How is the shutdown point of a business determined?

A shutdown point is a concept in managerial economics that suggests a business should at least temporarily stop production and close its doors because it's no longer profitable to sustain operations.

This theory grew out of the neoclassical models of perfect competition. Based on these models, a firm should never produce whenever it cannot cover all of its production and distribution costs in the long run. In the short run, a firm's willingness to produce should continue up until the point where its marginal cost curve is no longer above average variable costs. The supply curve in a short-run perfect equilibrium model is the marginal cost curve above the average variable cost curve.

There are three main factors that help determine the shutdown point of a business:

1. How much variable cost goes into producing a good or service
2. The marginal revenue received from producing that good or service
3. The types of goods or services provided by the firm

For a one-product firm, the shutdown point occurs whenever the marginal revenue drops below marginal variable costs. For a multi-product firm, shutdown occurs when average marginal revenue drops below average variable costs.

A firm might reach its shutdown point for reasons that range from standard diminishing marginal returns to declining market prices for its merchandise.

Under the perfect competition model, producers have a full understanding of their marginal expenditures, future revenues and opportunity costs. If the marginal variable cost of producing the 10,005th widget is $12 but the firm can only sell it for $11, then the firm is better off not producing past the 10,004th widget until the market price goes up or variable costs decline.

Obviously, businesses do not have perfect information in the real world. A firm with good cost accounting can approximate its average total cost of production and its projected marginal costs.

Perfect competition models show businesses that only produce one kind of product, and that product is indistinguishable from competitors' products.

Most producers offer more than one good or service, though. Even if marginal revenue drops below variable costs for one product, the firm might still generate a product through its other offerings.

For the multi-product firm, production can continue as long as the average marginal revenue from its various products exceeds average variable costs. Even then, a shutdown does not need to occur, since it is possible that only one product needs to be discontinued to regain profitability.

If prices and output were the only important factors, the shutdown price theory might work as advertised. Unfortunately, a business has a lot more variables to consider.

For instance, a temporary shutdown could have disastrous consequences for any professional relationships the business has forged. Its employees might need to be sent home without ongoing pay. Its vendors, distributors and other third-party partners might need to interrupt their normal business processes. For publicly traded companies, investor confidence would likely take a hit as well. All firms have to practice good relationship management.