Shutting Down or Continuing to Operate a Plant – Hallas Company

Hallas Company manufactures fast-bonding glue in its Northwest plant. The company normally
produces and sells 40,000 gallons of the glue each month. This glue, which is known as MJ-7, is
used in the wood industry to manufacture plywood. The selling price of MJ-7 is $35 per gallon,
variable costs are $21 per gallon, fixed manufacturing overhead costs in the plant total
$230,000 per month, and the fixed selling costs total $310,000 per month.

Strikes in the mills that purchase the bulk of the MJ-7 glue have caused Hallas Company’s sales
to temporarily drop to only 11,000 gallons per month. Hallas Company’s management
estimates that the strike will last for two months, after which sales of MJ-7 should return to
normal. Due to the current low level of sales, Hallas Company’s management is thinking about
closing down the Northwest plant during the strike.

If Hallas Company does close down the Northwest plant, fixed manufacturing overhead costs
can be reduced by $60,000 per month and fixed selling costs can be reduced by 10%. Start-up
costs at the end of the shutdown period would total $14,000. Because Hallas Company uses
lean production methods, no inventories are on hand.

Required:
1. Assuming that the strikes continue for two months, would you recommend that Hallas
Company close the Northwest plant? Explain. Show computations to support your
answer.
2. At what level of sales (in gallons) for the two-month period should Hallas Company be
indifferent between closing the plant or keeping it open? Show computations.

Hint: This is a type of break-even analysis, except that the fixed cost portion of your
break-even computation should include only those fixed costs that are relevant (i.e.
avoidable) over the two-month period.
Solution:
Product MJ-7 Selling Price $35
Variable Costs 21
Contribution Margin $14

Contribution margin lost by closing the plant for two months

($14 x 22,000 gallons of MJ-7) $(308,000)
Costs avoided by closing the plant for 2 months
Fixed manufacturing overhead
($60,000 x 2 months) $120,000
Fixed selling costs
($310,000 x 10% x 2 months) $62,000 $182,000
Net disadvantage of closing, before start-up costs $(126,000)
Start-up costs if plant is closed down (14,000)
Disadvantage of closing the plant $(140,000)

The company should not close the plant; it should continue to operate at the reduced level of
11,000 gallons produced and sold each month. Closing will result in a $140,000 greater loss
over the two-month period than if the company continues to operate.
Additional factors are the potential loss of goodwill among customers who need the 11,000
gallons of MJ-7 each month and the adverse effect on employee morale. By closing down, the
needs of customers will not be met (no inventories are on hand), and their business may be
permanently lost to another supplier.

Alternative Solution (not looking at the incremental costs and benefits)

Plant Open Plant Closed Difference
Sales (11,000 gallons x $35 x 2 months) $770,000 $0 $(770,000)
Variable expenses (11,000 x $21 x 2 months) 462,000 0 462,000
Contribution Margin $308,000 0 $(308,000)
Less fixed costs:
Fixed mfg. overhead ($230,000 x 2 months) $460,000
($170,000 x 2 months) $340,000 120,000
Fixed selling costs ($310,000 x 2 months) $620,000
($310,000 x 90% x 2 months) _______ 558,000 62,000
Total fixed costs $1,080,000 $898,000 $182,000
Net operating loss before start-up costs $(772,000) $(898,000) $(126,000)
Start-up costs _______ (14,000)________
Net operating loss $(772,000) $(912,000) $(140,000)
At what level of sales (in gallons) for the two-month period should Hallas Company be
indifferent between closing the plant or keeping it open? Show computations.

There are two ways of approaching this:

1. Consider the costs that will be avoided by closing the plant:

Reduction in fixed manufacturing overhead $120,000

Reduction in fixed selling costs 62,000
Total reduction in fixed costs 182,000
Less: startup costs 14,000
Net avoidable costs 168,000

Net avoidable costs/contribution margin = 168,000/14 = 12,000 gallons of glue

If sales for the two months drop to 12,000 gallons (6,000 gallons per month) the company will
be indifferent to closing the plant or keeping it open.

2. You can also use a target profit calculation to determine this:

(Fixed cost + target profit, or loss in this case)/contribution margin = sales volume

$1,080,000 – 912,000/14 = 12,000 gallons of glue

Verification of our determination:

Operate at 12,000 gallons Close
Sales (12,000 gallons x $35) $420,000 $0
Variable expenses (12,000 x $21) 252,000 0
Contribution margin 168,000 0
Less: Fixed expenses
Manufacturing overhead 460,000 340,000
Selling Costs 620,000 558,000
Total fixed costs 1,080,000 898,000
Start-up costs 14,000
Total costs 1,080,000 912,000
Net operating loss $(912,000) $(912,000)