Creating a Production Budget
A "production budget" is defined as a budget that covers the costs of ongoing business operations in the normal course of business.
Estimation Methods
In previous generations, we could assume that a business unit will do the exact same things from one year to another, and it will do them in the same ways, it will cost around the same amount. And this generally held true, as the pace of change was very slow. However, things change.
In some instances, change is intentional: a manager seeks ways to do things more efficiently, decreasing costs. Most businesses seek to experience growth, increasing costs.
In other instances, change is outside our control: costs increase, experienced employees leave, technology provides greater efficiency, our customers change their spending habits, etc.
Each of these things should be considered, and their impact of each line-item of an existing budget.
Arbitrary Changes
A dysfunctional, but all-too-common, method of top-down budgeting may be used, whether out of financial necessity or tyrannical whim: a decision may be made in a high place to arbitrarily cut all budgets by a fixed percentage.
It is assumed that managers have the skill to identify unnecessary expenses or invent more efficient practices to achieve the same (or increasing) levels of output with fewer resources. This may be possible, or it may be disastrous.
At the other end of the scale, mangers may set a specific budget as a fixed percentage increase, on every line, from previous years' budgets. This is no less arbitrary, and no less accurate - such an increase may be too much in some places and too little in others, and there's no guarantee it will balance out.
The point the author is trying to stress is that numbers should be based on something other than previous numbers in order to budget accurately.
Detailed Planning
The author suggests an eleven-step process for planning:
- Consider what changes will be made in the way the department works and determine their financial impact.
- Consider (or reconsider) purchases and leases, and check with vendors to get an idea of whether prices will change
- Where there are contracts coming up for renewal, try to get a sense of whether they will actually be renewed and how the terms may change. Ideally, get vendors and customers to renew early to lock in those decisions.
- Use production forecasts to estimate variable costs
- Examine any individual line-item that represents more than 10% of the total budget, with a careful eye to its accuracy.
- Review the budget as a whole to see if it makes sense (EN: no further elaboration of this)
- For each line item, calculate the percentage of the budget and decide which items are not substantial enough to merit detailed consideration
- For the remaining items, consider the likelihood that each item will change in quantity or price in the coming year, and the degree to which it can be reasonably expected to change.
- Check the relationships among items (some items are expressed as a percentage of others) in last year's budget to the current oen to identify errors.
- Check your math, then have someone else check it
- Document any budgetary assumptions.
The author suggests looking at each line-item in the budget separately, but it seems to me that some items are interrelated, and some changes may affect multiple line items.
Sample Manufacturing Budget
As a demonstration, the author gives a sample manufacturing budget. A lot of this is anecdotal, so I will document his process.
First, he asks how much will be produced in the coming year, and compares that to the figures from the current year. An increase or decrease in volume will have a direct affect on the costs of production, particularly the variable costs (but notably, not the fixed costs). He also suggests that if production quotas have not been set, it is possible to ask marketing how many units they intend to sell, and use that as a quota.
Then, he looks at inventory levels, knowing that the quantity in starting inventory will not need to be produced, but that there will also be a demand to have a specific number in ending inventory (otherwise, there will be nothing on the shelves to fill orders in January)
He then creates a budget for direct materials (the components that are needed to build the units), also accounting for beginning and ending inventory, to determine the amount needed to purchase supplies. He checks into the contracts with existing vendors to see if prices are fixed, and for how long. Where needed, he may call vendors to ask about planned price increases in the next year.
He then considers labor costs. As a basis, it's simple multiplication of the time per unit times number of units. Looking at a breakdown of month-to-month production, he decides where full-time employees can handle the load or where contractors and temporaries may need to be hired.
He then looks into overhead costs - fixed and variable. He considers the degree to which both may change in developing an estimated amount.
EN: this is pretty detailed, but I think he skipped a lot of steps and didn't take his own advice. For example, he calculated the cost of his employees without considering churn rate - if several senior employees are due to retire this year, that will decrease cost-per-hour but increase hours-per-part. He also applied the same hours-per-part to temporaries as he did to employees. There are a lot of little things he failed to do, even after advising the reader to do them.