Shutdown Analysis

#cfa #cfa-level-1 #economics #reading-15-demand-and-supply-analysis-the-firm #section-3-analysis-of-revenue-costs-and-profit

For the most recent financial reporting period, a business domiciled in Ecuador (which recognizes the US dollar as an official currency) has revenue of $2 million and total costs of $2.5 million, which are or can be broken down into total fixed cost of $1 million and total variable cost of $1.5 million. The net loss on the firm’s income statement is reported as $500,000 (ignoring tax implications). In prior periods, the firm had reported profits on its operations.

  1. What decision should the firm make regarding operations over the short term?

  2. What decision should the firm make regarding operations over the long term?

  3. Assume the same business scenario except that revenue is now $1.3 million, which creates a net loss of $1.2 million. What decision should the firm make regarding operations in this case?

Solution to 1:

In the short run, the firm is able to cover all of its total variable cost but only half of its $1 million in total fixed cost. If the business ceases to operate, its loss is $1 million, the amount of total fixed cost, whereas the net loss by operating is minimized at $500,000. The firm should attempt to operate by negotiating special arrangements with creditors to buy time to return operations back to profitability.

Solution to 2:

If the revenue shortfall is expected to persist over time, the firm should cease operations, liquidate assets, and pay debts to the extent possible. Any residual for shareholders would decrease the longer the firm is allowed to operate unprofitably.

Solution to 3:

The firm would minimize loss at $1 million of total fixed cost by shutting down compared with continuing to do business where the loss is $1.2 million. Shareholders will save $200,000 in equity value by pursuing this option. Unquestionably, the business will have a rather short life expectancy if this loss situation were to continue.


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