At A Recent Board Meeting, The President And CEO Got Into A

At A Recent Board Meeting The President And Ceo Got Into a Heated Arg

At a recent board meeting, the president and CEO got into a heated argument about whether to shut down the firm’s plant in Jackson. The Jackson plant currently loses $60,000 monthly. The president argued that the Jackson plant should continue to operate, at least until a buyer is found for the production facility. The president’s argument was based on the fact that the plant’s fixed costs are $68,000 per month. The CEO criticized the president for considering fixed costs in making the shutdown decision, claiming “Everyone knows fixed costs don’t matter!”

Paper For Above instruction

The disagreement between the president and the CEO at the recent board meeting centers on whether the Jackson plant should be shut down or continue operating despite its monthly losses. To approach this issue, it is essential to analyze the concept of fixed and variable costs, understand the relevant costs in the short run, and distinguish between economic and accounting perspectives on costs.

The key financial data includes:

- Monthly loss if the plant remains operational: $60,000

- Fixed costs: $68,000 per month

The president argues for continuing operations, citing the desire to find a buyer for the plant. The CEO counters that fixed costs are irrelevant for the decision to shut down or keep the plant open in the short run.

Understanding Fixed and Variable Costs

Fixed costs are expenses that do not change with the level of production within a relevant range and must be paid regardless of whether the plant operates or not. Examples include lease payments, certain salaries, and depreciation. Variable costs, on the other hand, vary directly with the level of production, such as raw materials and direct labor.

In the short run, when a company is facing a loss, the relevant costs for decision-making are typically the variable costs and the sunk fixed costs that cannot be avoided. This is because fixed costs that have already been committed are considered sunk costs—they cannot be recovered and should not influence the decision to continue or cease operations.

Short-Run Decision-Making Analysis

In this scenario, the Jackson plant is incurring a loss of $60,000 per month while fixed costs amount to $68,000. The critical consideration is whether the plant's revenue covers its variable costs. If the revenue from the plant’s operations exceeds its variable costs, then operating the plant would minimize losses compared to shutting down, which would result in losing the entire contribution margin and still paying fixed costs.

Suppose the plant's revenue covers the variable costs plus a contribution margin, and the only committed fixed costs ($68,000) are unavoidable in the short run. If the revenue does not cover the variable costs, the firm can minimize its losses by ceasing operations temporarily.

Decision: To Continue or Shut Down?

Given only the provided information, the monthly loss is $60,000, which is less than the fixed costs of $68,000. If the plant's operating revenue exceeds the variable costs—say, the plant produces and sells units that generate revenue covering the variable costs plus some contribution margin—then continuing operations minimizes losses.

If, however, the revenue does not cover the variable costs, then shutting down would prevent the firm from incurring additional variable costs, and the loss would be limited to the fixed costs that must be paid regardless of whether the plant operates or not.

Therefore, if the plant’s revenue covers the variable costs and contributes towards fixed costs, it makes sense to keep the plant operating, even at a loss. Conversely, if the revenue cannot cover variable costs, shutting down is the optimal decision to minimize losses.

Addressing the CEO’s Comment and Clarifying the Fixed Cost Misunderstanding

The CEO’s statement that “fixed costs don’t matter” in this context is incorrect because fixed costs, while irrelevant for incremental decision-making, are relevant when deciding whether to shut down or continue operations in the short run. The critical principle is that fixed costs are sunk in the short run; they have already been incurred and cannot be recovered, so they should not influence the decision to shut down or stay open.

However, fixed costs are relevant when considering the overall profitability of the firm and when evaluating long-term decisions, but not for short-term operational decisions based solely on marginal costs and revenues.

Conclusion

In the short run, the decision to continue operating the Jackson plant depends on whether the revenue from the plant covers its variable costs and contributes towards fixed costs. If so, it should stay open despite the $60,000 loss, as shutdown would lead to a more significant loss equal to fixed costs. If not, shutting down to avoid additional variable costs would reduce losses.

The fixed costs, while real expenses, are sunk for this decision and should not influence the decision to shut down or continue in the short run. The CEO is mistaken because ignoring fixed costs altogether can lead to poor decision-making that harms the company’s short-term financial position.

References

- Brealey, R., Myers, S., & Allen, F. (2020). Principles of Corporate Finance. McGraw-Hill Education.

- Horngren, C. T., Datar, S. M., & Rajan, M. (2021). Cost Accounting: A Managerial Emphasis. Pearson.

- Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial Accounting. McGraw-Hill Education.

- Drury, C. (2018). Management and Cost Accounting. Cengage Learning.

- Schmidt, R. (2022). Cost-Volume-Profit Analysis and Decision Making. Journal of Business & Economics.

- Simons, R. (2000). Performance Measurement & Control Systems for Implementing Strategy. Prentice Hall.

- Taub, A. (2021). The Role of Fixed and Variable Costs in Business Decisions. Harvard Business Review.

- Anthony, R., & Govindarajan, V. (2019). Management Control Systems. McGraw-Hill.

- Hilton, R. W., & Platt, D. (2019). Managerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-Hill.

- Kaplan, R. S., & Atkinson, A. A. (2019). Advanced Management Accounting. Pearson.