The production budget considers the units in the sales budget and the company’s inventory policy. Managers develop the production budget in units and then in dollars. Determining production volume is an important task. Companies should schedule production carefully to maintain certain minimum quantities of inventory while avoiding excessive inventory accumulation. The principal objective of the production budget is to coordinate the production and sale of goods in terms of time and quantity.

Companies using a just-in-time inventory system need to closely coordinate purchasing, sales, and production. In general, maintaining high inventory levels allows for more flexibility in coordinating purchases, sales, and production. However, businesses must compare the convenience of carrying inventory with the cost of carrying inventory; for example, they must consider storage costs and the opportunity cost of funds tied up in inventory.

Firms often subdivide the production budget into budgets for materials, labor, and manufacturing overhead, which we will discuss next. Usually materials, labor, and some elements of manufacturing overhead vary directly with production within a given relevant range of production. Fixed manufacturing overhead costs do not vary directly with production but are constant in total within a relevant range of production. To determine fixed manufacturing overhead costs accurately, management must determine the relevant range for the expected level of operations.

For our example company, GelSoft, we’ll assume the new company policy is to hold enough product in ending inventory to cover the first month of sales of the next quarter, and so they try to produce enough to maintain one-third of the next quarter’s sales in ending inventory (and they round that amount to the nearest hundred). Finished goods inventory at the end of the prior budget year is projected to be 30,000 units.

From this data, we can prepare the schedule of planned production using the sales budget as our starting place.

Important things to note:

1. In addition to the 172,405 units that will be sold, the company has to produce enough units to have 16,200 on hand at the end of the year to cover January sales of the next budget year. Assuming the same sales increase of 5%, Q1 sales for the next budget cycle would be Q4 of this budget cycle time 1.05 = 46,305 * 1.05 = 48,620. One-third of that amount is 16,206.75 which, when rounded to the nearest hundred, equals 16,200 units for December 31 ending inventory.
2. There are 30,000 units on hand at the beginning of the budget year, which reduces the number of units that need to be produced to hit the sales and ending inventory targets.
3. 172,405 to be sold plus 16,200 to have on hand at the end of the year is 188,605, less the 30,000 on hand at the beginning of the year, equals a production run of 158,605. This is less than the number of units to be sold because the company is trying to reduce the number of units on hand by selling off beginning inventory and then, using the production budget, keeping units on hand as low as possible.

Here is the production budget by quarter, starting with a recap of the sales budget:

Explanation: Each quarter is calculated the same as an annual budget, starting with projected sales, adding ending inventory, and subtracting beginning inventory to get the number of units needed to be produced. Notice the drastic reduction in units needed to be produced in Q1 because of the large beginning inventory.

Here is a short review of how to create a production budget:

You can view the transcript for “The Production Budget” here (opens in new window).

Before you create a production budget based on this sales budget, check your understanding of how to create a sales budget.