Principal Budget Factor and Limiting Factor Analysis: Two Worked Examples

The principal budget factor is the factor that limits how much an organization can do in a budget period. Most of the time it is sales demand: you cannot budget to sell more than customers will buy. Sometimes it is a scarce resource instead, such as a material in short supply, skilled labour hours or machine capacity. Whatever it is, it has to be identified first, because every other budget is built around it.

The same idea appears in a short-term decision as the limiting factor. When a scarce resource stops you meeting all demand, you rank products by contribution per unit of that resource. This article explains both, then works through two numerical examples.

Where This Sits in ICAP's Syllabus

• CAF-5 Management Accounting: the syllabus outcome on analysing incremental cost-benefit and contribution margin "to take product mix, make or buy decision" (Area C, testing level 2, so up to 20 marks). Limiting factor analysis is the core technique. Our CAF-5 decision-making chapter and relevant costs chapter drill it.
• CAF-7 Business Insights and Analysis: preparing budgets, including setting metrics and targets, is in Area C (financial analysis). That is where the principal budget factor belongs. Practise in the CAF-7 question bank.
• PRC-2: when there are two or more scarce resources at once, ranking does not work and you need linear programming, which PRC-2 covers graphically.

The Method in Four Steps

• 1. Confirm the resource is actually limiting. Calculate how much of it you need to meet full demand and compare that with what is available. If there is enough, demand is the constraint and you simply make everything customers want.
• 2. Calculate contribution per unit for each product: selling price less variable cost. Ignore fixed costs; they do not change with the mix.
• 3. Divide by the scarce resource used per unit and rank products on contribution per unit of the limiting factor.
• 4. Allocate the resource in rank order, up to each product's demand, until it runs out. Then calculate total contribution and deduct fixed costs.

Worked Example 1: Product Mix with Scarce Machine Hours

A manufacturer makes three products. Next month it has 10,000 machine hours available. Fixed costs are Rs. 250,000.

Step 1: is it limiting? Hours needed for full demand: A 4,000 + B 4,000 + C 3,000 = 11,000. Only 10,000 are available, so machine hours are the limiting factor.

Steps 2 and 3: rank by contribution per machine hour.

• A: 200 / 4 = Rs. 50 per hour (rank 3)
• B: 300 / 5 = Rs. 60 per hour (rank 2)
• C: 140 / 2 = Rs. 70 per hour (rank 1)

Step 4: allocate.

Profit = 600,000 - 250,000 = Rs. 350,000.

Why the ranking matters. A student who ranks on contribution per unit makes B first (800 units, 4,000 hours), then A (1,000 units, 4,000 hours), then C with the last 2,000 hours (1,000 units). Contribution = 240,000 + 200,000 + 140,000 = Rs. 580,000. That is Rs. 20,000 less, from a product C that looks the weakest per unit but earns the most per scarce hour.

Variations examiners like: a contract that requires a minimum quantity of one product (allocate hours to that first, then rank the rest); the option to buy in a product from outside (compare the saving per scarce hour with the outside price); and asking what an extra machine hour is worth. Here, the next hour would make more of A, so it is worth Rs. 50 of contribution, the most you should pay above the normal variable cost for extra capacity.

Worked Example 2: Material as the Principal Budget Factor

A company makes one product and is preparing next year's budget. Marketing forecasts demand of 12,000 units. Each unit needs 3 kg of a material, and the only approved supplier can deliver 30,000 kg in the year. Opening finished goods inventory is 800 units; the company wants at least 300 units in closing inventory.

Unit data: selling price Rs. 2,000; material 3 kg at Rs. 150 = Rs. 450; labour Rs. 600; variable overhead Rs. 250. Variable cost is Rs. 1,300, so contribution is Rs. 700 per unit.

Identify the principal budget factor.

• Maximum production from material: 30,000 / 3 = 10,000 units.
• Maximum sales = production + opening inventory - closing inventory = 10,000 + 800 - 300 = 10,500 units.
• That is below the 12,000 demand, so material, not sales demand, is the principal budget factor.

Build the budgets in the right order. Start from the constraint: the materials budget is 30,000 kg, the production budget is 10,000 units, and the sales budget is 10,500 units (Rs. 21,000,000 of revenue), not the 12,000 marketing asked for. A budget built on 12,000 units would promise sales the factory cannot supply, and every downstream budget (labour, overhead, cash) would be overstated.

What is extra material worth? Each kg makes one-third of a unit, so the contribution per kg is 700 / 3 = Rs. 233.33. If another supplier offers more material, the company gains as long as it pays less than 150 + 233.33 = Rs. 383.33 per kg. Unmet demand is 1,500 units, needing 4,500 kg. At, say, Rs. 300 per kg, buying all 4,500 kg adds 4,500 × (383.33 - 300) = about Rs. 375,000 of contribution. Once the extra material is secured, the principal budget factor shifts back to sales demand.

That last point is the one examiners test: the principal budget factor is not fixed. It changes as soon as management removes the constraint, and the budget has to be rebuilt around the new one.

Common Mistakes

• Ranking on profit per unit after absorbing fixed overheads. Fixed costs do not change with the mix. Use contribution.
• Skipping step 1. If the resource is not actually scarce, there is no ranking to do, and a ranked answer is wrong.
• Ignoring demand ceilings. You cannot allocate more hours to the top product than its demand needs.
• Assuming the principal budget factor is always sales. It is usually sales, but the question will tell you if a resource binds first.

Once you have the mix, check its margin of safety with our break-even and CVP calculator. For the rest of the paper, see our CAF-5 tips and study plan, and drill the technique in the CAF-5 question bank.

FAQs

Is the principal budget factor the same as the limiting factor?
They are the same idea used in two contexts. "Principal budget factor" is used in budgeting, for whatever caps activity for the whole budget period (usually sales demand). "Limiting factor" is used in short-term decisions, for a scarce resource that decides the product mix.

What if there are two limiting factors?
Ranking by contribution per unit of one resource can break the other constraint. With two or more binding constraints, use linear programming.

Should fixed costs be included in limiting factor ranking?
No. Rank on contribution. Deduct fixed costs only at the end to arrive at profit.

Which ICAP paper tests this?
Product-mix and make-or-buy decisions with limiting factors are CAF-5. Budget preparation is in CAF-7's syllabus. Both papers can use the technique.

Sources

• ICAP: CAF Syllabus, Education Scheme 2025, for Spring 2027 (CAF-5 Area C; CAF-7 Area C)
• ICAP: Pre-Requisite Competencies Syllabus (PRC-2 linear programming)