As explained in an earlier post, management accounting is an important base for a successful company. One part of it is related to determine the best use of internal resources. Assuming companies aim for profit maximization they need to figure out how to best use their assets. Limiting factor analysis is a technique supporting this process.
A limiting factor is a resource that is not infinitely available to a company. Examples of such scarce resources are material, hours (labour or machinery) as well as money. Limiting factor analysis calculates the contribution of a scarce unit used.
In theory, limiting factor analysis is performed in three consecutive steps.
Firstly, the contribution of each product needs to be calculated. This means variable product costs are subtracted from the sales price.
Secondly, the contribution of each unit of scarce resource used needs to be identified. In order to do so, the contribution of each product is taken (step 1) and divided by the amount of scarce resource required to produce one product.
Thirdly, products can be ranked by how much they earn per unit of scarce resource. This ranking can then be used to determine which products should be produced and sold first.
Let’s have a look at these three steps using an example of a company producing three different computers:
Which computer sales should be pushed most in order to maximise profit is calculated like this:
The calculation shows that Computer 3 returns the highest contribution per manufacturing minute and thus should be pushed most.
Limiting factor analysis in practice
In practice, the limiting factor is often the sales volume. All the internal resources like production staff and machinery are ready and not fully utilised because of the order volume. Although this appears as a difference of the theoretical approach, the same ideas can be applied. The scarce resource is to be replaced by sales force hour.
It is also possible that there are multiple limiting factors. The technique explained only works for a single scarce factor. If multiple limitations are present, complex algorithms need to be used to determine the optimal solution.
Furthermore, in practice, it doesn’t stop with finding out the product with the highest contribution per limiting resource. Optimisation is also the essential part of further maximising profits. Sales appointments, as an example, can be scheduled in a way so they visit those customers with the highest likelihood of purchasing. Another aspect is increasing the conversion. This could be reached by sales training.
Theory suggests a three-step approach to limiting factor analysis. Maximisation in practice can be more complex as optimisation plays a role and multiple limiting factors can occur.