Limiting factor or theory of constraints
Limiting factors in management accounting relate to limits in the availability of production resources (e.g., labour, machine hours, or materials) that hinder a firm from maximising its sales. The theory of constraints is an approach which helps in the identification of limiting factors, which are risks or bottlenecks that cause inefficiency in a process. There are three components in the production process: material, cost, and labour. A production facility with malfunctioning machinery, with certain components unavailable for replacement at this moment, or a material scarcity is a production constraint. Scope creep puts a project's spending at risk of surpassing the budget; in other words, financial limitations are a constraint. An organisation that does not have enough staff to finish a labour-intensive project are an example of constraint.
Apart from physical or production process constraints, business organisations have to deal with policy, paradigm, and market constraints. Policy constraints, such as laws, regulations, and contracts, are restricting factors inside an organisation or industry structure. A paradigm constraint is a workplace habit or established sociocultural standard that inhibits development. A market constraint is a factor that restricts output, such as rivals, consumers, and supply and demand regulations.
In a single limiting factor scenario, 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.
In the key factor analysis, assumptions are as (i) 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. (ii) 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. (iii) 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 and there may be economies of scale, for example, a discount for buying in bulk. (iv) Products are independent - in reality: customers may expect to buy both products together and the products may be manufactured jointly together. (v) The scenario is short-term. This allows us to ignore fixed costs.
Example :
Hester Plc. is a manufacturing company which is reviewing its product range as the basic material used in all its products has suddenly increased in price. The Managing Director wishes to make the best use of the company’s capacity and resources and has come to you, the cost accountant, for advice.
On inspection, the budget figures for the next period are as follows:
Product A B C D
Max, production (units) 5,000 5,000 5,000 5,000
Selling price per unit (£) 25 33 43 56
Variable costs (£):
Materials 9 12 17 20
Labour 8 10 12 15
Overhead 4 5 6 9
The total amount of material available to the company is limited by the supplier’s production capacity of £200,000. The budgeted fixed costs total £50,000.
Calculate the product mix that would produce the maximum profit and calculate the maximum profit.
Calculate Contribution
Product A B C D
Selling Price 25 33 43 56
Less:- Variable Cost 21 27 35 44
Contribution 4 6 8 12
Calculation of scoring by key factor (Limiting factor here Materials)
Contribution 4 6 8 12
(÷ )Limiting factor 9 12 17 20
=Contribution per limiting factor
0.44 0.50 0.47 0.60
Ranking 4 2 3 1
Product Units Cost /unit Total Cost Cash avail Cont./unit Contr’n
200,000
D 5000 20 100, 000 100, 000 12 60, 000
B 5000 12 60, 000 40, 000 6 30, 000
C 2353 (40000/17) 17 40, 000 0 8 18, 824
Total 12, 353 200, 000 108, 824
Less: Fixed Costs 50, 000
Profit 58, 824
Product Units Cost /unit Total Cost Cash avail Cont./unit Contr’n
200,000
D 5000 20 100, 000 100, 000 12 60, 000
B 5000 12 60, 000 40, 000 6 30, 000
C 2353 (40000/17) 17 40, 000 0 8 18, 824
Total 12, 353 200, 000 108, 824
Less: Fixed Costs 50, 000
Profit 58, 824