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Key notes in Limiting factor analysis

• An organization might be faced with just one limiting factor (other than max. sales demand) but there might also be several scarce resources, with two or more of them putting an effective limit on the level of activity that can be achieved.

• Examples of limiting factors include sales demand and production constraints.

– Labor. The limit may be either in terms of total quantity or of particular skills.

– Materials. There may be insufficient available materials to produce enough units to satisfy sales demand.

– Manufacturing capacity. There may not be sufficient machine capacity for the production required to meet sales demand.

• It is assumed in limiting factor analysis that management would make a product mix decision or service mix decision based on the option that would maximize profit and that profit is maximized when contribution is maximized (given no change in fixed cost). In other words, marginal costing ideas are applied.

– Contribution will be maximized by earning the biggest possible contribution per unit of limiting factor. For example if grade A labor is the limiting factor, contribution will be maximized by earning the biggest contribution per hour of grade A labor worked.

– The limiting factor decision therefore involves the determination of the contribution earned per unit of limiting factor by each different product.

– If the sales demand is limited, the profit-maximizing decision will be to produce the top- ranked product(s) up to the sales demand limit.

• In limiting factor decisions, we generally assume that fixed costs are the same whatever product or service mix is selected, so that the only relevant costs are variable costs.

• Where there is one limiting factor, the technique for establishing the contribution-maximizing product mix or service mix is to rank the products or services in order of contribution-earning capacity per unit of limiting factor.
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