Chapter 5 Limiting Factors and Throughput Accounting

1. Objectives

1.1 Identify limiting factors in a scarce resource situation and select an appropriate
technique.
1.2 Determine the optimal production plan where an organization is restricted by a single
limiting factor.
1.3 Explain the concept of optimized production technology.
1.4 Explain the theory of constraints.
1.5 Explain the concept of throughput accounting.
1.6 Calculate and interpret a throughput accounting ratio (TPAR).
1.7 Compare the techniques of limiting factors and throughput accounting in the
determination of optimal production.

O p t im a l
P r o d u c t io n
P la n

L im it in g T h ro u gh p u t C o m p a r is o n o f
F a c to rs A c c o u n t in g lim it in g f a c t o r s
a n d th ro u g h p u t
a c c o u n t in g

R a n k p r o d u c tio n O p t im iz e d T h e o ry T h ro u gh p u t
b y c o n tr ib u t io n P r o d u c t io n of A c c o u n t in g
p e r lim it in g f a c t o r T e c h n o lo g y C o n s t r a in ts R a tio

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2. Limiting Factors

2.1 Limiting Factors

A limiting factor is any factor that is in scarce supply and that stops the organisation
from expanding its activities further, that is, it limits the organisations activities.

2.2 An organisation might be faced with just one limiting factor (other than maximum
sales demand) but there might also be several scarce resources, with two or more of
them putting an effective limit on the level of activity that can be achieved.
2.3 Examples of limiting factors include sales demand and production constraints.
(a) Labour. The limit may be either in terms of total quantity or of particular
skills.
(b) Materials. There may be insufficient available materials to produce enough
units to satisfy sales demand.
(c) Manufacturing capacity. There may not be sufficient machine capacity for
the production required to meet sales demand.
2.4 It is assumed in limiting factor analysis that management would make a product mix
decision or service mix decision based on the option that would maximise profit and
that profit is maximized when contribution is maximised (given no change in fixed
cost expenditure incurred). In other words, marginal costing ideas are applied.
(a) Contribution will be maximised by earning the biggest possible
contribution per unit of limiting factor. For example if grade A labour is the
limiting factor, contribution will be maximised by earning the biggest
contribution per hour of grade A labour worked.
(b) The limiting factor decision therefore involves the determination of the
contribution earned per unit of limiting factor by each different product.
(c) If the sales demand is limited, the profit-maximising decision will be to
produce the topranked product(s) up to the sales demand limit.
2.5 In limiting factor decisions, we generally assume that fixed costs are the same
whatever product or service mix is selected, so that the only relevant costs are variable
costs.
2.6 When there is just one limiting factor, the technique for establishing the contribution-
maximising product mix or service mix is to rank the products or services in order
of contribution-earning ability per unit of limiting factor.

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2.7 Example 1
Sausage makes two products, the Mash and the Sauce. Unit variable costs are as
follows.
Mash Sauce
$ $
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
8 7

The sales price per unit is $14 per Mash and $11 per Sauce. During July the available
direct labour is limited to 8,000 hours. Sales demand in July is expected to be as
follows.
Mash 3,000 units
Sauce 5,000 units

Required:

Determine the production budget that will maximize profit, assuming that fixed costs
per month are $20,000 and that there is no opening inventory of finished goods or
work in progress.

Solution:

1. Determine the limiting factor

Mash Sauces Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs

Labour is the limiting factor on production.

2. Identify the contribution earned by each product per unit of scarce resource,
that is, per labour hour worked.

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 Mash Sauce
$ $
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hour per unit 2 hrs 1 hr
Contribution per labour hour (= per unit of
limiting factor) $3 $4
Ranking 2 1

3. Determine the budgeted production and sales.

Product Units Hours Contribution Total
needed per unit
$ $
Sauces 5,000 5,000 4 20,000
Mashes (Bal.) 1,500 3,000 6 9,000
8,000 29,000
Less: fixed costs 20,000
Profit 9,000

Conclusion:
(1) Unit contribution is not the correct way to decide priorities.
(2) Labour hours are the scarce resource, therefore contribution per labour hour is
the correct way to decide priorities.
(3) The Sauce earns $4 contribution per labour hour, and the Mash earns $3
contribution per labour hour. Sauces therefore make more profitable use of the
scarce resource, and should be manufactured first.

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Question 1
Triproduct Limited makes and sells three types of electronic security systems for which the
following information is available.

Standard cost and selling prices per unit

Product Day scan Night scan Omni scan
$ $ $
Materials 70 110 155
Manufacturing labour 40 55 70
Installation labour 24 32 44
Variable overheads 16 20 28
Selling price 250 320 460

Fixed costs for the period are $450 000 and the installation labour, which is highly skilled, is
available for 25 000 hours only in a period and is paid £8 per hour.

Both manufacturing and installation labour are variable costs.

The maximum demand for the product is:

Day scan Night scan Omni scan
2,000 units 3,000 units 1,800 units

Required:

(a) Calculate the shortfall (if any) in hours of installation labour. (2 marks)
(b) Determine the best production plan, assuming that Triproduct Limited wishes to
maximise profit. (5 marks)
(c) Calculate the maximum profit that could be achieved from the plan in part (b) above.
(3 marks)
(d) Having carried out an investigation of the availability of installation labour, the firm
thinks that by offering $12 per hour, additional labour would become available and
thus overcome the labour shortage.

Required:
Based on the results obtained above, advise the firm whether or not to implement the

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 proposal. (5 marks)
(Total 15 marks)

3. Throughput Accounting (產量會計)

3.1 Optimized production technology (OPT)

3.1.1 During the 1980s Goldratt and Cox (1984) advocated a new approach to production
management called OPT. OPT is based on the principle that profits are expanded by
increasing the throughput of the plant. The OPT approach determines what prevents
throughput being higher by distinguishing bottleneck and non-bottleneck resources.
3.1.2 A bottleneck might be a machine whose capacity limits the throughput of the whole
production process. The aim is to identify bottlenecks and remove them or, if this is
not possible, ensure that they are fully utilized at all times.
3.1.3 Non-bottleneck resources should be scheduled and operated based on constraints
within the system, and should not be used to produce more than the bottlenecks
can absorb. The OPT philosophy therefore advocates that non-bottleneck resources
should not be utilized to 100% of their capacity, since this would merely result in
an increase in inventory.

3.2 Theory of constraints

3.2.1 Goldratt and Cox (1992) describe the process of maximizing operating profit when
faced with bottleneck and non-bottleneck operations as the theory of constraints
(TOC).
3.2.2 The TOC aims to increase throughput contribution while simultaneously reducing
inventory and operational expenses. However, the scope for reducing the latter is
limited since they must be maintained at some minimum level for production to take
place at all. In other words, operational expenses are assumed to be fixed costs.
3.2.3 The TOC adopts a short-run time horizon and treats all operating expenses
(including direct labour but excluding direct materials) as fixed, thus implying that
variable costing should be used for decision-making, profit measurement and
inventory valuation.
3.2.4 It emphasizes the management of bottleneck activities as the key to improving
performance by focusing on the short-run maximization of throughput contribution.

3.2.5 Example 1 – Illustration of the TOC

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 Machine X can process 1,000 kg of raw material per hour, machine Y 800 kg. Of an
input of 900 kg, 100 kg of processed material must wait on the bottleneck machine
(machine Y) at the end of an hour of processing.

The traditional view is that machines should be working, not sitting idle. So if the
desired output from the above process were 8,100 kgs, machine X would be kept in
continual use and all 8,100 kgs would be processed through the machine in nine
hours. There would be a backlog of 900 kgs [8,100 – (9 hrs × 800)] of processed
material in front of machine Y, however. All this material would require handling
and storage space and create the additional costs related to these non-value added
activities. Its processing would not increase throughput contribution.

3.3 Throughput Accounting (TA)

3.3.1 Galloway and Waldron (1988) advocate an approach called throughput accounting to
apply the TOC philosophy.

3.3.2 Throughout Accounting

Throughput accounting is a product management system which aims to maximise

throughput, and therefore cash generation from sales, rather than profit. A just
in time (JIT) environment is operated, with buffer inventory kept only when there
is a bottleneck resource.

3.3.3 TA for JIT is said to be based on three concepts.

(a) Concept 1
In the short run, most costs in the factory (with the exception of materials
costs) are fixed (the opposite of ABC, which assumes that all costs are

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 variable). These fixed costs include direct labour. It is useful to group all
these costs together and call them Total Factory Costs (TFC).
(b) Concept 2
In a JIT environment, all inventory is a 'bad thing' and the ideal inventory
level is zero. Products should not be made unless a customer has ordered
them. When goods are made, the factory effectively operates at the rate of the
slowest process, and there will be unavoidable idle capacity in other
operations.

Work in progress should be valued at material cost only until the output is
eventually sold, so that no value will be added and no profit earned until the
sale takes place. Working on output just to add to work in progress or finished
goods inventory creates no profit, and so should not be encouraged.
(c) Concept 3
Profitability is determined by the rate at which 'money comes in at the door'
(that is, sales are made) and, in a JIT environment, this depends on how
quickly goods can be produced to satisfy customer orders. Since the goal of
a profit-orientated organisation is to make money, inventory must be sold for
that goal to be achieved. The bottleneck resource slows the process of making
money.

3.3.4 Throughout Accounting and Decision Making

In a throughput environment, production priority must be given to the products best

able to generate throughput, that is those products that maximize throughput per
unit of bottleneck resource.

The TA ratio can be used to assess the relative earning capabilities of different
products and hence can help with decision making.

Return per factory hour

TA ratio =
Total conversion cost per factory hour
Where:
Sales – direct material costs
Return per factory hour = Usage of bottleneck resource in hours
(factory hours)

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 Total conversion cost Total factory
=
per factory hour Total time available on bottleneck resource

3.3.5 Example 2 – Throughput accounting

A Ltd produces three products, X, Y and Z. The capacity of A Ltd’s plant is restricted
by process alpha. Process alpha is expected to be operational for eight hours per day
and can produce 1,200 units of X per hour, 1,500 units of Y per hour, and 600 units
of Z per hour.

Selling prices and material costs for each product are as follows.
Product Selling price Material cost Throughput contribution
$ per unit $ per unit $ per unit
X 150 80 70
Y 120 40 80
Z 300 100 200

Conversion costs are $720,000 per day.

Required:

(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500
units of Y and 1,200 units of Z.
(b) Calculate the TA ratio for each product.
(c) In the absence of demand restrictions for the three products, advise A Ltd’s
management on the optimal production plan.

Solution:

(a) Profit per day = throughput contribution – conversion cost

= [($70 x 6,000) + ($80 x 4,500) + ($200 x 1,200)] – $720,000
= $300,000
(b) TA ratio = throughput contribution per factory hour / conversion cost per
factory hour

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 Conversion cost per factory hour = $720,000 / 8 = $90,000

Product Throughput contribution per Cost per factory TA ratio

factory hour hour
X $70 x 1,200 = $84,000 $90,000 0.93
Y $80 x 1,500 = $120,000 $90,000 1.33
Z $200 x 600 = $120,000 $90,000 1.33

(c) An attempt should be made to remove the restriction on output caused by

process alpha's capacity. This will probably result in another bottleneck
emerging elsewhere. The extra capacity required to remove the restriction
could be obtained by working overtime, making process improvements or
product specification changes. Until the volume of throughput can be
increased, output should be concentrated upon products Y and Z (greatest TA
ratios), unless there are good marketing reasons for continuing the current
production mix.

Product X is losing money every time it is produced so, unless there are good
reasons why it is being produced, for example it has only just been introduced
and is expected to become more profitable, A Ltd should consider ceasing
production of X.

3.3.6 How can a business improve a throughput accounting ratio?

Measures Consequences
 Increase sales price per unit  Demand for the product may fall
 Reduce material cost per unit, e.g.  Quality may fall and bulk discounts
change materials and/or suppliers may be lost
 Reduce operating expenses  Quality may fall and/or errors
increase

3.3.7 Throughput and limiting factor analysis

The throughput approach is very similar to the approach of maximising

contribution per unit of scarce resource. Throughput is defined as sales less
material costs whereas contribution is defied as sales less all variable costs.
Throughput assumes that all costs except materials are fixed in the short run.

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Question 2 – Throughput Accounting
Yam Co is involved in the processing of sheet metal into products A, B and C using three
processes, pressing, stretching and rolling. Like many businesses Yam faces tough price
competition in what is a mature world market.

The factory has 50 production lines each of which contain the three processes: Raw material
for the sheet metal is first pressed then stretched and finally rolled. The processing capacity
varies for each process and the factory manager has provided the following data:

Processing time per metre in hours

Product A Product B Product C
Pressing 0.50 0.50 0.40
Stretching 0.25 0.40 0.25
Rolling 0.40 0.25 0.25

The factory operates for 18 hours each day for five days per week. It is closed for only two
weeks of the year for holidays when maintenance is carried out. On average one hour of
labour is needed for each of the 225,000 hours of factory time. Labour is paid $10 per hour.

The raw materials cost per metre is $3.00 for product A, $2.50 for product B and $1.80 for
product C. Other factory costs (excluding labour and raw materials) are $18,000,000 per
year. Selling prices per metre are $70 for product A, $60 for product B and $27 for product
C.

Yam carries very little inventory.

Required:

(a) Identify the bottleneck process and briefly explain why this process is described as a
‘bottleneck’. (3 marks)
(b) Calculate the throughput accounting ratio (TPAR) for each product assuming that
the bottleneck process is fully utilised. (8 marks)
(c) Assuming that the TPAR of product C is less than 1:
(i) Explain how Yam could improve the TPAR of product C. (4 marks)
(ii) Briefly discuss whether this supports the suggestion to cease the production
of product C and briefly outline three other factors that Yam should consider

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before a cessation decision is taken. (5 marks)
(Total 20 marks)
(ACCA F5 Performance Management June 2009 Q1)

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 Additional Examination Style Questions

Question 3 – Limiting Factor

Red Hot Ltd manufactures electronic components in the Mainland of China and exports to the
US market. In the past few years, demand for the components has increased dramatically. The
company is currently preparing various business plans for its investments and operations for
the next year. At a recent board meeting, the management discussed how to determine an
economical sales and production mix in the business plans. Below is the estimated data and
information for next year:

Demand Selling price Direct Direct

Product (units) per unit ($) materials ($) labour ($)
A 5,000 135 43 32
B 4,200 55 11 20
C 3,500 210 65 56
D 4,000 100 20 40
E 32,500 80 32 16

The direct labour rate of $80 per hour is expected to remain unchanged during the coming
year. The company’s plant has a maximum capacity of 13,000 direct labour hours per year on
a single-shift basis. Overtime work is paid at a premium of 50%. The company’s present
facilities and resources including employees and equipment can produce all the five products.
Fixed manufacturing costs total $320,000 per year and variable overhead costs are $20 per
direct labour hour. Selling and administrative costs are fixed at an estimated amount of
$200,000 per year. Having adopted the just-in-time inventory management system, the
company’s finished goods inventory is negligible and can be ignored.

Required:

(a) Assuming there is no overtime work, determine the optional production mix of the five
products to maximize the profit for next year and calculate the amount of maximum
profit. Show all supporting calculations. (15 marks)
(b) What is the highest price (in terms of a rate per hour) that the company would be
willing to pay for additional direct labour time? Suggest whether it is justified to work
overtime to satisfy any unmet demand. (5 marks)
(Total 20 marks)
(HKIAAT PBE Paper II Management Accounting June 2007 Q1)

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Question 4 – Limiting Factor and Throughput Accounting
Ride Ltd is engaged in the manufacturing and marketing of bicycles. Two bicycles are
produced. These are the ‘Roadster’ which is designed for use on roads and the ‘Everest’ which
is a bicycle designed for use in mountainous areas. The following information relates to the
year ending 31 December 2005:

(1) Unit selling price and cost data is as follows:

Roadster Everest
$ $
Selling price 200 280
Material cost 80 100
Variable production conversion costs 20 60

(2) Fixed production overheads attributable to the manufacture of the bicycles will
amount to $4,050,000.
(3) Expected demand is as follows:

Roadster 150,000 units

Everest 70,000 units

(4) Each bicycle is completed in the finishing department. The number of each type of
bicycle that can be completed in one hour in the finishing department is as follows:

Roadster 6.25
Everest 5.00

There are a total of 30,000 hours available within the finishing department.
(5) Ride Ltd operates a just in time (JIT) manufacturing system with regard to the
manufacture of bicycles and aims to hold very little work-in-progress and no finished
goods stocks whatsoever.

Required:

(a) Using marginal costing principles, calculate the mix (units) of each type of bicycle
which will maximise net profit and state the value of that profit. (6 marks)
(b) Calculate the throughput accounting ratio for each type of bicycle and briefly discuss
when it is worth producing a product where throughput accounting principles are in

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 operation. Your answer should assume that the variable overhead cost amounting to
$4,800,000 incurred as a result of the chosen product mix in part (a) is fixed in the
short-term. (5 marks)
(c) Using throughput accounting principles, advise management of the quantities of each
type of bicycle that should be manufactured which will maximise net profit and
prepare a projection of the net profit that would be earned by Ride Ltd in the year
ending 31 December 2005. (5 marks)
(d) Explain two aspects in which the concept of ‘contribution’ in throughput accounting
differs from its use in marginal costing. (4 marks)
(Total 20 marks)
(ACCA Paper 3.3 Performance Management December 2004 Q2)

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