A breakpoint is a concept in managerial economics that suggests that a business should at least temporarily stop production and close its doors because it is no longer profitable to maintain its operations.

This theory was born from neoclassical models of perfect competition. According to these models, a company should never produce if it cannot cover all of its production and distribution costs in the long run.

In the short run, a firm’s willingness to produce should continue to the point where its marginal cost curve no longer exceeds average variable costs. The supply curve in a short-run perfect equilibrium model is the marginal cost curve above the average variable cost curve.

Determining the point of closure of a business

Three main factors help determine a business’s stopping point:

1. What is the variable cost necessary to produce a good or service
2. THE marginal income received from the production of this good or service
3. The types of goods or services provided by the business

For a single-product company, the breakpoint occurs whenever marginal revenue falls below marginal variable costs. For a multi-product firm, closure occurs when average marginal revenue falls below average variable costs.

A business may reach its closing point for reasons ranging from falling standard marginal returns to falling market prices for its goods.

In the perfect competition model, producers have a full understanding of their marginal expenses, future revenues, and revenues. opportunity costs. If the marginal variable cost of producing the 10,005th widget is $12, but the firm can only sell it for $11, then the firm is better off not producing beyond the 10,004th widget until ‘when the market price increases or variable costs decrease.

Businesses don’t have perfect information in the real world. A company with good cost accounting can approximate its average total cost of production and its projected marginal costs.

The approach for multi-product companies

Perfect competition models show firms that produce only one type of product, and that product cannot be distinguished from competing products.

However, most producers offer more than one good or service. Even if marginal revenue falls below variable costs for a product, the company can still generate a product through its other offerings.

For the multi-product firm, production can continue as long as the average marginal revenue of its different products exceeds the average variable costs. Even then, a shutdown is not necessary, as it is possible that only one product may need to be discontinued to return to profitability.

The impact of a shutdown

If prices and production were the only important factors, the stopping price theory could work as advertised. Unfortunately, a business has many more variables to consider.

For example, a temporary closure could have disastrous consequences on the professional relationships established by the company. Its employees may have to be sent home without permanent pay. Its suppliers, distributors and other third-party partners may have to interrupt their normal business processes. For publicly traded companies, investor confidence would likely suffer as well. All companies must adopt good practices relationship management.

The essentials

The breakpoint occurs when a business can no longer cover its variable costs, making it temporarily unprofitable to continue operating. For single-product firms, closure occurs when marginal revenue falls below variable costs, while multi-product firms may continue if other products make up for the losses. Despite the financial justification, a closure can strain relationships between employees, suppliers and investors.