Management Accounting · Applications of Marginal Costing in Short Term Decision Making

Shutdown, Continue or Drop a Product Line Decisions

Q: What is the difference between a shutdown decision and a continue decision?

They are the same comparison with opposite outcomes. You compare the unit's contribution with its avoidable fixed cost. If contribution is lower you shut down, and if it is higher you continue.

Q: Which fixed costs are relevant in a drop a product line decision?

Only the avoidable fixed costs, which are saved if the product is dropped. Common costs that continue after closure, such as allocated head-office cost, are not relevant.

Q: How do you calculate the shutdown point with avoidable fixed cost?

Divide the avoidable fixed cost by contribution per unit to get units. Divide it by the P/V ratio to get sales value. Below that level the unit does not cover its avoidable fixed costs.

Q: Can I continue a product that shows a loss in the books?

Yes, if its contribution is more than its avoidable fixed cost. The book loss comes from allocated common costs that would remain after closure. Closing the product would then reduce total profit.

Updated 10 October 2026 · Fact-checked

A shutdown or drop decision compares what you lose and what you save by closing. Keep the unit if its contribution is more than the fixed costs that would actually be avoided by closing it. Drop it if contribution is lower than those avoidable fixed costs. Unavoidable fixed costs are ignored.

Understand Shutdown, Continue or Drop a Product Line Decisions

Every business unit, such as a plant, a product line or a department, earns revenue and uses resources. When a unit shows a loss in the books, the owner wonders if it should be closed. The loss in the books can mislead you, because it includes fixed costs that are shared out from head office.

Marginal costing handles this well. It splits cost into variable cost and fixed cost. Contribution is sales minus variable cost. If you close a unit, you lose its contribution. You also save only those fixed costs that disappear with it. These are the avoidable (specific) fixed costs, for example the supervisor's salary or rent of a rented shed that you can exit.

Fixed costs that continue even after closure are unavoidable (common) fixed costs. Examples are allocated head-office cost, depreciation on a building you cannot sell, or the managing director's salary. They are not relevant, because they are the same whether you keep the unit or not. After closure, the other units simply have to bear them.

So the rule is simple. Compare contribution with avoidable fixed cost. If contribution is higher, the unit adds to the firm's profit, so continue. If it is lower, closing saves more than it loses, so drop it. A unit with a book loss can still be worth keeping if it covers its avoidable fixed costs and contributes towards common costs.

Two more points matter. In the short run, a shutdown point is the activity or sales level where contribution just equals avoidable fixed cost. Also, if closing a unit frees capacity or resources, or if it hurts sales of other products, you must add those effects. Qualitative factors such as employee morale, customer goodwill and restart costs also count, but numbers come first in the exam.

Key rules to remember

Contribution: Contribution = Sales − Variable cost; Use total variable cost, including variable selling and distribution cost.
Continue or drop rule: Continue if Contribution > Avoidable fixed cost; Drop if Contribution < Avoidable fixed cost; If the two are equal, you are indifferent on financial grounds. Then decide on qualitative factors.
Advantage of continuing: Advantage of continuing = Contribution − Avoidable fixed cost; A positive figure is the amount by which total profit falls if you close the unit.
Shutdown point (in units): Shutdown units = Avoidable fixed cost ÷ Contribution per unit; Below this volume the unit does not recover its avoidable fixed cost.
Shutdown point (in sales value): Shutdown sales = Avoidable fixed cost ÷ P/V ratio; P/V ratio = Contribution ÷ Sales. Use it when only value data is given.
Net effect with alternative use: Gain from closing = Avoidable fixed cost saved + Alternative income − Contribution lost; Include only if the freed capacity has a real alternative use, such as renting out or making another product.

How to solve Shutdown, Continue or Drop a Product Line Decisions questions

Use this method for any shutdown, continue or drop question. It keeps you on relevant costs and earns step marks.

1Read the question and list the unit being studied, with sales, variable costs and each fixed cost given.
2Separate fixed costs into avoidable and unavoidable. Allocated or apportioned common costs are normally unavoidable unless the question says they will be saved.
3Compute contribution of the unit: sales minus all variable costs.
4Compare contribution with avoidable fixed cost. Show the difference as the advantage or disadvantage of continuing.
5Adjust for other effects stated in the question: alternative use of space, loss of sales of other products, scrap or sale value of assets, or extra costs of closure.
6Optionally show a total profit statement with and without the unit. The difference must match your answer in step 4.
7State the decision clearly in one sentence, with the amount, and add one or two qualitative points such as goodwill, employees or restart costs.

Quickest way: Contribution minus avoidable fixed cost in one line

When to use it: Use it when the question gives costs for one product or department and asks whether to drop it. It is also the check for any longer statement.

Ignore the profit or loss shown in the books. Cross out every unavoidable fixed cost.
Write: Contribution − Avoidable fixed cost = ? for the unit.
If the answer is positive, continue. If it is negative, drop.
Add any alternative income or lost sales of other products as a final adjustment.
Write the final profit change in rupees with the decision.

Common mistakes in Shutdown, Continue or Drop a Product Line Decisions

Deciding on the net profit or loss shown in the books after allocated fixed cost.
Students see a loss and assume closure is right. Absorption costing statements mix avoidable and unavoidable costs.
Fix: Rebuild the statement in contribution form. Judge the unit only on contribution against avoidable fixed cost.
Subtracting all fixed costs of the unit from contribution.
Students do not read whether a fixed cost will really be saved on closure.
Fix: Tag each fixed cost as avoidable or unavoidable before any calculation. Unavoidable costs still remain and fall on other units.
Forgetting that unavoidable fixed costs are re-spread over the remaining units.
Students think the cost vanishes when the unit is closed.
Fix: Show the total company profit before and after closing. You will see that the common cost still reduces profit after closure.
Ignoring alternative use of freed capacity or the effect on other products.
Students stop once they have compared contribution and avoidable cost.
Fix: Re-read the question for rent income, a new product or knock-on losses in sales. Include them as extra items in the comparison.
Using the shutdown point as the break-even point.
Both formulas divide fixed cost by contribution, so they look alike.
Fix: Break-even uses total fixed cost and gives zero profit. Shutdown uses only avoidable fixed cost and shows when the unit stops paying for itself.
Not giving a final decision statement.
Students stop after the numbers.
Fix: Close every answer with a clear sentence: continue or drop, and by how much profit changes.

Worked examples

Example 1

Ganga Textiles has three product lines. Data for the year: Line A: sales ₹8,00,000, variable cost ₹5,00,000. Line B: sales ₹6,00,000, variable cost ₹4,50,000. Line C: sales ₹4,00,000, variable cost ₹3,40,000. Fixed costs: avoidable fixed costs of A ₹1,00,000, B ₹90,000, C ₹80,000. Common fixed cost of ₹2,40,000 is shared equally among the three lines and cannot be avoided. Which lines should be continued?

Show the solution

Contribution of A = 8,00,000 − 5,00,000 = ₹3,00,000.
Contribution of B = 6,00,000 − 4,50,000 = ₹1,50,000.
Contribution of C = 4,00,000 − 3,40,000 = ₹60,000.
Compare with avoidable fixed cost. A: 3,00,000 − 1,00,000 = +₹2,00,000. B: 1,50,000 − 90,000 = +₹60,000. C: 60,000 − 80,000 = −₹20,000.
Check with total profit. Total contribution = 3,00,000 + 1,50,000 + 60,000 = ₹5,10,000. Total avoidable fixed cost = 1,00,000 + 90,000 + 80,000 = ₹2,70,000. Common fixed cost = ₹2,40,000. Profit with all three = 5,10,000 − 2,70,000 − 2,40,000 = ₹0.
If C is dropped: contribution = 4,50,000; avoidable fixed cost = 1,90,000; common cost = 2,40,000. Profit = 4,50,000 − 1,90,000 − 2,40,000 = ₹20,000.
Profit rises from ₹0 to ₹20,000, which equals the ₹20,000 shortfall of C.

Answer: Continue Lines A and B. Drop Line C, because its contribution of ₹60,000 is less than its avoidable fixed cost of ₹80,000. Dropping it raises profit by ₹20,000, from ₹0 to ₹20,000, assuming no other effects.

Example 2

Kaveri Engineering makes a component in Plant X. Annual sales are ₹12,00,000 and variable cost is 70% of sales. Avoidable fixed cost of the plant is ₹3,00,000. The plant could be closed, and its space let out for ₹40,000 a year. (a) Find the shutdown sales level. (b) Should the plant be closed?

Show the solution

Variable cost = 70% of 12,00,000 = ₹8,40,000.
Contribution = 12,00,000 − 8,40,000 = ₹3,60,000.
P/V ratio = 3,60,000 ÷ 12,00,000 = 30%.
(a) Shutdown sales = Avoidable fixed cost ÷ P/V ratio = 3,00,000 ÷ 0.30 = ₹10,00,000.
(b) Advantage of continuing before alternative use = 3,60,000 − 3,00,000 = ₹60,000.
If closed, rent of ₹40,000 is earned. Gain from closing = 3,00,000 + 40,000 − 3,60,000 = −₹20,000, so closing loses ₹20,000.
Check: continuing earns ₹60,000 net of avoidable cost. Closing earns ₹40,000 rent. 60,000 − 40,000 = ₹20,000 in favour of continuing.

Answer: (a) Shutdown sales level is ₹10,00,000. Current sales of ₹12,00,000 are above it. (b) Continue the plant. Letting out the space gives only ₹40,000, whereas continuing gives ₹60,000 after avoidable fixed cost, so closure would reduce profit by ₹20,000.

Exam tips

Mark each fixed cost as avoidable or unavoidable in the margin before you calculate. Examiners often hide this in one line of the question.
Show a short statement of profit before and after closure. It checks your answer and picks up step marks.
In MCQs, look for options that use total fixed cost or book profit. These are usually the wrong answers.
Always add the final decision sentence with the rupee effect. Add one qualitative point if the question asks for comments.
If the question mentions a capacity limit or a substitute product, check whether a key factor or alternative use changes the decision.

Practice questions from Applications of Marginal Costing in Short Term Decision Making