The inventory purchases budget shows the business how much inventory it needs to purchase each period to maintain inventory levels. This ensures the availability of products in appropriate quantities and costs to meet anticipated demand.
Purchases Formula
The inventory purchase budget is calculated using the following formula
Each of the values used in the inventory purchases budget formula can be found from the financial projections template as follows:
- Cost of sales is from the income statement for the current period.
- Ending inventory is from the balance sheet for the current period.
- Beginning inventory is from the balance sheet for the previous period.
Inventory Purchases Budget Example
Suppose for example, the financial projection is showing that cost of sales for the period is 50,000. Additionally is shows an ending inventory level of 8,000 and a beginning inventory level of 6,000. Accordingly using the inventory purchases budget formula, the calculation of the purchases requirement during the period is as follows:
Purchases = Cost of sales + Ending inventory - Beginning inventory Purchases = 50,000 + 8,000 - 6,000 Purchases = 52,000
As shown above, during the period purchases of 52,000 are required in order to be able to sell goods costing 50,000 (cost of sales), and to increase inventory levels by 2,000 from 6,000 (beginning inventory) to 8,000 (ending inventory).
Purchases Budget and Cash Payments
The inventory purchases budget simply tells the business how much product it needs to purchase in order to satisfy sales demand and maintain inventory levels. The budget does not tell the business the amount of cash it will need in order to pay for the inventory purchases.
To convert the inventory purchases budget into a cash payments budget, the effect of credit given by trade suppliers needs to be taken into account. The calculation of the cash payments is as follows.
Cash payments = Purchases + Beginning accounts payable - Ending accounts payable
It should be noted that in the formula purchases and accounts payable refer only to those relating to inventory suppliers.
In the above formula, purchases is the inventory purchases budget calculated earlier (52,000). The values for beginning and ending accounts payable can be found in the balance sheets for the previous and current accounting periods respectively.
To continue our example, if the beginning accounts payable was 5,000 and the ending accounts payable was 7,500, then the cash payments required during the period is calculated as follows:
Cash payments = Purchases + Beginning accounts payable - Ending accounts payable Cash payments = 52,000 + 5,000 - 7,500 Cash payments = 49,500
As can be seen the cash payments (49,500) are less that the required inventory purchase budget (52,000). This occurs because additional credit (2,500) has been taken from suppliers by increasing accounts payable from 5,000 to 7,500 during the accounting period.
Based on information from the financial projections, the business now knows that if the forecast cost of sales is 50,000, then given the required levels of inventory and accounts payable, it must purchase products to the value of 52,000, and make cash payments of 49,500 during the accounting period.
The benefit of an inventory control purchases budget is that minimizes the working capital and consequently cash invested in inventory, while ensuring that there is enough raw materials, work in process, and finished goods to satisfy production levels and customer demand.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.