ACCA F5 – PERFORMANCE MANAGEMENT

Handout # 4

 Limiting Factor Analysis

 Practice Questions
LIMITING FACTOR

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

To identify a limiting factor the comparison is made between the available and the requirement
of each resource. Once the requirements exceed the availability, a limiting factor exists.

A company will maximize its contribution by producing and selling the product the gives the
highest contribution per unit of limiting factor. This is used to rank product in order of priority
for production and sales.

contribution per unit

Contribution per limiting factor =
limiting factor required per unit

Example 1

Solution

Step 1: Identify limiting factor

Machine 1 Machine 2
Hours Required:
Product X 2,000 1,000
Product Y 1,500 3,000
Total Hours Required 3,500 4,000
Hours Available 3,000 4,200
Shortfall 500 0

Limiting factor is machine 1

Step 2: Rank product base on contribution per limiting factor

Product X Product Y
Contribution per Unit $7 $5
Hours of machine 1 required per unit 10/60 6/60
Contribution per machine 1 hour $42 $50
Rank 2nd 1st

Step 3: Production plan and profit maximization

Machine 1 Machine 1
Production Hours per Hours Contribution Total
Units unit Used per unit Contribution
Product Y 15,000 6/60 1,500 $5 $75,000
Product X 9,000 10/60 1,500 Bal. $7 $63,000
3,000 $138,000

Linear Programming

Linear programming is a technique for solving problems of profit maximization or cost

minimization and resource allocation. Where more than one input is limited, linear programming
is used to determine the mix of output that maximizes contribution.

The steps involve in formulating a linear programming are as follows:

1. Define variables
2. Formulate the objective function (use contribution not profit)
3. Establish constraints in forms of inequalities
4. Plot constraints on a graph and establish feasible region – area on the graph where any
combination of the two (2) variables are possible
5. Determine optimal solution using the slide rule (the optimal point is the last point the
ruler touches before leaving the feasible region)
6. Solve the optimal solution using simultaneous equation.

The following example will be used to illustrate the graphical method of linear programming.

WX Co manufactures two products, A and B. Both products pass through two production
departments, mixing and shaping. The organization’s objective is to maximize contribution to
fixed costs.

Product A is sold for $1.50 whereas product B is priced at $2.00. There is unlimited demand for
product A but demand for B is limited to 13,000 units per annum. The machine hours available
in each department are restricted to 2,400 per annum. Other relevant data are as follows.

Machine hours required Mixing Shaping

Hrs Hrs
Product A 0.06 0.04
Product B 0.08 0.12

Variable cost per unit $

Product A 1.30
Product B 1.70

State what production mix will maximize contribution and calculate the total contribution of that
mix.
Answer

Step 1: Define Variables

Let X = number of units of product A produced and Sold

Let Y = number of units of product B produced and Sold

Step 2: Formulate the objective function

Product A contribution =$1.50 - $1.30 = $0.20

Product B contribution =$2.00 - $1.70 = $0.30

The objective function is to maximize contribution (C), therefore to do so:

C = 0.2X + 0.3Y

Step 3: Establish Constraints inequalities

Both Departments constraint is machine hours, as the maximum of 2,400hours is

available per annum in each department. There is also a constraint on the sales of Product
B which is 13,000units per annum.

The final constraint to consider is the non-negativity as there cannot be a negative

number of units for either product. This non-negativity must be stated at all times when
answering question on linear programming.

The inequalities are:

0.06X + 0.08Y ≤ 2,400 - (Mixing Dept)

0.04X + 0.12Y ≤ 2,400 - (Shaping Dept)
Y ≤ 13,000 - (Sales of Product B)
X ≥ 0, Y ≥ 0 - (Non-negativity)

Step 4: Plot constraints on a graph and establish feasible region

To plot points, we convert the inequalities to equation and find the value for each variable
when the other variable equals zero (this is done for all constraints). These points are then
plotted on the graph and straight line is drawn connecting both points (do this for each
constraint).
Using the constraint - 0.06X + 0.08Y = 2,400
When X = 0, Y= 2,400 ÷ 0.08 = 30,000
When Y = 0, X= 2,400 ÷ 0.06 = 40,000

These point can now be plot and form the straight line 0.06X + 0.08Y = 2,400.

The other constraints are also plotted using the same approached i.e.
X = 0, Y = 20,000 and Y = 0, X = 60,000:
Y = 13,000

The feasible region represents the area in which any combination for X and Y can be
produce and sell taken all constraints into consideration. The area is highlight in grey on
the graph below.
Step 5: Determine optimal solution

The optimal solution is the combination at which contribution will be maximized. In

order for this to be done, we need to draw an iso-contribution line. This is a line which is
plotted from identify a value (any value) for the contribution in the objective function and
use the same approach as in step 4 above to plot the points. Although any value could be
use it is strongly recommended that the contribution selected should be a multiple of both
constant in the objective function equation (i.e. multiple of 0.2 and 0.3, the easiest way to
do this is by multiplying both figure).

Once the iso-contribution line is drawn we can then use the ‘slide rule’ to identify the
optimal solution. The ‘slide rule’ requires you to place a rule directly on the iso-
contribution line and slide it outwards (i.e. to the right). The last point the ruler passes
before leaving the feasible region is the optimal point. The coordinates for this point will
indicate the production/sales units that will maximize contribution. The value for Product
A and Product B are then substituted in the objective function equation and solve for the
total contribution.

Let C = 3,000. Then 0.2X + 0.3Y = 3,000

Therefore, When X = 0, Y =10,000 and when Y = 0, X = 15,000.
 The graph shows that the optimal solution point is where the line 0.06X + 0.08Y = 2,400
intersect the line 0.04X + 0.12Y = 2,400.

The coordinates at the optimal point are (24,000, 12,000) X = 24,000 and Y = 12,000

Step 6: Solve the optimal solution using simultaneous equation

Although the coordinates at the optimal point on the graph can be read to give the values
for X and Y, it is usually advisable to use simultaneous equation to solve for the values as
this will provide more accurate as it might be difficult to accurately read the coordinates
at all times based on the graph. The equation of the two lines that intersects at the optimal
point is then solved using simultaneous equation to give the values for X and Y which
will maximize contribution.

0.06X + 0.08Y = 2,400 (1)

0.04X + 0.12Y = 2,400 (2)
Multiply (1) by 1.5;
0.09X + 0.12Y = 3,600 (3)
Subtract (2) from (3);
0.05X = 1,200
X = 24,000
Substitute X in (1)
0.08Y = 2,400 – (0.06 x 24,000)
0.08Y = 960
Y = 12,000

The maximum contribution will be:

C = (0.2 x 24,000) + (0.3 x 12,000)
C = 8,400

Please Note - Simultaneous equation could be used to solve for the optimal solution instead of
the ‘slide rule’. This is not advisable though as it will required you to solve all equations for the
intersect lines along the feasible region. The combination for each point will then be use to solve
the objective function equation to see which gives the highest contribution. Clearly this will be
time consuming.

Slack and surplus

If at the optimal solution the resource used is less than the resource available (spare capacity),
then there is a slack

If, at the optimal solution, the resource used equals the resource available (no spare capacity),
then the constraint is binding

If a minimum quantity of a resource must be used and, at the optimal solution, more than that
quantity is used, there is a surplus on the minimum requirement.
Example: Using the above example on WX Co.

At the optimal solution the machine hours used in the mixing department:
Machine hrs used = (0.06 x 24,000) + (0.08 x 12,000) = 2,400
Hours available = 2,400
The constraints is binding as available hours = hours used.

This is also the case for the Shaping department (0.04 x 24,000) + (0.12 x 12,000) = 2,400

However for the sales of Product B there is a slack of 1,000 units as only 12,000 is produced

Shadow Prices

The shadow price (dual price) is the increase in contribution created by the availability of an
extra unit of a limited resource at its original cost. In terms of linear programming, the shadow
price is the extra contribution or profit that may be earned by obtaining one extra unit of a
binding resource constraint.

Points to Note on Shadow Price:

 The shadow price represents the maximum premium above the basic rate that an
organization should be willing to pay for one extra unit of a resource.
 Since shadow prices indicate the effect of a one unit change in a constraint, they provide
a measure of the sensitivity of the result.
 The shadow price of a constraint that is not binding at the optimal solution is zero.
 Shadow prices are only valid for a small range before the constraint becomes non-binding
or different resources become critical.

Example: Using the above example on WX Co.

As the mixing and shaping department constraints are binding, the shadow price for both is as
follows:

Mixing department 0.06X + 0.08Y =2,401 (1)

0.04X + 0.12Y =2,400 (2)
Multiply (1) by 1.5 to give (3) and subtract (2) from (3) gives
0.05X = 1,201.5
X= 24,030; and Y = 11,990 ((2,400 -0.04 x 24,030) ÷ 0.12)

New contribution = 0.2 x 24,030 + 0.3 x 11,990 = 8,403

Original contribution = 8,400
Shadow price = $3

Shaping department 0.06X + 0.08Y =2,400 (1)

0.04X + 0.12Y =2,401 (2)
Multiply (1) by 1.5 to give (3) and subtract (2) from (3) gives
0.05X = 1,199
X= 23,980; and Y = 12,015 ((2,400 -0.06 x 23,980) ÷ 0.08)

New contribution = 0.2 x 23,980 + 0.3 x 12,015 = 8,400.5

Original contribution = 8,400
Shadow price = $0.50
PRACTICE QUESTIONS

Question 1 - Albion Company

Question 2 - RAB Consulting
Question 3 – Higgins Co

Question 4 – Metallica Co

The following scenario relates to questions 4.1 - 4.5.

Metallica Co is an engineering company that manufactures a number of products, using a team of
highly skilled workers and a variety of different metals. A supplier has informed Metallica Co
that the amount of M1, one of the materials used in production, will be limited for the next three-
month period.

The only items manufactured using M1 and their production costs and selling prices (where
applicable) are shown below.
Product P4 Product P6
$/unit $/unit
Selling price 125 175
Direct materials:
M1* 15 10
M2 10 20
Direct labour 20 30
Variable overhead 10 15
Fixed overhead 20 30
Total cost 75 105

* Material M1 is expected to be limited in supply during the next three months. These costs are
based on M1 continuing to be available at a price of $20 per square metre. The price of M2 is
$10 per square metre.
Required

4.1 Calculate the contribution per unit for each product.

A). P4 $100, P6 $70

B). P4 $50, P6 $70
C). P4 $70, P6 $100
D). P4 $70, P6 $50
(2 marks)

4.2 Metallica Co carried out some market research which suggested that a change should be
made to the selling price of both Product P4 and P6. As a result, the new contribution per
unit for P4 is $85 and for P6 it is $95. Which of the following answers is correct?

A). The contribution per limiting factor of P4 and P6 is $85 and $47.50 respectively,
therefore P4 should be produced first.
B). The contribution per limiting factor of P4 and P6 is $113.33 and $190 respectively,
therefore P6 should be produced first.
C). The contribution per limiting factor of P4 and P6 is $85 and $47.50 respectively,
therefore P6 should be produced first.
D). The contribution per limiting factor of P4 and P6 is $113.33 and $190 respectively,
therefore P4 should be produced first.
(2 marks)

4.3 If Metallica Co operated in a throughput accounting environment, which of the following

costs would not be included in the calculation for throughput contribution?

A). Selling price

B). Direct materials
C). Direct labour
D). None of the above
(2 marks)

4.4 Which of the following constraints would necessitate the performance of limiting factor
analysis by Metallica Co?

A). Limited demand for P4 or P6

B). Limited M1 or M2
C). Limited labour
D). All of the above
(2 marks)

4.5 Once a scarce resource is identified, Metallica Co carries out a limiting factor analysis
using 4 steps. What is the correct order for carrying out these steps?

A). Step 1: Rank the products in order of the contribution per unit of the scarce resource
Step 2: Allocate resources using the ranking
Step 3: Calculate the contribution per unit of the scarce resource for each product
Step 4: Calculate the contribution per unit for each product

B). Step 1: Calculate the contribution per unit of the scarce resource for each product
Step 2: Rank the products in order of the contribution per unit of the scarce resource
Step 3: Allocate resources using the ranking
Step 4: Calculate the contribution per unit for each product
 C). Step 1: Calculate the contribution per unit of the scarce resource for each product
Step 2: Calculate the contribution per unit for each product
Step 3: Rank the products in order of the contribution per unit of the scarce resource
Step 4: Allocate resources using the ranking

D). Step 1: Calculate the contribution per unit for each product
Step 2: Calculate the contribution per unit of the scarce resource for each product
Step 3: Rank the products in order of the contribution per unit of the scarce resource
Step 4: Allocate resources using the ranking
(2 marks)
(Total = 10 marks)

Question 5
A company makes two products, X and Y, with the same machines and the same direct labour
workforce. The following information is available for the next budget period.

Labour hours Machine hours

per unit per unit
Product X 0.6 hours 0.3 hours
Product Y 0.5 hours 0.2 hours

During the period there will be a maximum of 20,000 machine hours and 48,000 direct labour
hours available, and these resources could be limiting factors on output and sales. If linear
programming is used to determine the optimum production quantities of Product X and Product
Y, which one of the following would be a constraint in the linear programming model?

A). 0.3x + 0.2y ≤ 48,000

B). 0.5x + 0.2y ≤ 20,000
C). 0.6x + 0.3y ≤ 20,000
D). 0.6x + 0.5y ≤ 48,000

Question 6