therefore, understanding fixed costs is crucial in analyzing whether or not to sustain operations during economic downturns or off-peak seasons.

Shutdown Point

The shutdown point is a critical concept for businesses facing financial difficulties. It occurs when a firm's revenue is no longer sufficient to cover its variable costs. At this juncture, continuing production results in losses for every additional unit produced.
Reaching the shutdown point suggests that a firm would minimize losses by halting operations temporarily rather than worsening its financial condition. This decision requires careful analysis of current and projected financial conditions to determine when shutting down might be the best course of action.
Recognizing the shutdown point helps businesses take strategic actions, such as reassessing operational efficiency or planning for reopening when economic conditions improve.

Temporary Closure

Temporary closure is not a permanent exit from the market. It is a strategy businesses adopt to avoid further financial loss when experiencing adverse conditions. Firms might choose this route if revenues fall below variable costs, but they anticipate conditions improving in the future.
During temporary closures, businesses maintain their fixed costs, such as rent and salaries, but avoid additional variable costs incurred in production. An example includes a ski lodge closing during the summer months when demand is low, with plans to reopen during the winter season when demand returns.
This approach allows firms to manage their resources effectively, preserving capital for more profitable times while ensuring the potential to resume operations once the market becomes favorable again.