Scarce Resource Utilization Decision

Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce resources so as to maximize the total net income of a business. Scarcity of different resources puts constraints on the amount of product that can be produced using those resources. For example, a business may have limited number of machine hours to utilize in production. Scarce resource allocation decision is also called limiting factors decision.

When resources are abundant, products generating relatively higher contribution margin per unit are preferred because it leads to highest net income. However when resources are scarce, a decision in this way is unlikely to maximize the profit. Instead the allocation of a scarce resource to various products must be based on the contribution margin per unit of the scarce resource from each product.

A simple scarce resource allocation decision involves the following steps:

  1. Calculate the contribution margin per unit of the scarce resource from each product.
  2. Rank the products in the order of decreasing contribution margin per unit of scarce resource.
  3. Estimate the number of units of each product which can be sold.
  4. Allocate scarce resource first to the product with highest contribution margin per unit of scarce resource, then to the product with next highest contribution margin per unit of scarce resource.

A scarce resource decision can be better explained using an example.

Example

A company has 4,000 machine hours of plant capacity per month which are to be allocated to products A and B. The following per unit figures relate to the products:

ProductAB
Sale Price$300$240
Costs:
Direct Material10070
Direct Labor6550
Variable Overhead2040
Fixed Overhead1530
Variable Operating Expenses4020
Total Costs$240$210
Net Income$60$30
Machine Hours Required1.51.00

Assuming that the company can sell all its output, determine how many machine hours shall be allocated to each product.

Solution

ProductAB
Sale Price$300$240
− Variable Cost225180
CM Per Unit$75$60
÷ Machine Hours Required1.501.00
CM Per Machine Hour$50$60

Since the company can sell all its output, the best decision is to allocate all machine hours (i.e. scarce resource) to product B.

Written by Irfanullah Jan