The management of the company may face a problem of dropping/shutdown or continuing the manufacturing and marketing facilities. It is always in the interest of company to continue to operate facilities as long as products or services sold to recover variable cost and make a contribution toward recovery of fixed cost.But the problem of drop or continue arise when the income statement regarding the product shows a loss. Then management of the company attempts to find out the reasons for loss and makes decision regarding drop or continue the manufacturing and marketing facilities.
In deciding whether to continue or drop, expected future revenue should be compared with the relevant cost. For this, the relevant cost must be separated into variable/avoidable and fixed/unavoidable cost. Certain cost- fixed cost- does not eliminate by dropping facilities, like depreciation, interest, property tax and insurance. These costs continue during complete inactivity also.
If operations are continued, certain expenditure connected with shutting down will be saved. Such expenditure includes reopening cost.expenses, cost for recruiting and training to new workers etc.
For taking decision to drop or continue the facilities, income statement should be prepared under contribution margin format. Income statements for drop or continue facilities will show:
- Contribution margin
- Net profit and,
- Percentage of net income to net sales
Alternative which has higher contribution margin should be chosen as it will absorb the fixed cost and gives higher profit. Facilities with high amount of fixed cost cannot be dropped as the fixed cost is irrelevant cost and fixed cost will not decrease by dropping the particular facilities.
Fixed cost imposed by dropping the facilities will have to be paid cumulatively in total resulting extra burden of fixed cost to continuing facilities and thereby reduced overall profit of the company.
So, the decision of dropping or continuing the facilities should be judged on the basis of overall company profit.
