Key Factor Analysis

Firms face many constraints on their activity and plan accordingly:

• limited demand ;
• limited skilled labour and other production resources ;
• limited finance ('capital rationing').

For example, a firm is facing a labour shortage this month due to sickness and, as a result, cannot produce the number of units that it would like to. How should its production plan be revised?

Key factor analysis is a method used for decision making in the short term with one limiting factor. If there are two or more scarce resources, then linear programming should be used instead.

Key factor analysis - calculations

The usual objective in questions is to maximise profit. Given that fixed costs are unaffected by the production decision in the short run, the approach should be to maximise the contribution earned.

If there is one limiting factor, then the problem is best solved using key factor analysis.

Step 1: identify the scarce resource.

Step 2: calculate the contribution per unit for each product.

Step 3: calculate the contribution per unit of the scarce resource for each product.

Step 4: rank the products in order of the contribution per unit of the scarce resource.

Step 5: allocate resources using this ranking and answer the question.

Assumptions

• There is a single quantifiable objective - e.g. maximise contribution. In reality there may be multiple objectives such as maximising return while simultaneously minimising risk.
• Each product always uses the same quantity of the scarce resource per unit. In reality this may not be the case. For example, learning effects may be enjoyed.
• The contribution per unit is constant. In reality this may not be the case:
  • the selling price may have to be lowered to sell more
  • there may be economies of scale, for example a discount for buying in bulk.
• Products are independent - in reality:
  • customers may expect to buy both products together
  • the products may be manufactured jointly together.
• The scenario is short term. This allows us to ignore fixed costs

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Tags:	limiting factors;key factor analysis