Operating Budget

M.Sc. Elham Safari

[email protected]
Based on the lecture slides by
Senior Lecturer Jukka Sirki

Outline
Preparing the Operating Sub-Budgets
Sales Budget & Production Budget (recap.)
Direct Material (DM) Budget
Direct Manufacturing Labor (DL) Budget
Manufacturing Overhead (MOH) Budget
Ending Inventory Budget
Cost of Goods Sold Budget

Preparing the Budgeted Income Statement

Basic Operating
Budget Steps
1.
2.
3.

4.

5.

Prepare the revenues

budget.
Prepare the production
budget (in units).
Prepare the direct materials
(usage and purchases)
budget.
Prepare the direct
manufacturing labor budget.
Prepare the manufacturing
overhead costs budget.

Basic Operating
Budget Steps
6.
7.
8.
9.

Prepare the ending

inventories budget.
Prepare the cost of goods
sold budget.
Prepare the operating
expense budget.
Prepare the budgeted
income statement.

Remark1: Manufacturing Costs

Manufacturing costs are divided into three groups:
Direct Material (DM) Costs
Cost of buying materials that will become part of output product
(e.g. cost of buying cocoa in Fazer Co.)
Direct Manufacturing Labor (DL) Costs
All cost associated with manufacturing labors who are directly related to
output products (e.g. wages and benefits paid to assembly-line workers who
convert direct materials to finished goods)
Manufacturing Overhead / Indirect Manufacturing Costs
All manufacturing costs that are indirectly related to the output product.
In other words, all manufacturing costs that cannot be put into DM or DL costs
(e.g. indirect materials such as lubricants,
indirect manufacturing labor such as plant maintenance and cleaning labor,
plant rent, plant insurance, property taxes on the plant, plant depreciation,
and the compensation of plant managers)

Remark2: Types of Inventory

Manufacturing-sector companies usually have one or more of the
following types of inventories:
Finished Goods (FG) Inventory includes products that are ready to
be sold (but not sold yet).

Direct Materials (DM) Inventory includes direct materials that will

later be used in production.
Work-in-Process / Work-in-Progress (WIP) Inventory includes
goods that are not complete yet (for example, mobile phones that are
at different stages of completion, but are not finished yet).

Sales Budget / Revenues Budget

A detailed plan which identifies the product (or service)
sales that are expected in the accounting period
Expressed in terms of both units & (or $, or etc.)
Prepared before any other budget
To prepare this budget, a sales forecast by managers
should be done.
Estimation of the future sales revenues is important:
It will affect the level of operating activities and the amount of
resources needed for the operations
When this estimation is done, other budgets can be developed
based on it.

Sales Budget / Revenues Budget

x
=

Number of units to be sold

Sales price per unit
Total Sales Revenue

Example 1: XYZ company

XYZ company is preparing budgets for the quarter ending in
June 30, 2014. (a) The budgeted sales for the months April to
August are as follows: 10000, 20000, 30000, 35000, and
40000 (all in units) respectively. Prepare a Sales Budget.
Selling price is10/unit.
April
Budgeted Sales (in units)
Selling Price ( per unit)
Total Budgeted Sales ()

10000

May

20000

June

30000

Quarter

60000

10

10

10

10

100000

200000

300000

600000

Production Budget
A detailed plan which shows the number of units a company
must produce to meet budgeted sales and budgeted
inventory levels
Expressed in terms of units
Production managers use this information to plan for the
materials and human resources that production activities will
requires
To prepare a production budget, managers must know:
Budgeted number of sales units (from the sales budget)
Desired level of ending inventory for each period in the
budget year

Production Budget
In inventory accounts, there are two items on
the debit side, and two items on the credit side
Beginning
Inventory

Additions to
Inventory
(To be produced)

Additions
to
Inventory

Withdrawals
(To be sold)

Withdrawals

Ending
Inventory
(EI)

(Desired)
Ending
Inventory
Beginning
Inventory
(BI)

Production Budget

+
=
=

Units needed for sales

Desired ending inventory
Total units needed
Beginning inventory
Required Production
(or: To Be Produced)

Example 1b: Production Budget

(b) Suppose that the management of XYZ company wants the
ending inventory to be equal to 20% of the following months
budgeted sales in units. Prepare a Production budget. On
March 31, 2000 units were on hand.
April
Budgeted Sales (in units)
ADD: Desired Ending Inv.

10000
4000

May

20000
6000

June

30000

Quarter

60000

7000

7000

Total Needs

14000

26000

37000

=
67000
-

LESS: Beginning Inv.

2,000

4000

6000

2000

Required Production

12000

22000

31000

65000

Direct Material Purchases/Usage Budget

A detailed plan that identifies
the quantity of direct materials required to meet budgeted
production & the cost of acquiring them (DM Usage)
the quantity of direct materials required to meet budgeted
production as well as inventory needs, and the costs
associated with purchasing them (DM Purchases)

To prepare a DM budget, managers must know:

The amount of production needs in the next period
Desired level of direct material inventory for each period
Per unit cost of direct materials

Direct Material Usage Budget

x
=
x
=

Quantity of Finished Goods Production

Quantity of Materials needed per unit of FG
Quantity of DM to be used for production
Cost of direct material per (its) unit
Total cost of (DM) to be used

Direct Material Purchases Budget

+
=
=
x
=

Quantity of DM to be used for production

Target DM ending inventory
Total quantity of DM needed
DM beginning inventory
Quantity of DM to purchase
Cost of direct material per (its) unit
Total direct material (DM) cost

Purchasing managers prepare this budget to know the

amount of purchases in each period.

Example 1b: Production Budget

(revisited)
Let us expand this table:
April

May

June

July

August

Budgeted Sales (in units)

10000

20000

30000

35000

40000

ADD: Desired Ending Inv.

4000

6000

7000

8000

Total Needs

14000

26000

37000

43000

LESS: Beginning Inv.

2000

4000

6000

7000

Required Production

12000

22000

31000

36000

REMINDER:
Additions to Inv. = Withdrawals EI + BI
To be Purchase = To be Sold + Desired EI BI
= 35000 + 8000 7000 = 36000

8000

Example 1c: DM Purchases Budget

(c) At XYZ company, 5 Kg of materials are required per unit of
product. Management wants materials on hand at the end of
each month equal to 10% of the following months production.
On March 31, 10000 Kg of material are on hand. Material cost
is 0.50 per Kg. Prepare the Direct Materials Purchases
budget for the quarter.
What do we need?
- Amount of Production (from production budget)
- Material needed per unit of production ( = 5 Kg)
- Cost of raw material per unit ( = 0.50)

Example 1c: DM Purchases Budget (cont.)

The DM needs for July: 36000units * 5 Kg/unit = 180000 Kg
Junes ending inventory is equal to 10% of this, or 18000 Kg.
April

May

June

Quarter

12000

22000

31000

65000

60000

110000

155000

325000

0.50

0.50

0.50

0.50

DM Usage Cost ( )

30000

55000

77500

162500

Target Ending Inv. of DM (in Kg)

11000

15500

18000

18000

Total Material Needed (Kg)

71000
x

125500

173000

343000

11000

15500

10000

61000

114500

157500

333000

30500

57250

78750

166500

Production (in units )

Material needs (Kg per unit )
Production Needs (of DM, in Kg)
Cost ( per Kg)

Beginning Inv. of DM (in Kg)

Materials to be Purchased (Kg)
Direct Material Purchases Cost ()

=
x
=

10000
=
=

Example 3
Marina company makes and sells dresses. Three meters
of silk are needed to make one dress. Budgeted
productions for the next four months are as follow:
Production in units

April

May

June

July

14000

14500

15500

12600

The company wants to maintain monthly ending

inventories of material equal to 20% of the following
months production needs. On March 31, this requirement
was not met since only 2500 meters of silk were on hand.
The cost of silk is 0.60 per meter.

Example 3 (cont.)
(a) What is the desired ending inv. of material for May?
We have to calculate Junes needs for materials.
15500

Production for June

Material Needed per unit

3 meters

Total Material Required

46500 meters

20% Ending Inv.

9300 meters

The desired ending inventory of material for May is equal to 20%

of total material required in May:
46500 * 20% = 9300

Example 3 (cont.)
(b) What is the total cost of material to be purchased in
April?
April

May

14000

14500

Production Needs

42000

43500

ADD: Targeted Ending Inv.

8700

Total Material Needed

50700

LESS: Beginning Inv.

2500

Materials to be purchased (meters)

48200

Cost per meter

0.60

Production (units)
Materials (per unit) (meters)

Material Cost

28920

Example 3 (cont.)
(b) What is the total cost of material to be purchased in
April?
SECOND APPROACH (without using the table):
We can directly use the formula to solve for the material needed
and then multiply it by the cost per unit of use the statement
method.
Additions to Inv. = Withdrawals EI + BI
Purchases of materials = Needed for production + Desired EI BI
= (14000 units * 3 meters) + 8700 2500
= 42000 8700 + 2500 = 28920

Direct (Manufacturing) Labor budget

A detailed plan that estimates the direct labor hours needed in an
accounting period and its associated cost.
Production Managers use estimated direct labor hours to plan:
How many employees will be required during the period?
How many hours each employee will work.

Accountants use estimated direct labor cost to plan:

Cash Payments to workers

HR managers use information on direct labor budget to:

Decide whether or not to hire new employees.

Reduce the existing work force (if necessary).
Train employees.
Prepare schedules of employee fringe benefits.

Direct Manufacturing Labor Budget

x
=
x
=

Required production
Direct labor hours per unit of production
Total direct labor hours needed
Cost of direct labor per hour
Total direct labor (DL) costs

Example 1d: DL Budget

(d) At XYZ company, each unit of product requires 0.05 hours
(3 minutes) of direct labor. The company pays an hourly rate of
10. Prepare the Direct Labor budget for the quarter.
What do we need?
- Number of hours the labor works each month
- Per hour rate of payment to labor (to get the cost of labor for the
quarter in Euros)
April

May

June

Quarter

12000

22000

31000

65000

Direct Labor Hours (per unit)

0.05

0.05

0.05

0.05

Total Hours Required

600

1100

1550

3250

Hourly Wage Rate ( per hour)

10

10

10

10

11000

15500

32500

Production (in units )

Total Labor Costs ()

=
x

6000

Example 4
Lubriderm corporation (specialized in daily skin care
products) goes through two department in the production
process. Each bottle requires two direct labor hours in
dept. A and one hour in dept. B. Labor cost is 20 per
hour in dept. A and 15 per hour in dept. B. (a) Assuming
the amount budgeted to be produced in January is 30000
units, what is the budgeted direct labor cost for January?
(b) The labor capacity for a normal 8-hour shift for a
month is 50000 direct labor hours for each of the depts.
Overtime is paid at time and a half. What would be the
budgeted direct labor cost for January, assuming a
budgeted production of 30000 units?

Example 4 (cont.)
(a) Production units: 30000
Dept. A

Dept. B

30000

30000

60000

30000

Hourly Wage Rate

20

15

Total Labor Costs

1200000

450000

Production in units
Direct Labor Hours per unit
Total Hours Required

Total

1650000

Example 4 (cont.)
(b) Labor Capacity : 50000

Production in units
Direct Labor Hours per unit
Total Hours Required

Hourly Wage Rate

Regular Labor Costs
Overtime (10000 hrs @ 30)
Total Labor Costs

Dept. A

Dept. B

Total

30000

30000

60000

30000

20

15

1000000

450000

1450000

300000

300000

1300000

450000

1750000

Manufacturing Overhead (Costs) Budget

The manufacturing overhead budget contains all manufacturing
costs other than the costs of direct materials and direct labor.
The total of all costs in this overhead budget are converted into a
per-unit overhead allocation, which is used to derive the cost of
ending finished goods inventory, and which in turn is listed on the
budgeted balance sheet.
It may also be divided into fixed and variable (and maybe even
mixed) groups.
Examples: indirect materials (e.g. lubricants for machinery),
indirect labor (e.g. administrative salaries: wages paid to
manufacturing supervisors, the purchasing staff, production clerks,
and logistics planning staff), rent, utilities (e.g. electricity and heat),
factory insurance, factory taxes, etc.

Example 1e: MOH Budget

(e) At XYZ company, manufacturing overhead is applied to
units of products on the basis of direct labor hours. The variable
manufacturing overhead is 20 per direct labor hour. The fixed
manufacturing overhead is 30000 per month. Prepare XYZs
Manufacturing Overhead budget for the quarter.
What should we do?
Here, the variable MOH is only on the basis of direct labor hours, so:
- We need the number of hours worked each month (from DL budget)
- We should multiply it by variable rate to get total variable OH costs.
- Finally, we should add fixed MOH to the result of previous
multiplication to get total MOH costs.

Example 1e: MOH Budget (cont.)

April

May

June

Quarter

Labor Needed (hours)

600

1100

1550

3250

Variable MOH Rate ( per hour)

20

20

20

20

Variable MOH Costs ( )

12000

22000

31000

65000

Fixed MOH Costs ()

30000

30000

30000

90000

Total MOH Costs ()

42000

52000

61000

155000

Ending Inventory Budget

A detailed plan that estimates the cost of goods
(direct material, incomplete good, & finished good)
that are planned to be in the inventory at the end of
the period.
Can be prepared for any (or all) of the inventories
the company posses.

We do not consider the Ending Work-in-Process

inventory.

Ending DM Inventory Budget

For Ending DM inventory, it is easy! Just write the
amount of direct materials that are planned to be on
hand at the end of the period along with their costs.
At the end, the (cost of) EI of all direct materials should
be added together!

x
=

Target DM ending inventory

Cost of direct material per (its) unit
Total EI of direct materials

Ending FG Inventory Budget

The ending finished goods inventory budget
calculates the cost of the finished goods
inventory at the end of each budget period.

The ending finished goods inventory budget

contains per unit values of three main costs that
are required to be included in the inventory
asset: direct material, direct labor, & overhead.

Ending FG Inventory Budget

For DM part, multiply the cost of direct material by the
quantity of direct material needed for the production of
one unit of FG.
For DL part, multiply the cost of DL (per hour) by the
number of hours needed for production of one unit of
FG.
For MOH, it depends on the thing the cost is associated
with (we will see an example).
NOTE: total MOH costs divided by the required amount of
production gives the per unit MOH cost.

Example 1f: Ending (FG) Inv. Budget

Production Costs
(per unit)

Quantity of
Input (per unit)

Cost of Input
(per unit)

Total

5 Kg

0.50 (per Kg)

2.50

0.05 hrs

10 (per hour)

0.50

0.05 hrs

47.69 (per hour)

2.385

Direct Materials
Direct Labor

Input

Total MOH Costs

Per Unit Production Cost

5.385

Ending Inv. (in units)

7000

Total Ending FG Inv. Costs

from MOH budget:
Cost per unit of input = Total MOH
costs / Total labor hours needed
= 155000 / 3250 hrs = 47.69

37695
from production budget
(EI at the quarter)

Cost of Goods Sold (CGS) Budget

Summary of companys expected costs of production
for the goods sold
Combines information from DM, DL, MOH and Ending
Inv. Budgets
For a CGS statement, we need:

Beginning FG inventory
Cost per unit of Beginning FG Inv.
Quantity of Units produced
Product cost per unit
Quantity of units in Ending inv. (its per unit cost is equal
to the FG cost)

Cost of Goods Sold (CGS) Budget

DM cost + DL cost + MOH cost = Cost of goods manufactured

x
=
+
=
=

Cost of Beginning FG inventory

Per unit cost of beginning FG inv.
Beginning finished goods inventory cost
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods inventory cost
Cost of Goods Sold (CGS)

Example 1g: Cost of Goods Sold Budget

Suppose the cost of beginning inventory at XYZ company is 5.00
per unit. Prepare the Cost of Goods Sold Budget for the quarter.
Units

Rate (/unit)

Total ()

2000

5.00

10000

Direct Materials Used

65000

2.50

162500

Direct Labor

65000

0.50

32500

Total MOH Costs

65000

2.385

155000

Beginning Inv.
ADD: Cost of Goods Manufactured

360000

Cost of Goods Available for Sale

LESS: Cost of Ending Inv.
Cost of Goods Sold

7000

5.385

37.695
322.305

Operating Expenses
Includes all non-manufacturing costs (for example,
R&D costs, design costs, marketing costs, distribution
costs, customer service costs, labor costs of sales floor
personnel, distribution costs: costs of shipping products
to customers)
For service companies, this includes all costs that are
not directly related to the service offered
Similar to MOH, this cost can also have fixed and
variable parts (we will see an example!)

Example 1h: Operating Expenses

April

May

June

Quarter

10000

20000

30000

60000

Sales Commission Exp.(0.5/unit sold) 5000

10000

15000

30000

Shipping Expenses (0.40/unit sold)

4000

8000

12000

24000

Bad-credit Customers (1% * 10)

1000

2000

3000

6000

10000

20000

30000

60000

Office Rent

10000

10000

10000

30000

Advertising

5000

5000

5000

15000

Non-manufacturing Staff Salaries

35000

35000

35000

105000

Total Fixed Operating Expenses

50000

50000

50000

150000

Total Operating Expenses

60000

70000

80000

210000

Budgeted Unit Sales (in units)

VARIABLE OPERATING EXPENSES

Total Variable Operating Expenses

FIXED OPERATING EXPENSES

Income Statement
=
=
=
=

Sales Revenue
Cost of Goods Sold (CGS)
Gross Profit
Operating Expenses
Operating Profit
Depreciation & Amortization
Trading Profit
Interest & Tax expenses
Net Profit

Example 1i: Budgeted Income Statement

Total Sales Revenue

600000

LESS: Cost of Goods Sold

322305

Gross Margin (Gross Profit)

277695

LESS: Operating Expenses

210000

Operating Income (Operating Profit)

67695