BUS601: Financial Management

Estimating sales leads to identifying the desired quantity of inventory to meet the demand. Management wants to have enough inventory to meet production, but they do not want too much in the ending inventory to avoid paying for unnecessary storage. Management often uses a formula to estimate how much should remain in ending inventory. Management wants to be flexible with its budgeting, wants to create budgets that can grow or shrink as needed, and needs to have inventory on hand. So the amount of ending inventory often is a percentage of the next week's, month's, or quarter's sales.

In creating the production budget, a major issue is how much inventory should be on hand. Having inventory on hand helps the company avoid losing a customer because the product isn't available. However, there are storage costs associated with holding inventory as well as having a lag time between paying to manufacture a product and receiving cash from selling that product. Management must balance the two issues and determine the amount of inventory that should be available.

When determining the number of units needed to be produced, start with the estimated sales plus the desired ending inventory to derive the maximum number of units that must be available during the period. Since the number of units in beginning inventory are already produced, subtracting the beginning inventory from the goods available results in the number of units that need to be produced.

After management has estimated how many units will sell and how many units need to be in ending inventory, it develops the production budget to compute the number of units that need to be produced during each quarter. The formula is the reverse of the formula for the cost of goods sold.

The number of units expected to be sold plus the desired ending inventory equals the number of units that are available. When the beginning inventory is subtracted from the number of units available, management knows how many units must be produced during that quarter to meet sales.

In a merchandising firm, retailers do not produce their inventory but purchase it. Therefore, stores such as Walmart do not have raw materials and instead substitute the number of units to be purchased in place of the number of units to be produced; the result is the merchandise inventory to be purchased.

To illustrate the steps in developing a production budget, recall that Big Bad Bikes is introducing a new product that the marketing department thinks will have strong sales. For new products, Big Bad Bikes requires a target ending inventory of 30% of the next quarter's sales. Unfortunately, they were unable to manufacture any units before the end of the current year, so the first quarter's beginning inventory is 0 units. As shown in Figure 7.7, sales in quarter 2 are estimated at 1,000 units; since 30% is required to be in ending inventory, the ending inventory for quarter 1 needs to be 300 units. With expected sales of 1,000 units for quarter 2 and a required ending inventory of 30%, or 300 units, Big Bad Bikes needs to have 1,300 units available during the quarter. Since 1,300 units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units, as shown in Figure 7.8

The ending inventory from one quarter is the beginning inventory for the next quarter and the calculations are all the same. In order to determine the ending inventory in quarter 4, Big Bad Bikes must estimate the sales for the first quarter of the next year. Big Bad Bikes's marketing department believes sales will increase in each of the next several quarters, and they estimate sales as 3,500 for the first quarter of the next year and 4,500 for the second quarter of the next year. Thirty percent of 3,500 is 1,050, so the number of units required in the ending inventory for quarter 4 is 1,050.

The number of units needed in production for the first quarter of the next year provides information needed for other budgets such as the direct materials budget, so Big Bad Bikes must also determine the number of units needed in production for that first quarter. The estimated sales of 3,500 and the desired ending inventory of 1,350 (30% of the next quarter's estimated sales of 4,500) determines that 4,850 units are required during the quarter. The beginning inventory is estimated to be 1,050, which means the number of units that need to be produced during the first quarter of year 2 is 3,800.

The number of units needed to be produced each quarter was computed from the estimated sales and is used to determine the quantity of direct or raw material to purchase, to schedule enough direct labor to manufacture the units, and to approximate the overhead required for production. It is also necessary to estimate the sales for the first quarter of the next year. The ending inventory for the current year is based on the sales estimates for the first quarter of the following year. From this amount, the production budget and direct materials budget are calculated and flow to the operating and cash budget.