Limiting Factor Analysis

1 Limiting Factor Analysis

be
In most business situations only a limited number of business opportunities may
undertaken. Some factor will limit the ability to undertake all the alternatives. This
factor is referred to as the limiting factor.

A limiting factor is any factor which is in scarce supply and which stops the
from expanding its activities further, that is, it limits the
organization
organization's activities.

The limiting factor for many trading organizations is sales volume because they
cannot sell as much as they would like. However, other factors may also be limited,
in the short term. For example, machine capacity or the supply of skilled
especially
labour may be limited for one or two periods until some action can be taken to
alleviate the shortage.

llustration 1
e.g
Xmakesa single product (Z) that requires Rs. 5of materials and two hours of labour.
There are only 80 hours of labou: aval.au e coct week and the maximum amount of
material available each week is Me.

Assuming unlimited demand for piru i c h o i these two factors is a limiting

factor on production?

Solution

It can be said that the supply of both labour hours and materials is limited and that
therefore they are both scarce resources. The maximum production within these
constraints can be shown to be:

Materials: Rs. 500/Rs.5 100 units

Labour hours: 80 hours/2 hours = 40 units

Thus the shortage of labour hours is the limiting factor.

Decisions involving a single limiting factor

e.g
The concept of contribution can be used to make decisions about the best use of a
limited resource.

Ifan organization is faced with a single limiting factor, for example machine capacity,
then it must ensure that a production plan is established which maximizes the profit
from the use of the available capacity. Assuming that fixed costs remain constant,
44
 Limiting Factor Analysis

this is the same as saying that the contribution must be maximized from the use of
the available capacity. The machine capacity must be allocated to those products
which earn the most contribution per machine hour.

This decision rule can be stated as:

'maximizing the contribution per unit of limiting factor'.

To calculate the contribution per unit of limiting factor

Contribution per unit

Units of limiting factor required per unit

When limiting factors are present, contribution (and therefore profits) are maximized
when products earning the highest amount of contribution per unit of limiting factor
are manufactured first. The profit-maximising production mix is known as the
optimal production plan.
The optimal production plan is established as follows:

Step 1lfnot ciearai7the question, establish the single limiting factor

Step 2 Calcu :rrttionper unit for each product.
Step 3 Calcula tion per unit of limiting factor.
Step 4 Rank the 3 according to their contribution per unit of limiting
factor.
Step 5 Allocate the limiting factor to the highest-ranking product.
Step 6 Once the demand for the highest-ranking product is satisfied, move
on to the next
highest-ranking product and so on until the (limiting factor)
scarce resource is used up.

Illustration 2

LMN Ltd. manufactures three products L, M and N. The

company which supplies the
two raw materials which are used in all three
products has informed LMN that their
employees are refusing to work overtime. This means that supply of the materials is
limited to the following quantities for the next period:
Material A 1,030 kg
Material B 1,220kg
No other source of supply for materials A and B can be found
for the next period.

Information relating to the three products manufactured

by LMN Ltd. is as follows:
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 Limiting Factor Analysis

Quantity of material used perunit manufactured:

L M N

Material A (kg) 2 1
Material B (kg) 5 3 7
Maximum sales demand (units) 120 160 110
Contribution per unit sold Rs. 15 Rs. 12 Rs. 17.50

Required:
Recommend a production mix which will maximize the profits of LMN Ltd. for the
forthcoming period.
Solution

Step 1: Check whether the supply of each material is adequate or whether either
or both of them represent a limiting factor.

Material A required to produce the total sales demand of products L,M and N:
(120 x 2) + (160 x 1)+(110x4) =840 kg (available: 1,030 kg)

Therefore material A is not a limiting factor.

Material Brequired to produce the total sales demand of products L,M and N:
(120x5) +(160 x 3)+ (110x7) =1,850 kg (available: 1,220 kg)

Therefore material B is the liming factor.

Step 2: Calculate the contribution per unit of product. This is given in the
question:
L M N
Contribution per unit sold Rs. 15 Rs. 12 Rs. 17.50

Step 3: Calculate the contribution per unit of limiting factor

L M N
Contribution per unit sold Rs. 15 Rs. 12 Rs. 17.50
Material B consumed (kg) 5 3 7
Contribution per kg of materialB Rs. 3 Rs. 4 Rs. 2.50

Step 4: Rank the products

L M N
Contribution per kg of material B Rs.3 Rs.4 Rs. 2.50
Ranking 2 1 3
 Limiting Factor Analysis

Once the
Step 5/6: Allocate material B to the products according to this ranking.
move to the next highest
demand for the highest ranking product is satisfied,
until all of material B is used up.
ranking product, and so on,
Production (units) Material B utilized (kg)
Product
M 160 (max) 480 (160x 3)
120 (max) 600 (120x 5)
L
201 40 (balance)
N
1,220

market demand for products

The available material B is able to satisfy the maximum
the last product in the
M and L. The balance of available material is allocated to
ranking, product N.

The optimum production mix is to produce:

160 units of M

120 units of L

20 units of N

If required by the questic ,

maximum profit (or contribution if the
se total contribution for this caiculation:
question has no fixed costs

Product M Product L Product N Total

(160x 12)+ (120x 15) +(20 x 17.50) = Rs. 4,070

Note: This is the maximum profit which can be made given the limiting factor. No
other combination can achieve a higher profit.

Illustration 3

Following on from the previousillustration

LMN Ltd. has a valued customer to whom they wish to guarantee the supply of 50
units of each product next period. Would this alter your recommended production
plan?

The recommended production plan in the previous part does not include sufficient
product N to satisfy the requirement of 50 units for the valued customer. Some of the
47
 Limiting Factor Analysis

must be allocated to product

material allocated to product L (second
in the ranking)
plan will now be as follows:
N. The recommended production

Product Production (units) Material B utilized (kg)

N 50 350 (50x 7)
M 160 480(160x3)
78 390 (balance)

1.220

available "material B" within the

This recommendation makes the best use of the
the overall profit
restriction of the market requirements for each product, although
as calculated in
will be lower as we have not followed the optimum production plan
the previous part.

Example1

ABC Ltd. makes three products, all of which use the same machine, which is
available for 50,000 hours per period

The unit costs of the product are:

Product A Product B ProductC

Rs Rs Rs
Direct materials 70 40 80
Direct labour:
Machinists (Rs. 8/hour) 48 32 56
Assemblers (Rs. 6/hou) 36 40 42

Total variable cost 154 112 178

Slling price per unit 200 158 224

Maximum demand (units) 3,000 2,500 5,000

Fixed costs are Rs. 300.000 per per

Required:
a) The deficiency in machine hours for the next
period is
The optimum production plan that will maximize ABC Ltd's
hours.
b)
profit for the next
period is:

48
 Limiting Factor Analysis

Product A units
Product B units
Product C units

2 Make or buy decisions

Businesses may be faced with the decision about whether to make

components or
products themselves (in house) or to obtain these from outside suppliers.
If the items are bought
in from external
suppliers, their purchase cost is wholly
marginal (i.e. direct). However, if it is decided to manufacture the items
the comparative costs of internally
doing so will be the variable production cost (direct
materials and direct labour costs,
plus the variable factory overhead). Allocated
fixed costs will not be relevant to the
decision as they will not change, but
any
specific or avoidable fixed costs incurred in the
consideration would be included as part of the internal
production of the item under
manufacturing cost.
Note: Relevant costing
principles are behind all decisions, remember to look out for
opportunity costs
If the total internally manufactured
cost is greater than the
cost of obtaining similar
items elsewhere, it is
obviously uneconomic to produce these items internally and
they would be purchased externally. An item should be made in
house only if the
relevant cost of making the
product in house is less than the cost of
buying the
product externally.
If spare capacity exists:

The relevant cost of

making the product in house =the variable cost of internal
manufacture plus any fixed costs directly related to
that product.
If no spare
capacity exists:
The relevant cost of
making the product in house the variable cost of internal
=

manufacture plus any fixed costs

cost of internal manufacture
directly related to that product plus the opportunity
(e.g. lost contribution from another product).
llustration 4
Albax Ltd.manufactures three components
manufactured using the same (A, B and
C). All the components are
general purpose machinery. The
cost data are available,
together with the purchase prices from anfollowing production
outside supplier.
 Limiting Factor Analysis

A B C
Production cost: Rs Rs Rs
Direct material 14 20 10
Direct labour 24 13 12
Variable overhead 8 8
Allocated fixed overhead 9 6 4

Total 55 46 34

Purchase price from outside supplier 54 50 28

Required:
Which, if any, components should be purchased from the outside supplier?

Solution
When comparing internal production costs and external buy in costs, the relevant
cOst to use for the internal production cost is the variable cost of production.

A B C
RS. Rs Rs.
Internal production cost
(variable production costs only) 46 40 30
Purchase price from outside supplier 54 50 28

Incremental (cost)/saving (8) (10) 2

In this case, Albax should purchase component C
externally. Components A
and B should be manufactured internally.

Example 2

Following on from illustration 4, further details of A, B and C are now available:

B
Machine hours per unit A 5
The external price of
Chas risen to Rs. 42.
Manufacturing requirements show a need for 1,500 units of each
week. The maximum number of component per
general purpose machinery hours available per
week is 15,000.
What should be
purchased from the outside supplier?

50
 Limiting Factor Analysis

3 The shadow price

The shadow price of a scarce resource (limiting factor) is the extra contribution that
would arise if one more unit of that scarce resource became available, or it is the
drop in contribution that would result from having one fewer unit of that scarce
resource.

It is also, therefore, the premium (over and above the normal price) it would be worth
paying to obtain one more unit of the scarce resource (limiting factor).
Chapter summary

Decision
meking

Limiting factor analysis Make or buy decisions

Limiting factor International Production
Contribution per unit of Costs
limiting factor Limiting factors
Optimum production
plan