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Limiting Factors Lecture Notes
Limiting Factors Lecture Notes
When an organization provides a range of products or services to its markets, but has a limited
amount of resources available to it, then it will have to make a decision about what product mix
(or mix of services) it will provide. Its volume of output and sales will be constrained by the
limited resources rather than by sales demand, and so management faces a decision about how
scarce capacity should be best used.
The scarce resource(s) might be any or all of the following:
(a) a restricted supply of an item of raw material or components;
(b) a maximum capacity of machine time;
(c) a limited amount of cash, and a bank overdraft limit;
(d) a maximum amount of available labour hours for a particular grade of labour.
A resource is scarce if the organization does not have enough to undertake every available
opportunity for making more contribution towards profit. Thus machine time would be scarce if
every machine was being operated at a full capacity, without being able to produce enough output
to meet sales demand in full.
From a management accounting point of view, the assumption would be that a firm faced with a
problem of one or more scarce resources would select a product mix or service mix that would
maximize its overall profitability and so maximize its total contribution.
The technique for establishing the contribution- maximizing product mix or service mix differs
according to whether there is only one scarce resource or two or more scarce resources. For our
purposes we will look at decisions involving only one scarce resource.
Note that the word scarce is potentially misleading, because it does not necessarily mean that
there is a worldwide shortage, it simply means that the firm cannot in the short term obtain all the
resources it needs to carry out a particular task.
DECISIONS INVOLVING ONE SCARCE RESOURCE
When there is only one scarce resource, the technique for establishing the contributionmaximising product mix is to rank the products or services in order of contribution per unit
of the limiting factor.
EXAMPLE
Builders Ltd. makes two products, windows and doors. A door takes 3 hours to make, and has a
variable cost of $18 and a sales price of $30. A window takes 2 hours to make, and has a
variable cost of $10 and a sales price of $20. Both products use the same type of labour,
which is in restricted supply.
Which product should be made in order to maximize profits?
SOLUTION
There is no limitation on sales demand, but labour is in restricted supply, and so to determine the
profit maximizing production mix, we must rank the products in order of contribution per labour
hour.
Doors
Windows
$
$
Sales
Variable Costs
Contribution
Hours per unit
Contribution per labour hour
The ranking is :
30
18
12
3
$4
20
10
10
2
$5
1st
2nd
Although Doors have the higher contribution per unit, Windows are more profitable because they
make a greater contribution for each hour of labour time worked.
Three Windows (with contribution of 3 x $10 = $30) can be made in the same time as two Doors
(with contribution of only 2 x $12 = $24)
Other Considerations
The profit- maximizing budget would therefore be to produce Windows only, within the
assumptions made. It is important to remember, however, that other considerations, so far
excluded from the problem, might alter the decision entirely.
(1) Can the sales price of either product be raised, therefore increasing contribution per
unit, and the contribution per labour hour, and also reducing sales demand?
(2) To what extent are sales of each product independent? For example a manufacturer of
knives and forks could not expect to cease production of knives without affecting the
demand for the forks.
(3) Would a decision to cease production of widgets really have no effect on the fixed
costs? The assumption that fixed costs are unaffected by limiting factor decision is
not always valid, and closure of either the widgets or splodgets production line might
result in fixed costs savings (for example a reduction in production planning costs,
product design costs, or equipment depreciation).
Qualitative Factors
There are also qualitative factors to consider.
(1) Would a decision to make and sell just windows have a harmful effect on customer
loyalty and sales demand?
(2) Is the decision going to affect the long-term plans of the company as well as the
short-term? If widgets are not produced next year, it is likely that competitors will
take over the markets vacated by Builders Ltd. Labour skilled in the manufacture of
doors will be lost, and a decision in one years time to reopen manufacture of doors
might not be possible.
(3) Why is there a shortage of labour? Are the skills required difficult to obtain, perhaps
because the company is using old-fashioned production methods, or is the company a
high-tech new comer located in a low-tech area? Or perhaps the conditions of work
are so unappealing that people simply do not want to work for the company.
(4) The same question should be asked whatever the scarce resource. If machine hours
are in short supply is this because more machines are needed, or newer, more reliable
and efficient machines? If materials are in short supply, what are competitors doing?
Have they found an equivalent or better substitute? Is it time to redesign the product?
Example: one scarce resource and limited sales demand
When there is a maximum potential sales demand for an organisations products or services, they
should be ranked in order of contribution-earning ability per unit of the scarce resource.
However, the profit-maximising decision will be to produce the top-ranked products (or to
provide the top-ranked services) up to the sales demand limit.
Haydn Ltd. maufactures and sells three products, X, Y and Z, for which budgeted sales demand,
unit selling prices and unit variable costs are as follows:
Budgeted sales demand
Units sales price
Variable costs: materials
labour
Unit contribution
X
550 units
$
$
16
8
4
12
4
Y
500 units
$
$
18
6
6
12
6
Z
400 units
$
$
14
2
9
11
3
The company has existing stocks of 250 units of X and 200 units of Z, which it is quite willing to
use up to meet sales demand.
All three products use the same direct materials and the same type of direct labour. In the next
year, the available supply of materials will be restricted to $4,800 (at cost) and the available
supply of labour to $6,600 (at cost). What product mix and sales mix would maximize the
companys profits in the next year?
Solution and discussion
There appears to be two scarce resources, direct materials and direct labour. However, this is not
certain, and because there is limited sales demand as well it might be that there is:
(a) no limiting factor at all, except sales demand ie none of these resources is scarce;
(b) only one scarce resource that prevents the full potential sales demand being achieved.
When faced with a problem of this kind, you should begin by establishing how many scarce
resources there are, and if there are any, which one or which ones are they?
In this example we have:
X
Units
550
250
300
Budgeted sales
Stock in hand
Minimum production to meet demand
Minimum
production to
meet sales
demand
Units
X
Y
Z
Total required
Total available
Y
Units
500
0
500
Required materials
at cost
$
300
500
200
2,400
3,000
400
5,800
4,800
(1,000)
Z
Units
400
200
200
Required labour at
cost
$
1,200
3,000
1,800
6,000
6,600
600
Product
Sales demand
less units in stock
st
Units
200
2nd
3rd
Y
X
500
300
Production
quantity
Materials at cost
Units
200 (x $2)
500
175
Total available
* Balancing amount using up total available.
(x $6)
(x $8)
$
400
3,000
*1,400
4,800
Opening stock
Add production
Sales
Revenue
Variable costs
Contribution
X
Units
250
175
425
Y
Units
0
500
500
Z
Units
200
200
400
Total
$
6,800
5,100
1,700
$
9,000
6,000
3,000
$
5,600
4,400
1,200
$
21,400
15,500
5,900
________________________________________________________________________
Exercise 2
What other considerations should be taken into account by Haydn Ltd?
Solution
Refer back to the previous example for suggestions if you cannot think of any for yourself .
________________________________________________________________________
Assumptions in limiting factor analysis: one scarce resource
In the previous example, certain assumptions were made. If any of the assumptions are not valid,
then the profit-maximizing decision might be different. These assumptions are as follows:
(a)
Fixed costs will be the same regardless of the decision that is taken, and so the profit
maximizing and contribution-maximizing output level will be the same.
This will not necessarily be true, since some fixed costs might be directly attributable
to a product or service. A decision to reduce or cease altogether activity on a product
or service might therefore result in some fixed cost savings, which would have to be
taken into account.
(b)
(c)
The unit variable cost is constant, regardless of the output quantity of a product or
service. This implies that:
(i)
(ii)
The estimate of sales demand for each product, and the resources required to make
each product, are known with certainty.
In the previous example, there were estimates of the maximum sales demand for each
of 3 products, and these estimates were used to establish the profit-maximising
product mix. Suppose the estimates were wrong? The product mix finally chosen
would then either mean that some sales demand of the most profitable item would be
unsatisfied, or that production would exceed sales demand, leaving some stock
unsold. Clearly, once a profit-maximising output decision is reached, management
will have to keep their decision under continual review, and adjust their decision as
appropriate in the light of actual results.
(d)
Given that these basic assumptions usually apply, a suitable adjustment will have to be made for
any problem involving a scarce resource where one (or more) of the assumptions is invalid.