How to Calculate a Production Budget

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After developing the operating budget, the next step is a production budget, which tells the business owner or financial manager how many units the firm needs to produce to meet sales requirements as delineated in the sales budget of the firm.

Operating Budget

Before considering a production budget, the operating budget must be determined.

The operating budget is one of the two parts of the master budget. The purpose of the operating budget is to describe the income-generating activities of the firm, such as sales, production, and finished goods inventory.

The ultimate conclusion of the operating budget is the pro forma income statement and the operating profit margin. The operating profit margin is not the same as net profit, which you cannot calculate until you prepare the financial budget. The operating budget is prepared before the financial budget since many of the financing activities aren't known until the operating budget is prepared.

Production Budget

Directly after developing the sales budget, the next task in developing the operating budget is to put together the production budget. The production budget tells the business owner how many units of the product to produce to meet sales needs and ending inventory requirements.

There are three parts to the production budget: direct materials purchases budget, direct labor budget, and overhead budget. Each is required to produce the production budget.

Calculation of Production Needs

The formula to calculate production needs is as follows:

Units to be Produced = Expected Unit Sales + Units in Desired Ending Inventory (EI) - Units in Beginning Inventory (BI)

Example of a Production Budget

Below is a simple production budget:

The Art Pottery Company expects sales of 1,000 pots. They expect 240 pots in ending inventory at the end of the first quarter. Where will 1,240 pots come from? Beginning inventory supplies 180 of them leaving 1,060 to be produced. You can put this in the format of the equation above to see how it works. Production budgets are always expressed in terms of units, not dollars.

Sales Budget

Most business owners and managers use what is called a "bottom-up" sales forecasting technique. In other words, they solicit sales figures from the salespeople out in the field as they figure they have the most knowledge of what sales will be in future time periods. These sales figures are then put together to form an aggregate sales forecast.

If the company has a brick and mortar shop, forecasted sale from that shop must also be included as must forecast online sales if the company has an online presence.

Other factors that go into the sales forecast include the general state of the economy, pricing policies, advertising, competition and other factors. In our example, the pottery store may have suffered during the Great Recession because art pottery at that time would have been considered a luxury. Since unemployment is high after the Great Recession and the recovery is slow, it may still be considered a luxury and sales may be forecasted as slow.

The sales budget may be slightly different from the sales forecast after it is adjusted according to the desires of management.