Production Budget

After determining the Sales Budget, the Production Budget can be developed because it incorporates the budgeted sales. The Production Budget also incorporates the company’s production capacity and inventory objectives to determine how many units to produce during the period.

The Production Budget needs to include production from any new capital projects planned to begin production during the year, which should be available from the Sales Budget.

If the company would like to increase its finished goods inventory level by year-end, it will need to include the desired inventory increase in its production plans. Similarly, if the company wants to decrease yearend inventory, it will need to produce fewer units than it plans to sell so it can sell down the units in inventory.

The Production Budget also includes when the units will be produced. The units must be produced prior to the time they will be needed for sale but not too far in advance. If increased sales are expected in the early part of the year, production should be planned to be higher early in the year. If higher sales are expected later in the year, increased production needs to take place later in the year or else the company will need to plan to pay significant inventory storage costs.

If the prices of the direct materials needed in production are expected to change significantly in the future, the expected changes must also be considered in determining the timing of production. As much as possible, the company will want to purchase direct materials needed when the prices of the materials are lower rather than higher.

The Production Budget in number of units to be produced provides the foundation for the development of the following four budgets:

1-Direct Materials Usage Budget

The Direct Materials Usage Budget makes use of the number of units to be produced from the Production Budget, the number of units of direct materials allowed per unit produced, and the budgeted costs per unit of materials to determine the total quantity of direct materials that will be needed in production and the budgeted costs of the materials to be used.

2-Direct Materials Purchases Budget

The Direct Materials Purchases Budget uses information from the Direct Materials Usage Budget but also incorporates the desired change in inventories of raw materials to determine the direct materials to be purchased during the period.

3-Direct Labor Usage Budget

The Direct Labor Usage Budget uses the units planned to be produced from the Production Budget, the number of direct labor hours allowed per unit produced, and the budgeted direct labor rates per hour to determine the budgeted total direct labor hours to be used and the budgeted cost of the direct labor used.

4-Manufacturing Overhead Costs Budget

The Manufacturing Overhead Costs Budget draws on the Production Budget for planned production volume to determine the budgeted amount of variable manufacturing overhead costs such as equipment maintenance that increases and decreases as production increases and decreases. It uses the Production Budget also to determine the budgeted fixed manufacturing overhead costs such as plant supervisors’ salaries. Although fixed manufacturing overhead costs do not change as production levels change as long as the change in activity remains within the relevant range, if the budgeted production is outside that range, appropriate adjustments need to be made to budgeted fixed manufacturing costs. The Manufacturing Overhead Costs Budget also utilizes the budgeted amounts allowed of the allocation bases used for overhead application (usually budgeted direct labor hours from the Direct Labor Usage Budget or budgeted machine hours) to calculate the predetermined overhead application rates.

The Direct Materials Usage and Purchases Budgets, Direct Labor Usage Budget, and Manufacturing Overhead Costs Budget feed into the Ending Inventories Budget, Budgeted Cost of Goods Manufactured, and Budgeted Cost of Goods Sold.

Because all these budgets are interrelated, a change in one budget will require a change in another budget or budgets. As the level of production changes, the amount of direct labor and direct material required will change. As the amount of direct labor changes, there may need to be a change as well in indirect materials and indirect labor, both of which are manufacturing overhead costs.

• Indirect materials ⇒ are materials used in the manufacturing process, but their costs are not directly traceable to any specific product. Indirect materials may represent a very minor part of a finished product’s costs, or they may not be an integral part of a finished product at all. Examples are screws, glue, cleaning chemicals, and disposable tools. Indirect materials are usually variable manufacturing overhead costs.
• Indirect labor ⇒  is likewise not directly traceable to any specific product. For example, the wages of a janitor who cleans up the plant are indirect labor costs because the janitor’s wages cannot be traced to any one product. Because indirect labor is a fixed manufacturing overhead cost, it is less likely to respond to changes in the production level than a variable cost would. However, the effect on indirect labor of production changes should be considered since in the long run, all costs are variable.

As the production level changes, changes will be required in the Manufacturing Overhead Costs Budget.

Because of the way the individual budgets are connected to each other, a change in one budget will almost always affect at least one other budget.