For small businesses, budgeting is one of the most important tasks to accomplish. A business budget details your expected revenue and expenses, and provides you with a plan to follow so you know what to expect to stay solvent.
One of the key methods to develop your business budget is financial forecasting, which is the process of estimating or predicting your business’s performance using models like income statements and balance sheets.
Small-business budgets can be as simple or as complex as you want to make them, but if your business manufactures products instead of providing services, the development of a production budget is critical to the budgetary process.
- The production budget provides your business with a plan for how much product must be manufactured during a given time period.
- Before preparing a production budget, the sales budget must first be calculated so your business will know how much to produce.
- Without a production budget, you wouldn’t know how much raw material to purchase, what size facility you should use, the amount of workers needed, or how much equipment you’ll need.
What Is a Production Budget?
The production budget calculates the number of units of products manufactured by a business that are necessary to meet its sales budget for a given time period. The production budget is stated in units of the product to be produced rather than in dollar amounts. It is derived from the business’s sales budget and how many units of safety stock the business wants to keep on hand.
Safety stock is the excess amount of the product in finished goods inventory that the business keeps so it won’t stock out.
Before preparing a production budget, however, the sales budget must be calculated so the business will know how much to produce. If you are setting up a sales budget for a new product, it is difficult to know the consumer demand. You can do market research to see what businesses similar to yours charge for the product. If it is an established product, you can use historical information based on past sales. Also take into consideration any changes in economic conditions that can affect your business.
Why the Production Budget Is Important
The production budget tells you how much of your product you must manufacture in a given time period given your sales budget for that same period. The amount of product you must manufacture has implications for your workforce, your production facility, your equipment needs, and the materials you need to purchase. These items have sub-budgets of their own: raw materials budget, direct labor budget, and overhead budget.
The production budget takes into account the beginning inventory of the product that the firm has in stock. The beginning inventory from one quarter is the ending inventory, or finished goods inventory, carried over from the previous quarter.
The production budget is also an important part of the firm’s system of inventory control. You want to keep enough of your product on hand so you don’t stock out but not so much that you are holding obsolete inventory. Stockouts cost the firm customer goodwill, while obsolete inventory costs the firm in storage space.
Many decisions are dependent on your production budget. Without it, you don’t know how much raw material to buy, how many people to employ, the size your production facility should be, or how much equipment you’ll need.
How to Calculate a Production Budget
A production budget is usually calculated for each quarter but may be calculated for any time period.
Use this formula to calculate your production budget:
Here is a breakdown of the elements of the formula:
- Budgeted Sales: Taken from the sales budget for each time period
- Desired Ending Inventory: Another term for finished goods inventory; it is the usually the amount of safety stock a business wants to keep on hand.
- Beginning Inventory: The Desired Ending Inventory carried over from the previous time period
- Required Production: What your business must produce in the current time period to meet all its needs as detailed by the sales budget
Production Budget Example
Sue owns a small bakery that is a two-person operation. Sue is the sole proprietor and she has one employee. Sue wants to forecast how many loaves of rye bread she needs to make each quarter in order to fulfill her sales budget. Here is Sue’s production budget.
Sue’s Bakery Production Budget for the Year Ended December 31, 20XX
|First Quarter||Second Quarter||Third Quarter||Fourth Quarter|
|Forecasted Unit Sales||2000||3,000||5,000||4,000|
|+ Ending Inventory (Finished Goods)||250||250||250||250|
|= Total Production Required||2250||3,250||5,250||4,250|
|- Beginning Inventory||250||250||250||250|
|= Units to be Manufactured||2,000||3,000||5,000||4,000|
Sue’s initial forecast for sales increases then declines in the fourth quarter. The first line, forecasted unit sales, comes from the sales budget. The ending finished goods inventory is forecast to stay the same for the year at 250 units. This is the company’s safety stock. The third line item is the production required to cover forecasted sales, taking safety stock into account. The ending finished goods inventory becomes the beginning inventory for the next quarter in line item 5. Subtracting that from the total production required gives Sue the loaves of bread she will need to produce.
The Bottom Line
If your business manufactures a product instead of a provider of services, the development of a production budget is critical to keep your operations on track. The production budget is usually the next budget developed after the sales budget, and its development depends on a variety of financial forecasting models, like income statements and balance sheets. By learning how to prepare and calculate a production budget, you can be better equipped to understand your business’s needs.
Frequently Asked Questions (FAQs)
Why is a company’s sales budget developed before its production budget?
Unless a business knows how much it expects to sell in a given time period by preparing a sales budget, it can’t know how much of its product it must produce. Companies that provide services do not prepare a production budget.
What info do you need for a production budget?
In order to develop a production budget, you first need to look at the sales budget. The sales budget will give you forecasted sales for the time period for which you are budgeting. It will state forecasted sales in units and dollars. For the production budget, however, you use only the unit figure. You also need to know how much safety stock your business wants to keep on hand.