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Strategic Cost Management · Relevant Cost Analysis

Shutdown, Drop or Continue Product Decisions: Relevant Cost Method

Updated 11 October 2026 · Fact-checked

A shutdown or drop decision asks whether closing a product, segment or plant makes the firm better off. Compare the contribution you lose with the avoidable fixed costs you save. If lost contribution is higher, continue. If avoidable costs saved are higher, drop. Unavoidable fixed costs and sunk costs do not matter.

Understand Shutdown, Drop or Continue Product Decisions

A firm often finds that a product line, department or plant shows a loss in the segment profit statement. The natural reaction is to close it. That can be wrong, because the loss is computed after charging fixed costs that may continue even after closure.

The decision rests on relevant costs: future costs and revenues that differ between the alternatives. If you drop the product, you lose its sales and save its variable costs. The difference is the contribution you give up. You also save only those fixed costs that actually disappear. These are avoidable (traceable, escapable) fixed costs, such as a supervisor's salary, rent of a leased shed or a product-specific advertising budget.

Unavoidable fixed costs continue whether you keep or drop the product. Examples are head-office allocations, depreciation on a shared building and general administration. They are not relevant. They will simply be spread over fewer products after the drop, so the remaining products look worse.

So a product with a negative segment profit can still be worth keeping if its contribution covers its avoidable fixed costs and contributes something to unavoidable costs. Equally, a product with positive profit after allocations may be worth dropping if its contribution is less than the avoidable costs.

A good answer also looks beyond the numbers. Consider the effect on sales of other products, use of the freed capacity or space, closure costs such as severance, and strategic factors like customer relationships and the product's life cycle stage.

Key rules to remember

Contribution
Contribution = Sales − Variable costs
Variable costs include variable selling and distribution costs that stop on closure.
Net advantage of continuing
Advantage of continuing = Contribution − Avoidable fixed costs
If positive, continue. If negative, drop (before other factors).
Decision rule
Drop if Avoidable fixed costs saved > Contribution lost
Ignore unavoidable fixed costs and sunk costs; they are the same under both options.
With alternative use of capacity
Drop only if Avoidable fixed costs saved + Benefit from alternative use > Contribution lost
Add net cash gain from renting out or redeploying freed resources. Deduct one-time closure costs where relevant.
Shutdown point (short run)
Continue if Sales ≥ Variable costs + Avoidable fixed costs
Same rule stated as a break-even for closure.

How to solve Shutdown, Drop or Continue Product Decisions questions

Use this method for any question on closing a product, segment, department or plant.

  1. 1Read the data and list every cost. Mark each as variable, avoidable fixed, unavoidable fixed or allocated.
  2. 2Ignore sunk costs, allocated common costs that continue and any past outlays.
  3. 3Compute contribution of the segment: sales less all variable costs.
  4. 4Deduct avoidable fixed costs to get the segment's net advantage (the incremental profit from keeping it).
  5. 5Adjust for other effects: loss of sales of related products, alternative use of space or capacity, closure costs, sale of assets at relevant values.
  6. 6Compare Continue versus Drop in a two-column statement showing total profit under each, or give the incremental figure.
  7. 7State a clear recommendation, then add qualitative points such as customer goodwill, employee impact and long-term prospects.

Quickest way: Contribution minus avoidable fixed cost test

When to use it: Use when the question gives a segment-wise profit statement and asks whether to drop one segment, and time is short.

  1. Pick only the segment under review.
  2. Write Sales − Variable cost = Contribution.
  3. Subtract only the fixed costs described as avoidable, specific or discontinued on closure.
  4. If the result is positive, continue; if negative, drop.
  5. Check the answer by confirming company profit changes by exactly this amount, then add any capacity or closure adjustment.

Common mistakes in Shutdown, Drop or Continue Product Decisions

  • Dropping a product because the segment profit statement shows a loss.

    Allocated fixed costs are included in the reported profit, so the loss looks real.

    Fix: Rebuild the figure as contribution less avoidable fixed costs only.

  • Treating all fixed costs as avoidable.

    Students assume closing a unit removes every fixed cost.

    Fix: Check the wording. Deduct only costs that stop on closure. Allocated head-office cost and shared depreciation stay.

  • Ignoring effect on other products.

    The question is solved as a single-product exercise.

    Fix: If the dropped item drives sales of others, deduct their lost contribution from the saving.

  • Including sunk costs or book depreciation as a saving.

    Depreciation appears in the cost sheet, so it looks like a cost you can save.

    Fix: Depreciation is a non-cash, usually unavoidable item. Include only the cash effect of closure, such as the sale value of assets.

  • Forgetting closure costs and alternative use of freed capacity.

    Students stop once the contribution comparison is done.

    Fix: Add a line for severance, rent income or contribution from a replacement product, then decide.

  • Giving a number without a recommendation.

    Students treat it as pure computation.

    Fix: End with 'Continue' or 'Drop', the rupee impact and one or two non-financial factors.

Worked examples

Example 1

Sundaram Foods Ltd makes three products. Data for the year (₹ lakh): Product X: sales 120, variable cost 70, fixed cost allocated 60. Product Y: sales 90, variable cost 50, fixed cost allocated 30. Product Z: sales 60, variable cost 45, fixed cost allocated 25. Of the fixed costs allocated to Z, ₹10 lakh is avoidable if Z is dropped; the rest continues. Should Z be dropped?

Show the solution
  1. Reported profit of Z = 60 − 45 − 25 = ₹(10) lakh, a loss.
  2. Contribution of Z = 60 − 45 = ₹15 lakh.
  3. Avoidable fixed costs of Z = ₹10 lakh.
  4. Net advantage of continuing = 15 − 10 = ₹5 lakh.
  5. Unavoidable fixed costs of 25 − 10 = ₹15 lakh will continue and fall on X and Y if Z is dropped.
  6. Check: company profit with Z = (120−70−60) + (90−50−30) + (−10) = −10 + 10 − 10 = ₹(10) lakh. Without Z, X and Y bear the extra ₹15 lakh and Z's avoidable ₹10 lakh goes: −10 + 10 − 15 = ₹(15) lakh. The difference is ₹5 lakh against dropping.

Answer: Continue Z. It adds ₹5 lakh to company profit, since its contribution of ₹15 lakh exceeds avoidable fixed costs of ₹10 lakh.

Example 2

Kaveri Textiles has a Dyeing Department with sales of ₹48,00,000, variable costs of ₹30,00,000, avoidable fixed costs of ₹14,00,000 and unavoidable fixed costs of ₹6,00,000. If the department is closed, its floor space can be let out for ₹5,00,000 a year, and a one-time closure cost of ₹2,00,000 is incurred (ignore it for the annual comparison but mention it). Also, closing the department will reduce contribution of the Weaving Department by ₹1,50,000. Advise whether to close it.

Show the solution
  1. Contribution lost on closing = 48,00,000 − 30,00,000 = ₹18,00,000.
  2. Add contribution lost from Weaving = ₹1,50,000. Total annual loss = ₹19,50,000.
  3. Annual savings on closing: avoidable fixed costs ₹14,00,000 plus rent income ₹5,00,000 = ₹19,00,000.
  4. Unavoidable fixed costs of ₹6,00,000 continue in both cases, so ignore them.
  5. Net annual effect of closing = 19,00,000 − 19,50,000 = ₹(50,000), a reduction in profit.
  6. The one-time closure cost of ₹2,00,000 makes closure even less attractive in the first year.

Answer: Do not close the department. Closing reduces annual profit by ₹50,000, and the one-time closure cost of ₹2,00,000 worsens this. Revisit if the floor space can earn more than ₹5,50,000 a year.

Exam tips

  • Look for the words 'avoidable', 'specific', 'allocated' and 'continue' in the question. They tell you which fixed costs to include.
  • Show a two-column Continue versus Drop statement. It earns method marks even if one figure goes wrong.
  • Always write a one-line recommendation and at least one qualitative factor, such as effect on customers or workforce.
  • In MCQs, test each option by contribution minus avoidable fixed cost. Ignore any option that uses total fixed cost.
  • If capacity is freed, check whether the question gives an alternative use. It often changes the answer.

Practice questions from Relevant Cost Analysis

Shutdown, Drop or Continue Product Decisions in other exams

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

Shutdown, Drop or Continue Product Decisions: frequently asked questions

What is the difference between avoidable and unavoidable fixed costs?

Avoidable fixed costs stop if you close the product or segment, such as a dedicated supervisor's salary or leased premises. Unavoidable fixed costs continue anyway, such as head-office allocations or depreciation on shared assets. Only avoidable costs are relevant in a drop decision.

Can I keep a product that shows a loss?

Yes, if its contribution is greater than its avoidable fixed costs. It then contributes towards unavoidable costs that would otherwise fall entirely on other products. The reported loss comes from allocated costs that do not disappear on closure.

How do I treat closure costs and asset sale proceeds?

Include them as relevant cash flows if they arise only because of closure. Severance pay is a cost of dropping; sale proceeds of assets are a benefit. Compare them with the ongoing gain from continuing, using the annual or total period asked in the question.

Is the shutdown decision only about numbers?

No. The numbers give the starting point, but you should also mention effects on sales of related products, customer relationships, employee morale and the product's long-term prospects. Exam answers that add these points usually score better.