Before I got into accounting, I regularly made fun of my wife’s budgeting habits. Every month, she’d write down all her expenses from the month before in a little diary and calculate how much she’d spent on various credit cards and for utilities. Depending on how the month went, she’d allocate money for the next month.
I look back on those days now and laugh. As an accountant, my life is now dominated by budgets, including the master budget, capital budget, and, the subject of this article, the production budget.
Overview: What is a production budget?
The production budget, or manufacturing budget, is used by accountants and managers to determine how many units need to be produced in a certain period to keep up with demand and manage inventory. There are four components to the production budget:
- Beginning inventory
- Ending inventory
The production budget formula is:
Ending Inventory + Demand – Beginning Inventory = Production Required
How to create your production budget
Clothes Call makes reflective orange vests that traffic workers wear to be seen by drivers. Usually it takes a few months for permits for traffic work to be completed, which is good for Clothes Call because the company has plenty of lead time on its orders and can accurately forecast demand.
Let’s take a look at its production budget for next month.
Clothes Call has 200 units left over from last month, and the owner knows the company needs to end this month with 400 units since winter is their busy season. Demand based on current contracts is for 1,500 units to be sold during the month. Using the units of production formula above, we can calculate that Clothes Call needs to make 1,700 new vests this month to keep up with demand and look forward to next month.
Production budget example
I worked at KFC for four years in high school and college. As an enterprising 16-year-old, I decided I wanted to be a supervisor. Many of the supervisor responsibilities were what you’d expect: coordinate where employees would work that shift, complete the closing/opening checklists, make sure food safety guidelines were being followed, etc.
My favorite responsibility was deciding how much chicken needed to be cooked. Fried chicken production may not be where you thought I’d go for my real-world example, but it works perfectly.
When I worked at KFC, it took about 16 minutes to cook a batch of chicken, and we would decide every hour or so how much to cook. Using this example, let’s go over each step of the production budget formula.
- Beginning inventory: I usually supervised afternoons and nights, so we always had at least a little chicken in the heater at the beginning of my shift. We used a computer system to track how much chicken had been cooked and how much had been purchased to let us know how many pieces were in the heater.
- Demand: The computer system also predicted how many pieces we would sell each hour based on how much was sold on that day last year and the trends over the past few weeks.
- Production: As we told the cooks to cook more chicken, we would enter into the system how many new pieces were produced.
- Ending inventory: We always needed to have the ending inventory either to make sales at the beginning of the next hour or, at the end of the shift, to pick the meat off the bone for BBQ sandwiches and pot pies.
The fried chicken finished goods formula is pretty straightforward and was designed to make it so 16-year-olds could make decisions on how much chicken to cook. But there was a problem: The chicken predictions were often inaccurate and difficult to apply.
In reality, supervisors typically ordered more chicken to be cooked when they felt like we needed it. KFC probably paid a ton of money to produce the algorithm to predict demand, but, after three or four shifts being caught chickenless at a busy time or throwing out old chicken because it wasn’t purchased, no one paid attention to demand predictions.
And no one had the time to go back to the office every 15 minutes to manually type in how many pieces were cooked, how many were thrown away as waste, and how many were eaten by employees.
There was another inventory control problem as well. Most people bought either a leg and thigh combo (the correct choice) or a breast combo. No one wanted wings. So, at the end of the shift, we would often have 50 or more wings left over. The fancy computer system had no way to enter in that we had 30 wings in the heater but no breasts.
Over time, I got a feel for how much demand would change over different nights, and I would make calls based on that. I would also see what the chicken cooks who had worked at KFC for years thought.
This example is a reminder that production budgets only work if they take into account real-world problems and your business’ unique situation.
Production budgets can be a very effective way to reduce waste and plan ahead in your business. Keep in mind that production budgets can quickly become a classic garbage-in, garbage-out formula if you’re not careful. No matter how much you spend building out the budget, if it has bad inputs or ones that are hard to enter, your employees may decide to totally ignore it.
View more information: https://www.fool.com/the-blueprint/production-budget/