In a manufacturing business, one of the most important operational decisions to make and forecast is how many units to produce. This information is usually based on forecast sales and inventory levels and set out in the form of a production budget.
If insufficient units are produced and the sales forecast is achieved, then the business may well run out of inventory resulting in stock-outs and customer complaints and ultimately in lost sales and revenue.
On the other hand, if the business produces too many units, inventory will start to increase. As production requires cash to pay for labor and materials, and that cash is tied up in the inventory until the items are sold, the business will need additional working capital funding in order to operate. In addition, the business will incur additional carrying costs necessary to deal with the excess inventory which in turn will reduce profitability.
How to Prepare a Production Budget
Using the financial projections template a business has to establish its sales forecast and target level of inventory days. These two pieces of information can also be used to prepare a production budget, allowing the business to set its target production levels.
Production Planning Formula
Production budgets are normally prepared in unit terms using the production planning formula set out below.
The formula simply states that the business needs to produce sufficient units to satisfy the forecast sales demand and the required ending inventory level after allowing for the units already held in inventory at the beginning of the period.
In the financial projections template, the ending inventory is based on the forecast sales and the inventory days assumption.
If this is included in the production planning formula above, we can rearrange the formula as follows.
The production budget for the period depends on the units in inventory at the start of the period, the forecast sales, and the inventory days assumption. It is normal when preparing production budgets to allow extra production, say 5%, to cover faults which occur during the manufacturing process.
When calculating production budgets based on sales forecasts, care must be taken to understand that sales is used to represent demand for the product. It may be that the actual demand for the product is higher than sales, but is unsatisfied due to a lack of available inventory.
Production Budget Example
Suppose a business forecasts annual sales of 1,825 units and makes the assumption that ending inventory should be the equivalent to 60 days sales.
Based on these values the ending inventory level calculation is as follows:
Ending inventory = Inventory days x Sales units / 365 Ending inventory = 60 x 1,825/365 = 300 units
The business requires an ending inventory of 300 units.
Assuming the business had no beginning inventory, the production budget can now be calculated using using the production planning formula.
Production budget = Sales units + Ending inventory - Beginning inventory Production budget = 1,825 + 300 - 0 = 2,125
So starting with zero units, the business should produce 2,125 units of which 1,825 are sold, and 300 remain in inventory at the year end.
If should be noted that the same answer is obtained with the rearranged formula.
Production budget = Sales units x (1 + Inventory days / 365) - Beginning inventory Production budget = 1,825 x ( 1 + 60/365) - 0 = 2,125
The information is normally presented in a suitable production budget format as shown by the example below.
|Required Ending inventory
|Less: Beginning inventory
Effect of Beginning Inventory
If the business in the above example has beginning inventory of 120 units, then the production budget forecast calculation is as follows.
Production budget = Sales units + Ending inventory - Beginning inventory Production budget = 1,825 + 300 - 120 = 2,005
As the business has beginning inventory, the required production to satisfy sales demand and the required ending inventory level has fallen to 2,005 units.
The business begins with 120 units and produces 2,005 units giving a total of 2,125 units available. Again the business sells 1,825 units and leaves 300 units in ending inventory as before.
|Required Ending inventory
|Less: Beginning inventory
What Happens if the Sales Forecast is Wrong?
Unfortunately sales forecasts are not normally achieved, sales will usually be higher or lower than expected.
If in the above example, sales were expected to vary within +/- 10% of the forecast level, the number of sales units will vary from 1,643 to 2,008 units. If the production budget is maintained at 2,005 units, then the ending inventory will vary as follows.
The inventory days level now varies between 21 and 107 days sales, the business must decide whether this is an acceptable range in which to operate or to amend the production budget so that the ending inventory days are brought back to the required 60 days level.
Production Budget and the Financial Projections Template
The calculations used above assume that the business has the manufacturing capacity available to meet the production budget. When preparing a business plan using the financial projections template it is important to ensure that the production levels required are matched by available manufacturing capacity either by increasing the labor budget, so that multiple production line shifts can be operated, or by increasing capital investment to allow for additional manufacturing capacity as the business grows.
By using a typical 3 year sales forecast and the inventory days assumption (60 days), a production budget can be developed for the 3 year business plan as shown below.
Notice that in each year the beginning inventory is the ending inventory for the previous year.
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.