#3 Master Budget : Production Budgeting

#3 The Production Budget - Service Capacity Budget

The balancing act of demand, carrying costs and financing considerations

If the Sales Budget is the hinge, the production budget is the door.  It is the bulk of operations and the focus of nearly all short-term and long-term strategic decisions. 

               Is the current product offering in demand?

               Do we want to enter a new industry or product line?

               Do we have the current equipment to produce the product?

               Do we consider an acquisition?

               If our current product is in demand, do we have the best current technology?

               Will an equipment upgrade save money?

Do we have the capacity to meet current demand?

               Can our throughput meet demand in a timely manner?

               Is our operation streamlined to optimize performance?

               Do we have the ability to finance current operations internally?

               Is our ending inventory planning adequate to meet continual demand?

               Is our material buffer adequate to support continual demand?

               Is our lead time on material orders adequate?

               Is our storage capacity for inventory adequate?

               Is our labor force adequate and competent to meet specifications and throughput?

If any area could make use of the coordinated activities with FP&A and bottom-up budgeting, it is the production budget.  There are numerous complex decisions to be made that determine how to keep operations flowing smoothly, effectively, and efficiently and all of them involve operational understanding integrated with financial knowledge.  If you recall any studies or experience in a manufacturing setting, for example, then you may recall throughput, bottlenecks, buffers, process arrangement, specifications, scraps, reworks, WIP inventory and, of course, overhead allocation.  All of these operational activities and metrics will initiate and translate to a financial transaction or aggregated financial transactions.  Why not the integrated, participative budget and the further benefits of communication and cooperation?    

This production budget can be referred to/planned for in a couple of ways in my opinion depending on your business model and from which additional pieces of the budget it will be fed data.  Expanding on this, production is initiated to meet demand for a product, and, in that relationship, is similar to service capacity availability to meet demand for a service.  In both instances a company may want to have available product, as product inventory, or service capacity, as labor inventory, to avoid stock-outs and missed sales or to offer a buffer to mitigate the possibility of supply chain issues which would prolong production times. 

[While many will easily draw the association with materials and inventory, some will have trouble with the labor concept.  Labor is not generally thought of in the same way as materials.  However, from a transactional perspective, the labor directly associated with the product or service is a product or service cost in the same way there is a direct material cost.    Whether you have enough labor to meet demand is just as much of an issue as to whether you have enough material.  We experienced this first-hand during the pandemic.  And in the same way material costs rose, labor costs rose.  In short, you are paying for and inventorying labor in the same way you do so for material, even in a service department.  The issue that arises in labor in regard to time and the ability for dynamic changes in labor is also not that different from material.  A change in customer demand may mean you have too much material inventory, it may spoil, it may suffer obsolescence, it may not meet upgraded technology specifications.  This is actually why I believe the ability to contract and part-time working is beneficial to a company, however government often complicates the ability to react and is, often, the source of resource waste.]       

It is obvious that you don’t want to have too much capacity or too much inventory, as you will suffer under-utilization and obsolescence that translates into lost money, but it is not ideal to want for capacity or inventory since you will also suffer losses of revenues through stock-outs, customer dissatisfaction, customer switching to substitutes and competitors, loss of sales and long-term loyalty, and a hit to brand reputation.  The degree to which customers will put up with inventory issues varies amongst industries.  In some cases, the lack of capacity becomes so synonymous with a particular industry that it becomes a part of folk culture … what thoughts do you immediately associate with cable TV?  That said, once investment is put into capacity or production of inventory you have also lost liquidity until such a time that you can collect on those investments. 

The need for accurate and complete budgeting that offers for dynamic planning and measurement would seem to be critical and quite bluntly can only be achieved and evaluated at the activity sources of the cost drivers in relationship to the top-line revenue drivers.  Again, this is bottom-up and integrated budgeting, but if we were to put a more familiar label to this, it is the contribution margin that would offer the CVP (Cost-Volume-Profit) analysis and perhaps most accurate performance measurements and data for decisions. 

Certainly, there are some notable assumptions associated with the contribution method, but I believe that given this is an internal tool, there are some steps that can be taken to remedy the issues with assumptions and facilitate the end goals of a useful, measurable model. 

               Assumptions/Issues

                              Sales mix is constant

                              Inventory levels remain stable

                              Inventory Costing  (Absorption vs Variable)

                              Contribution Margin is not used for financial reporting

              Allowances

           Sales mix is generally presented as constant for any budget, just as any relationship in costs of production or OPEX to the revenues is also generally considered constant. Sales Budget may present options. One of the options is the categorization of the various products by price and margin (eventually contribution margin as opposed to the more readily available gross margin). The separation into price and margin should be roughly the grouping of cost-based priced goods, value priced goods and even luxury goods. If the groupings have common cost basis and common customers trends, a sales-volume sensitivity can be done amongst the groups and should still give a heads up on changing market dynamics and trends and the impact on revenues.

                              Inventory is generally a strategic planning unto itself. End Inventory Budget. Given that inventory is usually set against future demand and ordered to minimize order costs and carry costs, it is not too far of a stretch to lean on the assumption of a minimally changing inventory. If a deep reduction occurs, such as a change to a Just-in-Time styled inventory system, this project would have its own budgeting to enact. Once in place, again, inventory levels would return to relatively constant levels.

                              Absorption Costing allocates overhead to units produced.  Fixed Overhead Budget. The gross margin method allocates fixed overhead to units produced, and fixed over head becomes an inventoriable cost (product cost). The Variable Costing method treats fixed overhead as a period cost and expenses the cost in the period incurred. In order to have the most versatile budget and make use of the information provided in a contribution margin, it is best to create a fixed overhead budget and have the ability to restructure the contribution margin method into the gross margin method for reporting and external stakeholder usage.

                              Contribution Margin and Gross Margin methods are related by Overhead. As previously read, there is a relationship between the two methods and their net incomes will varying dependent upon units production vs sales. If unit production is greater than sales and finished goods end up being added to ending inventory, the gross margin method will have the higher net income. It unit production is less than sales and finished goods must draw units out of inventory, the contribution margin method will have a higher net income.

There are always assumptions in a model.  It is the model that provides the most versatility and usefulness relative to cost that should be pursued.  What I continue to hope is that a look at how activity drivers and complexities within operations can influence top margin and bottom margin will inspire an interest in an integrated and coordinated budget for better planning and more accurate profitability analysis.

Looking at the complexities that lay with operations and the respective decisions that will be represented in the financials, there is a need, even at the highest levels to have some understanding of the cost drivers and how top-level financials will be impacted by changes in these drivers.  One may be surprised at the impacts, which I will show through some production budget examples below.  This can be accomplished through a more integrated budgeting process that will offer better measurement analysis over the course of the year.   

               -added complexities will depend on the classification of responsibility center

This method obviously isn’t for every managerial decision-maker, and many will scoff at the persistent belief that time isn’t an issue.  This impulse is, again, derived without consideration of the negative impacts of a top-down view of a company.  However, decisions are influenced from beliefs, and I have seen peculiar circumstances where executive management has only been concerned with two or three data points due to their belief or philosophy and the actual activity cost drivers were completely overlooked as in the Working Example.

-----------------------------------------------------------------------------------------------------------------------------

Working example:

I will say that sometimes, activity level drivers and all the data in the world will not change the executive decisions.

In one case, the executive decision maker’s philosophy was “you can’t sell it if you don’t have it.”

Through this philosophy the driving data point was TOTAL unit inventory.  It wasn’t based on category.  It wasn’t based on analysis of customer preference by location.  It was total inventory by location.  And with this there was a drive to purchase and INCREASE inventory at a time demand was slowly trending down and interest rates were ticking up. 

In my capacity I tried to offer the perspective that “it only sells if it is demanded by a consumer”.

This attempt, on my part, to offer an accompanying strategy to align with the general, albeit naïve, approach by the executive decision maker was in vain though I had conducted considerable analysis in an attempt to optimize this goal.

There was no consideration to distribute the category and product models so that variety met the desire of the customer for options … nope.  There was no consideration that this inventory was draining an already tightening liquidity and would impact loan covenants.  There was no consideration for the rising interest rates and the dependence on varying rate revolvers for financing of inventory. 

Sometimes, details will not be considered regardless of the power of the data for decisions.

-----------------------------------------------------------------------------------------------------------------------------

Corporate leadership strategic peculiarities aside, I will mention some of the impactful production considerations that link finance, operations, budgeting and planning during the assimilation of data for the Production Budget.

Constraint considerations

• Capacity    

• Production Throughput and associated Bottleneck

• Inventory Storage

                         Storage of Finished Goods

                              Storage of Raw Materials

• Supply

• Distributions/Logistics

Financial considerations

• Carry Costs

• Order Costs

• Leases – Space, Equipment

• Labor Changes

• Material Changes

Any constraints will obviously relate to how your business generates revenues, but all processes have a bottleneck impacting throughput and all operations have constraints that will impact utilization.  Note, that just because you project revenues for a budget and can plug in production to support these revenues in a model, reality may not agree with the model.   

In a manufacturing company, unit production occurs, units produced per unit of time, but

• is material available to keep operations running,

• is storage available to stock finished goods,

• is labor and equipment maintained to keep operations running,

• is overproduction occurring,

• are carry costs rising,

• and so on.

In a retail environment, inventory needs to be maintained to avoid stock-outs, but

• is the storage space available,

• is the space in close proximity or are there added logistical issues to take into account,

• is there a significant behavioral trend to the purchasing of an item that will change purchases,

• is there a change in the anticipated obsolescence of a product,

• and so on. 

In a service company, an evaluation of how many resources will be needed could be taken into account,

• is the labor available with the necessary skillsets to meet the specific needs of a client,

• is the equipment available to meet the needs of the laborer,

• is there an optimization of the operational expenses (direct costs) of the service or is a plan development in progress that would lower cost,

• and so on. 

Regardless of the industry, understanding the impacts of even the basic considerations of constraints and associated financials can offer both accuracy and planning triggers for strategic short-term and long-term decisions.  Note, that many of these considerations mentioned were either variably associated with production or a mixture of variable and fixed costs that would be associated with production.  Quite frankly, any assets or expenses that are associated with production should be known, as well as, the degree of influence, to make fully informed decisions.  Again, this would be found in an integrated, bottom-up budget that coordinates input from many departments throughout the company.

Let’s take a look at the planned Production Budget associated with the Sales Budget from #2 Master Budget – Sales Budget.

The production of the units needed for sales is going to be closely associated to inventory levels of both finished goods and materials.  As was done in the Sales Budget, the Price Tier I category is the only variance from budget when the actuals are used.  Since production can only be accomplished using materials, the attributable direct material costs are listed with the budgeted material costs.  We will get a better look at the reasons for the variance in the Purchase Budget.

The Production Budget is divided into quarters, B-Q1 (Budget – Quarter 1), with the anticipated material costs and the A-Q1 (Actuals – Quarter 1) production and material costs for comparison.  This Production Budget is going to be tied to several other budgets, through the material, the labor and the overhead, the physical activity and the costs for each.  For now, I included material costs, but this will be broken out further in the Purchase Budget and note that we still only display the changes for the Price Tier I products.  These three products alone can have a significant impact on the budget.

The ‘devil is in the details’ is so true for the tracking and calculating of the units and the costs of Finished Goods inventory.  Inventory is easily the best example to view the blending of operational data and financial data due to this fact that we have both physical units and the accounting representation of the dollar value of these units.  This is further complicated by materials and material inventory needed to create the finished goods and the added accounting method chosen to value inventory, LIFO (Last-In, First-Out), FIFO (First-In, First-Out), Weighted Average, DV LIFO (Dollar-Value LIFO). 

I am using a weighted-average approach.  It is easy to calculate averaging units in beginning inventory with the units produced during the period.  Since this is only an example, I will use this straight-forward method, but your inventory method may differ and adjustments would need to be made to give a better apples-to-apples comparison.     

When looking into the future and attempting to project production, we are concerned with the beginning Finished Goods inventory and the required ending Finished Goods inventory.  If we already have inventory available, we only want to produce the number desired, however, we also may want some units held in inventory so that we can continue operations and sales into the next quarter without worry of stock-outs or stoppages of operations.  Some companies can have drastic negative consequences if production does cease.  But, once again, holding too much inventory costs money as well as not holding enough inventory so a cost-benefit assessment must be done to determine your company’s various inventory levels for finished goods and materials.

Below is the planning for the aforementioned, Price Tier I and the three products within this segment that feeds into the total roll-up for the Production Budget.  The ‘Plugs’ section is the determined percentage of ending inventory that we would like to have on-hand relative to the projected sales for the next quarter.

As you may have noticed, the orange and green boxes are the same.  We, as people, tend to think of time frames linearly and segmented by period, a day, a week, a quarter, a year.  Of course, operations continue regardless and there should be a circularity to the planning process period over period.  This is what the orange and green boxes suggest.  If it is determined that the orange boxes were adequate for the sales that occurred in Q1, then the percent change anticipated for the next year’s Q1 sales should simply require a percentage adjustment to the beginning inventory in the orange box for the next years budget.  This is another instance that supports why I believe the budget should be allocated across departments for coordination and integrated into operations so that it is able to be used for performance measurement, variance analysis, and completed more quickly as time goes on.  

[consider… FP&A is being used to create budgets, the drivers of which are at the operational level and consist of understanding the activities (the variable costs) to provide the service or product, how can an individual that has minimal understanding of operations provide technically sound and reasonably accurate budgets? 

Over the past ten to twenty years, the financial system has allowed companies a considerable amount of slack (errors) in planning and strategy.   With the very brief exception of the few months the Fed Funds Rate was ~4%, this time period offered cheap debt funding and significant financial leverage opportunity.  This implies that any errors were effectively cheaper than they should have been historically.  As debt is no longer cheap, companies that can’t plan will suffer the consequences that come with debt now holding the strategies accountable.]