What is a Death Spiral?

//What is a Death Spiral?
What is a Death Spiral? 2017-10-02T18:42:37+00:00

Definition: The death spiral is a cost accounting phenomenon that occurs when a company repeatedly eliminates products or services without reducing fixed costs. The concept refers to situations in which a company falls into a spiral of increased fixed costs and lower production volumes.

What Does Death Spiral Mean?

What is the definition of death spiral? This term is used when a company tries to cut down overhead costs by reducing the number of products or services being offered. If overhead costs are not cut down accordingly, the company will get higher per unit fixed costs. This will force them to increase prices, which will, in turn, reduce demand, resulting on even higher fixed costs per unit.

This situation could be lethal for a company with a weak financial structure in an environment of decreasing demand. The company’s management team must be aware of the impact a reduction in the number of products being manufactured will have on the overall fixed cost structure. If the management team doesn’t fully understand the new structure that will come out after such reduction has taken place the company could fall into this “death spiral”, at the risk of bankruptcy.

Let’s take a look at an example.

Example

The CEO of Good and Services, Inc. has been reviewing the latest financial report, which shows that X product has high fixed costs. The accounting department of the company divided all fixed costs equally between the total production output in units. This is not a fair allocation of fixed costs since product X is the least complex of all the products offered by the company and constitutes a high percentage of the total volume produced. What could happen to the company if the CEO decides, in view of this report, to take product X out of the product line?

As we discussed previously this decision will lead the company to a death spiral situation in which per-unit overhead costs will increase and the company will be forced to increase prices to keep profit margins up. This will in turn, reduce the volume of products being manufactured even more, which will again increase fixed costs per unit, and the cycle will go on, risking the company’s financial stability.

Summary Definition

Define Death Spirals: Death spiral means a situation where convertible securities are converted into stock by outside investors diluting the original owners and causing them to lose control of their company.