Knowing when it's time to shut down your business
Ten years after the dream was launched, things start heading south. Cash leaks out like running water. Revenue dries up like a shriveled prune. You start questioning your entrepreneurial spirit. However, just before throwing in the towel, there is one check that you should do before deciding to close down a business.
Before making any critical business decision, it is vital that you analyze the very latest financial information for your business. One such report is the income statement which this article will focus on. The income statement shows your business’s income and expenses. This report needs to be set out in a format that shows variable costs (costs that increase with output quantity), fixed costs (costs that remain constant regardless of output quantity) and contribution margin (revenues minus all variable costs. The contribution margin shows how much of a business’s revenue will be contributing to fixed costs and net income).
SIMPLE EXAMPLE
Rhythmic Jams Ltd runs a recording studio that gets used by a number of promising, up-and-coming musicians. With a recent streak of flops, the studio has run into some financial difficulty. The owners are unsure whether to keep the studio or not. The studio has generated revenues of $153 000. The total costs of running the studio amounted to $273 000. Of that amount, $170 000 was fixed costs. Based on the given information, advise the directors if they should close or continue to operate the recording studio.
SUGGESTED SOLUTION
The current situation is as follows :
Revenue: $153 000;
Total cost : $273 000
Loss : $120 000
The studio costs need to be analyzed between variable and fixed costs :
Revenue : $153 000
Variable costs : $103 000 (Calculated as : $273 000 – $170 000)
Contribution margin : $50 000
Fixed costs : $170 000
Loss : $120 000
From the above analysis, we can see that the studio is generating a positive contribution margin of $50 000. Fixed costs will be incurred regardless of whether the studio is closed or not. The directors should continue to operate the studio as it is generating a positive contribution.
OTHER FACTORS TO CONSIDER IN MAKING THE DECISION
1) Analyzing other reports such as cash flow forecasts, budgets and balance sheet.
2) Reducing the fixed overhead, variable overhead or increasing revenue.
3) Payment of retrenchment packages to workers.
4) Using the space to expand existing activities.
5) Using the space to manufacture a new product.
6) Renting out the space to a tenant.
7) Availability of funds.
8) Existing and future market conditions/opportunities.
In the real world, deciding to end a business is a difficult challenge. There are not only financial and legal issues to consider, there’s also human emotions that can make the decision-making process harder too. The purpose of the above example was to illustrate how crucial accounting knowledge is in making key business decisions. Every business owner must have some basic understanding of accounting and its importance to succeeding in business.
Contact CFO Nik Consulting Services Inc. to learn more about how accounting knowledge can help you make critical business decisions. Comments and questions are also welcome.
