Limiting Factors in Budgets
To obtain knowledge of the limiting factors in an organisation
To identify the limiting factors in a case study scenario
To apply the marginal costing method to compute the contribution
To assess the mix of products to maximise contribution and profit
- In this session, you will be focusing on limiting factors or constraints that are mainly found in a manufacturing organisation.
- Resources such as material and labour are essential requirements in the production process and organisations make every effort to ensure that they can acquire sufficient of these resources.
- However, at times, it will not be possible to obtain all the resources due to the non-availability of the correct labour skill(s) and finite materials due to increased demand for it.
- You will be able to prepare computations using the marginal costing approach, to determine how to maximise contributions in light of the limiting factor(s).
- In an organisation, there is at least one factor which limits its activities, for example, sales demand.
- If a company manufactures vehicles, say motor vans and the demand for them is 98,000, but the production capacity is 120,000, this means that the production department will be underutilised by the limiting factor of sales demand for vans.
- In a manufacturing organisation, the most common limiting factors are resources such as materials and labour hours which can prevent it from producing products to its maximum capacity.
- Therefore, the production department manager would need to revise the planned production level of activities in order to accommodate the shortage of resources.
- In a situation where there is a shortage of a resource, the business should seek to maximise the use of the limited resource.
- To do this, they must apply the marginal costing method approach to determine the maximum contribution it can obtain from the mix of products it makes.
- The marginal cost of an item is its variable cost.
- The marginal production cost of an item is the sum of its direct materials cost, direct labour cost, direct expenses cost (if any) and variable production overhead cost.
- As the volume of production and sales increases total variable costs rise proportionately.
- Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the volume of production and sale.
- Marginal production cost is the part of the cost of one unit of production service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.
- Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.
- Notes:
- Variable costs are those which change as output changes – these are treated under marginal costing as costs of the product.
- Fixed costs, in this system, are treated as costs of the period.
- Marginal costing is also the principal costing technique used in decision making. The key reason for this is that the marginal costing approach allows management’s attention to be focussed on the changes which result from the decision under consideration.
The contribution concept lies at the heart of marginal costing. Contribution can be calculated as follows.
Contribution = Sales price – Variable costs
The idea of profit is not a particularly useful one as it depends on how many units are sold. For this reason, the contribution concept is frequently employed by management accountants.
- Contribution gives an idea of how much ‘money’ there is available to ‘contribute’ towards paying for the overheads of the organisation.
- At varying levels of output and sales, contribution per unit is constant.
- At varying levels of output and sales, profit per unit varies.
- Total contribution = Contribution per unit x Sales volume.
- Profit = Total contribution – Fixed overheads
Example:
James Company manufactures a product that sells for £60 per unit. The company incurs a variable cost per unit of £35 and £2,400,000 in total fixed costs to produce this product. They are currently selling 100,000 units.
REQUIREMENTS:
a) What is the contribution margin per unit?
b) Compute the profit
a) Contribution per unit = Selling price per unit – variable costs per unit
= 60 – 35 = £25 per unit
(b) Total contribution = contribution per unit x number of units sold
= £25 x 100,000 = £2,500,000
Less: fixed costs (2,400,000)
Profit 100,000
Let’s go straight into doing some activities to demonstrate how to deal with resource shortages and how to maximise profit from the making of products.
Jane Company manufactures a product that sells for £70 per unit. The company incurs a variable cost per unit of £30 and £5,000,000 in total fixed costs to produce this product. They are currently selling 200,000 units.
Tasks:
a) What is the contribution margin per unit?
b) Compute the profit
a) Contribution per unit = Selling price per unit – variable costs per unit
= 70 – 30 = £40 per unit
(b) Total contribution = contribution per unit x number of units sold
= £40 x 200,000 = £8,000,000
Less: fixed costs (5,000,000)
Profit 3,000,000
A manufacturing company makes two products, Gee and Heych, each utilising the same material and the same labour force.
The planned budget for the month of November is as follows.
The material costs £8 per kilo and the labour force is paid on an hourly basis at £5 per hour. Employees only work when there is work available and overheads are fixed.
Product Gee sells for £180 per unit and Heych for £145 per unit.
Due to the skill of labour required, the company is experiencing a shortage of employees and therefore labour hours expected for the month of November is only 8,500 hours.
Required
Prepare a revised production budget in units for the month of November that maximises contribution and profit.
In this session, you have covered constraints or limiting factors such as shortage of material and labour that affect how many products an organisation can make and, at the same time, maximising contribution to cover fixed costs.
These are not the only limiting factors; you could have limitations in machine hours, factory space and even warehouse capacity to store finished products.
The importance of knowing how to maximise profit as a management accountant in an organisation is helpful to the decision-making process of the board of directors of the organisation.
Make sure that you are able to master the techniques used in the solution to enable you to use it and apply it in assignments and employment.
In the next session, you will move on to Flexi budgeting.