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1.6 Key Factors or Limiting Factor

The marginal costing technique provides that the product with highest contribution per unit is preferred. This inference holds true so long as it is possible to sell as much as it can produce. But sometimes an organisation can sell all it produces but production Is limited due to scarcity of raw material, labour, electricity, plant capacity or capital.

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These are called key factors or limiting facto$ A key factor or limiting factor puts a limit on production and profit of the firm. In such situation, management has to take a decision whose production is to be increased, decreased or stopped. In such cases, selection of the product is done on the basis of contribution per unit of scarce factor of production. The key factor or scarce factor should be utilized in such a manner that contribution per unit of scarce resource is the maximum.

Mathematically,

Contribution

Profitability = —————

Key Factor

For example, if raw material is the limiting factor, the profitability of each product is determined by contribution per Kg of raw material. If machine capacity is a limiting factor then contribution per machine hour is calculated. It electricity is the limiting factor, then contribution per unit of electricity of each product is calculated.

Example:

A company produces two products X and Y. The cost information is as follows:

Products X Y

Sale Price $20 $15

Variable Cost $10 $ 8

Required Machine hours per unit 2 1

Sales Potential (Units) 1000 1200

Available production hours 2000

Calculate and find the best product mix?

Solution:

Products X Y

Sale Price $20 $15

Variable Cost $10 $8

Contribution $10 $7

Required machine hours per unit 2 1

Contribution per machine hour 7

Product Y gives the highest contribution per machine hours. The best solution would be to produce Y to the maximum extent that can be sold and remaining hours should be devoted for production of X. Hence 1200 units of Y be produced and remaining 800 hours be devoted to product X which means 400 units of X. Thus the optimum mix is 400 units of X and 1200 units of Y.

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