Decision Making in the Face of Limiting Factors

Decision making in the face of limiting factors

In the examples which we have examined so far, the selection of alternative courses of action has been made on the basis of seeking the most profitable result. Business enterprises are limited in the pursuit of profit by the fact that they have limited resources at their disposal, so that quite apart from the limitation on the quantities of any product which the market will buy at a given price, the firm has its own constraints on the volume of output. Hence at a given price, which may be well above costs of production, the firm may be unable to increase its overall profit simply due to its inability to increase its output.

The limiting factors which affect the level of production may arise out of shortages of labour, material, equipment and factory space to mention but a few obvious examples. Faced with limiting factors of whatever nature, the firm will wish to obtain the maximum profit from the use of the resources available, and in making decisions about the allocation of its resources between competing alternatives, management will be guided by the relative contribution margins which they offer. Since the firm will be faced with limiting factors, however, the contribution margins must be calculated not in terms of units of product sold which fail to reflect constraints on the total volume of output, but should be related to the unit of quantity of the most limited factor. A simple example will serve to explain this point.

Example

Multiproduct Ltd manufactures three products about which is derived the following data:

Machine hours required per unit - Margin per unit - Margin per machine hour

A 3 hours £9 £3.0

B 2 hours £7 £3.5

C 1 hour £5 £5.0

The three products can be made by the same machine, and on the basis of this information, it is evident that product C is the most profitable product yielding a contribution of £5 per machine hour, as against product A, which shows the smallest contribution per machine hour. Hence, in deciding how to use the limiting factor the firm should concentrate on the production of product C, rather than products A and B. If there were no limits to the market demand for product C, there would be no problem in deciding which product to produce-it would be product C alone.

Firms undertake the manufacture of different products because the market demand for any one product is limited, so that firms seek to find that product-mix which will be the most profitable. Let us assume that the maximum weekly demand for the three products and the total machine capacity necessary to meet this demand is as follows:

Maximum demand in Machine hours - Product units equivalents

A 100 300

B 100 200

C 100 100

This product-mix reflects the order of priority in allocating machine use to the products with the highest contribution margin per hour. Product C receives the highest priority, then product B, and lastly product A. If machine hours were further limited to 300 hours, the firm would cease to make product A.


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Read on: Opportunity Costs

Opportunity costs are not recorded in the accounting process, and although they are favoured by economists as appropriate costs for decision making, they are difficult to identify and to measure in practice. Hence, accountants prefer to record and use more objective measures of costs, such as past costs or budgeted future costs as guidelines for decision making. There are a number of decision problems, however, in which the only relevant cost is the opportunity cost. The opportunity cost may be defined as the value of the next best opportunity foregone, or of the net cash inflow lost as a result of preferring... see: Opportunity Costs