SALES AND PRODUCTION BUDGETS

Overview
▪ The Master Budget demonstrates the relationship between strategy and budget schedules.
▪ The core of the master budget is the operational budget, which is driven by the sales budget schedule.
▪ In this lesson, we focus on the specifics of building a sales budget, followed by the production budget.

Upon completion of this lesson, candidates should be able to:

✓ Explain the role of the sales budget in the development of an annual profit plan
✓ Identify the factors that should be considered when preparing a sales forecast
✓ Identify the components of a sales budget and prepare a sales budget
✓ Explain the relationship between the sales budget and the production budget
✓ Identify the role that inventory levels play in the preparation of a production budget and define other factors that should be considered when preparing a
production budget
✓ Prepare a production budget

I. Budgeting is Personal
A. Organizations that are good at operational budgeting have similar characteristics as individuals who are good at personal bud geting.
1. These characteristics include being disciplined, organized, flexible, proactive, and goal orientated.
2. Strong communication skills are also paramount when the budget is used to guide an organization, whether it be a company or a household.
B. Successful budgeting is a function of having both good budgeting skills and a good budgeting system.

II. The Master Budget System

A. Operational budgeting involves the creation and coordination of many interrelated budget
schedules.

B. At the top of the master budget is the organization's strategic plan. That plan drives both
the strategy-focused allocation of resources to long-term capital projects, and the
strategy-focused deployment of spending and employees to short-term operating
objectives.

C. Beginning with the sales budget schedule, the operational budget establishes an
operational path to the pro forma income statement. (Note that pro forma essentially
means budgeted.) The sales budget is the key driving force for the overall operational
budget.

D. If the company is a manufacturing or service organization, the next schedule in the operational budget is the production budget, which then determines the
three product cost budgets for direct materials, direct labor, and manufacturing (production) overhead.
1. Remember that the cost structure for service organizations is very similar to manufacturing organizations. The “product” is a service for the client
that is produced using labor and overhead, as well as, for certain service organizations, some materials or supplies.

2. Merchandising organizations do not create the product they sell. Instead of a production budget, these organizations will use a purchasing budget,
which does not subsequently lead to budgets for direct materials, direct labor, and manufacturing overhead.

E. A budgeted product cost sheet, which specifies the standard input costs (quantity and price) for each product, summarizes the product costs used to
establish cost of goods sold for the pro forma income statement.

F. In addition to budgeted product costs, the pro forma income statement also needs budgeted selling and administrative expenses (sometimes called selling,
general, and administrative expenses). The selling and administrative expense budget is driven directly by the sales budget.

G. The pro forma income statement, sometimes called the budgeted statement of operations, completes the overall operational budget. The pro forma balance
sheet and pro forma statement of cash flows then follow (and flow from) the pro forma income statement.

H. The cash budget is different from the pro forma statement of cash flows. Overall, the statement of cash flows is used to “translate” accrual accounting into
cash flows while the cash budget is focused more directly on cash management.

I. The capital projects budget is where the long-term strategic spending is planned and managed. These investment expenditures are carried forward into the
organization's cash budget.

J. Beginning with the sales budget, the structure of each budget will be demonstrated using the example of a manufacturer of custom wood-built rowboats
called the Sunbird Boat Company.

III. The Sales Budget

A. Remember that accurate forecasting is crucial to successful budgeting. The most challenging forecasting work in the organization is done for the sales
budget (also called the revenue budget).

B. The sales budget itself looks fairly straightforward. As demonstrated in the budget below for the Sunbird Boat Company, the sales budget is a simple
composition of volume × price.

1. However, volume and price measures (statistics) are not independent. This fact complicates the forecast work since sales volume and sales price
interact with each other (and, for some industries, interact very strongly).

2. Depending on the nature of the price economics in the boat industry in this example operational budget, increasing prices can actually shift sales
volumes either up or down. [Note: The economics of sale price management is explored in a separate lesson in Part 2 Section C.]

C. Organizations generally have more ability to control expenses compared to controlling revenue. Hence, sales volumes and prices that make up revenue need
to be carefully forecasted. Sales prices and sales volumes are impacted significantly by many external factors that have been described in earlier lessons
using models like SWOT, PESTLE, and Porter's Five Forces.
 D. Organizations invest significant time and resources researching the market industry, economic environment, and competitive landscape to reduce the
uncertainty around the sales forecast. Common tools employed include:
i. Cross-functional research teams
ii. External Consultants
iii. Market Surveys
iv. Customer-focus groups
v. Leading economic indicators
vi. Test markets in controlled (or isolated) regions and customer groups
vii. Sophisticated analysis of large internal and external data sets (sometimes called big data analytics)

IV. The Production Budget

A. For some organizations, the production budget may be relatively simple to assemble once the sales budget is complete. Whatever is needed for the
budgeted sales volume is then scheduled to be produced.

B. However, inventory complicates the relationship between these two budgets. Organizations typically use inventory as a “cushion” against unexpected or
uncontrollable sales or production events. When organizations must hold inventory, the result is that the budgeted sales volume will not equal the budgeted
production volume.

C. When inventory is present in the budget, the relationship between sales volume and production volume is
Sales volume + End.Invty−Beg. Invty = Production volume
Remember that one production period's ending inventory level becomes the next production period's beginning inventory level. Inventory levels are
established according to budget policy.

D. Consider the production budget below for the Sunbird Boat Company.

1. Note that sales volume in the first row has been carried forward
from the sales budget.

2. Sunbird management has a budget policy of planning for ending

inventory levels equal to 40% of the following quarter's sales
volume needs. This pattern is demonstrated above in the second
row. Since the planned ending inventory for Q4 (Quarter 4) is 16
boats, management must be forecasting the following year's Q1
sales volume to be 40 boats (16 boats ÷ 40%).

3. The sales volume plus ending inventory determines the number of boats needed for the quarter. To determine the budgeted production volume, the
number of boats needed is reduced by the boats on hand at the beginning of the quarter (the beginning inventory level). It is important to see that
the beginning inventory level in one quarter is the ending inventory level in the previous quarter. Since the planned beginning inventory for
upcoming Q1 is 10 boats, management must be planning to end the current year with 10 boats on hand.

E. Be sure to take the time you need to understand how inventory levels are adjusting Sunbird's budgeted sales volume to determine its budgeted production
volume.

F. Finally, note that the bottom line of the production budget is not a dollar amount. It is stated in terms of production units. The organization can't simply
multiply the budgeted production volume by a cost per unit (as is done with the budgeted sales volume multiplied by price per unit). There are three types
of costs involved in the production process, each requiring its own budget (direct materials, direct labor, and manufacturing overhe ad). We'll study these
budgets in the next lesson.

Summary

✓ The master budget is introduced in this lesson, which is effectively a “big picture map” of the organization's entire budgeting system.
✓ Be sure to study this master budget diagram to understand how the individual budget schedules interconnect together to support the organization's strategy.
✓ A crucial subset of the master budget is the operational budget, which is driven by the sales budget schedule.
✓ The sales budget requires significant forecasting effort to determine the expected sales volume and sales price that then determine budgeted sales revenue.
✓ Following the sales budget is the production budget schedule.
✓ Most organizations plan to maintain inventory levels. When they do, the production budget formula is: sales volume + ending inventory – beginning
inventory = production volume

Practice Question
The sales forecast for birdhouses built by Ryan Enterprises is provided below.

The company uses a budget policy of maintaining an ending inventory of 20% of the next quarter's sales. Due to some unexpected events, the production manager
expects to end the current year with an inventory of 10,000 birdhouses.

Requirement: Prepare a quarterly production budget.

Assumption: Sales forecast for the first quarter of the following year is the same as the first-quarter forecast for this upcoming year.