Many manufacturing organisations use standard costing to calculate the expected costs of products. Standard costing is different from general budgeting as it focusses on cost units. In other words, the cost of what the business produces, as opposed to the costs of the business’s sections or departments.
Standard costing can be used in all stages of the budgetary process; planning, decision-making, monitoring and control. In this article we consider how it can be used to help plan production when resources are limited.
Limiting factors when planning production
A limiting factor is anything that restricts an organisation’s ability to maximise its sales due to constraints in demand or the availability of production resources. Strategically, the most significant limiting factor for any organisation is money. But practically, day to day capacity constraints are usually the result of shortages in labour, machine hours or materials.
Using standard costing alongside budgeting
Let’s suppose we’re the budget accountant for a company that manufactures specialist windscreen wipers. Standard costing is used alongside budgeting because the components for its products are identical and the manufacturing process is repetitive. The company makes a product coded WR450 and one unit requires:
- direct materials – 0.75kg at £5.44 per kilo
- direct labour – 30 minutes paid at £15 per hour
- fixed overheads – absorbed at £20 per direct labour hour
Standard costing establishes, in detail, the standard cost of each component of a product and then calculates its total standard cost. For WR450 that is:
The information on the cost card can be used in the preparation of budgets, and simplifies the calculations required. For example, planned production of 1,000 units will cost £21,580 (1,000 x £21.58).
Now let’s consider another product, PT620. According to its standard cost card, each unit requires:
- 0.5kg of materials
- 20 minutes of direct labour
- 5 minutes of machine time
The budgets have been approved and show:
- Maximum sales demand is 5,600 units
- 2,500 kg of materials is available
- 1,600 hours of direct labour time is available without using overtime
- 500 machine hours are available
The standard costing data can be used to calculate the resources needed in order to fulfil the sales demand. The requirements are:
- 2,800kg of materials
- 5,600 units x 0.5kg
- 1,867 labour hours
- 5,600 units x 20 minutes ÷ 60 minutes*
- 467 machine hours
- 5,600 units x 5 minutes ÷ 60 minutes*
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Breaking down the limiting factors
We said at the start of this article that a limiting factor is anything that restricts an organisation’s ability to maximise its sales due to constraints in demand or the availability of production resources. We can easily see, by comparing the resources from the budgets to the standard requirements, that both the amount of materials and labour hours available are insufficient for production levels that will meet the sales achievable.
So, what production levels are possible?
- There’s enough material available to make 5,000 units
- 2,500kg ÷ 0.5kg
- There are enough labour hours to make 4,800 units without the need to use overtime
- 1,600 hours x 60 minutes ÷ 20 minutes
- The machine hours available are sufficient to make 6,000 units
- 500 hours x 60 minutes ÷ 5 minutes
The calculations show production levels ranging from 4,800 to 6,000 units when each component is viewed in isolation. However, we need to decide how many units can actually be produced and consequently sold, given the overall circumstances.
So how much can we produce and sell?
There are enough machine hours to make 6,000 units. However, there’s not enough material or labour for that production level and even if there was, there would be no point making more than the 5,600 units which we can actually sell.
That leaves three production constraints; the materials, labour hours and sales demand. Production is constrained the most by the availability of labour because there are only sufficient hours to make 4,800 units. Unless circumstances change, 4,800 units is the maximum sales volume possible.
If overtime hours can be utilised the situation will change, and sales are then constrained by materials. The sales achievable would increase to 5,000 units.
The results of this limited factor analysis will enable management to make well-informed decisions. It could be that there’s nothing they can do, and the loss of sales and consequent profit is accepted. Or they may be able to authorise some overtime and source some extra raw materials. Whilst these factors are unknown in our scenario, they’re representative of decisions taken regularly in the work place where calculations with respect to limiting factors are common-place.
* rounded up to the nearest whole hour.
Read more study tips for AAT level 4:
- Understanding fixed overhead variances
- Launching your finance career after your AAT studies
- Tricky Topics Deciphered: Cost benefit analysis
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.