Business — Banking — Management — Marketing & Sales

Sales and production budget preparation

Category: Budgeting Methodology

Basic rules to observe

The sales budget — what products at what prices plans the company to sell – is, as pointed out earlier, the starting point for preparing a budget. Three basic rules have to be observed when preparing the sales budget.

  • The sales budget must be compiled by multiplying product quantities with unit prices. This principle originates from the fact that the costs which have to be budgeted (material, production, sales and administrative costs ) are determined by the sold/produced quantities, and not by the sales/production value. Due to this, previous year sales numbers multiplied by factors are not a sales budget!

In practice, the adherence to this rule is not always easy. Companies manufacture what the market demands, and the ability of a company to meet specific demands, priced with specific prices, represents a competitive advantage. This means that a sales budget which strictly adheres to the “quantity multiplied by unit price principle” in many cases has to deal with a large number of specific products and prices. Specific products, however, are difficult to forecast and experience shows that if forecasted specifically, minor changes in the sales mix can cause big forecasting errors. Therefore, generally, fictitious type products (commonly called planning units) are defined for sales planning purposes which stand for a certain number of specific products. However when using type products for budgeting, certain rules have to be observed. If a brewery, for instance, sells different kinds of beer which essentially all use the same materials, go through the same production process, and have very similar prices, it can be envisaged, to just use the planning unit “hectolitres of beer” with one budgeted average price. If the brewery chooses to add a prestige beer product to its product range, produced with different materials, using a specific production process, and sold at higher prices, a specific planning unit should be created to budget this activity. If this is not done, the impact of this activity on sales and cost will not be adequately reflected in the budget. The decision of which planning units to use, and how to define them, is therefore essential for the informational value of a budget. This leads to the second basic rule:

  • Planning units have to be selected in such a way that they reflect closely enough the prices and cost attached to the different products.
  • Because of the reason explained in the “Theoretical Background” paragraph, the sales budget – as all other budgets – has to be established by month.

How to do it

Sales have to be budgeted – as explained in the previous paragraph – in planning quantities which are multiplied by unit prices, and in choosing adequate planning units.

Eurotransform’s production programme consists of electrical power transformers which are characterized by a specific technological design and by specific electrical properties which make them fit specific utilizations. Each transformer produced is a specific product for a specific customer. The quantity of products delivered annually is limited (approximately 100 orders each of which comprises one, or several items of a specific transformer type). Due to the limited number of product types which are produced per year, there is no need to define planning units in order to aggregate individual product sales forecasts into easier to handle summary numbers. The decision, therefore, was taken to budget sales by individual – and customer specific — transformer.

In the previous paragraph the comment was made that specific products are difficult to forecast, and that minor misjudgements in relation to future sales of specific products might cause big forecasting errors. In the case of the transformer plant this, for example, would mean that at budget preparation time in October the detailed sales forecast is available until the month of July next year, and that the specific products to be sold would have to be estimated for the remaining five months. This can be extremely difficult because the price of a power transformer can go from 1,000 US$ to 300,000 US$, with production processes for the low end and high end which show important differences. Hence, the risk to commit misjudgements if, for instance, high end transformers are budgeted for the remaining five months, although low end ones, finally, will be ordered.

However, at Eurotransform this problem, normally, does not exist. The project development lead time in this economic sector is long (electrical power plants, electrical distribution networks, large industrial projects) so that at the time of the budget preparation the sales for the coming year are already known in detail.

The planning in accordance with the principles explained above has been done by month. In order to reflect the different price and VAT behaviour, planned sales are split into “domestic”, ”CIS”, and “foreign markets”. The planning is made in UAH. US$ conversion has been done at 5,40 UAH per 1 US$.

Because Eurotransform produces for firm customer orders only (not “on stock”), production has been set equal to sales.

As the objective of budgeting sales is twofold, i.e.

  • on the one hand it provides for the quantity base for planning and costing the manufacturing activity, i.e. it determines what is planned to be sold, and what, consequently, has to be produced at what point in time,
  • on the other hand it anticipates the cash flow which is to be expected from the sales during the budget period, the cash flow resulting from sales has to be budgeted too. In doing this the procedure has to take into account the timing differences between the physical delivery, the setting up of the invoice, and the point in time when payments are made. Because the payments depend on the agreed upon contractual terms, and on the attitude of the business partners with regards to payments, a multitude of situations can arise which are difficult to anticipate. Therefore, for budgeting purposes, one uses generally a scenario which attempts to reflect the average behaviour with regard to payments, generally by type of customer, or type of business.

In the case of sample company Eurotransform the scenario chosen is relatively simple. A typical behaviour is applied to the two business types “domestic/CIS” and “foreign markets” as follows:

  • Domestic/CIS: Production cycle from signing of order till delivery 3 months. Payments: 10% at signature, 90% at delivery.
  • Foreign markets: Production cycle from signing the contract till delivery 4 months. Payments: 50% at signature, 50% at delivery.

Using such a scenario does not exclude the possibility to use the contractually agreed payment pattern for those planned sales where such information is available.

If one attempts to apply the basic rules of sales budgeting — planning of quantities which are multiplied by unit prices, and selection of adequate planning units – to the process industry environment of a tannery, one realizes very quickly that the problems here are quite different. Production cycle times here are much shorter (approximately 2 weeks). The company knows it’s detailed sales program only 1-2 months ahead of time, and not 10-12 months ahead of time as in the power transformer activity. The annual budget, therefore, has to be estimated based on the knowledge which the company has about its main customers (shoe, leather goods, and furniture producers; tanneries in the West which subcontract the environmentally-problematic tanning operations). Such estimates are possible because about 90% of the sales are made to customers with which the company maintains regular business relations. However, operating in an industry where the final product is subject to fashion trends, and to fluctuations of consumer demand, there is always a certain degree of uncertainty about the precise products which will be ordered. Theoretically, the number of products, which are the result of possible combinations of leather qualities, and colours, is very high.

The company Top K, initially, attempted to budget sales as much as possible by individual products. This, however, led to high data volumes to handle, and – at the end of the exercise – to little additional knowledge about the future business. As the precise leather types that will be ordered could not be obtained earlier than 1- 2 months before the delivery date, estimating of precise types did not yield any higher budget precision. Therefore, for simplicity reasons, 15 planning units were created for budgeting the sales as follows:

  • Chrome leather: 6 planning units, planned in m2: home market, and export each time split into the qualities A, B, C.
  • Wet blue (semi-finished product): 4 planning units, planned in kg: related to the four main end-utilizations.
  • Split leather, 2 planning units, planned m2: home market and export
  • Scrap products, 3 planning units, representing the type of scrap, planned in kg.

Average prices were budgeted for each of the planning units. Domestic and export sales are shown separately in order to permit consideration of the different price levels, different payment terms and different VAT treatment (export sales not submitted to VAT; domestic sales charged with 20%). No advance payments are customary in this industry. Payment terms are 30 days for exports, and 22 days on the home market. Because the numbers have been prepared to test the program, they only cover a 3 months period.

In a market economy, production is not a stand alone objective. Production is justified only to the extent that it can be sold, i.e. meets market demand in relation to quality and prices. Arithmetically, production is connected with sales through the following formula

Arithmetically, production is connected with sales through the following formula

Whether, or not inventory needs to be budgeted depends on the type of business. In companies working on orders inventory should be at minimum levels, and should be limited to contractually imposed situations (summary shipments), or to instances where cost effective purchasing and/or production requires the building up of some stocks (economic purchase/production lot sizes). No particular inventory planning was therefore defined when preparing the budget for Eurotransform. The fluctuations of inventory over the months result here from the acting together of the planned starting and delivery dates of production orders, and the assumed timing of direct material and direct labour input. In a retail company, and in a company serving the consumer product market, the holding of some inventory generally cannot be avoided. However, one should never forget that any inventory “freezes” working capital, and that one runs a risk to end up with slow-moving, or obsolete stock. On the other hand, if the inventory policy is too restrictive the company might fail to satisfy demand and lose customers.

In the case of the Top K company inventory has been planned for chrome leather. The production budget is expressed in quantities only.

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