1

LIMITING FACTORS LECTURE

'hen an organi(ation provides a range of products or services to its markets) but has a limited amount of resources available to it) then it &ill have to make a decision about &hat product mix (or mix of services) it &ill provide *ts volume of output and sales &ill be constrained b% the limited resources rather than b% sales demand) and so management faces a decision about ho& scarce capacit% should be best used +he scarce resource(s) might be an% or all of the follo&ing: (a) a restricted suppl% of an item of ra& material or components, (b) a maximum capacit% 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 - resource is scarce if the organi(ation does not have enough to undertake ever% available opportunit% for making more contribution to&ards profit +hus machine time &ould be scarce if ever% machine &as being operated at a full capacit%) &ithout being able to produce enough output to meet sales demand in full .rom a management accounting point of vie&) the assumption &ould be that a firm faced &ith a problem of one or more scarce resources &ould select a product mix or service mix that &ould maximi(e its overall profitabilit% and so maximi(e its total contribution +he techni#ue for establishing the contribution/ maximi(ing product mix or service mix differs according to &hether there is onl% one scarce resource or t&o or more scarce resources .or our purposes &e &ill look at decisions involving onl% one scarce resource 0ote that the &ord scarce is potentiall% misleading) because it does not necessaril% mean that there is a &orld&ide shortage) it simpl% means that the firm cannot in the short term obtain all the resources it needs to carr% out a particular task
DECISIONS INVOLVING ONE SCARCE RESOURCE

When there is only one scarce reso rce! the techni" e #or esta$lishin% the contri$ tion& 'a(i'isin% )ro* ct 'i( is to ran+ the )ro* cts or ser,ices in or*er o# contri$ tion )er nit o# the li'itin% #actorE.AM/LE

1uilders Ltd makes t&o products) &indo&s and doors - door takes $ hours to make) and has a variable cost of 213 and a sales price of 2$4 - &indo& takes ! hours to make) and has a variable cost of 214 and a sales price of 2!4 1oth products use the same t%pe of labour) &hich is in restricted suppl% 'hich product should be made in order to maximi(e profits5
SOLUTION

+here is no limitation on sales demand) but labour is in restricted suppl%) and so to determine the profit maximi(ing production mix) &e must rank the products in order of contribution per labour hour 6oors 'indo&s 2 2 Sales 7ariable "osts "ontribution 8ours per unit "ontribution per labour hour +he ranking is : $4 13 1! $ 29
1st

!4 14 14 ! 2:
!nd

-lthough 6oors have the higher contribution per unit) 'indo&s are more profitable because the% make a greater contribution for each hour of labour time &orked +hree 'indo&s (&ith contribution of $ x 214 ; 2$4) can be made in the same time as t&o 6oors (&ith contribution of onl% ! x 21! ; 2!9) Other Consi*erations +he profit/ maximi(ing budget &ould therefore be to produce 'indo&s onl%) &ithin the assumptions made *t is important to remember) ho&ever) that other considerations) so far excluded from the problem) might alter the decision entirel% (1) "an the sales price of either product be raised) therefore increasing contribution per unit) and the contribution per labour hour) and also reducing sales demand5 (!) +o &hat extent are sales of each product independent5 .or example a manufacturer of knives and forks could not expect to cease production of knives &ithout affecting the demand for the forks ($) 'ould a decision to cease production of &idgets reall% have no effect on the fixed costs5 +he assumption that fixed costs are unaffected b% limiting factor decision is not al&a%s valid) and closure of either the &idgets or splodgets production line might result in fixed costs savings (for example a reduction in production planning costs) product design costs) or e#uipment depreciation) 0 alitati,e Factors +here are also #ualitative factors to consider (1) 'ould a decision to make and sell just &indo&s have a harmful effect on customer lo%alt% and sales demand5 (!) *s the decision going to affect the long/term plans of the compan% as &ell as the short/term5 *f &idgets are not produced next %ear) it is likel% that competitors &ill take over the markets vacated b% 1uilders Ltd Labour skilled in the manufacture of doors &ill be lost) and a decision in one %ear<s time to reopen manufacture of doors might not be possible ($) 'h% is there a shortage of labour5 -re the skills re#uired difficult to obtain) perhaps because the compan% is using old/fashioned production methods) or is the compan% a high/tech ne& comer located in a lo&/tech area5 Or perhaps the conditions of &ork are so unappealing that people simpl% do not &ant to &ork for the compan% (9) +he same #uestion should be asked &hatever the scarce resource *f machine hours are in short suppl% is this because more machines are needed) or ne&er) more reliable and efficient machines5 *f materials are in short suppl%) &hat are competitors doing5 8ave the% found an e#uivalent or better substitute5 *s it time to redesign the product5 E(a')le1 one scarce reso rce an* li'ite* sales *e'an* 'hen there is a maximum potential sales demand for an organisation<s products or services) the% should be ranked in order of contribution/earning abilit% per unit of the scarce resource 8o&ever) the profit/maximising decision &ill be to produce the top/ranked products (or to provide the top/ranked services) up to the sales demand limit 8a%dn Ltd maufactures and sells three products) =) > and ?) for &hich budgeted sales demand) unit selling prices and unit variable costs are as follo&s: 1udgeted sales demand @nits sales price 7ariable costs: materials labour @nit contribution = ::4 units 2 2 1A 3 9 1! 9 > :44 units 2 2 13 A A 1! A ? 944 units 2 2 19 ! B 11 $

+he compan% has existing stocks of !:4 units of = and !44 units of ?) &hich it is #uite &illing to use up to meet sales demand

-ll three products use the same direct materials and the same t%pe of direct labour *n the next %ear) the available suppl% of materials &ill be restricted to 29)344 (at cost) and the available suppl% of labour to 2A)A44 (at cost) 'hat product mix and sales mix &ould maximi(e the compan%<s profits in the next %ear5 Sol tion an* *isc ssion +here appears to be t&o scarce resources) direct materials and direct labour 8o&ever) this is not certain) and because there is limited sales demand as &ell it might be that there is: (a) no limiting factor at all) except sales demand C ie none of these resources is scarce, (b) onl% one scarce resource that prevents the full potential sales demand being achieved 'hen faced &ith a problem of this kind) %ou should begin b% establishing ho& man% scarce resources there are) and if there are an%) &hich one or &hich ones are the%5 *n this example &e have: 1udgeted sales Stock in hand Dinimum production to meet demand = @nits ::4 !:4 $44 > @nits :44 4 :44 ? @nits 944 !44 !44

Minimum production to meet sales demand @nits

Required materials at cost 2

Required labour at cost 2

= > ? +otal re#uired +otal available

$44 :44 !44

!)944 $)444 944 :)344 9)344 (1)444)

1)!44 $)444 1)344 A)444 A)A44 A44

Daterials are a limiting factor) but labour is not +he next step is to rank =) > and ? in order of contribution earned per 21 of direct materials consumed = > ? 2 2 2 @nit contribution 9 A $ "ost of materials 3 A ! "ontribution per 21 materials 24 :4 21 44 21 :4 Eanking $rd !nd 1st ? should be manufactured up to the limit &here units produced plus units in stock &ill meet sales demand) then > second and = third) until all the available materials are used up
Ranking Product Sales demand less units in stock Production quantity Materials at cost

1st
!nd $rd

?
> =

@nits !44
:44 $44

@nits !44 (x 2!)

2
944 $)444 21)944

+otal available 2 3alancin% a'o nt sin% ) total a,aila$le-

9)344

+he profit/maximising budget is as follo&s:

Opening stock -dd production Sales

= @nits !:4 1F: 9!: =

> @nits 4 :44 :44 > 2 B)444 A)444 $)444

? @nits !44 !44 944 ? 2 :)A44 9)944 1)!44 Total 2 !1)944 1:):44 :)B44

Eevenue 7ariable costs "ontribution

2 A)344 :)144 1)F44

444444444444444444444444444444444444444444444444444444444444444444444444 E(ercise 5
'hat other considerations should be taken into account b% 8a%dn Ltd5

Sol tion
Eefer back to the previous example for suggestions if %ou cannot think of an% for %ourself

44444444444444444444444444444444444444444444444444444444444444444444444 4 Ass ')tions in li'itin% #actor analysis1 one scarce reso rce *n the previous example) certain assumptions &ere made *f an% of the assumptions are not valid) then the profit/maximi(ing decision might be different +hese assumptions are as follo&s: (a) .ixed costs &ill be the same regardless of the decision that is taken) and so the profit maximi(ing and contribution/maximi(ing output level &ill be the same +his &ill not necessaril% be true) since some fixed costs might be directl% attributable to a product or service - decision to reduce or cease altogether activit% on a product or service might therefore result in some fixed cost savings) &hich &ould have to be taken into account (b) +he unit variable cost is constant) regardless of the output #uantit% of a product or service +his implies that: (i) (ii) the price of resources &ill be unchanged regardless of #uantit%, for example) there &ill be no bulk purchase discount of ra& materials, efficienc% and productivit% levels &ill be unchanged, regardless of output #uantit% the direct labour productivit%) the machine time per unit) and the materials consumption per unit &ill remain the same

(c)

+he estimate of sales demand for each product) and the resources re#uired to make each product) are kno&n &ith certaint% *n the previous example) there &ere estimates of the maximum sales demand for

each of $ products) and these estimates &ere used to establish the profit/maximising product mix Suppose the estimates &ere &rong5 +he product mix finall% chosen &ould then either mean that some sales demand of the most profitable item &ould be unsatisfied) or that production &ould exceed sales demand) leaving some stock unsold "learl%) once a profit/maximising output decision is reached) management &ill have to keep their decision under continual revie&) and adjust their decision as appropriate in the light of actual results (d) @nits of output are divisible) and a profit/maximising solution might include fractions of units as the optimum level 'here fractional ans&ers are not realistic) some rounding of the figures &ill be necessar%

Given that these basic assumptions usuall% appl%) a suitable adjustment &ill have to be made for an% problem involving a scarce resource &here one (or more) of the assumptions is invalid