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.

The marginal cost of production measures the change in the total cost of a good that arises from
producing one additional unit of that good. The marginal cost (MC) is calculated by dividing the
change (Δ) in the total cost (C) by the change in quantity (Q). Using calculus, the marginal cost is
calculated by taking the first derivative of the total cost function with respect to the quantity:

MC = ΔC/ΔQ

As an example, if a company that makes 150 widgets has production costs for all 150 units it
produces. The marginal cost of production is the cost of producing one additional unit. For example,
say the total cost of producing 100 units of a good is $200. The total cost of producing 101 units is
$204. The average cost of producing 100 units is $2, or $200 ÷ 100. However, the marginal cost for
producing unit 101 is $4, or ($204 - $200) ÷ (101-100).

The marginal costs of production may change as production capacity changes. If, for example,
increasing production from 200 to 201 units per day requires a small business to purchase
additional business equipment, then the marginal cost of production may be very high. However,
this expense may be significantly lower if the business is considering an increase from 150 to 151
units using existing equipment.

A lower marginal cost of production means that the business is operating with lower fixed costs at a
particular production volume. If the marginal cost of production is high, then the cost of increasing
production volume is also high and increasing production may not be in the business's best
interests.

The marginal revenue is calculated by dividing the change in the total revenue by the change in the
quantity. In calculus terms, the marginal revenue (MR) is the first derivative of the total revenue
(TR) function with respect to the quantity:

MR = ΔTR/ΔQ

For example, suppose the price of a product is $10 and a company produces 20 units per day. The
total revenue is calculated by multiplying the price by the quantity produced. In this case, the total
revenue is $200, or $10 x 20. The total revenue from producing 21 units is $205. The marginal
revenue is calculated as $5, or ($205 - $200) ÷ (21-20).

When marginal revenue and the marginal cost of production are equal, profit is maximized at that
level of output and price:
For example, a toy company can sell 15 toys at $10 each. However, if the company sells 16 units, the
selling price falls to $9.50 each. The marginal revenue is $2, or ((16 x 9.50) - (15 x10)) ÷ (16-15).
Suppose the marginal cost is $2.00; the company maximizes its profit at this point because the
marginal revenue is equal to its marginal cost.

When marginal revenue is less than the marginal cost of production, a company is producing too
much and should decrease its quantity supplied until marginal revenue equals the marginal cost of
production. When the marginal revenue is greater than the marginal cost, the firm is not producing
enough goods and should increase its output until profit is maximized.

The Shutdown Rule

The shutdown point denotes the exact moment when a company’s (marginal) revenue is equal to
its variable (marginal) costs—in other words, it occurs when the marginal profit becomes negative.

In the short run, a firm that is operating at a loss (where the revenue is less that the total cost or the
price is less than the unit cost) must decide to operate or temporarily shutdown. The shutdown
rule states that “in the short run a firm should continue to operate if price exceeds average variable
costs.

When determining whether to shutdown a firm has to compare the total revenue to the total
variable costs. If the revenue the firm is making is greater than the variable cost (R>VC) then the
firm is covering it’s variable costs and there is additional revenue to partially or entirely cover the
fixed costs. One the other hand, if the variable cost is greater than the revenue being made (VC>R)
then the firm is not even covering production costs and it should be shutdown immediately.

The contribution margin is computed as the selling price per unit, minus the variable cost per unit.
Also known as dollar contribution per unit, the measure indicates how a particular product
contributes to the overall profit of the company. It provides one way to show the profit potential of
a particular product offered by a company and shows the portion of sales that helps to cover the
company's fixed costs. Any remaining revenue left after covering fixed costs is the profit generated.

The contribution margin is computed as the difference between the sale price of a product and the
variable costs associated with its production and sales process.

\text{Contribution Margin}=\text{Sales Revenue }-\text{ Variable Costs}Contribution

Margin=Sales Revenue − Variable Costs

The above formula is also used as a ratio, to arrive at an answer in percentage terms, as follows:

Qualitative factors
A decision to discontinue a business operation should not be based entirely on its short-term
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.
The following factors must be taken into account when considering shutdown problems.
Strategic fit
Does the location, product, or customer have any strategic significance to the business that
outweighs any short-term losses?

Customer relations
Discontinuing a product line may cause an adverse reaction from customers (e.g., discontinuation
of spare parts).

Supplier relations
Relationship with suppliers may suffer if a product line is dropped, causing loss of goodwill.

Employee relations
Shutting down may cause redundancies, which could hurt staff morale.

Loss leader
Certain products are not profitable on their own, but they may help generate sales for other
products that are more profitable.

Timing of shutdown
If a shutdown is inevitable, the timing of the move should be considered carefully to minimize the
potential losses.