The Plant Closure Decision Under a Capacity Constraint
Halden Foods operates three plants. Plant C loses $4M per year on a full-cost basis: revenue $60M, variable costs $42M, fixed costs $22M (of which $9M is allocated corporate overhead and $13M is plant-specific, including $5M of depreciation on equipment with no resale value and $8M of avoidable cash costs). Halden's total capacity is constrained: Plants A and B are at 95% utilization and could absorb only $30M of Plant C's $60M revenue if C closes. The remaining $30M would be lost because no other facility can serve those customers, and those customers are not expected to return. Closing C also triggers $6M of one-time severance and environmental remediation. The CFO recommends closing because 'C loses $4M a year.'
1. Perform a relevant-cost analysis of closing Plant C for the first year and state a recommendation.
Read the worked answer
Relevant costs and benefits of closing (Year 1):
Costs avoided:
- Variable costs on retained volume: cannot avoid all variable cost; only the portion tied to volume that transfers.
- Plant-specific avoidable cash fixed costs: $8M.
- Allocated corporate overhead ($9M) is NOT avoided - it is reallocated to A and B. Exclude.
- Depreciation ($5M) is a sunk non-cash allocation - exclude.
Revenue and contribution:
- Current contribution = $60M − $42M = $18M.
- Retained volume $30M carries roughly half the variable cost ($21M), so retained contribution ≈ $30M − $21M = $9M.
- Lost contribution from the $30M that cannot be served ≈ $9M.
Net Year 1 effect of closing ≈ +$8M avoided cash fixed − $9M lost contribution − $6M one-time costs = −$7M.
Recommendation: do not close on the CFO's reasoning. The full-cost loss is misleading because it includes $14M of non-avoidable or non-cash items. Closing destroys about $7M in Year 1 and more thereafter once the one-time costs drop out but the lost contribution persists.
2. The CFO argues that in later years, without the $6M one-time cost, closing is clearly better. Test that claim and identify what would change the answer.
Read the worked answer
Steady-state comparison (Year 2+): avoided cash fixed $8M vs. lost contribution $9M = net −$1M per year. Closing is still value-destructive, though narrowly. The CFO's claim fails because the $9M lost contribution is recurring, not one-time.
What would flip the answer to 'close':
- If A and B could absorb more than ~$47M of C's revenue (so lost contribution falls below $8M), closing becomes neutral or positive.
- If the $8M avoidable fixed cost were higher, or if the at-risk customers could be served by a contract manufacturer at a contribution above $1M.
- If Plant C's equipment had resale value, the $5M depreciation would have an associated cash recovery.
The strategic point: a segment showing a full-cost loss can still be contribution-positive and worth keeping under a capacity constraint. The decision hinges on recoverable volume, not on the reported loss.