Inventory is an extremely difficult part of the balance sheet to budget, because of the multitude of individual inventory items, as well as the impact of seasonality, purchasing volumes, product customization, and other factors. Many companies do not attempt a detailed budgeting effort in this area, instead opting to back into an inventory budget by applying the existing inventory turnover rate to the projected sales level. Although this approach may work in a general sense, a company’s investment in inventory is sometimes so large that a more detailed approach is warranted. This post series discusses how to apply a variety of budgeting techniques to the three main areas of inventory: raw materials, work-in-process, and finished goods.
For pageload effectiveness, I would break the three inventory area into three post series you can follow. Now Let’s start with the Raw Materials Inventory.
Budgeting for Raw Materials Inventory
There are two methods of developing the raw materials inventory budget. First, budget each important inventory item separately based on the production plan. Second, budget materials as a whole or classes of material, based on selected production factors. Practically all companies must use both approaches to some extent, although one or the other predominates. The former method is always preferable to the extent that it is practicable, because it allows quantities to be budgeted more precisely.
The following steps should be taken in budgeting the major individual items of raw materials:
- Determine the physical units of material required for each item of goods to be produced during the budget period.
- Accumulate these into total physical units of each material item required for the entire production plan.
- Determine for each item of material the quantity that should be on hand periodically to fulfill the production plan with a reasonable margin of safety.
- Deduct material inventories that are expected to be on hand at the beginning of the budget period to ascertain the total quantities to be purchased.
- Develop a purchasing plan that will ensure that the quantities will be on hand at the time they are needed. The purchasing plan must consider such factors as economically sized orders, economy of transportation, and margin of safety against delays.
- Test the resulting budgeted inventories by standard turnover rates.
- Translate the inventory and purchasing requirements into dollars by applying the expected prices of materials to budgeted quantities.
In practice, many difficulties arise in executing the foregoing plan. In fact, it is practicable to apply the plan only to important items of material that are used regularly and in relatively large quantities. Most manufacturing companies find that they must carry hundreds or even thousands of different items of raw materials to which this plan cannot be practically applied. Moreover, some companies cannot express their production plans in units of specific products. This is true, for example: where goods are partially or entirely made to customers’ specifications. In such cases, it is necessary to look to past experience to ascertain the rate and regularity of movement of individual material items and to determine the maximum and minimum quantities between which the quantities must be held. This necessitates a program of continuous review of material records as a basis for purchasing and frequent revision of maximum and minimum limits to keep the quantities adjusted to current needs.
For those raw material items that cannot be budgeted individually, the budget must be based on general factors of expected production activity, such as total budgeted labor hours, productive hours, standard allowed hours, cost of materials consumed, or cost of goods manufactured.
To illustrate, assume that the cost of materials consumed (other than basic materials, which are budgeted individually) is budgeted at $1 million and that past experience demonstrates that these materials should be held to a turnover rate of five times per year; that an average inventory of $200,000 should be budgeted. This would mean that individual items of material could be held in stock approximately 73 days (one-fifth of 365 days). This could probably be accomplished by instructing the executives in charge to keep on hand an average of 60 days’ supply. Although such a plan cannot be applied rigidly to each item, it serves as a useful guide in the control of individual items and prevents the accumulation of excessive inventories.
In the application of this plan, other factors must also be considered. The relationship between the inventory and the selected factor of production activity will vary with the degree of production activity. Thus, a turnover of five times may be satisfactory when materials consumed are at the $1 million level, but it may be necessary to reduce this to four times when the level goes to $750,000. Conversely, it may be desirable to hold it to six times when the level rises to $1.25 million. Moreover, some latitude may be necessitated by the seasonal factor, because it may be necessary to increase the quantities of materials and supplies in certain months in anticipation of seasonal demands. The ratio of inventory to selected production factors at various levels of production activity and in different seasons should be plotted and studied until standard relationships can be established. The entire process can be refined somewhat by establishing different standards for different sections of the raw materials inventory.
The plan, once in operation, must be closely checked by monthly comparisons of actual and standard ratios. When the rate of inventory movement falls below the standard, study the records of activity for individual raw material items to detect the slow-moving items. Some of the problems and methods of determining the total amount of expected purchases may be better understood by illustration. Assume, for example, that this information is made available regarding production requirements after a review of the production budget:
Solely for illustrative purposes, the following four groups of products have been assumed:
- Class W: Material of high unit value, for which a definite quantity and time program is established in advance, such as for stock items. Also, the inventory is controlled on a Min-Max inventory basis for budget purposes.
- Class X: Similar to Item W, except that, for budget purposes, Min-Max limits are not used.
- Class Y: Material items for which definite quantities are established for the budget period but for which no definite time program is established, such as special orders on hand.
- Class Z: Miscellaneous material items grouped together and budgeted only in terms of total dollar purchases for the budget period.
In actual practice, of course, decisions about production time must be made regarding items using Y and Z classifications. However, the bases described later in this post are applicable in planning the production level. Further discussion of each inventory class follows:
(a) Class W:
Where the items are budgeted on a Min-Max basis, it usually is necessary to determine the range within which purchases must fall to meet production needs and stay within inventory limits. A method of making such a calculation is shown next:
Within these limits, the quantity to be purchased will be influenced by such factors as unit transportation and handling costs, price considerations, storage space, availability of material, capital requirements, and so forth.
A similar determination would be made for each month for each such raw material, and a schedule of receipts and inventory might then be prepared, somewhat in this fashion:
(b) Class X:
It is assumed that the class X materials can be purchased as needed. Because other controls are practical on this type of item and because other procurement problems exist, purchases are determined by the production requirements. A simple extension is all that is required to determine the dollar value of expected purchases:
(c) Class Y:
The breakdown of the class Y items may be assumed to be:
A determination about the time of purchase must be made, even though no definite delivery schedules and the like have been set by the customer. In this instance, the distribution of the cost and units might be made on the basis of past experience or budgeted production factors, such as budgeted machine hours. The allocation to periods could be made on past experience, as below:
The breakdown of units is for the benefit of the purchasing department only, in as much as the percentages can be applied against the total cost and need not apply to individual units. In practice, if the units are numerous regarding types and are of small value, the quantities of each might not be determined in connection with the forecast.
(d) Class Z:
Where the materials are grouped, past experience again may be the means of determining estimated expenditures by the period of time. Based on production hours, the distribution of class Z items may be assumed to be (cost of such materials assumed to be $2 per production hour):
When all materials have been grouped and the requirements have been determined and translated to cost, the materials budget may be summarized below:
A similar approach would be taken with respect to manufacturing supplies. A few major items might be budgeted as the class W or X items just cited, but the bulk probably would be handled as Z items.
Once the requirements as measured by delivery dates have been made firm, it is necessary for the finance department to translate such data into cash disbursement needs through average lag time and so forth.