The course of managerial accounting dedicates up to two chapters on the subject of budgeting.  One of those chapters goes into the process of preparing budgets in manufacturing companies. This chapter goes into the process for preparing production budgets, direct materials budgets, direct labor budgets, and manufacturing overhead budgets.  Going into these types of budgets may be helpful for students but I don’t want this article to be a repeat of what appears in textbooks.  I want this article to focus on the process of financial planning and how it can be used in your company’s production function.

The Process of Financial Planning

The process of financial planning is described by the following illustration:

The process illustrated above is described in greater detail through three articles I wrote for FP&A Trends:

• Using Economics in your Financial Plans
• Using Accounting in your Financial Plans
• Using Finance in your Financial Plans

Choices

The first choice is whether to engage your company in manufacturing products; if your choice is yes, you face more choices in your company’s production process.

Raw Materials

Production begins with raw materials.  Raw materials are the inputs that go into the products being created.  The choices involved with raw materials incorporate purchase and use.

The choices involved with the purchase of raw materials include:

• The types of materials necessary for conversion into finished goods.
• The vendors who will supply these materials.
• The characteristics that these materials will provide for the value propositions of the finished goods like durability and flexibility.
• The characteristics that these vendors possess in order to support the production process like availability and timeliness.
• The amount of materials necessary for creating products.

The choices involved with the use of raw materials include:

• The quality of materials being put into production.
• The accessibility of materials for those involved in the production process.
• The amount of time required for incorporating materials into the production process.

Work in Process

Work in process is the introduction of labor and overhead to raw materials.  Labor, most notably direct labor, represents people who will convert materials into products.  Overhead represents elements in factories – equipment, facilities, utilities, etc. – that envelope the production process.

The choices involved with the introduction of labor include

• Whether the labor will be employees or outside contractors.
• How the labor will be compensated.
• The number of hours required to convert materials into finished goods.
• The characteristics of labor must possess in order to fulfill the company’s value proposition.
• The ability of labor to handle materials in the production process.

The choices involved with the introduction of overhead include

• Whether the overhead will be handled internally or through vendors.
• The types of overhead required.
• The amount of time required by overhead to convert materials into finished goods.
• The characteristics overhead must possess in order to fulfill the company’s value proposition.
• The ability of overhead to handle materials in the production process.

Finished Goods

Finished goods represent the products that the company will sell.  Finished goods also represent the combination of raw materials and work in process.  In addition, finished goods represent the value proposition that the company wants its customers to not only see but also buy.

The primary choice involved with finished goods is the characteristics the company wants customers to not only see but also buy.  Characteristics like accessibility, durability, and flexibility are a direct to the wealth that the company wants to accumulate.  Characteristics also an extension of the raw materials and work in process that go into what is being seen as well as bought.  In addition characteristics unite other functions in the company, most notably selling and administration. The choices companies make in their finished goods have multiple effects on the employment of other company functions as well as the relationships needed for the company to not only maintain but also strengthen its existence; as a result financial planning is a vital part of your company’s production function.

Transactions

Transactions are the second step in the process of thinking about how to accumulate wealth, i.e. financial planning.  I define transactions as the exchange or use of capital.  The production function will exchange capital when it acquires direct materials, direct labor, and manufacturing overhead.  The production function will use capital when it puts materials into production and converts materials into finished goods.  The acts of exchanging and using capital needs to be addressed in financial planning by focusing on the tried and true concepts of money and time.

When it comes to money financial planning needs to think about the payment terms for acquiring direct materials, direct labor, and manufacturing overhead.  Payment terms for direct labor will be dictated by the company’s payroll so financial planning must take the company’s obligation to its employees under consideration.  Payment terms for direct materials and manufacturing overhead will be dictated by the company’s vendors so financial planning must consider the company’s ability to meet the vendors’ dictates.  Not considering the company’s ability to meet terms set by vendors can cause two problems.  One problem is delays in receiving items critical in manufacturing products and the other problem is damaging relationships with customers.

When it comes to time financial planning needs to think about how fast companies can acquire materials, put materials into production, and convert materials into finished goods.  Thinking about these tasks is important due to the following example.  A manufacturing company commits itself to ship products on the day the order is placed or the day after the order is placed.  Failing to fulfill this commitment can adversely affect relationships with customers that can lead to the company going out of business.  How companies can understand its ability to use capital in its production function is to incorporate elements of The Balanced Scorecard which I describe in my FP&A Trends article titled “Balance your Financial Planning.”

Wealth

I define wealth as the abundance of valuable possessions.  Your company’s production function accumulates a variety of valuable possessions.  Inventories like raw materials, work in process, and finished goods represent one category of wealth.  Elements like direct materials, direct labor, and manufacturing overhead represent another category of wealth. What makes inventories and elements valuable?  The answer goes beyond financial statements. 

The abundance of valuable possessions in your company’s production function can be defined through the use of The Balanced Scorecard.  The purpose of The Balanced Scorecard is to look at a company’s performance through the perspectives of employees, internal processes, and customers.  Your company can use The Balanced Scorecard to look at wealth in the production function through a variety of measurements.

Examples of measurements to look at wealth from the perspective of employees include the

• Number of suggestions for improving the use of direct materials, direct labor, and manufacturing overhead.
• Number of suggestions for improving the quality of raw materials inventories.
• Number of suggestions for reducing the amount of work in process inventories.
• Number of suggestions for improving the quality of finished goods inventories.
• Number of suggestions for decreasing the amount of time to sell finished goods inventories.

Examples of measurements to look at wealth from the perspective of internal processes include the

• Number of defects in raw materials purchased.
• Amount of scrap in work in process activities.
• Movement of materials during work in process activities.
• Transfer of work in process to finished goods.
• The relationship between the characteristics of finished goods inventories to selling and administrative objectives.

Examples of measurements to look at wealth from the perspective of customers include the

• Number of new customers acquired.
• Number of existing customers retained.
• Number of referrals from existing customers.
• Percentage of sales returns.
• Percentage of new products manufactured.

Conclusion

The purpose of a production function is to create what a company sells.  Creating what a company sells goes beyond products.  Creating what a company sells comprises the characteristics of products.  The characteristics of products exist in a company’s raw materials, work in process, and finished goods inventories as well as a company’s direct materials, direct labor, and manufacturing overhead.  In order to organize these elements, it is necessary to use financial planning in your company’s production function.