Continue Operations or Shut Down

Continue Operations or Shut Down

Demand for products vary due to seasonal, cyclical

or random variations.
Shutdown Costs – costs incurred even after operations are
temporarily stopped.

Ex. Salaries of remaining executives and skeletal personnel

security, insurance, rental, interests, depreciation, property taxes,
advertising, and similar unavoidable costs
Shutdown Costs – costs incurred even after operations are
temporarily stopped.

Ex. Salaries of remaining executives and skeletal personnel

security, insurance, rental, interests, depreciation, property taxes,
advertising, and similar unavoidable costs

Incur Restart-up Costs once it resumes its operations.

Includes: cost of rehiring and retraining personnel,

refueling, aligning, and retuning machineries and equipment,
and refurbishing the plant.
 Loss from continuing = loss from discounting

Where: Loss from continuing = (CM – FC)

Loss from discounting = (0-Shutdown costs)
 Loss from continuing = loss from discounting

Where: Loss from continuing = (CM – FC)

Loss from discounting = (0-Shutdown costs)

Where:
(CM – FC) = (0-SDC)
QS (UCM) – FC = (0-SDC) CM = Contribution Margin
QS (UCM) = FC – SDC FC = Fixed Costs
SDC = Shutdown costs
Therefore: UCM = Unit contribution margin
QS = Quantity sold

QS = FC – SDC
UCM
Sample Problem 9.6

FAT Company produces and sells 40,000 units monthly except for the months of July and
August when the number of units sold normally decline to 10,000 units per month.
Management contemplates of temporarily shutting down operations in the months of July
and August with the belief that the business will be spared of more losses during the period.

If the business temporarily shuts down, security and maintenance amounting to P220,000 per
month would still be incurred. Restarting the operations will cost the business P300,000 for
mobilization and other costs.

The business incurs a total of P24 million annual fixed costs allocated evenly over a 12-month
period. This fixed cost is expected to drop by 60% during the months the operations are shut
down.

Other data:
Unit sales price P300
Unit variable production costs 140
Unit variable expenses 40
Requirements:

1. How much is the total shutdown cost?

2. What is the shutdown point?
3. Should the business continue or shut down?
Solutions

1.
Allocated fixed costs (P24M x 2/12 x 40%) P 1,600,000
Security and insurance (P220,000 x 2 months) 400,000
Restart-up cost 300,000
Shutdown cost P 2,340,000
Solutions

1.
Allocated fixed costs (P24M x 2/12 x 40%) P 1,600,000
Security and insurance (P220,000 x 2 months) 400,000
Restart-up cost 300,000
Shutdown cost P 2,340,000

2.
To prove:
Shutdown point = Fixed costs – Shutdown costs
Unit contribution margin CM (13,833.33 x P120) P 1,660,000
Less: Fixed costs and expenses 4,000,000
= P4,000,000 – P2,340,000 Loss from continuing operations 2,340,000
120 Shutdown costs P 2,340,000

= 13,833.33 units Shutdown point is where the loss from continuing

equals the shutdown costs.
3. Continue or Shutdown?

Contribution Margin (10,000 units x 2 mos. X P120) P 2,400,000

Less: Fixed costs and expenses 4,000,000
Loss from continuing the operations (1,600,000)
Less: Shutdown costs (2,340,000)
Advantage of continuing operations P 740,000

Alternatively, the P740,000 may be computed as follows.

[(20,000-13,833) x P120]
Bid Price Maximize or Minimize?
Seller = Minimum Bid Price

Buyer = Maximum Bid Price

 Seller = Minimum Bid Price

Buyer = Maximum Bid Price

Minimum bid price = Incremental costs + Opportunity costs - Savings

Sample Problem 9.7

Continental Systems, Inc., manufactures truck engines for industrial users. The cost of a
particular jet engine the company manufactures is shown below:
Direct materials P 300,000
Direct labor 190,000
Overhead:
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Depreciation 50,000
Rent 10,000
Total Costs P 609,000

If production of the engine were discontinued, the production capacity would be idle and the
supervisor would be laid off. When asked to bid on the next contract for this engine, what
should be the minimum bid price?
Solution:

• Minimum bid price should be equal to the incremental cost of manufacturing

Direct materials P 300,000
Direct labor 190,000
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Incremental costs/Minimum Price P 549,000
Solution:

• Minimum bid price should be equal to the incremental cost of manufacturing

Direct materials P 300,000
Direct labor 190,000
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Incremental costs/Minimum Price P 549,000

• The depreciation and rent expense are unavoidable costs whether the contract is obtained
or not. They are constant regardless of alternatives, they are therefore irrelevant.
Sample Problem 9.8

Frank Dean Company has its own cafeteria with the following annual costs:
Food P 2,300,000
Labor 820,000
Overhead 550,000
Total P 3,670,000

The overhead is 30% fixed. Of the overhead, P72,000 go to the salary of the cafeteria
supervisor. The remainder of the fixed overhead has been allocated from total company
overhead. Assuming the cafeteria supervisor remains and that Frank Dean continues to pay
the supervisor’s salary, what is the maximum cost Frank Dean would be willing to pay an
outside firm to service the cafeteria?
Solution:

• The incremental cost of operating the cafeteria is the maximum price that the company
should be willing to pay an outside canteen operator.
Food P 2,300,000
Labor 820,000
Variable overhead 385,000
Incremental costs/Maximum price P 3,505,000
Solution:

• The incremental cost of operating the cafeteria is the maximum price that the company
should be willing to pay an outside canteen operator.
Food P 2,300,000
Labor 820,000
Variable overhead 385,000
Incremental costs/Maximum price P 3,505,000

• The salary of the cafeteria supervisor and the remaining fixed overhead is irrelevant.