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Decision-Making-II
Learning Objectives
Introduction
In this lesson, we will be discussing how marginal costing technique helps in decision-making for
scarce resources and limiting factor. We will also be discussing certain cases relating to scarce
resources and limiting factor, and how does marginal costing technique helps in decision-making.
A limiting factor (also known as key factor or principal budget factor) is one the extent of whose
influence should first be assessed in order to ensure maximization of resources with the help of
managerial decision-making.
In simple words, a limiting factor is the factor the supply of which is not unlimited or freely
available to the manufacturing enterprise. For example, in case of labor shortages, labor becomes a
limiting factor. Raw material or plant capacity may be a limiting factor during budget period.
The limiting factor is also known by the names of scarce factor, key factor, principal budget factor
and governing factor.
In order to maximize profits, a concern should employ all its resources to manufacture and sell
maximum quantities of products which yield the highest contribution under a particular
circumstance.
Key factors are one or more factors of production and sales such as capital, labor of suitable skill,
efficient staff and executive, plant and machinery, raw materials, consumer demand and sales
personnel.
When contribution and key factor are known, we can assess the relative profitability as follows:
Profitability = Contribution
Key or Limiting Factor
When sales become the key factor, profitability is determined by contribution sales ratio or P/V
ratio. When material is in short supply, profitability is determined by contribution per kg of raw
material and so on.
Now, it may be noted that sometimes there are more than one key factor. In case of one key factor,
the marginal costing approach may be sufficient to quantify the problem and its solution. But in
case of multiple key factors, operational research approach of problem solving has to be applied.
You should be aware of the fact that sometimes, production has to be carried with certain limiting
factors.
The consideration of limiting factors is essential for the success of any production plan. This is
because the manufacturing firm cannot increase the production to the level it desires when a
limiting factor is combined with other factors of production.
So, the commodity which has maximum contribution per unit or which yields maximum P/V ratio
is the most profitable commodity. This is true when there is no limitation or production factor. In
case different products are manufactured with a particular limiting factor, it is not the contribution
per unit or P/V ratio which rightly guides in fixing production priorities. It is actually the
profitability per unit of limiting factor which is the proper guiding star. Supposing labor is a
limiting factor, relative profitability will be calculated as under:
Illustration 1
The following information in respect of product X and Y of ABC Co. Ltd. is obtained:
Product X Product Y
Rs. Rs.
Selling Price 105 68
Direct Material 40 40
Direct Labor Hour
(Re 0.50 Per Hour) 20 Hours 4 Hours
Variable Overhead – 100 % of Direct Wages
Fixed Overhead – Rs. 3000
Solution
We can prepare a statement of profitability and contribution under marginal costing method as
under:
Illustration 2
From the above illustration, recommend which of the following sales mix should be adopted:
What recommendations would you make if due to labor shortage, the direct labor hours available
were 1200 hours only. Assess that the maximum production capacity otherwise available for each
of the products X and Y is 200 units.
Solution
From the above discussed example, we have observed that contribution per unit of X is Rs. 45
while that of Y is Rs. 24.
X Y Total
i. 100 units of X and 50 units of Y Rs. Rs. Rs.
Contribution 4500 1200 5700
Fixed overheads 3000
Profit 2700
In times of labor shortage, we have already seen that product Y is more profitable. Therefore,
production of maximum of product Y, i.e. 200 units, is recommended. Two hundred units of Y
will consume 800 hours and the balance hours will be utilized in producing X, i.e. 400/20 hrs = 20
units.
In any other sales mix, profit will be less than Rs. 2700, provided labor hours remain the key
factor.
Illustration 3
From the following data, which product would you recommend to be manufactured in a factory,
time being the key factor:
Per unit of Product M Per unit of Product N
Direct material 24 14
Direct labor (Re 1 per hour) 2 3
Variable overhead (Rs. 2 per hour) 4 6
Selling price 100 110
Standard time to produce 2 hours 3 hours
Solution
Marginal Cost Statement
On the basis of the marginal cost statement, we can give our recommendations as follows:
Product N is more profitable if there is no limiting factor. Since labor is the limiting factor, product
M should be manufactured in the factory as its profitability per hour is Rs. 35 which is more than
the profitability of N. If sales is not the limiting factor, all the available labor should be diverted
for the production of product M.
Illustration 4
On the basis of following information in respect of an engineering company, determine the product
mix which will give the highest attainable profit. Do you recommend working overtime per unit
details?
A 100 24 2 4 2 hours
B 110 14 3 6 3 hours
Solution
Marginal Cost Statement
Marginal cost 30 23
Contribution 70 87
Based on the marginal costing statement, we can recommend that product B is more profitable if
there is no limiting factor. Since labor is the limiting factor, product A should be manufactured in
the factory as its profitability per hour is Rs. 35, which is more than the profitability of B. If sales
is not the limiting factor, all the available labor should be diverted for the production of product A.
It is possible that the production is limited by two or more limiting factors. For example, labor and
raw material may be in short supply. The amount of availability of one factor affects the utilization
of other factors. Under such a condition, the best product mix is one which optimizes overall
profits but is achievable under the given constraints.
Illustration 5
On the basis of following information in respect of an engineering company, determine the product
mix which will give the highest attainable profit. Do you recommend working overtime up to a
maximum of 15,000 hours at twice the normal wages (overheads are ignored for the purpose of
this question)?
Products
P Q R
Raw materials per unit (kg) 10 6 15
Labor hours per unit 15 25 20
(Re 1 per hour)
Maximum production
6,000 4,000 4,000
possible
Selling price per unit (Rs.) 125 100 200
One lakh kg of raw material is available @ Rs.10 per kg. Maximum production hours are 1,84,000,
with a facility for further 15,000 hours on overtime basis at twice the normal wage rate.
Solution
From this statement, we can say that since raw material and labor are the limiting factors, the
production of Q and R should be encouraged to the maximum level as these products show
maximum profitability both per kg of raw material and per labor hour. Any raw material and labor
hours remaining after their use in the production of products Q and R should be utilized for the
production of P. The consumption of inputs in Q and R and the balance available for P is
calculated below:
With 31,000 kg of raw material and 24,000 labor hours, how many units of product P can be
produced? Thirty one thousand kg of raw material is sufficient to produce 31,000 kg of P, but the
labor available to produce 31,000 units is not sufficient. 24,000 labor hours are sufficient just to
produce 1,600 units (15 hrs. are required to produce one unit). Therefore, 1,600 units of P can be
produced working at current normal conditions. The contribution from the production of 1,600
units of P @ Rs. 10 per unit will be Rs. 16,000.
If the work is done for additional 15,000 hours for which the facility exists, additional 1,000 units
can be produced but at twice the normal wage rates. The contribution form the total 2,600 units of
A will be as follows:
Sales of 2,600 units @ Rs. 125 per unit = 3,25,000; Marginal cost of 2,600 units:
(b) Wages:
1,600 units @ Rs. 15 24,000
(c) Wages:
1,000 units @ Rs. 30 30,000
3,14,000
Marginal Contribution 11,000
From the above cost analysis, we can observe that the production of 1,600 units yields a
contribution of Rs. 16,000 whereas 2,600 units generate a contribution of Rs. 11,000. Thus, the
contribution is reduced if additional 1,000 units, by working overtime, are produced. Therefore,
overtime work is not recommended. The best product mix will be as follows:
Products Units
A 1,600
B 4,000
C 3,000
Illustration 6
The following particulars are obtained from the records of a company engaged in manufacturing
two products X and Y from a certain raw material:
Product X Product Y
(per unit) (per unit)
Rs. Rs.
Sales 100 200
Material’s cost
(Rs. 10 per kg) 20 50
Direct wages
(Rs. 6 per hour) 30 60
Variable overhead 10 20
Total fixed overhead – Rs. 10,000
Solution
Statement showing Comparative Profitability
Product X Product Y
(per unit) (per unit)
Rs. Rs. Rs. Rs.
Sales 100 200
Less: Marginal cost:
Material 20 50
Direct wages 30 60
Variable overhead 10 20
60 130
(i) Contribution 45 80
(ii) P/V ratio = C/S 40% 35%
(iii) Contribution per kg Rs. 40/2 kg Rs. 70/5 kg
= Rs. 20 = Rs. 14
(iv) Contribution per hour Rs. 40/3 hrs Rs. 70/10 hrs
= Rs. 8 = Rs.7
(a) Thus, when sales potential in units is limited, product Y is more profitable as is revealed by
the contribution per unit.
(b) When total sales potential in value is limited, the P/V ratio of product X is higher, and hence
more profitable.
(c) When raw material is in short supply, contribution per kg of raw material for product X is
more, and hence more profitable.
(d) When capacity is limited, contribution per hour of product X is more, and hence more
profitable.
(e) It is a case of two limiting factors. When raw material is in short supply, product X is more
profitable. So maximum, i.e. 1000 units of product X, should be produced consuming 2000
kg of raw material, and with the balance quantity, i.e. 4000 – 2000 kg, 400 units (2000 kg/5
kg) of product Y will be produced. This can be shown as follows: