Death Spiral Meaning
The death spiral or the downward demand spiral occurs when an entity finds itself in a series of troubles. It is a phenomenon of cost accounting where an entity tries to eliminate its goods or services repeatedly instead of lowering its fixed costs.
It chooses to eliminate the entire range of products or services instead of identifying and battling the root causes resulting in such troubles. In such situations a series of events lead to a decline of the business and its financial position which becomes difficult to stop of irreversible. One negative situation leads to another, ultimately leading to a spiral of downward movement.
Death Spiral Explained
Death spiral economics is a situation where an entity finds itself trapped in specific problems that arise due to a non-stop rise in fixed costs. However, the company chooses to lower all its overhead costs by cutting down on the volume of production of goods or services that it offers its customers.
The entity in such a situation of death spiral phenomenon feels compelled enough to increase the selling prices of the goods or services that it offers to its customers, which in return impacts the demand for its goods or services, causing it to lower down. It ultimately impacts the fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. again, thus, causing it to go even higher. The entity ends up feeling trapped in a spiral where there is no way out and finds itself on the verge of bankruptcy.
In case of death spiral economics one negative feedback and result leads to a downward spiral of operational situations, one after another. This situation may be the result of certain financial disagreements and external causes like fall in demand of goods and services that the company produces, leading to a reduction in revenue and profits. All the above situations will result in the wastage of goods and services that have already been manufactured or piling up of inventory a debt death spiral. This will increase cost of all resources used in the business.
In such situations, the business may decide to end production of a product that are no longer demanded by customers, leading to closure of departments to save cost. If the company follows a good strategic planning technique, it might think of innovative ideas to use the existing product in some other manner instead to just closing off the unit.
In order to prevent the situation from turning negative, it is necessary for companies to continuously keep track of market conditions, movement of competitors and other players, changes in market trends and taste of consumers or availability of raw materials.
As already highlighted above the situation of death spiral phenomenon may occur due to many reasons, like lack of demand, competitor entry, failure to implement innovative strategies, or company trying to do or manage too many things at the same time without skilled manpower or machinery. However, the concept of death spiral financing is easy to understand with the help of a suitable example, as given below.
ABC Limited is in the business of various types of footwear manufacturing. X shoe brand is the highest volume product manufactured by the company, and it requires little manufacturing attention. financial statement of the companyFinancial Statement Of The CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. finds out that one of its footwear brands (X shoes) is resulting in a higher amount of fixed costs, which he finds unusual as such a phenomenon has never occurred since the inception of the company.
It is possible that the accounts department of ABC Limited equally distributed all the fixed costs based on volume for all the brands that the company produces, and as a result of this, X shoes tend to reflect the higher amount of fixed costs. However, in reality, X shoes result in a minimum amount of fixed costs compared to the other brands of shoes that the same company manufactures.
The CEO of ABC Limited, based on his findings regarding death spiral financing in the company’s financial department, might choose to enhance the selling price of the X shoes, which will ultimately come across as an opportunity for its competitors to overtake the market and impact the demand for the brand as mentioned above or might choose to outsource the production to another company or might even cease to manufacture the brand in the nearing time which might hurt the production volume of the company.
If the CEO of ABC Limited continued to react to the inappropriate distribution of the fixed costs and make impulsive decisions instead of identifying the real issue behind such discrepancies, the company would soon find itself in a debt death spiral or on the verge of bankruptcy. ABC Limited can avoid the scenario of a death spiral by allocating fixed costs based on activities and product complexities instead of equally distributing them based on the volume of goods or services manufactured by the same.
However, a company can break out of its death spiral situation. But is requires a good level of intervention by the management, who should have the skill and experience to identify reasons for it and drive the company in the opposite direction by designing strategies for refinancing, restructuring, or using innovation techniques. Sometimes, it requires intervention by the government, which may provide funding to bring the company or perhaps an economy out of the adverse condition.
Sometimes, such cases of death spiral financing lead to drastic falls in stock prices, reducing its market capitalization, and resulting in competitors taking over the market. It is necessary to stimulate growth and restore the confidence of employees and management so that they do not reach the point of no return.
This has been a guide to what Death Spiral is and its definition. Here we discuss its overview along with a practical example. You can learn more about financial analysis from the following articles –