A downward demand spiral occurs when a business eliminates products without sufficiently reducing the overhead costs associated with them. When this happens, overhead is allocated across the fewer remaining products, which increases their cost per unit. With a higher cost base, management is more likely to increase the prices of the remaining products, which makes them harder to sell. This process may go on through several cycles, where the same (or insufficiently reduced) overhead base is assigned to fewer and fewer products. Eventually, a company may go out of business, because it has continually ramped up its prices.
For example, Tsunami Products manufactures several types of shower heads. There is a high flow-rate model, a water-saver model, and a dual shower head model. Each model sells 50,000 units per year, for a total of 150,000 units. The company has factory overhead of $600,000. This means that the average overhead allocation per unit is $4. After a detailed analysis of margins, the company’s cost accountant recommends to management that the dual shower head model be cancelled. Management agrees. The total number of units produced is now 100,000. Management is able to cut factory overhead down to $500,000, but the result is still an increase in the overhead charge, to $5 per unit. Management decides to increase prices to compensate for the increased overhead charge, which results in a 20% decline in sales, to 80,000. This is a death spiral, since costs per unit continue to climb as unit sales decline.
The key to avoiding a death spiral is for management to focus on the excess capacity that is no longer being used by the business when a product is eliminated. The amount of overhead allocated to this excess capacity should not be charged to any products – it is simply a cost of maintaining excess capacity. For example, a factory’s capacity is fully utilized, and its total factory overhead is $1,000,000. The company sells a total of 100,000 units, which are distributed among five products. The average overhead allocation per unit sold is $10. Management elects to terminate one of the products, which means that 10,000 units are no longer being produced. The correct approach is to leave the allocation per unit as is. The $10,000 of overhead no longer being allocated to products is now considered a cost of unused capacity; this cost can be allocated once again if the company can increase its sales by 10,000 units. If management had instead elected to allocate the $1,000,000 of overhead among the 90,000 remaining units produced, this would have increased the cost allocation to $11.11 per unit, making it more difficult to sell these units if prices were increased to offset the amount of the allocation.
A downward demand spiral is also known as a death spiral.