Limiting Factor Analysis

A limiting factor is any factor that is in scarce supply and that stops the organisation from expanding
itsactivities further, so that there is a maximum level of activity at which the organisation can operate.
For example;
 Limiteddemand
 Skilled labour
 Material
 Machine capacity
 Limited finance(‘capital rationing’) etc.

In limiting factor analysis management will decide to use its scarce resourcesin such a way as to
maximize total contribution (and so profit). In other words, marginal costing ideas are applied.
If there is just one limiting factor, total contribution will be maximized by earning the highest possible
contribution per unit of limiting factor.

Limiting factor Analysis Calculation (one factor only)

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

Example 1:
XLtdmakesthreeproducts,A,BandC,ofwhichunitcosts,machine hoursandsellingpricesareasfollows:

ProductA ProductB ProductC

Machinehours 10 12 14
$ $ $
Directmaterials
@ 50cperkg 7(14kg) 6(12kg) 5(10kg)
Directwages
@$7.50perhour 9(1.2hours) 6(0.8hours) 3(0.4hours)
Variableoverheads 3 3 3
––– ––– –––
Marginalcost 19 15 11
Sellingprice 25 20 15
––– ––– –––
Contribution 6 5 4
––– ––– –––
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.

Limiting Factor Analysis

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:
 Maximize contribution and/or
 Minimize costs.
The graphical method of linear programming can be used when there are just two products
(orservices). The steps involved are as follows.
 Define variables
 Establish constraints
 Construct objective function
 Draw the constraints on a graph
 Establish the feasible region for the optimal solution
 Determine the optimal solution
Finding the optimal solution using the graph

Once feasible region the problem now is to find the optimal solution within this feasible region.
There are two approaches to this final stage.

 By inspection it is clear that the maximum contribution will lie on one of the corners of the
feasible region. The optimal solution can be reached simply by calculating the contributions at
each corner. This approach is not recommended in the exam since it tends to be quite
timeconsuming.
 By drawing an isocontribution line (an objective function for a particular value of C), which is a
line where all points represent an equal contribution. This is the recommended approach,
particularly for more complex problems.
Example 3:
WX Co manufactures two products, A and B. Both products pass through two production departments,
mixing and shaping. The organisation'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

Required:
Use linear programming to calculate the optimum number of each product which WX Co should make
assuming it wishes to maximize contribution.

Slack and Surplus:

When discussing constraints, slack is the amount by which a resource is underutilized, 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.

 The optimal solution will typically occur where twoconstraint 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 noncritical constraints, gaining or losing a small number of units of the scarce resource will
have no impact on the total contribution earned.
 Shadow Price

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.
 Noncritical 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. The increase is the shadow price for the constraint
under consideration.

Example 4:
Higgins Co (HC) manufactures and sells pool cues and snooker cues. The cues both use the same type of
good quality wood (ash) which can be difficult to source in sufficient quantity. The supply of ash is
restricted to 5,400 kg per period. Ash costs $40 per kg.
The cues are made by skilled craftsmen (highly skilled labour) who are well known for their
workmanship. The skilled craftsmen take years to train and are difficult to recruit. HC’s craftsmen are
generally only able to work for 12,000 hours in a period. The craftsmen are paid $18 per hour.
HC sells the cues to a large market. Demand for the cues is strong, and in any period, up to 15,000 pool
cues and 12,000 snooker cues could be sold. The selling price for pool cues is $41 and the selling price
for snooker cues is $69.
Manufacturing details for the two products are as follows:
Pool cues Snooker cues
Craftsmen time per cue 0·5 hours 0·75 hours
Ash per cue 270 g 270 g
Other variable costs per cue $1·20 $4·70
HC does not keep inventory.

Required:
(a) Calculate the contribution earned from each cue.
(b) Determine the optimal production plan for a typical period assuming that HC is seeking to
maximize the contribution earned. You should use a linear programming graph (using the
graph paper provided), identify the feasible region and the optimal point and accurately
calculate the maximum contribution that could be earned using whichever equations you
need.
Some of the craftsmen have offered to work overtime, provided that they are paid double time for the
extra hours over the contracted 12,000 hours. HC has estimated that up to 1,200 hours per period could
be gained in this way.

Required:
(c) Explain the meaning of a shadow price (dual price) and calculate the shadow price of both the
labour (craftsmen) and the materials (ash).
(d) Advise HC whether to accept the craftsmen’s’ initial offer of working overtime, discussing the rate
of pay requested, the quantity of hours and one other factor that HC should consider.

Example 5:
The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The creams and
lotions are sold to a variety of retailers at a price of $23·20 for each jar of face cream and $16·80 for
each bottle of body lotion. Each of the products has a variety of ingredients, with the key ones being silk
powder, silk amino acids and aloe vera. Six months ago, silk worms were attacked by disease causing a
huge reduction in the availability of silk powder and silk amino acids. The Cosmetic Co had to
dramatically reduce production and make part of its workforce, which it had trained over a number of
years, redundant.
The company now wants to increase production again by ensuring that it uses the limited ingredients
available to maximise profits by selling the optimum mix of creams and lotions. Due to the redundancies
made earlier in the year, supply of skilled labour is now limited in the short-term to 160 hours (9,600
minutes) per week, although unskilled labour is unlimited. The purchasing manager is confident that
they can obtain 5,000 grams of silk powder and 1,600 grams of silk amino acids per week. All other
ingredients are unlimited. The following information is available for the two products:
Cream Lotion
Materials required: silk powder (at $2·20 per gram) 3 grams 2 grams
– silk amino acids (at $0·80 per gram) 1 gram 0·5 grams
– aloe vera (at $1·40 per gram) 4 grams 2 grams
Labour required: skilled ($12 per hour) 4 minutes 5 minutes
– unskilled (at $8 per hour) 3 minutes 1·5 minutes

Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion generates a
contribution of $8 per unit. The maximum demand for lotions is 2,000 bottles per week, although
demand for creams is unlimited. Total Fixed costs $1,800 per week. The company does not keep
inventory although if a product is partially complete at the end of one week, its production will be
completed in the following week.

Required:
(a) On the graph paper provided, use linear programming to calculate the optimum number of each
product that the Cosmetic Co should make per week, assuming that it wishes to maximize
contribution. Calculate the total contribution per week for the new production plan. All workings
MUST be rounded to 2 decimal places.
(b) Calculate the shadow price for silk powder and the slack for silk amino acids. All workings MUST be
rounded to 2 decimal places.
Example 6:
Tablet Co makes two types of tablet computer, the Xeno (X) and the Yong (Y). X currently generates a
contribution of$30 per unit and Y generates a contribution of $40 per unit. There are three main stages
of production: the build stage, the program stage and the test stage. Each of these stages requires the
use of skilled labour which, due to a huge increase in demand for tablet computers over recent months,
is now in short supply. The following information is available for the two products:
Stage Xeno (X) Yong (Y)
Minutes per unit Minutes per unit
Build ($10 per hour) 24 20
Program ($16 per hour) 16 14
Test ($12 per hour) 10 4

Tablet Co is now preparing its detailed production plans for the next quarter. During this period it
expects that the skilled labour available will be 30,000 hours (1,800,000 minutes) for the build stage,
28,000 hours (1,680,000 minutes) for the program stage and 12,000 hours (720,000 minutes) for the
test stage. The maximum demand for X and Y over the three-month period is expected to be 85,000
units and 66,000 units respectively. Fixed costs are $650,000 per month.
Due to rapid technological change, the company holds no inventory of finished goods.

Required:
(a) On the graph paper provided, use linear programming to calculate the optimum number of each
product which Tablet Co should make in the next quarter assuming it wishes to maximise
contribution. Calculate the total profit for the quarter.
(b) Calculate the amount of any slack resources arising as a result of the optimum production plan and
explain the implications of these amounts for decision-making within Tablet Co.