How Budget is Defined in Accounting?

A budget can be defined as a financial plan designed by an undertaking for a definite period in the future that can contribute towards enhancing the financial success of the business undertaking. It is used to estimate the revenue and expenses. The budget generally takes into account both current and future income and expenses.

Importance of a Budget

• Helps an organization to figure out long-term goals and work towards them.
• Helps an organization to tackle unforeseen situations that may occur in the near future like recession, economic crisis, competition in the market, etc.
• Enables the business to meet its objectives and make financial decisions confidently.
• Ensures that the business has enough money for future projects.

Production Budget 

A production budget is a type of financial plan in which the corporate undertaking lists the estimated number of units that a plant needs to produce within a given time period. This type of budget is generally used by accountants and managers to keep up with the demand of the products and manage inventory.

Example of a Production Budget

ABC company manufactures glass bottles.  It is anticipated that 2000 glass bottles will be sold in the next quarter. The company only had 250 units of the product left at the end of the last quarter. The company keeps at least 50 units in safety stock.

The Production Budget of the ABC Company for the next quarter is as follows:

Therefore, the ABC company must produce 1800 units of glass bottles in the following quarter to meet customer's demand.

Main Components of a Production Budget

A production budget is made up of four major components:

• Opening Stock
• Estimated Volume of Sales
• Closing Stock
• Estimated Production

Opening Stock

It is defined as the number of units carried forward from the previous budgetary period which can be either monthly, quarterly, or yearly. It is the ending inventory of the previous production period.

Estimated Volume of Sales

It is the quantity of a given unit that the company expects to sell in the given time period. It signifies the demand for the company's product. 

Closing Stock

It is the amount of inventory that is left over in the current period which becomes the beginning inventory for the upcoming production period.

Estimated Production

It generally signifies the number of units that are to be produced during the given time period after opening stock, closing stock, and sale volume is considered.

Requirements of the Production Budget in Accounting

A production budget is used for:

Increase in Demand for a Product

The increase in demand for a product leads to an increase in the manufacturing of the product, while the decrease in demand forces a company to cut back its production. In case a company is well aware of the fact that the demand and production level of a particular product will be low in the upcoming month, then in such a scenario, it can use the downtime to produce an extra number of units to be held in hand for the period when there is a certain spike in demand for the products.

The Cost Incurred in Product Manufacturing

This budget helps in the cost estimation of manufacturing a product. A company may either manufacture its products or outsource its manufacturing to a third party. A production budget therefore also helps in forecasting the costs of having the goods manufactured by someone else which generally include costs for making the product by itself and the costs which the third-party manufacturer charges for its time and labor.

Fluctuation in Prices due to Uncertainty

A production budget generally works on the estimation that may change over a period of time. In case when there is an increase in the price of the raw materials during the production, the production cost increases. Moreover, in case of unavailability of raw material, the business may look for a new material to be used in the manufacturing of the product. It may subsequently lead to an increase in production cost or cost savings for the company if the company is able to obtain the new raw materials at a price less than the original cost.

Importance of a Production Budget in Accounting

• The production budget forms the basis of planning in any corporate undertaking. This form of budget helps in streamlining the production process and machine utilization.
• The budget also helps in taking managerial decisions in purchasing raw materials and other consumables.
• The budget helps the management to take key decisions in hiring new labour force depending on how much production is to be done by the company in the coming period.
• The production budget also helps in forecasting the production of the business and giving targets to the employees of the company for achieving the desired level of output with maximum efficiency and incurring minimal expenses.
• The production budget also helps in controlling the expenses that is to be incurred while producing a product and setting a clear objective for the people in the organization.
• The production budget also helps in the proper and effective utilization of available resources.

Limitations of the Production Budget

• This budget is entirely based on the estimated value of the sales and there is a possibility of a lot of variation. In case there is a sudden fluctuation in the demand for a product or there is a change in the economic situation or recession, the entire estimation of the management regarding sales and production can go wrong.
• The budget involves a very lengthy process in its preparation and any wrong estimation can lead to wastage of a considerable number of productive hours.
• There are different types of people in the organization having different mindsets and different way of thinking, so each one of them may have different opinions of the production budget. So, in such cases employees of the organization might not accept the budget which is prepared by the top-level management of the company.
• This budget also makes it very difficult for the companies who have started working recently to estimate the figures while preparing the production budget because of the lack of past data and required experience.

Formulas

Production Budget (units) = Expected unit of sales in the given period - Opening Stock of finished goods + Closing Stock of finished goods.

Common Mistakes

Since the production budget is based on estimation, care must be taken that costs are not underestimated which might lead to discrepancies within the organization in the future. Moreover, care must be taken to ensure that the financial data produced is not vague and decisions are taken appropriately.

Context and Applications

This content of "Production Budget" is significant for the professional exams for both undergraduate and graduate courses, especially for:

• MBA
• BBA
• B. Com
• B. Com (Hons)

Related Concepts

• Static Budget.
• Last in First Out Method.
• First in First Out Method.
• Operations Management.
• Capital Budget.