Tuesday, July 5, 2011

Limiting Factor Analysis (LFA) Concept

• For short-run product-mix, decisions with capacity constraints/bottlenecks and the assumed objective is to maximise short-run profits.

• If fixed costs remained unchanged, maximisation of total contribution will result in maximisation of short-run profits.

(A) Single limiting factor analysis - Two approaches:
• Using marginal costing principles
• Using throughput accounting principles – developed for a JIT environment

(B) Multi-limiting factor analysis
A Linear Programming Model using marginal costing principles can be used to determine the profit-maximisation product-mix.

(Key point: Always use marginal costing principles for decisions involving limiting factors. Throughput accounting principles is relevant only if specifically required in the question)

LFA Using Marginal Costing Principles
Decision rule: Rank products based on contribution per unit of the scarce resource/limiting factor.

Contribution = Sales – All Variable Costs

Contribution per unit of scarce resource
= Variable contribution per unit of output / Scarce resources required per unit of output

LFA Using Throughput Accounting Principles
Decision rule: rank products based on throughput accounting ratio (TA ratio)

TA ratio = Throughput contribution per bottleneck hour / Total factory cost per bottleneck hour

Throughput contribution or throughput return = Sales – Direct Material Costs

Total factory cost include all operating costs, except direct materials.

Note: Product ranking using TA ratios is identical to ranking products using throughput contribution per unit of the bottleneck.

TA ratios can be used to measure product profitability in the following context:
• As a relative measure of profitability for ranking products – the higher the ranking, the more profitable is the product.

• As an absolute measure – a product is profitable only if its TA ratio is more than one (1), otherwise not profitable.


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