3.7.3 Principal Budget Factor

Optimal utilisation of scarce resources
Objectives
After studying the chapter, learners should be able to:
 List the procedures for dealing with a limiting factor.
 Carryout all the procedures and advice management on the most
profitable production plan.
 Calculate the maximum profit from the most optimal production plan.
Introduction
Scarce resource utilization (or allocation) decision is a judgment regarding the best
use of scarce resources so as to maximize the total net income of a business.
Scarcity of different resources puts constraints on the amount of product that can be
produced using those resources.
DEFINITIONS
Key factor/principal budget factor
Any resource which puts a constraint on the budgeted level of activity of a business.
Examples are shortage of direct materials, direct labour hours, and machine hours or
demand.
A simple scarce resource allocation decision involves the following steps:
1. Calculate the contribution margin per unit of the scarce resource from each
product.
2. Rank the products in the order of decreasing contribution margin per unit of
scarce resource.
3. Estimate the number of units of each product which can be sold.
4. Allocate scarce resource first to the product with highest contribution margin
per unit of scarce resource, then to the product with next highest contribution
margin per unit of scarce resource.
A scarce resource decision can be better explained using an example.
Example
A company has 4,000 machine hours of plant capacity per month which are to be
allocated to products A and B. The following per unit figures relate to the products:
Product A B
Sale Price $300 $240
Costs:
Direct Material 100 70
Direct Labour 65 50
Variable Overhead 20 40
1
Fixed Overhead 15 30
Variable Operating
40 20
Expenses
Total Costs $240 $210
Net Income $60 $30
Machine Hours Required 1.5 1.00
Assuming that the company can sell all its output, determine how many machine
hours shall be allocated to each product.
Solution
Product A B
Sale Price $300 $240
− Variable Cost 225 180
CM Per Unit $75 $60
÷ Machine Hours
1.50 1.00
Required
CM Per Machine Hour $50 $60
Since the company can sell all its output, the best decision is to allocate all machine
hours (i.e. scarce resource) to product B.
Assuming maximum demand for each product is 2 500 units, how many units of
each product should be manufactured taking into account the shortage of machine
hours?
Calculate the total profit to be earned
Solution
OUTPUT MACHINE HOURS

PRODUCT 4000
B 2 500 (2500)
1500
A 1000 (1 500)
NOTE
The product with the highest contribution per unit of the limiting factor is given a full
budgetary allocation i.e. produced to the maximum.
Then the remaining machine hours are used to manufacture the quantity of output
that suffices for product A
That quantity is found by dividing remaining machine hours of 1500 by machine
hours needed to produce each unit of product B
1500/1.5=1000 Units of product B
2
Calculation of expected profit from the resultant product mix
product A Product B TOTAL

$ $ $
Contribution 75 000 150 000 225 000
less fixed costs (37 500) (75 000) (112 500)
net profit 37 500 75 000 112 500
Note
Contribution has been calculated by multiplying the contribution per unit by actual
units produced per product.
Fixed costs however have been calculated by multiplying fixed cost per unit by
maximum production per unit from your understanding of fixed costs.
Chapter summary
 Key factor refers to any factor which may place a constraint on the budgeted
level of business activity prompting the firm to revise the product mix.
 The scarce resource is allocated based on the contribution per unit of the
limiting factor
 Contribution per unit of the limiting factor is obtained by dividing the
contribution per unit by the units of a limiting factor required to produce one
unit of each product.
 The aim is to maximise profits from the scarce resource
Questions for your practice

Question 1
A company manufactures two products A and B using the same type of raw
materials. Data for the next period is as follows:
PRODUCT A PRODUCT B
demand in units 27 000 18 000
selling price per unit $20 $25
variable cost per unit:
direct material $6 $10
direct labour $6 $10
production overhead $3 $2
allocated fixed overhead $50 000 $35 000
3
raw material required /unit 5KG 4KG
direct labour hours required/unit 10 hours 8 hours
The company can obtain 180 000 kgs of raw materials for the period.
Required
a) Work out the optimal production plan for the company given that raw materials are
a limiting factor. [15 marks]
b) Calculate the total contribution and profit under the optimal production [5 marks]
Question 2

3.7.3 Principal Budget Factor

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Optimal utilisation of scarce resources

A scarce resource decision can be better explained using an example.

OUTPUT MACHINE HOURS

product A Product B TOTAL

Questions for your practice

demand in units 27 000 18 000

selling price per unit $20 $25

variable cost per unit:

direct material $6 $10

direct labour $6 $10

allocated fixed overhead $50 000 $35 000

direct labour hours required/unit 10 hours 8 hours

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