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Dealing with limiting factors
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DEALING WITH LIMITING
FACTORS
Multiple limitingfactors - linear
programming
Optimal productionplan where there is asingle limiting
factor
Algebraic solutions
1 What is a limiting factor?
• Alimiting factor is a factor that prevents a company from
achieving thelevel of activity that itwould like to.
Limiting factor analysis looks atusing the contribution concept
toaddress the problem of scarce resources.
Scarce resources are where one or more of the manufacturing
inputs(materials, labour, machine time) needed to make a product is
in shortsupply.
Production can also be affected by the number of units of a
product thatis likely to bedemanded in a period (the sales
demand).
Illustration 1 - What is a limiting factor?
Suppose ALtd makes two products, Xand Y. Both products use
thesame machine and the same raw material that are limited to 600
hoursand $800 per week respectively. Individual product details are
asfollows.
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Product X per Product Y perunit unit
Machine hours 5.0 2.5
Materials $10 $5
Contribution $20 $15
Maximum weekly demand 50 units 100 units
Comment on whether machine hours and/or materials are
limitingfactors
Solution
To make the maximum demand of 50 units of X and 100 units of
Yrequires the following inputs:
Machine hours:
Materials:
50x5+100x2.5
50x10+100x5
= 500 hours
= $1,000
Thus there are enough machine hours available to make all units
thatcould be sold but materials limit the production plan.
Test your understanding 1
Two products, Alpha and Gamma are made of Material X and
requireskilled labour in the production process. The product
details are asfollows:
Selling price
Variable cost
Contribution
Material X required per unit
Skilled labour time required per unit
Alpha Gamma
$ $
10.00 15.00
6.00 7.50
4.00 7.50
2 kg 4 kg
1 hour 3 hours
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The maximum demand per week is 30 units of Alpha and 10 units
ofGamma. '
The company can sell all the Alphas and Gammas that it can make
buthere is a restriction on the availability of both Material Xand
skilled
labour There are 150 kg of material, and 45 hours of skilled
labouravailable per week.
Identify the limiting factor.
2Optimal production plan where there is asingle limiting
factorpontributipn perunit of limiting factor
In order to decide which products should be made in which order
it isnecessary to calculate the contribution per unit of limiting
factor (or scarceresource). K
Contribution per unitof limiting factor
Optimal production plan
Contribution per unit
Units of limiting factor required per unit
When limiting factors are present, contribution (and therefore
profits) aremaximised when products earning the highest amount of
contribution perunit of limiting factor are manufactured first. The
profit-maximisingproduction mix is known as the optimal production
plan.
The optimal production plan is established as follows.
Step 1 Calculate the contribution per unit of product.Step 2
Calculate the contribution per unit of scarce resource.Step 3 Rank
products.
Step 4 Allocatethe scarce resource to the highest-ranking
product.Step 5 Once the demand for the highest-ranking product is
satisfied,move on to the next highest-ranking product and so on
until the scarceresource (limiting factor) is used up.
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Illustration 2 - Optimal production plan where there is a
single
Acompany is able to produce four products and is planning
itsproduction mix for the following period. Relevant data is given
below:
A B C D
Selling price ($) per unit 19 25 40 50
Labour cost per unit ($) 6 12 18 24
Material cost per unit ($) 9 9 15 16
Maximum demand (units) 1,000 5,000 4,000 2,000
Labour is paid $6 per hour and labour hours are limited to
12,000 hoursin the period.
Required:
Determine the optimal production plan and calculate the
totalcontribution it earnsfor the company.
Solution
Selling price19
Variable costs:
Direct labour (6)
Direct material (9)
Contribution per unit
Hours perunit (labour cost/$6)
Contribution per hour $4
Rank
B
25 40
(12) (18)
(9) (15)
$2 $2.33
D
$
50
(24)
(16)
10
D
$2.50
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Dealing with limiting factors
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Remember to allocate the scarce resource (labour hours) to the
highest-ranking product first (A). Once the demand for the
highest-rankingproduct is satisfied, move on to the next
highest-ranking product (D) andthen the next (C) until the scarce
resource (labour hours) is used up.
Optimal production plan
Product Units Hours
used
Hours
left
Contribution
per unit ($)Total
contribution
($)
A 1,000 1,000 11,000 4 4,000
D 2,000 8,000 3,000 10 20,000
C 1,000 3,000 0 7 7,000
31,000
Test your understanding 2
The following data relates to Products Able and Baker.
Product
Able Baker
Direct materials per $10 $30unit
,
Direct labour:
Grinding $5 per 7 hours per unit 5 hourshour per unit
Finishing $7.50 15 hours per unit 9 hoursper hour per unit
Selling price per $206.50 $168.00unit
Budgeted 1,200 units 600 unitsproduction
•
Maximum sales for 1,500 units 800 units
the period
t
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Notes:
(1) No opening or closing inventory is anticipated.
(2) The skilled labour used for the grinding processes is
highlyspecialised and in short supply, although there
isjustsufficient tomeet the budgeted production. However, it will
not be possible toincrease the supplyfor the budget period.
Determine the optimal production plan and calculate the
totalcontribution it earns for the company.
3 Multiple limiting factors - linear programmingLinear
programming
As we have seen, when there is only one resource that limits the
activities ofan organisation (other than sales demand), products
are ranked in order ofcontribution per unit of limiting factor in
order to establish the optimalproduction plan.
• When there is more than one limiting factor (apart from sales
demand)the optimal production plan cannot be established by ranking
products.In such situations, a technique known is linear
programming is used.
Formulating a linear programming problem
Thefirst stage in solving a linear programming problem is to
'formulate' theproblem, i.e. translate the problem into a
mathematical formula.
The steps involved in this stage are as follows.
Step 1 Define the unknowns, i.e. the variabJes (that need to
bedetermined).
Step 2 Formulate the constraints, i.e. the limitations that must
beplaced on the variables.
Step 3 Formulate the objective function (that needs to be
maximised orminimised).
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Formulating the problem
The constraints are determined bythe scarce resources,
forexample, if labour or materials are restricted.
There is also a constraint known as the non-negativity
constraint.The non-negativity constraint fulfils the requirement of
linearprogramming that there should be no negative values in a
linearprogramming solution. You cannot make a negative amount of
aproduct. Each variable in a linear programming problem
musttherefore be greater than or equal to 0.
The objective function ofa linear programming problem mustalsobe
formulated. The objective ofa linear programming problem isusually
to maximise or minimise something. Most organisations willwish to
maximise profit orcontribution. Sometimes organisationsmay wish to
minimise costs.
Illustration 3 - Multiple factors - linear programming
A company makes two products, Xand Y, and wishes to
maximiseprofit. Information on X and Y is as follows:
Material kg per unit
Labour hours per unit
Selling price per unit
Variable cost per unit
Contribution per unit
Product X Product Y
1 1
5 10
$ $
80 100
50 50
30 " 50
The company can sell anynumber of product X, butexpects
themaximum annual demand for Y to be 1,500 units. Labour is limited
to20,000 hours and materials to 3,000 kg per annum.
Required:
Using the information given, formulate the linear programming
problem.
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Solution
Step 1: Define the unknowns, i.e. the variables that need to
bedetermined
Let x=number of units of Xproduced and sold each year
Let y=number of units of Yproduced and sold each year
Step 2: Formulate the constraints, i.e. the limitations that
must beplaced on the variables
Materials x +y 0
Step 3: Formulate the objective function that needs to
bemaximised or minimised
The objective is to maximise contribution, C=30x +50y.
Test your understanding 3
Abuilder has purchased 21,000 square metres of land on which it
isplanned to build two types of dwelling, detached and town houses,
withinan overall budget of $2.1 million. '
Adetached costs $35,000 to build and requires 600 square metres
of
Atown house costs $60,000 to build and requires 300 square
metres of
To comply with local planning regulations, not more than 40
buildingsmay be constructed on this land, but there must be at
least 5of each
From past experience the builder estimates the contribution on
theS ™nerh°.Ul81° bG ab°Ut $1°'000 8nd °n the town house t0 be
about$6,000. Contribution is to be maximised.
Using the information given, formulate the linear programming
problem.
chapter 10
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Determine the optimal solution to this linear programming
problem usinga graphical approach. (Note: do not draw the
iso-contribution line inorder to determine the optimal
solution.)
5 Algebraic solutions
Using equations to solve linear programming problems
Equations can be used to determine where two lines cross.
For example, in Illustration 4, we established that the optimal
solutionwas at Point C using the graphical method.
Point C represents the point at which the sales constraint
intersects thelabour constraint.
Labour constraint 5x + 10y = 20,000 (1)
Materials constraint x + y = 3,000 (2)
The basic method is to eliminate one of the two unknowns between
the
equations.
• This is achieved by adding or subtracting the equations.
• This process is known as solving simultaneous equations.
Illustration 5 - Algebraic solutions
Solve the following simultaneous equations.
5x+10y = 20,000(1)
x + y = 3,000 (2) "
Solution
Stepl
By multiplying equation (2) by 10, the coefficients of y
becomeequal:
(1): 5x + 10y = 20,000
10 x (2).: 10x + 10y = 30,000. ... Equation (3)
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Dealing with limiting factors
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Equation (2) when multiplied is called equation (3). You can
deductequation (1) from equation (3) to eliminate y.
1' '̂.M ^ -(3) 10x-+ 10y = 30,000
(1) 5x +•10y == 20,000
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5x 10,000
IP
• Obtain a value for x by r
v *'* "5
5x =10,000
x =10,000/5 = 2,000
Step 4
• Substitution into any of (1), (2) or (3) is possible but in
this case(2)is most convenient giving:
2,000 + y = 3,000
therefore y = 1,000
• So the solution is x = 2,000 y = 1,000 as before.
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Dealing with limiting factors
6 Further exam-style OT questions on linear programming
Many of the OT questions used throughout this chapter are longer
than thoseyou would expect to see in the exam. This is to ensure
that you understandthe full process of linear programming as many
students consider it a
.': difficult part of the syllabus and it is essential deemed
knowledge for F5. Inthis section you can practise shorter
exam-style OTs.
240
Test your understanding 6
Which of the following is not an assumption of linear
programming?
A There are only two variables
B There must be a single objective
C The problem must be a static one
D The constraints must be linear
Test your understanding 7
In a linear programming problem to determine the optimal
contributionC=10x+20y, the optimal solution is given by the
intersection of 5x+3y=19and 4x+y=11. The maximum profit is $ .
Test your understanding 8
In a linear programming problem one constraint is that a company
mustmake at least four times as manychairs as tables. If t and c
representthe number of tables and chairs made respectively, what is
the correctequation for this constraint?
A t = 4c
B c = 4t
C c>4t
D t>4c
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7 Chapter summary
DEAUNGWITH LIMITING
FACTORS
What is the limiting factor?
Alimiting factor is a factor that preventsacompany from
achieving the level of
activity that itwould like to. It is usuallysales demand but it
might be material,
labour, machine capacityand so on.
Multiple limiting factors - linearprogramming
Step 1 Define the unknowns, i.e. thevariables (that need to be
declared).Step 2 Formulate the constraints, i.e.thelimitations that
mustbe placed on thevariables.
Step 3 Formulatethe objectivefunction(that needs to be maximised
orminimised).
Graphical solutions
Step 4 Graph the constraints andobjective function.Step 5
Determine the optimal solutionto the problem by manipulating the
iso-contibution line and reading from thegraph or calculating the
contributionearned at each pointof feasible area.
Optimal production plan where there is asingle limiting
factor
Make products in order of contributionearned per unit of
limiting factor(start
with the highest earner).
Contribution per unitof limiting factor =
Contribution per unitUnits of limiting factor required per
unit
Algebraic solutions
When it is difficult to read therequiredpoints from a linear
programming graph,the optimal solution to the problem canbe
established (or confirmed) by solving
the relevant simultaneous equations.Simultaneous equations are
used in
conjunction with the graphical method insolving linear
programming problems, and
not on their own.
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BudgetingChapter learning objectives
Upon completion ofthis chapter you will be able to:
explain why organisations use budgeting, planning,
control,communication, co-ordination, authorisation,
motivation,evaluation
explain the stages in the budget process, including
theadministrative procedures
explain, giving examples, the term 'principal budget factor'
(or'limiting factor')
from data supplied, prepare budgets for sales
from data supplied, or derived, about the sales budget,
preparebudgets for production
from data supplied, or derived, about the production
budget,prepare budgets for material usage
from data supplied, or derived, about the materials usagebudget,
prepare budgets for material purchases
from data supplied, or derived, about the production
budget,prepare budgets for labour
from data supplied, or derived, about the production
budget,prepare budgets for overheads
explain, and prepare from information provided: fixed,
flexible,flexed budgets.
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SALES
BUDGETS
THE PURPOSES
OF
BUDGETING
BUDGETING
I
THE STAGES OF
BUDGET
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PREPARATION4
FIXED, FLEXIBLE AND FLEXED BUDGETS
PRODUCTION
BUDGETS
MATERIAL
BUDGETS
LABOUR
BUDGETS
1 The purposes of budgeting
Budget theory
OVERHEAD
BUDGETS
A budget is a quantitative expression of a plan of action
prepared inadvance of the period to which it relates.
Budgets set out the costs and revenues that are expected to be
incurred orearned in future periods.
• For example, ifyou are planning to take a holiday, you will
probably havea budgeted amount that you can spend. This budget will
determinewhere you go and for how long.
• Most organisations prepare budgets for the business as a
whole. Thefollowing budgets may also be prepared by
organisations:
- Departmental budgets.
- Functional budgets (for sales, production, expenditure and so
on).
- Income statements (in order to determine the expected
futureprofits).
- Cash budgets (in order to determine future cash flows).
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Purposes of budgeting
The main aims of budgeting are as follows:
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Planning for the future - in line with the objectives of the
organisation.
' Controlling costs - by comparing the plan of the budget with
the actualI •- results and investigating significant differences
between the two.£s§K
• Co-ordination of the different activities of the business by
ensuring that1HI managers are working towards the same common goal
(as stated in thejjjj budget).
• Communication-budgets communicate the targets of
theorganisation to individual managers.
• Motivation - budgets can motivate managers by encouraging them
tobeat targets or budgets set at the beginning of the budget
period.
§|§| Bonuses are often based on 'beating budgets'. Budgets, if
badly set,can also demotivate employees.
• Evaluation - the performance of managers is often judged by
lookingIIIp at how well the manager has performed 'against
budget'.gfpl • Authorisation - budgets act as a form of
authorisation of expenditure.
2 The stages in budget preparation
How are budgets prepared?
IISBefore any budgets can be prepared, the long-term objectives
of anorganisation must be defined so that the budgets prepared are
workingtowards the goals of the business.
Once this has been done, the budget committee can be formed, the
budgetmanual can be produced and the limiting factor can be
identified.
Budget committee is formed - a typical budget committee is
madeup of the chief executive, budget officer (management
accountant) anddepartmental or functional heads (sales manager,
purchasing manager,production manager and so on). The budget
committee is responsiblefor communicating policy guidelines to the
people who prepare thebudgets and for setting and approving
budgets.
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If sales is the principal budget factor, then the sales
budgetmust beproduced first.
Final steps in the budget process - oncethe budget relating to
thelimiting factor has been produced then the managers responsible
for theother budgets can produce them. The entire budget
preparation processmay take several weeks or months to complete.
Thefinal stages are asfollows.
- 1 Initial budgets are prepared. Budget managers may
sometimestry to build in an element of budget slack - this is a
deliberate over-estimation of costs or under-estimation of revenues
which canmake it easier for managers to achieve their targets.
- 2 Initial budgets are reviewed and integrated into the
completebudget system.
- 3After any necessary adjustments are made to initial budgets,
theyare accepted and the master budget is prepared (budgeted
incomestatement, balance sheetand cash flow). This master budget
isthen shown to top management for final approval.
- 4 Budgets are reviewed regularly. Comparisons between
budgetsand actual results are carried out and any differences
arising areknown as variances.
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Budget preparation
The preparation of budgets is illustrated as follows.
Illustration 1 - The stages in budget preparation
RAW MATERIALS
SELLING AND
DISTRIBUTION
EXPENSES BUDGET
SALES BUDGET
^«
PRODUCTION BUDGET
» 1 i
LABOUR FACTORY OVERHEAD) •COST OF GOODS
SOLD BUDGET
MASTER: BUDGET
BUDGETED INCOME
STATEMENT
CASH BUDGET
BUDGETED BALANCE SHEET
GENERAL AND
ADMINISTRATION
EXPENSES BUDGET
.%.....
CAPITAL
EXPENDITURE
BUDGET
The diagram shown above is based on sales being the
principalbudget factor. This is why the sales budget is shown in
Step 1.
Remember that if labour were the principal budget factor, then
thelabour budget would be produced first and this would determine
theproduction budget. .
Once the production budget has been determined then theremaining
functional budgets can be prepared.
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Budgeting
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Continuous budgets
Continuous budget - this type of budget is prepared a year
(orbudget period) ahead and is updated regularly by adding a
further .accounting period (month, quarter) when the first
accounting period hasexpired. If the budget period is a year, then
itwill always reflect thebudget for a year inadvance. Continuous
budgets are also known asrolling budgets.
3 Sales budgets
Budget preparation - functional budgets
A functional budget is a budget of income and/or expenditure
which appliesto a particular function. The main functional budgets
that you need to be ableto prepare are as follows:
sales budget
production budget
raw material usage budget
raw material purchases budget
labour budget
overheads budget.
Sales budgets
We shall begin our preparation of functional budgets by looking
at salesbudgets. Sales budgets are fairly straightforward to
prepare as the followingillustration will demonstrate.
Illustration 2 - Sales budgets
A company makes two products - PS and TG. Sales for next year
arebudgeted to be 5,000 units of PS and 1,000 units of TG. Planned
sellingprices are $95 and $130 per unit respectively.
Required:
Prepare the sales budget for the next year.
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