In spite of your best efforts as a business owner, sometimes you must think about closing a company division or product line. Exiting a particular business is one of the most difficult decisions you’ll make as an owner. You may deal with feelings of failure and rejection, given how much effort you’ve put into the operation. So, how do you make an informed decision? Use these tips to understand the financial and non-financial issues related to closing a business.
John owns Quality Sporting Goods, a company that manufactures cricket, basketball, and hockey equipment. The company’s Centrefield Gloves division produces cricket gloves, and the division has lost money for the last three years. Management has tried various strategies to improve Centrefield’s results. John invested more dollars in sales and marketing and attempted to negotiate lower material costs with vendors. Centrefield’s glove competitors sell a high-quality glove at a low price, and John’s firm cannot gain any market share.
John is now considering shutting down the Centrefield division.
Where are you now?
The first step to making an informed decision is to understand your current financial results. Here is the Centrefield income statement and balance sheet for the end of December:
Income Statement ending December 31, 2018
|Cost of Sales|
|Total Cost of Sales||420,000|
|Home office lease||10,000|
|Repair and maintenance||4,000|
|Total Operating Expenses||90,500|
Balance Sheet ending December 31, 2018
|Current portion – long term debt||20,000|
The income statement indicates that Centrefield generated a $30,500 loss for the year, and this report separates costs into the cost of sales and operating expenses.
Cost of sales includes material costs (leather and plastic), and labour costs that are directly related to production. If the division is closed, these costs are eliminated.
Operating expenses include costs that are not directly related to production, and this category requires more analysis.
Dealing with sunk costs
Sunk costs are expenses that will continue, even if your close a division or product line, and these costs need to be carefully reviewed.
Centrefield, for example, has five years remaining on the home office lease, which will cost $50,000 over the remaining lease term. All other costs can be eliminated.
If the division is closed, all of the incoming revenue will stop, along with all division costs – except for the $50,000 in lease payments.
Liquidating the Balance Sheet
If John decides to close the division, he can generate cash from selling assets, and use that cash to pay off any outstanding liabilities. If assets are greater than liabilities, this “liquidation” process will leave John with an ending cash balance. Here’s the balance sheet impact if the Centrefield division is closed:
- Cash inflows: In addition to the $40,000 cash balance, John collects the $70,000 in receivables from customers, and sells the $30,000 glove inventory to the existing client base. The business also sells the machinery and equipment, and Centrefield receives a total of $185,000 from asset sales and the original cash balance.
- Cash outflows: John pays $30,000 to eliminate the accounts payable balance, and repays both the $20,000 current portion and $100,000 long-term portion of the bank balance.
- Remaining cash: The net impact of liquidating the balance sheet is a $35,000 increase in cash, which equals owner’s equity. The equity balance is the current amount of cash and other assets that John invested in the business.
The bottom line is that John will recover his $35,000 equity investment in the business, and John will have to pay $50,000 to finish the lease term. However, Quality Sporting Goods may be able to use the office for some other purpose until the lease ends.
Closing a division involves non-financial costs that will impact your business, and John should carefully think about the impact of closing his company division.
If the division is closed, it will impact on employee morale. The staff may wonder if other departments will be closed and if more jobs will be eliminated. Low morale can impact productivity, and some workers may consider leaving the business.
Investors, creditors, and vendors may question management’s ability to operate the business moving forward. Investors may consider selling their ownership interest, and creditors may ask for more collateral to secure a business loan. Vendors may be hesitant to sell goods and services to Quality Sporting Goods unless cash is paid up front.
When a company division is closed, many people will question the owner’s ability to manage the business.
Take everything into account
Closing a division is a tough decision, and you must evaluate both the financial and non-financial impact of your change. However, in many cases, closing a business unit is the right thing to do, and will allow you to focus on more profitable areas of your company. Think carefully about this decision, and take everything into account, so you can grow your business profitability.