Limiting factor: the issue

It is often assumed in budgeting that a company can produce as many units of its products (or
services) as is necessary to meet the available sales demand. Sales demand is therefore normally
the factor that sets a limit on the volume of production and sales in each period.
Sometimes, however, there could be a shortage of a key production resource, such as an item of
direct materials, or skilled labor, or machine capacity. In these circumstances, the factor setting a
limit to the volume of sales and profit in a particular period is the availability of the scarce
resource, because sales are restricted by the amount that the company can produce.
If the company makes just one product and a production resource is in limited supply, profit is
maximized by making as many units of the product as possible with the limited resources
available.
However, when a company makes and sells more than one different product with the same scarce
resource, a budgeting problem is to decide how many of each different product to make and sell
in order to maximizes profits.

Identifying limiting factors

A question might tell you that there is a restricted supply of a resource without telling you which
one it is.
In this case you must identify the limiting factor by calculating the budgeted availability of each
resource and the amount of the resource that is needed to meet the available sales demand.

Maximizing profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will be maximized in
a period by maximizing the total contribution earned with the available scarce resources.
The approach is to select products for manufacture and sale according to the contribution per unit
of scarce resource in that product.
Step 1: Calculate the contribution per unit of each type of good produced.
Step 2: Identify the scarce resource.
Step 3: Calculate the amount of scarce resource used by each type of good produced.
Step 4: Divide the contribution earned by each good by the scarce resource used by that good to
give the contribution per unit of scarce resource for that good.
Step 5: Rank the goods in order of the contribution per unit of scarce resource.
Step 6: Construct a production plan based on this ranking. The planned output and sales are
decided by working down through the priority list until all the units of the limiting factor (scarce
resource) have been used.