Breakeven and Shutdown Analysis | CFA Level I Economics
Welcome back as we dive into the economics perspective regarding breakeven and shutdown conditions for a firm. Let’s continue with the management of your cafe and analyze its costs and revenue.
Costs can be categorized into two main types:
- Fixed costs – These costs remain the same in the short run, regardless of the output. For example, if you signed an agreement to rent a space for $50 per day for a year, this would be a fixed cost.
- Variable costs – These costs change according to the level of production. For instance, labor costs are variable costs, assuming you can hire and fire workers without delay.
By plotting the average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) against the quantity produced, we can observe how these costs behave with changes in production levels.
Revenue and Market Conditions
To understand revenue, we must consider the competitive market in which the firm operates. For a firm in a perfectly competitive market, it is a price taker, meaning it has a perfectly elastic demand curve. In this case, marginal revenue (MR) equals average revenue (AR), which equals the market price.
Let’s say all your competitors sell coffee at $2.50 per cup, you have to sell your coffee at $2.50 too under perfect competition. For every additional cup you sell, you earn $2.50 more, so your marginal revenue is $2.50, and average revenue per cup is also $2.50.
Profit Maximization, Breakeven, and Shutdown Conditions
Under perfect competition, the profit-maximizing point is where the marginal revenue (MR) equals the marginal cost (MC). This is because you want to increase production as long as the revenue from an additional unit is greater than the cost to produce it.
If the market price is above the breakeven level (where ATC equals MC), the firm makes a profit. If the market price is below this level but above the shutdown level (where AVC equals MC), the firm makes a loss but should continue to operate in the short run to minimize fixed costs. If the market price is below the shutdown level, the firm should shut down in both the short and long run.
Imperfect Competition: The Monopolist Example
For a monopolist, the demand curve is downward sloping. The profit-maximizing output is where the marginal cost (MC) equals the marginal revenue (MR). To determine if the firm is making a profit, compare the average revenue (AR) with the average total cost (ATC).
If the demand is so low that it goes below the AVC curve, the firm should shut down in both the short and long run. Otherwise, if it is above the AVC but below the ATC, the firm should continue to operate in the short run but consider shutting down in the long run if conditions don’t improve.
Applying Breakeven and Shutdown Analysis to Real-World Scenarios
Now that we’ve covered the basics of breakeven and shutdown analysis, let’s see how these concepts can be applied to various business scenarios.
Seasonal businesses, such as ice cream stands or ski resorts, often face fluctuating demand throughout the year. In this case, it’s crucial to determine the breakeven point and make informed decisions on whether to continue operations or shut down temporarily during low-demand periods.
Start-ups and New Ventures
Start-ups and new business ventures must closely monitor their breakeven point and shutdown conditions, as they often have limited resources and face significant competition. By identifying the breakeven point, these businesses can set realistic goals and make strategic decisions about pricing, production, and marketing to achieve profitability more quickly.
Businesses Facing Economic Downturns
During economic downturns, businesses may experience decreased demand for their products or services. By assessing their breakeven and shutdown points, these companies can make informed decisions about whether to continue operations, pivot their business model, or temporarily shut down to minimize losses.
Manufacturers and Production Facilities
Manufacturers and production facilities can also benefit from breakeven and shutdown analysis. Understanding the relationship between fixed costs, variable costs, and revenue enables them to optimize their production processes to minimize costs and maximize profits.
Scooby is an E-scooter manufacturer with a demand function of Q = 10,000 – 12P. The firm has a fixed cost of $1 million per year. Scooby sells each E-scooter at $500, and at this level of production, the total variable cost is $1.08 million. Determine if Scooby should continue operating if it wants to continue selling E-scooters at $500 each.
First, let’s calculate the quantity of demand at a price of $500:
Q = 10,000 – 12(500) = 4,000 units
Now, let’s calculate total revenue and total cost:
Since the total cost is higher than the total revenue, Scooby is running at a loss and should shut down in the long run. However, as the revenue is higher than the total variable cost, the firm should still continue operating in the short run to minimize losses from fixed costs.
EXAMPLE (Part 2)
Scooby engaged a consultant, who advised that the average variable cost per unit could be reduced to $200 per scooter if the production level is increased to 5,200 units. Determine if Scooby should increase production, and what effect this would have on its shutdown decisions.
Let’s find the price that enables Scooby to sell 5,200 units:
5,200 = 10,000 – 12P
P = $400
The average revenue per scooter is now $400. Let’s calculate the average fixed and total costs:
Since the average total cost per unit ($392) is lower than the average revenue of $400, the firm makes a profit of $8 per unit. So, both in the short and long run, if Scooby can increase output to produce more at a lower cost, the company can make a profit and avoid a shutdown.