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:
1. 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.
2. Class X: Similar to Item W, except that, for budget purposes,
Min-Max limits are not used.
3. 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.
4. 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.
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