Production Budget Plan and Inventory Management

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.

Ending inventory units = Inventory days x Sales units / 365

If this is included in the production planning formula above, we can rearrange the formula as follows.

Production budget = Sales units x (1 + Inventory days / 365) – Beginning inventory

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.

Production Budget Format
Forecast Sales1,825
Required Ending inventory300
Less: Beginning inventory0
Production Budget2,125

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.

Production Budget and Beginning Inventory
Forecast Sales1,825
Required Ending inventory300
Less: Beginning inventory-120
Production Budget2,005

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.

Sales Variation Production and Inventory
Sales variation+10%Forecast-10%
Beginning inventory120120120
Production budget2,0052,0052,005
Less: Sales-2,008-1,825-1,643
Ending inventory117300482
Inventory days2160107

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.

Three Year Production Budget
Year 1Year 2Year 3
Sales1,8252,1902,628
Ending inventory300360432
Beginning inventory-120-300-360
Production2,0052,2502,700

Notice that in each year the beginning inventory is the ending inventory for the previous year.