What is a Death Spiral?
The death spiral or the downward demand spiral takes place when an entity finds itself in a series of troubles and it chooses to eliminate the entire range of products or services instead of identifying and battling the root causes resulting in such 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.
In simple words, it is a situation where an entity finds itself trapped in specific problems that arise as a result of non-stop rise in fixed costs. However, the company chooses to lower down 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 feels compelled enough to increase the selling prices of the goods or services that it offers to its customers which in return impacts the demandd of its goods or services causing it to lower down and all of this 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.
Death Spiral Example
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 insignificant manufacturing attention. The CEO of the company upon reviewing the current 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 really unusual as such a phenomenon has never occurred since the inception of the company.
This is possible that the accounts department of ABC Limited equally distributed all the fixed costs based on volume for all the brands that are produced by the company 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 at least in comparison with the other brands of shoes that are manufactured by the same company.
The CEO of ABC Limited based on his findings 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 afore-mentioned brand 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 would continue to react to the inappropriate distribution of the fixed costs and would take impulsive decisions instead of identifying the real issue behind such discrepancies then soon the company would find itself in a death spiral or at the verge of bankruptcy. ABC Limited can avoid the scenario of a death spiral by allocating fixed costs based on activities as well as product complexities instead of equally distributing them based on the volume of goods or services manufactured by the same.
This has been a guide to what is Death Spiral and its definition. Here we discuss its overview along with a practical example. You can learn more about financial analysis from the following articles –