The budget of finished goods inventory (or merchandise in the case of trading concerns) must be based on the sales budget. If, for example, it is expected that 500 units of item A will be sold during the budget period, it must be ascertained what number of units must be kept in stock to support such a sales program. It is seldom possible to predetermine the exact quantity that will be demanded by customers day by day. Some margin of safety must be maintained by means of the finished goods inventory so that satisfactory deliveries can be made. With this margin established, it is possible to develop a program of production or purchases whereby the stock will be replenished as needed.
Budgeting Finished Goods by Individual Items
Two general methods may be employed in budgeting the finished goods inventory:
Method-1: A budget is established for each item separately.
This is done by studying the past sales record and the sales program of each item and determining the quantity that should be on hand at various dates (usually, the close of each month) throughout the budget period. The detailed production or purchasing plan can then be developed to provide such quantities over and above current sales requirements. The total budget is merely the sum of the budgets of individual items. This total budget can then be tested by the rate of turnover desired as proof that a satisfactory relationship will be maintained between inventory and sales and that it harmonizes with the general finance plan. If it fails in either respect, revision must be made in the plans of sales, production, or finance until a proper coordination is effected.
Under this plan, control over the inventory is effected by means of enforcement of the sales and production plans. If either varies to any important degree from the budget, the other must be revised to a compensating degree and the inventory budget revised accordingly.
Method-2: Sales and Production Plans can be enforced with reasonable certainty.
Where the sales and production plans can be enforced with reasonable certainty, this is the preferable method. It is particularly suitable for those concerns that manufacture a comparatively small number of items in large quantities. The application is similar in principle to that illustrated in connection with raw materials controlled budget-wise by minimums and maximums.
Budgeting Total Finished Quantities and Values
Where the sales of individual items fluctuate considerably and where such fluctuations must be watched for hundreds or even thousands of items, a second plan is preferable.
Here basic policies are adopted relative to the relationship that must be maintained between finished goods and sales. This may be done by establishing standard rates of turnover for the inventory as a whole or for different sections of the inventory. For example: it may be decided that a unit turnover rate of three times per year should be maintained for a certain class of goods or that the dollar inventory or another class must not average more than one-fourth of the annual dollar cost of sales. The budget is then based on such relationships, and the proper executives are charged with the responsibility of controlling the quantities of individual items in such a manner that the resulting total inventories will conform to the basic standards of inventory.
With such standard turnover rates as basic guides, those in charge of inventory control must then examine each item in the inventory; collect information about its past rate of movement, irregularity of demand, expected future demand, and economical production quantity; and establish maximum and minimum quantities, and quantities to order. Once the governing quantities are established, they must be closely watched and frequently revised if the inventory is to be properly controlled.
The establishment and use of maximum, minimum, and order quantities can never be resolved into a purely clerical routine if it is to be effective as an inventory control device. A certain element of executive judgment is necessary in the application of the plan. If, for example, the quantities are based on past sales, they must be revised as the current sales trend indicates a change in sales demand. Moreover, allowance must be made for seasonal demands. This is sometimes accomplished by setting different limits for different seasons.
The most frequent cause of the failure of such inventory control plans is the assignment of unqualified personnel to the task of operating the plan and the failure to maintain a continuous review of sales experience relative to individual items. The tendency in far too many cases is to resolve the matter into a purely clerical routine and assign it to clerks who are capable only of routine execution. The danger is particularly great in companies carrying thousands of items in finished stock, with the result that many quantities are excessive, and many obsolete and slow-moving items accumulate in stock. The successful execution of an inventory control plan requires continuous study and research, meticulous records of individual items and their movement, and a considerable amount of individual judgment.
The plan, once in operation, should be continually tested by comparing the actual rates of turnover with those prescribed by the general budget program. If this test is applied to individual sections of the finished inventory, it will reveal the particular divisions that fail to meet the prescribed rates of movement. The work of correction can then be localized to these divisions.
Whenever possible, the plan of finished inventory control should be exercised in terms of units. When this is not practicable, it may be based on dollar amounts.
In the context of preparing the annual business plan in monetary terms, and based on the quantities of finished goods (furnished by the cognizant executive) deemed necessary for an adequate inventory, the inventory accountant can develop the budget for the finished goods inventory, much as is shown in condensed form as below:
When the total of the inventory segments is known, the total inventory budget for the company can be summarized as in shown below:
Such a summary can be useful in discussing inventory levels with management. Any pertinent ratios can be included.
Again, in testing the reasonableness of the annual business plan, the inventory—by segments, or perhaps in total—should be tested by turnover rate or another device suggested for control (or planning) purposes.