Shut down point : a logical explanation

Rahul Soni (Chartered Accountant) (48 Points)

07 May 2015  

Hello Friends.. Understanding the topic of Shut Down point logically in the chapter of DECISION MAKING was always a difficulty for me. So I want to share the explanation for the same in logical manner for those who are facing the same difficulty. Those who know this already PLESE DO CORRECT ME IF I AM WRONG AT ANY POINT SINCE I HAVE LEARNT IT IN MY WAY.. I would appreciate your efforts..

 So let's begin....

First of all let us start with the understanding of the name itself i.e. Shut Down Point.

Shut Down Point is that point of manufacturing (in terms of number of units) from where it is economical to discontinue the business. Shut Down may be of 2 types i.e. Permanently Shut Down or Temporary Shut Down.. Here we are talking about Permanently Shut Down.  Generally the decision to shut down the business/unit is taken in the extreme cases only where the company is incurring continuous losses from the past several years. No one would like to shut down its profitable business. And even if he/she wants to then the shut down point will be the point of BEP (Break Even Point) i.e. the situation where there is No profit or No loss.  

Now since the business/unit is incurring losses the owner must take decision on whether to continue for the business or to shut it down. Both the options need to be evaluated from the data of given facts. It is to be noted that the answer of both the evaluation will be resulted into loss only, because that is the reason why we are considering the decision of shut down. So the decision will be in favour of that option which gives lower loss that is obvious.

Now considering the costs you may be given that certain fixed costs may be avoided due to shut down; those are considered as Avoidable Fixed Costs. Certain fixed costs can’t be avoided even if you shut down the business; those are termed as Unavoidable Fixed Costs. And there may be certain costs which are exclusively incurred for the purpose of shut down, those are termed as Shut Down Costs. In the evaluation of option of Shut Down Consideration as mentioned in the last paragraph the loss resulted will generally be consist of these 2 costs only i.e. of Unavoidable Fixed Costs and Shut Down Costs.

Now let us understand the Shut down point calculation by way of example:

Fixed Costs if Business Continue: ` 80,000

Fixed Costs if Business is Shut Down (Unavoidable): ` 33,000

Contribution per Unit = ` 7

Shut Down Costs: ` 12,000

Loss if Business Continue (After considering above F.C and Contribution): ` 66,000

Loss if Business Shut Down: ` 45,000 (33000+12000)

(Facts given directly from answer of the Illustration from Study Material as my explanation is relevant to answer only)


                                                             Avoidable Fixed Cost

Now formula of Shut Down Point =  ------------------------------------

(Given in Practice Manual)                   Contribution per Unit


Recall the logic of the formula of BEP (Units) i.e. Fixed Costs/Contribution per unit. How many units we have to sell to recover the amount of fixed costs at the rate of contribution. It means fixed costs are to be recovered at the rate of contribution per unit. Now here also the same logic applies but in a bit different way.


In a shut down decision we have to consider the recovery of avoidable fixed costs which can be avoided if we shut down the operations. In the above given example the avoidable fixed costs are ` 47,000 (80,000-33,000). This ` 47,000 is savings in Fixed Costs due to shut down of business. But there is an additional cost of ` 12,000 which is shut down cost and which is resulted only due to the shut down of business. Therefore this shut down costs reduces our savings by ` 12,000 which leads to our net savings of Fixed Costs is `35,000 i.e. (47000-12000). [BENEFIT OF `47,000 BUT COST AGAINST IT `12,000]


Now these 35000 are the fixed costs which can be recovered by us by way of sell of units in the market resulting into contribution of ` 7 as given in the above facts. So in the same way as BEP we have to now decide that by selling how many units we can recover the amount of remaining fixed costs that is avoidable. Therefore the shut down point will be `35000/`7= 5000 Units. So at the production of 5000 Units it would be economical to shut down the business and our avoidable fixed costs are also be recovered.


Feel free to ask anything regarding this explanation. Reply if u find it helpful. Happy Reading.. smiley