Planning with limiting factors

Firms face many constraints on their activity and plan accordingly:

 limited demand
 limited skilled labour and other production resources
 limited finance (‘capital rationing’). Examination questions will focus on the problem of scarce
resources that prevent the normal plan being achieved.

Planning with one limiting factor

The usual objective in questions is to maximise profit. Given that fixed costs are unaffected by the
production decision in the short run, the approach should be to maximise the contribution earned. We
have covered a similar approach in Chapter 2, with Throughput Accounting.

If there is one limiting factor, then the problem is best solved using key factor analysis:

Step 1: identify the scarce resource.

Step 2: calculate the contribution per unit for each product.

Step 3: calculate the contribution per unit of the scarce resource for each product.

Step 4: rank the products in order of the contribution per unit of the scarce resource.

Step 5: allocate resources using this ranking and answer the question.

Exercise 1

X Ltd makes three products, A, B and C, for which unit costs, machine hours and selling prices are as
follows:

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Sales demand for the period is limited as follows.

Product A 4,000

Product B 6,000

Product C 6,000

Company policy is to produce a minimum of 1,000 units of Product A.

The supply of materials in the period is unlimited, but machine hours are limited to 200,000 and direct
labour hours to 5,000.

Required: Indicate the production levels that should be adopted for the three products in order to
maximise profitability, and state the maximum contribution.

Several limiting factors – linear programming

When there is only one scarce resource, the method above (key factor analysis) can be used to solve the
problem. However where there are two or more resources in short supply which limit the organisation’s
activities, then linear programming is required to find the solution.

In examination questions linear programming is used to:

 maximise contribution and/or

Formulating a linear programming problem involving two variables

The steps involved in linear programming are as follows:

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Exercise 2

A company produces two products in three departments. Details are shown below regarding the time per
unit required in each department, the available hours in each department and the contribution per unit
of each product:

Exercise 3

Alfred Co is preparing its production plan for the coming month. It manufactures two products, the flak
trap and the sap trap. Details are as follows.

The company’s fixed overhead absorption rate (OAR) is $1/labour hour (for both skilled and semi-skilled
labour). The supply of skilled labour is limited to 2,000 hours/month and the supply of semi-skilled labour
is limited to 2,500 hours/month. At the selling prices indicated, maximum demand for flak traps is
expected to be 150 units/month and the maximum demand for sap traps is expected to be 80
units/month.

Required:

(a) Formulate the constraints for Alfred Co.

(b) Plot the constraints on a graph and indicate on the graph the feasible region.

(c) Using the graph find the optimal production plan.

(d) Use simultaneous equations to accurately calculate the quantities produced at the optimal point and
calculate the maximum contribution at this point.

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Exercise 4

J Farms Ltd can buy two types of fertiliser which contain the following percentage of chemicals:

For a certain crop the following minimum quantities (kg) are required:

Type X costs $10 per kg and type Y costs $5 per kg. J Farms Ltd currently buys 1,000 kg of each type and
wishes to minimise its expenditure on fertilisers.

(a) Write down the objective function and the constraints for J Farms Ltd.

(b) Draw a graph to illustrate all the constraints (equations/inequalities), shading the feasible region.

(c) Recommend the quantity of each type of fertiliser which should be bought and the cost of these
amounts.

(d) Find the saving J Farms Ltd can make by switching from its current policy to your recommendation.

Limiting factor analysis – discussion aspects

Assumptions

 There is a single quantifiable objective – e.g. maximise contribution. In reality there may be
multiple objectives such as maximising return while simultaneously minimising risk.
 Each product always uses the same quantity of the scarce resource per unit. In reality this may
not be the case. For example, learning effects may be enjoyed.
 The contribution per unit is constant. In reality this may not be the case: – the selling price may
have to be lowered to sell more – there may be economies of scale, for example a discount for
buying in bulk.
 Products are independent – in reality: – customers may expect to buy both products together –
the products may be manufactured jointly together.
 The scenario is short term. This allows us to ignore fixed costs. The assumptions apply to the
analysis used when there is one limiting factor or if there are multiple limiting factors.

Shadow prices and slack

When discussing constraints, slack is the amount by which a resource is under u lised, i.e. slack occurs
when the maximum availability of a resource is not used. Graphically speaking, it will occur when the
optimum point does not fall on a given resource line.

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  The optimal solution will typically occur where two ("critical") constraint lines cross. There will be
no slack for these constraints/resources as they will be fully utilised.
 For other constraint lines, the fact that the optimal solution is not on these lines means that the
resources are not fully utilised, so there will be slack.

Slack is important for two reasons

 For critical constraints (zero slack), then gaining additional units of these scarce resources will
allow the optimal solution to be improved (e.g. higher contribution earned). Similarly if another
department wants these resources then it will result in lower contribution.
 For non-critical constraints, gaining or losing a small number of units of the scarce resource will
have no impact on the optimal solution.

To determine how much this makes scarce resources worth to the business, see the section below on
"shadow prices". Note: The term 'slack' can also apply to a product i.e. there can be unfulfilled demand.

Shadow (or dual) prices

The shadow price or dual price of a limiting factor is the increase in contribution created by the availability
of one additional unit of the limiting factor at the original cost.

 The shadow price of a resource can be found by calculating the increase in value (usually extra
contribution) which would be created by having available one additional unit of a limiting resource
at its original cost.
 It therefore represents the maximum premium that the firm should be willing to pay for one extra
unit of each constraint. This aspect is discussed in more detail below.
 Non-critical constraints will have zero shadow prices as slack exists already.

Calculating shadow prices

The simplest way to calculate shadow prices for a critical constraint is as follows:

Step 1: Take the equations of the straight lines that intersect at the optimal point. Add one unit to the
constraint concerned, while leaving the other critical constraint unchanged.

Step 2: Use simultaneous equations to derive a new optimal solution.

Step 3: Calculate the revised optimal contribution and compare to the original contribution calculated.
The increase is the shadow price.

Exercise 5

Using the following data, calculate the shadow price for machining time. Maximise C = 80x + 75y
(contribution), subject to

(i) 20x + 25y ≤ 500 (machining time)

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 (ii) 40x + 25y ≤ 800 (finishing time)

The optimal solution at the intersection of the above constraints is: x = 15, y = 8.

Implications of shadow prices

 Management can use shadow prices as a measure of the maximum premium that they would be
willing to pay for one more unit of the scarce resource.
 However, the shadow price should be considered carefully. For example, the shadow price of
labour may be calculated as $20 per hour. However, it may be possible to negotiate a lower
shadow price/*/* than this.
 In addition, if more of the critical constraint is obtained, the constraint line will move outwards
altering the shape of the feasible region. After a certain point there will be little point in buying
more of the scarce resource since any non-critical constraints will become critical.

Exercise 6

Suppose a linear programming problem gives the following results.

Required:

(a) Which two constraints give rise to the optimal solution?

(b) Overtime is paid at 'time-and-a-half'. Is it worth paying overtime to help relax constraints?

(c) A new product has been proposed with the following proposed costs and revenues.

Assuming that the constraints cannot be relaxed, should the new product be manufactured?

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