Strategic Cost Management · Decisions involving Alternative Choices

Shut Down or Continue Decisions in Cost Accounting

Updated 11 October 2026 · Fact-checked

A shut down or continue decision compares what the firm loses by closing a product, department or plant with what it saves. Continue if the unit's contribution is more than the avoidable (traceable) fixed costs. Shut down if it is less, after adding any lost contribution elsewhere and closure costs.

Understand Shut Down or Continue Decisions

A unit that shows a book loss is not always worth closing. The loss often includes fixed costs that are allocated from head office. Those costs continue even if the unit closes, so closing it does not remove them.

The decision therefore rests on relevant costs. A cost is relevant only if it changes because of the decision. Variable costs and avoidable fixed costs (such as the supervisor's salary or rent of a separate shed that you can stop paying) are relevant. Unavoidable fixed costs (such as allocated head office cost or depreciation of a building you cannot sell) are not.

The core test is simple. A unit earns contribution (sales minus variable cost). That contribution first pays the avoidable fixed costs of the unit. Anything left covers common fixed costs. If contribution exceeds avoidable fixed costs, the unit adds to the firm's profit, even when its reported net result is a loss. If it is less, closing the unit raises overall profit.

In the short run, a firm should keep operating while the price covers variable cost (and avoidable fixed cost, if the unit is to be kept open for the period). This is the shutdown point idea: the lowest level at which losses from operating are no worse than losses from closing.

Then widen the view. Check for effects on other products (a dropped product may reduce sales of others), the sale value of idle assets or released space, closure costs such as severance, and qualitative factors such as customer relationships, employee morale and capacity that is hard to rebuild.

Key rules to remember

Contribution: Contribution = Sales − Variable cost; Variable cost includes variable selling and distribution cost, not just production cost.
Continue/shut rule: Continue if Contribution > Avoidable fixed costs; shut if Contribution < Avoidable fixed costs; If equal, the firm is indifferent on financial grounds; qualitative factors decide.
Net advantage of continuing: Advantage of continuing = Contribution − Avoidable fixed costs (+ contribution gained on other products − closure costs avoided, where relevant); Include only items that change because of the decision.
Alternative use of capacity: Shut only if Benefit of alternative use (or rent/sale proceeds) > Contribution − Avoidable fixed costs of the unit; Use this when freed space or capacity can earn income.
Short-run shutdown point: Operate while Selling price per unit ≥ Variable cost per unit (plus avoidable fixed cost per unit if it is to be saved by closing); Unavoidable fixed costs are paid in either case, so ignore them.

How to solve Shut Down or Continue Decisions questions

Use this sequence for any drop, close or continue question. It keeps the working relevant and the recommendation clear.

1Read the data and list each cost as variable, avoidable fixed or unavoidable fixed. Look for words like 'allocated', 'apportioned', 'common' and 'can be saved'.
2Compute the contribution of the unit under review (sales less all variable costs).
3Deduct the avoidable fixed costs of that unit to find its net contribution to common costs.
4Adjust for side effects: lost contribution of other products, income from alternative use of space or sale of assets, and one-time closure costs.
5Compare the total profit if you continue with the total profit if you close. Alternatively, present an incremental statement.
6Write a clear recommendation in one sentence with the rupee impact.
7Add brief non-financial points: customer goodwill, employee impact, strategic fit, and whether the loss is temporary.

Quickest way: Contribution minus avoidable fixed cost test

When to use it: Use when the question gives product-wise or department-wise statements with allocated fixed costs and asks whether to drop one.

Ignore the reported profit or loss of the unit.
Take its sales minus variable costs.
Subtract only the fixed costs that disappear on closure.
If the answer is positive, continue; if negative, close.
Adjust once for other products' lost contribution or alternative income, then state the effect on total profit.

Common mistakes in Shut Down or Continue Decisions

Closing a unit because it shows a net loss
The loss is after allocated fixed costs, and students trust the bottom line.
Fix: Rebuild the statement from contribution. Deduct only avoidable fixed costs.
Treating all fixed costs as avoidable
Students treat 'fixed' as one category.
Fix: Read the wording. Allocated head office cost, depreciation of unsaleable assets and common rent usually continue.
Ignoring effects on other products
The question seems to concern only one product.
Fix: Check for complementary sales and shared facilities. Subtract the lost contribution of other products from the savings.
Forgetting alternative use of space or capacity
Students stop at the unit's own numbers.
Fix: If space can be rented out or used for another product, compare that income with the unit's net contribution.
Leaving out closure costs and sale proceeds
These items appear in the last line of the question.
Fix: Include severance and other one-time costs as outflows, and realisable value of assets as inflows, in the comparison.
Giving a number but no recommendation
Students stop after computing.
Fix: End with a clear 'continue' or 'close' statement, the rupee impact, and one or two qualitative points.

Worked examples

Example 1

Rao Textiles has three products. Per year: Product A sales ₹12,00,000, variable cost ₹7,00,000; Product B sales ₹8,00,000, variable cost ₹5,00,000; Product C sales ₹5,00,000, variable cost ₹4,00,000. Fixed costs directly traceable and avoidable: A ₹2,00,000, B ₹1,50,000, C ₹80,000. Common fixed costs of ₹3,00,000 are allocated in the ratio of sales and will continue even if any product is dropped. Product C shows a loss after allocation. Should C be dropped?

Show the solution

Total sales = 12,00,000 + 8,00,000 + 5,00,000 = ₹25,00,000. C's share of common cost = 5/25 × 3,00,000 = ₹60,000.
Reported result of C = 5,00,000 − 4,00,000 − 80,000 − 60,000 = −₹40,000 (a loss).
Contribution of C = 5,00,000 − 4,00,000 = ₹1,00,000.
Net contribution after avoidable fixed cost = 1,00,000 − 80,000 = ₹20,000.
The allocated ₹60,000 continues if C is dropped, so it is not relevant.
If C is dropped, total profit falls by ₹20,000: the firm loses ₹1,00,000 contribution and saves ₹80,000 fixed cost.

Answer: Continue Product C. It contributes ₹20,000 more than its avoidable fixed costs, so dropping it would reduce profit by ₹20,000. The reported loss of ₹40,000 arises only because of allocated common costs.

Example 2

Mehta Components has a Packaging Department. Annual figures: sales ₹6,00,000; variable costs ₹4,20,000; avoidable fixed costs ₹1,40,000. Closing it would release space that can be rented out for ₹30,000 a year. Closing it would also reduce the contribution of the Main Department by ₹10,000 a year because customers buy both. Should the department be closed?

Show the solution

Contribution of Packaging = 6,00,000 − 4,20,000 = ₹1,80,000.
Net contribution after avoidable fixed costs = 1,80,000 − 1,40,000 = ₹40,000.
If the department is closed, the firm loses ₹40,000 net contribution and ₹10,000 of Main Department contribution: total ₹50,000.
Closure gains rent of ₹30,000.
Net effect of closing = 30,000 − 50,000 = −₹20,000 (profit falls).
Therefore continuing is better by ₹20,000 a year.

Answer: Continue the Packaging Department. Closing it would reduce annual profit by ₹20,000. Even with the rent income, the lost contribution of the department and of the Main Department is larger. Also consider customer relationships and the chance of finding a better use of the space.

Exam tips

Draw a small three-column statement (continue, close, difference). It makes the relevant figures visible and earns method marks.
Underline words like 'allocated', 'apportioned' and 'unavoidable' in the question. They signal irrelevant costs.
Always scan for a side-effect sentence (effect on other products, rent income, severance). These are usually the point of the question.
State your recommendation clearly and add two brief qualitative points. Application marks depend on it.
In an MCQ, work out contribution minus avoidable fixed cost first. Most options are built around errors such as using the net loss.

Practice questions from Decisions involving Alternative Choices

Shut Down or Continue Decisions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Shut Down or Continue Decisions: frequently asked questions

What is the difference between a shut down and a drop decision?

A shut down usually refers to closing a plant, department or the whole operation, either temporarily or permanently. A drop decision concerns discontinuing one product or line within a continuing business. The relevant-cost logic is the same: compare contribution with avoidable fixed costs.

Why are allocated fixed costs ignored?

Allocated costs are shared expenses that usually continue after the unit closes. They only move to other units, so closing the unit does not save them. They are not relevant because they do not change with the decision.

When should a loss-making unit be continued?

Continue it when its contribution is greater than the fixed costs that would be saved by closing it, after adjusting for effects on other products. It then helps cover common costs. Also consider whether the loss is temporary and what strategic value the unit has.

How does a temporary shutdown differ from a permanent one?

In a temporary shutdown, you compare the loss of contribution with the fixed costs saved during the closure period. You also add restart costs. A permanent closure adds asset sale proceeds, severance and other long-term effects.