Limiting Factor or Principle Budget Factor

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Definition and Explanation with Solved Example:

Limiting factors also known as key factors or principle budget factors or governing factors which put a limit to the capacity of an organization and stand in the way of accomplishing a desired objective or prevent indefinite expansion or unlimited profits. Following are limiting factor examples which may include limit production or sales volume:

(i) Shortage of material due to non-availability of required quality of material, crop failure, legal or trade restrictions arising from quotas, etc.

(ii) Shortage of labor which may be of general nature or of a specific type of labor, overtime restrictions etc.

(iii) Shortage of plant capacity due to non-availability of machines or machine hours, machine breakdown, lack of finance to expand production facilities.

(iv) Shortage of factory space, i.e., lack of physical space to accommodate production facilities.

(v) Lack of market demand due to ineffective or insufficient advertising, insufficient sales team, lack of customer demand for particular products, availability of better or cheap substitutes, shortage of delivery vans etc.

(vi) Shortage of finance which may be of general nature or of a specific type of fund.

Reducing the Effects of Limiting Factors:

Having identified the limiting factor, the business will take action to reduce limiting factors effect by searching its alternatives or solutions to improve the levels of activity and profitability.

Each time the effect of a limiting factor is reduced, a new limiting factor comes into effect, limiting the operations of the business. In this way a limiting factor or constraint always exists, otherwise an organization could expand to infinity.

In the examples of limiting factors given above, the business may pursue the following strategies in order to mitigate their effects:

(i) Shortage of Raw Material: 

(a) Search for additional sources of raw materials.

(b) Reduce the dependency on a particular raw material by changing product design and therefore raw material requirements.

(ii) Shortage of Skilled Labor:

(a) Recruit skilled labor by giving incentives for skilled labor to move to the company, e.g., increased rates of pay, paying removal costs, etc.

(b) Encourage personnel to move from elsewhere by advertising vacancies.

(iii) Shortage of Production Capacity (e.g. machinery, machine hours):

(a) Purchase additional production machinery.

(b) Sub-contract some work to outside companies.

(iv) Shortage of Factory Space:

(a) Increase factory space by building an extension.

(b) Purchasing an additional factory.

(c) Subcontracting work to outside companies.

(v) Lack of Customer Demand for Particular Products:

(a) Increase sales levels by price changes.

(b) Advertising campaigns or giving sales incentives to staff and or customer.

(vi) Shortage of Finance:

(a) New investment by the owner.

(b) Borrowings from bank or other relatives.

How to Reduce the Effects of Limiting Factor in Decision Making Process?

In order to maximize profits, it is necessary to select the most profitable products and concentrate on the production and sale of those products. In normal circumstances the products with the highest contribution are the most profitable products on which the company should concentrate production.

However, if there is a shortage of a particular resource (known as limiting factor) a company normally cannot produce as many products as it wish. In that case a business should try to have optimum use of that resource to the maximum extent as to maximize profits. This is done so by the identifying an optimum production mix of products which is based on contribution per unit of product in relation to limiting factor used in the production of that product.

The following are the steps in decision-making process to minimize adverse effects of a limiting factor:

(i) Determine of contribution per unit of output.

(ii) Ascertain the requirement of limiting factor to produce one unit of output.

(iii) Determine contribution per unit of limiting factor (per kilo or per labor hour, etc.).

(iv) Rank the products on the basis of contribution per unit of limiting factor is given the highest rank i.e., it should be produced in performance to other products.

(v) Revise the production and sales mix on the basis of products’ rankings i.e., the highest rank product will be given the highest priority to be produced using the available resources whereas the remaining resources will then be used to produce the next most profitable ranked products until the scarcity of the limiting factor makes it impossible to produce further output.

(vi) Revise the budgeted profit on the basis of revised production and sales mix.

Solved Example:

Furniture City Ltd makes three different models of office chairs: for which the estimated costs, sales and production data per unit are given:

limiting-factor-example-data

The budgeted fixed costs for the company are estimated at $300000.

Required:

(i) Rank the products on the basis of their profitability keeping in mind the following mutually exclusive limitations:

(a) If supply of material is limited to 70000 kg in the period, or

(b) If labor hours are limited to 95600 hours in the period.

(ii) Calculate the numbers of each type of chairs to be produced and sold to maximize profit of Furniture City Ltd.

(a) If supply of material is limited to 70000 kg in the period, or

(b) If labor hours are limited to 95600 hours in the period.

(iii) Prepare a marginal cost statement showing the profit of Furniture City Ltd for the year.

(a) If supply of material is limited to 70000 kg in the period, or

(b) If labor hours are limited to 95600 hours in the period.

Solution (i):

(a) Identification of the most profitable production mix (if supply of material is limited):

limiting-factor-example-solution

(b) Identification of the most profitable production mix (if labor hours are limited):

limiting-factor-example-solution-1

Solution (ii):

(a) Production budget based on calculation in (i) part (if supply of material is limited):

limiting-factor-example-solution-2

(b) Production budget based on calculation in (i) part (if labor hours are limited):

limiting-factor-example-solution-3

Units to be produced:

limiting-factor-example-solution-4

Solution (iii):

(a) Marginal cost statement (if supply of material is limited):

limiting-factor-example-solution-5

(b) Marginal cost statement (if labor hours are limited):

limiting-factor-example-solution-6