Handloom unit at Bargarh: continue or shut down?
A family handloom unit in Bargarh runs 20 pit looms and produces 500 cotton sarees a month. Its monthly fixed costs are ₹60,000: shed rent ₹20,000, supervisor salary ₹25,000, insurance and loan interest ₹15,000. Variable cost is ₹1,200 a saree at current output, including yarn, dye and weaver wages. A powerloom cluster has pushed the wholesale price down from ₹1,500 to ₹1,250 a saree. The owner has ₹40,000 cash and a bank overdraft limit of ₹1,00,000. A trader offers to buy 500 sarees at ₹1,250, payment after 60 days. The owner's son argues that any price below the earlier ₹1,500 is a loss and the unit should close immediately. The owner wants a short-run decision and a long-run plan.
1. Calculate total revenue, total variable cost, total cost and profit or loss at ₹1,250. Should the unit produce in the short run?
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At 500 sarees and ₹1,250 each, total revenue = 500 × 1,250 = ₹6,25,000. Total variable cost = 500 × 1,200 = ₹6,00,000. Total fixed cost = ₹60,000, so total cost = ₹6,60,000. Loss = ₹6,25,000 - ₹6,60,000 = -₹35,000. Contribution = revenue minus variable cost = ₹25,000, which covers part of the fixed cost. Because price ₹1,250 is above average variable cost ₹1,200, the unit should continue producing in the short run. Shutting down immediately would leave the whole fixed cost of ₹60,000 to be paid, a loss of ₹60,000, which is worse than ₹35,000. The son's comparison with ₹1,500 is irrelevant: ₹1,500 is not the cost of production, and past price is a sunk reference. The cash-flow warning is separate: payment after 60 days may strain wages and yarn purchases, so the overdraft must be arranged.
2. Find the shutdown price and the break-even price. Explain the difference between them.
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The shutdown price is the minimum average variable cost. With constant variable cost per saree, that is ₹1,200. Below ₹1,200, each saree sold fails even to cover its own variable cost, so producing adds to the loss and the unit should shut down. The break-even price is the price at which total revenue equals total cost. At 500 sarees, average fixed cost = ₹60,000 / 500 = ₹120, so average total cost = ₹1,200 + ₹120 = ₹1,320. At any price between ₹1,200 and ₹1,320, the unit covers variable cost and part of fixed cost but still makes a loss; it should continue in the short run. At ₹1,250 the unit is inside this band. At a price of ₹1,320 or more it breaks even; above that it earns profit. The gap between the two prices exists because fixed costs must be paid whether output is positive or zero.
3. The trader offers ₹1,150 a saree for a one-year contract. What should the owner do, and what long-run adjustments could restore viability?
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At ₹1,150, total revenue = 500 × 1,150 = ₹5,75,000. Variable cost remains ₹6,00,000, so contribution is -₹25,000. Total loss = fixed cost ₹60,000 + negative contribution ₹25,000 = ₹85,000. Since price is below average variable cost, producing for the contract increases the loss; the short-run rule is to shut down and lose ₹60,000 rather than ₹85,000. The owner should reject the contract unless it preserves a market, keeps skilled weavers, or has a clause for renegotiation that makes the overall package worthwhile. In the long run, all costs become variable: the unit could shift to higher-value sarees, reduce supervision and rent, improve loom productivity, form a cooperative for marketing and yarn purchase, or exit the industry. A one-year loss-making contract is not a substitute for a viability plan.