The key factor in management decision making, and measuring relative profitability

Concept of the key factor

A key factor (limiting factor) is any resource or condition whose shortage limits the volume of output or sales, so that the organisation cannot expand activity beyond it. When a key factor operates, the usual rule of preferring the product with the highest contribution per unit, or the highest P/V ratio, may mislead. The correct rule is to rank products by the contribution earned per unit of the key factor and to allocate the scarce resource in that order, subject to demand, so that total contribution, and hence profit, is maximised. Fixed costs are not affected by the choice of mix, so they are ignored in ranking.

Examples

• Machine hours: product P earns contribution of ₹60 a unit using 3 machine hours (₹20 an hour); product Q earns ₹40 using 1 hour (₹40 an hour). If machine hours are scarce, Q is preferred despite its lower contribution per unit.
• Raw material: if a material is rationed, products are ranked by contribution per kilogram of that material.
• Labour: during a shortage of skilled workers, products are ranked by contribution per labour hour.
• Sales demand: when demand is the only limit, products are ranked by contribution per unit or P/V ratio.

Criteria for measuring relative profitability

1. Contribution per unit of the key factor: the main criterion: contribution per machine hour, per labour hour, per kilogram of material, or per rupee of material, as the case may be.
2. P/V ratio: when sales value is the limiting factor.
3. Contribution per unit of product: only when there is no limiting factor other than demand.
4. Several key factors together: when more than one resource is scarce, the best mix is found by linear programming rather than a simple ranking.

The optimum mix is built by producing the highest-ranked product up to its demand, then the next, until the key factor is exhausted; profit is total contribution less fixed costs.