Operating budgets are a primary component of the master budget and involve examining the expectations for the primary operations of the business. Assumptions such as sales in units, sales price, manufacturing costs per unit, and direct material needed per unit involve a significant amount of time and input from various parts of the organization. It is important to obtain all of the information, however, because the more accurate the information, the more accurate the resulting budget, and the more likely management is to effectively monitor and achieve its budget goals.
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Individual Operating Budgets
In order for an organization to align the budget with the strategic plan, it must budget for the day-to-day operations of the business. This means the company must understand when and how many sales will occur, as well as what expenses are required to generate those sales. In short, each component—sales, production, and other expenses—must be properly budgeted to generate the operating budget components and the resulting pro-forma budgeted income statement.
The budgeting process begins with the estimate of sales. When management has a solid estimate of sales for each quarter, month, week, or other relevant time period, they can determine how many units must be produced. From there, they determine the expenditures, such as direct materials necessary to produce the units. It is critical for the sales estimate to be accurate so that management knows how many units to produce. If the estimate is understated, the company will not have enough inventory to satisfy customers, and they will not have ordered enough material or scheduled enough direct labor to manufacture more units. Customers may then shop somewhere else to meet their needs. Likewise, if sales are overestimated, management will have purchased more material than necessary and have a larger labor force than needed. This overestimate will cause management to have spent more cash than was necessary.
The sales budget details the expected sales in units and the sales price for the budget period. The information from the sales budget is carried to several places in the master budget. It is used to determine how many units must be produced as well as when and how much cash will be collected from those sales.
For example, Big Bad Bikes used information from competitor sales, its marketing department, and industry trends to estimate the number of units that will be sold in each quarter of the coming year. The number of units is multiplied by the sales price to determine the sales by quarter as shown in (Figure).
The number of units expected to be sold plus the desired ending inventory equals the number of units that are available. When the beginning inventory is subtracted from the number of units available, management knows how many units must be produced during that quarter to meet sales.
In a merchandising firm, retailers do not produce their inventory but purchase it. Therefore, stores such as Walmart do not have raw materials and instead substitute the number of units to be purchased in place of the number of units to be produced; the result is the merchandise inventory to be purchased.
To illustrate the steps in developing a production budget, recall that Big Bad Bikes is introducing a new product that the marketing department thinks will have strong sales. For new products, Big Bad Bikes requires a target ending inventory of 30% of the next quarter’s sales. Unfortunately, they were unable to manufacture any units before the end of the current year, so the first quarter’s beginning inventory is 0 units. As shown in (Figure), sales in quarter 2 are estimated at 1,000 units; since 30% is required to be in ending inventory, the ending inventory for quarter 1 needs to be 300 units. With expected sales of 1,000 units for quarter 2 and a required ending inventory of 30%, or 300 units, Big Bad Bikes needs to have 1,300 units available during the quarter. Since 1,300 units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units, as shown in (Figure)
Management knows how much the materials will cost and integrates this information into the schedule of expected cash disbursements, which will be shown in Prepare Financial Budgets. This information will also be used in the budgeted income statement and on the budgeted balance sheet. With 6,000 units estimated for sale, 3.2 pounds of material per unit, and $1.25 per pound, the direct materials used represent $24,000 of the cost of goods sold. The remaining $7,240 is included in ending inventory as units completed and raw material.
Direct Labor Budget
Management uses the same information in the production budget to develop the direct labor budget. This information is used to ensure that the proper amount of staff is available for production and that there is money available to pay for the labor, including potential overtime. Typically, the number of hours is computed and then multiplied by an hourly rate, so the total direct labor cost is known.
If Big Bad Bikes knows that they need 45 minutes or 0.75 hours of direct labor for each unit produced, and the labor rate for this type of manufacturing is $20 per hour, the computation for direct labor simply begins with the number of units in the production budget. As shown in (Figure), the number of units produced each quarter multiplied by the number of hours per unit equals the required direct labor hours needed to be scheduled in order to meet production needs. The total number of hours is next multiplied by the direct labor rate per hour, and the labor cost can be budgeted and used in the cash disbursement budget and operating budget illustrated in Prepare Financial Budgets.
The total manufacturing overhead cost was $131,863 for 7,050 units, or $18.70 per unit (rounded). Since 6,000 units are sold, $112,200 (6,000 units × $18.70 /unit) will be expensed as cost of goods sold, while the remaining $19,663 will be part of finished goods ending inventory.
Sales and Administrative Expenses Budget
The direct materials budget, the direct labor budget, and the manufacturing overhead budget plan for all costs related to production, while the selling and administrative expense budget contains a listing of variable and fixed expenses estimated to be incurred in all areas other than production costs. While this one budget contains all nonmanufacturing expenses, in practice, it actually comprises several small budgets created by managers in sales and administrative positions. All managers must follow the budget, but setting an appropriate budget for selling and administrative functions is complicated and is not always thoroughly understood by managers without a background in managerial accounting.
If Big Bad Bikes pays a sales commission of $2 per unit sold and a transportation cost of $0.50 per unit, they can use these costs to put together their sales and administrative budget. All other costs are fixed costs per quarter: sales salaries of $5,000; administrative salaries of $5,000; marketing expenses of $5,000; insurance of $1,000; and depreciation of $2,000. The sales and administrative budget is shown in (Figure), along with the budgeted sales used in the computation of variable sales and administrative expenses.
Only manufacturing costs are treated as a product cost and included in ending inventory, so all of the expenses in the sales and administrative budget are period expenses and included in the budgeted income statement.
Budgeted Income Statement
A budgeted income statement is formatted similarly to a traditional income statement except that it contains budgeted data. Once all of the operating budgets have been created, these costs are used to prepare a budgeted income statement and budgeted balance sheet. The manufacturing costs are allocated to the cost of goods sold and the ending inventory.
Big Bad Bikes uses the information on direct materials ((Figure)), direct labor ((Figure)), and manufacturing overhead ((Figure)) to allocate the manufacturing costs between the cost of goods sold and the ending work in process inventory, as shown in ((Figure)).
Once they perform this allocation, the budgeted income statement can be prepared. Big Bad Bikes estimates an interest of $954. It also estimates that $22,000 of its income will not be collected and will be reported as uncollectible expense. The budgeted income statement is shown in (Figure).
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