CONTRIBUTION ANALYSIS AND LIMITING FACTORS

Basic Principles
 A limiting factor is a factor that is scarce in supply and thus limits the
organisation from expanding further. For instance, machine capacity,
supply of skilled labour and raw material may be limited for the period
until an action is taken.
 Assuming management aimed at maximising profit and there is no
changes in fixed cost occurs), contribution is maximized where the
highest possible contribution is earned from each unit of limiting
factor(s).
 Thus the limiting factor decision therefore involves the determination of
the contribution earned by each different product from each unit of the
limiting factor.
 If an organisation is faced with a single limiting factor, then it must
ensure that a production plan is established that maximizes the profit or
contribution from the use of the available limiting factor.
 The products are then ranked according to the contribution earning
capacity per limiting factor. The limiting factor is then allocated to the
products in accordance to the ranks.

Example 1
A company produces three products A, B and C all of which passes through
the same finishing process. For the coming month, the number of hours
available in the finishing process is 6,000.
Data relating to each product are as follows
Product Product B Product
A C
Selling price per unit (¢) 30 36 41
Variable cost per unit (¢) 20 27 35
Processing time per unit (minutes) 45 36 25
Maximum monthly demand (Units) 4,500 4,500 4,500
Required
Determine the production plan that will maximize profit for the forthcoming
month and calculate the total profit

Example 2
DFL produces three brands of soap A, B and C of which unit cost are as
follows:
A B C
Machine hours 10 12 14
¢ ¢ ¢
Direct material @¢50 per kg 700 600 500
 Direct wages @¢75 per hour 900 600 300
Variable Overheads 200 400 300
Marginal cost 1,800 1,600 1,100
Selling Price 2,400 2,100 1,500
Sales demand for the year is fixed as follows:
A Maximum of 4,000
B Maximum of 6,000
C Maximum of 6,000
In order to maintain its present in the market, DFL must produce a minimum
of 1,000 units of product A.
The supply of raw material is unlimited, but available machine hours are
limited to 200,000 and direct labour hours to 50,000
Required
Draw a proposed production strategy for the three products in order to
maximize profitability

Example 3
A company located in the Free Zone enclave is faced with resource constraints.
As a result of the technical nature of its operations, the monthly labour hours
are limited to 175,000 hours. The supplier of raw materials has also been
adversely affected by the recent climate change who has promised to supply
60,000 units of the materials monthly.
Details on the products are as follows:
A B C D
GHS GHS GHS GHS
Selling price per unit 60 45 50 65
Direct materials cost unit 15 10 10 15
Direct labour cost unit 20 16 16 24
Variable overhead 12 8 10 11

Direct materials required per unit 3 2 2 3

Direct labour hours required 5 4 4 6

The demand for the products are as follows

A = 10,000 units B = 6,000 units C = 12,000 units and D = 8,000 units. It is

the company’s policy to produce and sell at least 3,000 units of each product
every month.
Required:
Advise management on the most profitable production mix and ascertain the
most optimum profit expectation if the fixed costs of the month amount to
GHS240,000.
Example 4
Triproduct Limited makes and sells three types of electronic security systems
for which the following information is available
Standard cost and selling price per unit
Day Night Omni
Scan scan scan
GHS GHS GHS
Material 70 110 155
Manufacturing labour 40 55 70
Installation labour 24 32 44
Variable overheads 16 20 28
Selling price 250 320 460
Fixed cost for the period are GHS450,000 and installation labour, which is
highly skilled is available for 25,000 hours only in a period and is paid GHS8
per hour. Both manufacturing and installation labour are variable cost. The
maximum demand for the period is
Day scan 2,000 units;Night scan 3,000 units;Omni scan 1,800 units
Required
a) calculate the shortfall (if any) in hours of installation labour
b) determine the best production plan assuming the company wishes to
maximize profit
c) calculate the maximum profit that could be achieved from the plan in
part (b) above
d) Having carried out an investigation of the availability of installation
labour, the firm thinks that by offering GHS12 per hour, additional
installation would become available and thus overcome the labour
shortage. Based on the result obtained above, you are required to advice
the firm whether or not to implement this proposal.

Example 5
A market gardener is planning his production for next season, and has asked
you as a cost accountant, to recommend the optimal mix of vegetable
production for the coming year. He has given you the following data relating to
the current year:
Potatoes Turnip Parsnips Carrots
s
Area occupied (acres) 25 20 30 25
Yield per acre (tones) 10 8 9 12
Selling price per tonne (GHS) 100 125 150 135
Variable cost per acre (GHS)
Fertilizers 30 25 45 40
Seeds 15 20 30 25
Pesticides 25 15 20 25
Direct wages 400 450 500 570
Fixed overheads per annum is GHS54,000
The land is being used for the production of carrots and parsnips can be used
for either crop, but not for potatoes and turnips. The land being used for
potatoes and turnips can be used for either crop, but not for carrot and
parsnips.
In order to provide an adequate market service, the gardener must producer
each year at least 40 tonnes each of potatoes and turnips and 36 tonnes each
of parsnips and carrots.
Required
a) you are required to present a statement to show
i. the profit for the current year
ii. the profit for the production mix that you would recommend.
b) assuming that the land could be cultivated in such a way that any of the
above crop could be produced and there was no market commitment,
you are required to
i. advise the market gardener on which crop he should
concentrate his production
ii. calculate the profit if he were to do so
iii. calculate in value, the break even point of sales

Example 6
PE Limited produces and sells two products, P and E. Budgets prepared for the
next six months give the following information:
Product P E
GHS per unit GHS per unit
Selling price 10.00 12.00
Variable costs: production and selling 5.00 10.00
Common fixed costs:
production and selling for six months GHS561 600
(a) You are required, in respect of the forthcoming six months,
1. to state what the break-even point in GHSs will be and the number of
each product this figure represents if the two products are sold in the
ratio 4P to 3E;
2. to state the break-even point in GHSs and the number of products this
figure
represents if the sales mix changes to 4P to 4E (ignore fractions of
products);
3. to advise the sales manager which product mix should be better, that in
(1) above or that in (2) above, and why;
4. to advise the sales manager which of the two products should be
concentrated
on and the reason(s) for your recommendation assume that whatever
can be made can be sold, that both products go through a machining
process and that there are only 32 000 machine hours available, with
product
P requiring 0.40 hour per unit and product E requiring 0.10 hour per
 unit.

Assumptions of Limiting Factor Analysis

• 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.
• Products are independent – in reality:
– customers may expect to buy both products together
– the products may be manufactured jointly together.
• It applies to short term.

Several limiting factors – linear programming

When there is only one scarce resource the contribution per limiting factor
approach is 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 either maximise
contribution and/or minimise costs. In handling a problem involving serveral
limiting factors, the following steps may be applied;
i. Define the decision variables
ii. Formulate the objective function and the constraints including the
non negativity assumptions.
iii. Draw a graph to identify the feasible region
iv. Determine the optimal production plan
v. Calculate the maximum contribution

Shadow prices and slack

• 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.
• 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.

Slack
Slack is the amount by which a resource is underutilised. It will occur when
the optimum point does not fall on a given resource line. Slack is important
because unused resources can be put to another use, e.g. hired out to another
manufacturer.

Throughput Accounting
Throughput accounting aims to make the best use of a scare resource
(bottleneck) in a JIT environment. Throughput is a measure of profitability and
is defined by
Throughput = sales revenue direct - material cost
The aim of throughput accounting is to maximise this measure of profitability,
whilst simultaneously reducing operating expenses and inventory (money is
tied up in inventory).

The goal is achieved by determining what factors prevent the throughput from
being higher. This constraint is called a bottleneck, for example there may be a
limited number of machine hours or labour hours.
In the short term the best use should be made of this bottleneck. This may
result in some idle time in non-bottleneck resources, and may result in a small
amount of inventory being held so as not to delay production through the
bottleneck.

Main assumptions:
• The only totally variable cost in the short term is the purchase cost of
raw materials that are bought from external suppliers.
• Direct labour costs are not variable in the short term. Many employees
are salaried and even if paid at a rate per unit, are usually guaranteed a
minimum weekly wage.

When there is a bottleneck resource, performance can be measured in terms of

throughput for each unit of bottleneck resource consumed. There are three
interrelated ratios:
t h roug h put per unit
T h roug h put(return) per factory hour=
product time on t h e bottleneck resources

total factory cost

Cost per factory hour=
total bottleneck resorce time available

return per factory hour

t h roug h put accounting ratio ( TPAR )=
cost per factory hour

Note: The total factory cost is the fixed production cost, including labour. The
total factory cost may be referred to as 'operating expenses'.
 • When TPAR >1 would suggest that throughput exceeds operating costs
so the product should make a profit. Priority should be given to the
products generating the best ratios.
• TPAR <1 would suggest that throughput is insufficient to cover operating
costs, resulting in a loss.

Improving the TPAR

Options to increase the TPAR include the following:
• increase the sales price for each unit sold, to increase the throughput per
unit
• reduce material costs per unit (e.g. by changing materials or switching
suppliers), to increase the throughput per unit
• reduce total operating expenses, to reduce the cost per factory hour
• improve the productivity of the bottleneck, e.g. the assembly workforce or
the bottleneck machine, thus reducing the time required to make each
unit of product. Throughput per factory hour would increase and
therefore the TPAR would increase.

Example 1
X Limited manufactures a product that requires 1.5 hours of machining.
Machine time is a bottleneck resource, due to the limited number of machines
available. There are 10 machines available, and each machine can be used for
up to 40 hours per week. The product is sold for GHS85 per unit and the direct
material cost per unit is GHS42.50. Total factory costs are GHS8,000 each
week.
Calculate
(a) the return per factory hour
(b) the TPAR.

Multiproduct decision making

Throughput accounting may be applied to a multiproduct decision making
problem in the same way as conventional limiting factor analysis. 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 throughput earned.
• Step 1: identify the bottleneck constraint.
• Step 2: calculate the throughput per unit for each product.
• Step 3: calculate the throughput per unit of the bottleneck resource for
each product.
• Step 4: rank the products in order of the throughout per unit of the
bottleneck resource.
• Step 5: allocate resources using this ranking and answer the question.
Example 2
X Ltd manufactures four products, A, B, C and D. Details of sales prices, costs
and resource requirements for each of the products are as follows.
Product A B C D
Sales price 1.40 0.80 1.20 2.80
Materials cost 0.60 0.30 0.60 1.00
Direct labour cost 0.40 0.20 0.40 1.00
. Minutes Minutes Minutes Minutes
Machine time per unit 5 2 3 6
Labour time per unit 2 1 2 5
. Units Units Units Units
Weekly sales demand 2,000 2,000 2,500 1,500

Machine time is a bottleneck resource and the maximum capacity is 400

machine hours each week. Operating costs, including direct labour costs, are
GHS5,440 each week. Direct labour costs are GHS12 per hour, and direct
labour workers are paid for a 38hour week, with no overtime.
(a) Determine the quantities of each product that should be manufactured and
sold each week to maximise profit and calculate the weekly profit.
(b) Calculate the throughput accounting ratio at this profit maximising level of
output and sales.

Example 3
Yam Co is involved in the processing of sheet metal into products A, B and C
using three processes, pressing, stretching and rolling. Like many businesses
Yam faces tough price competition in what is a mature world market.
The factory has 50 production lines each of which contain the three processes:
Raw material for the sheet metal is first pressed then stretched and finally
rolled. The processing capacity varies for each process and the factory manager
has provided the following data:
Processing time per metre in hours
. Product A Product Product
B C
Pressing 0·50 0·50 0·40
Stretchin 0·25 0·40 0·25
g
Rolling 0·40 0·25 0·25
The factory operates for 18 hours each day for five days per week. It is closed
for only two weeks of the year for holidays when maintenance is carried out.
On average one hour of labour is needed for each of the 225,000 hours of
factory time. Labour is paid GHS10 per hour.
The raw materials cost per metre is GHS3·00 for product A, GHS2·50 for
product B and GHS1·80 for product C. Other factory costs (excluding labour
and raw materials) are GHS18,000,000 per year. Selling prices per metre are
GHS70 for product A, GHS60 for product B and GHS27 for product C. Yam
carries very little inventory.
Required:
(a) Identify the bottleneck process and briefly explain why this process is
described as a ‘bottleneck’.
(b) Calculate the throughput accounting ratio (TPAR) for each product
assuming that the bottleneck process is fully utilised.
(c) Assuming that the TPAR of product C is less than 1:
(i) Explain how Yam could improve the TPAR of product C.
(ii) Briefly discuss whether this supports the suggestion to cease the
production of product C and briefly outline three other factors that
Yam should consider before a cessation decision is taken.