Operating Budgets

Operating Budgets

Operating budget; summarize the level of activities such as sales,

purchasing, and production.
The Operating Budget consists of:
• Sales budget
• Production budget
• Direct materials budget
• Direct labor budget
• Factory overhead budget
• Selling and administrative expense budget
• Income statement

First Illustration :

Sales budget

Usually, the sales manager is responsible for the sales budget and
prepares it in units and then in dollars by multiplying the units by their
selling price. The sales budget in units is the basis of the remaining
budgets that support the operating budget.

To illustrate assume that ABC’s management forecasts sales for the year
at 100,000 units (each pair of shoes is one unit).

Quarterly sales are expected to be 15,000, 40,000, 20,000, and 25,000

units.

The selling price for each pair of shoes forecasted at $40.

 ABC’s sales budget would be prepared as by showing the sales unit for
each quarter x budgeted sales price to get the sales in dollars. The totals
for the year are added from each quarter.

ABC Company

Sales Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

Sales in
100,000 25,000 20,000 40,000 15,000
Units

Budgeted
x $40 x $40 x $40 x $40
price

Sales in
$4,000,000 $1,000,000 $800,000 $1,600,000 $600,000
Dollars

Production budget

The production budget considers the units in the sales budget and
the company’s inventory policy. Managers develop the production budget
in units and then in dollars. Determining production volume is an
important task. Companies should schedule production carefully to
maintain certain minimum quantities of inventory while avoiding
excessive inventory accumulation. The principal objective of the
production budget is to coordinate the production and sale of goods in
terms of time and quantity.

For our example company, ABC Company, we assume the

company’s policy is to maintain 40% of next quarters sales in ending
inventory. Finished goods inventory on January 1 is 10,000 units
(Note: You should be given this information but if you do not have the
beginning inventory, you can assume the company followed the same
ending inventory policy. This means, you can calculate beginning
finished goods inventory as Quarter 1 sales x 40% since we can assume
the company followed this policy and the ending inventory of 4th quarter
last year is the beginning inventory of this year). We anticipate the
December 31 ending inventory to be 6,000 units. From these data, we can
prepare the schedule of planned production using the Sales budget as our
starting place.
ABC Company

Production Budget

Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR

Sales in Units 15,000 40,000 25,000 100,000

20,000

Add: Desired
Ending 16,000 8,000 10,000 6,000 6,000
Inventory

(Next Qtr Sales (40,000 x (20,000 (25,000

(given)
x 40%) 40%) x 40%) x 40%)

Total Units
31,000 48,000 30,000 31,000 106,000
Needed

Less: Beginning (10,000

(10,000) (16,000) ( 8,000) ( 10,000)
Inventory )

Units to be
21,000 32,000 22,000 21,000 96,000
Produced

Important things to note:

1. Desired ending inventory is calculated as next quarter sales units x

40% in ABC’s case since the company policy is to maintain 40%
of next quarters sales in ending inventory.
2. Quarter 4 ending inventory is the same number used for ending
inventory for the year.
3. Quarter 1 beginning inventory is the same number used for
beginning inventory for the year.
4. Quarter 2 beginning inventory is quarter 1’s ending inventory since
the balance rolls over the to next period. This means, quarter 3
beginning inventory is quarter 2’s ending inventory and quarter 4
beginning inventory is quarter 3’s ending inventory.
5. Inventory refers to Finished Goods Inventory for a manufacturer.

For a merchandiser, this budget would be called a Purchases Budget and

would show how many units we would need to purchase for each
quarter. The inventory in this case would refer to merchandise
inventory.
Manufacturing Budgets

In a manufacturing company, you will have a budget for all of your

manufacturing costs including Direct Materials, Direct Labor and
Overhead. Each cost will have their own budget. You will need the
information from the Sales and Production budgets to complete these 3
budgets.

Materials Budget

The materials budget (or materials purchases budget) is used to plan how
much raw materials we need to have available to meet budgeted
production. This budget is prepare similarly to the production budget as
the company must decide how much raw materials inventory they want to
have on hand at the end of each quarter. This is typically determined as a
percent of next quarter’s material needs. In a materials budget, we will
deal with units first and then add the budgeted cost near the end. We also
need to know how many direct materials are needed for each unit.

For ABC Company, our budgeted cost is $2 per pound. We need 5

pounds of materials for each unit. We want to maintain 25% of next
quarter’s production needs in ending inventory. Beginning raw materials
inventory was 20,000 pounds (at $2 per pound) and we are expecting
ending raw materials inventory to be 30,000 pounds.
 ABC Company

Materials Purchases Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

Units to be produced (from

96,000 21,000 22,000 32,000 21,000
production budget)

x 5 lb x 5 lb. x 5 lb. x 5 lb. x lbs. of materials required per unit

Pounds of materials required for

480,000 105,000 110,000 160,000 105,000
production

30,000 30,000 26,250 27,500 40,000 Add: Desired Ending Inventory

510,000 135,000 136,250 187,500 145,000 Total Material Needed

(20,000) (26,250) (27,500) (40,000) (20,000) Less: Beginning Inventory

460,000 108,750 108,750 147,500 125,000 Material to be Purchased (in lbs)

x$2 x$2 x$2 x$2 x $2 cost per pound

$980,000 $217,500 $217,500 $295,000 $250,000 Total Material to be Purchased (in $)

Just like with the production budget, please note the following items:

 Ending inventory is calculated as NEXT quarter’s production

needs x 25% for all but quarter 4.
 Quarter 4 ending inventory is the same as the ending inventory for
the year and was given in the example.
 Beginning inventory refers to the previous quarters ending
inventory for all quarters except quarter 1. For quarter 1,
beginning raw materials was given in the problem and should also
be the beginning inventory for the YEAR. If beginning inventory
is not provided, assume the company followed the same inventory
policy last year and multiply Quarter 1 pounds of materials needed
x percent provided for ending inventory.
 Quarter 2 beginning is quarter 1 ending inventory. Quarter 3
beginning is quarter 2 ending inventory and quarter 4 beginning is
quarter 3 ending inventory.

The total material to be purchased will be used later in the cash

disbursement section of the CASH budget.

Direct Labor Budget

The direct labor budget is a very easy one. We need to know the units
required from the production budget. Next, we need to know how many
direct labor hours it takes to complete one unit and the cost per labor
hour. Using this information, we can determine how many direct labor
hours are required to meet the budgeted level of production. We will take
the production units x direct labor per unit to get the number of direct
labor hours. Finally, we will take the direct labor hours x the rate per
hour.

For ABC Company, each unit requires 0.5 hours of direct labor and the
hourly rate is $12 per hour. The direct labor budget would be:

ABC Company

Direct Labor Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

96,000 21,000 22,000 32,000 21,000 Units to be prod

x 0.5 hr x 0.5 hr x 0.5 hr x 0.5 hr x 0.5 DL hour p

48,000 10,500 11,000 16,000 10,500 Direct Labor H

x $12 x $12 x $12 x $12 x $12 per hour

$576,000 $126,000 $132,000 $192,000 $126,000 Budgeted direc

The budgeted direct labor dollar amount will be used later in the cash
disbursement section of the CASH budget.
Manufacturing Overhead Budget

The final budget for manufacturing is the manufacturing overhead

budget. The manufacturing overhead budget is prepare depending on
how the company allocates overhead. The company can choose to
allocate overhead using one predetermined overhead rate, departmental
rates or using activity-based costing. Further, the company can choose to
separate the fixed and variable overhead costs and assign costs to
overhead using only the variable overhead.

ABC Company has decided to allocate variable overhead on the basis of

$1.50 per direct labor hour and fixed overhead is $75,000 per quarter.
Depreciation on the factory machinery of $10,000 per quarter is included
in the fixed overhead.

ABC Company

Mfg. Overhead Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

Budgeted direct labor hours (from

48,000 10,500 11,000 16,000 10,500
direct labor budget)

x $1.50 x $1.50 x $1.50 x $1.50 x Variable OH per unit

$72,000 $15,750 $16,500 $24,000 $15,750 Variable Overhead Cost

300,000 75,000 75,000 75,000 75,000 Fixed Overhead Cost

$372,000 $90,750 $91,500 $99,000 $90,750 Total Overhead Cost

(10,000 Less: Depreciation on Factory

(40,000) (10,000) (10,000) (10,000)
) Machinery

Total Cash payments for mfg

$332,000 $80,750 $81,500 $89,000 $80,750
overhead

We will use the information from the overhead budget in the cash
disbursement section of the cash budget.
Cost of Goods Sold budget The cost of goods sold budget establishes
the forecast for the inventory expense and is usually on of the largest
expenses on an income statement. A cost of goods sold budget would not
be necessary for a service company since they do not sell a product.
Management must now prepare a schedule to forecast cost of goods sold,
the next major amount in the planned operating budget. We need to
understand the costs for making the product. ABC Company has the
following costs:

$ 10 per unit Direct Materials

$ 6 per unit Direct Labor

$ 0.75 per unit Variable Overhead

$75,000 per quarter Fixed Overhead

ABC Company

Cost of Goods Sold Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

100,000 25,000 20,000 40,000 15,000 Sales in Units

$400,00 Direct Materials

$1,000,000 $250,000 $200,000 $150,000
0 ($10 per unit)

Direct Labor ($6

600,000 150,000 120,000 240,000 90,000
per unit)

Variable Overhead
75,000 18,750 15,000 30,000 11,250
($0.75 per unit)

300,000 75,000 75,000 75,000 75,000 Fixed Overhead

$1,975,00 $745,00 Cost of Goods

$493,740 $410,000 $326,250
0 0 Sold
The cost of goods sold budget would use the sales budget in units. We
will take each of our variable costs (direct materials, direct labor and
variable overhead) x budgeted sales units. The cost of goods sold budget
would look like:

After managers forecast cost of goods sold, they prepare a separate

budget for all selling and administrative expenses.

Selling and administrative expense budget: The costs of selling a

product are closely related to the sales forecast. Generally, the higher the
forecast, the higher the selling expenses. Administrative expenses are
likely to be less dependent on the sales forecast because many of the
items are fixed costs (e.g. salaries of administrative personnel and
depreciation of administrative buildings and office equipment). Managers
must also estimate other expenses such as interest expense, income tax
expense, and research and development expenses.

For ABC Company, we need to know the following

information:

 Selling expenses are $2 per unit sold

 Administrative expenses are $100,000 per quarter
We can calculate ABC Company’s Selling and Administrative Expense
Budget using the information above and the sales budget. For selling
expenses, we will take the sales in units x $2 variable selling expense per
unit. Administrative expenses are fixed so they will not change based on
volume. Fixed expenses include depreciation on the office building of
$20,000 per quarter.
ABC Company

Selling and Administrative Budget

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

200,000 50,000 40,000 80,000 30,000 Selling Expenses

(25,000 (20,000 (40,000

(15,000 (Current qtr units sold x $2 per
units x units x units x
units x $2) unit)
$2) $2) $2)

400,000 100,000 100,000 100,000 100,000 Administrative Expenses

Total Selling and Admin

$600,000 $150,000 $140,000 $180,000 $130,000
Expenses

(80,000) (20,000) (20,000) (20,000) (20,000) Less: Office Bldg Depreciation

Total Cash payments for selling

$520,000 $130,000 $120,000 $160,000 $110,000
and admin. expenses

Notice, depreciation is subtracted from the total budget to get total cash
payments — why? Because, depreciation is a non-cash expense and is
not paid with cash so we will remove it from the other cash payments to
use in the cash budget. The next step is to prepare the budgeted income
statement.

Budgeted Income Statement

We will use a standard multi-step income statement showing sales minus

cost of goods sold is gross profit (or gross margin). Gross profit minus
operating expenses is the income from operations. We will need the
Sales budget, Cost of goods sold budget, and the Selling and
Administrative expense budgets.

We will use the information from the sales budget, cost of goods sold
budget, and selling and administrative expense budget. Note:
Remember, to use the full budget amount for selling and administrative
expenses and not the cash payments amount. ABC Company pays a 40%
income tax rate (multiply income from operations x 40% for each
quarter).

Budgets completed to this point include sales, production, direct

materials,
direct labor, manufacturing overhead, and selling and administrative.
Now the company has enough information to prepare the budgeted
income statement.

What is a budgeted income statement, and how is it prepared?

The budgeted income statement is an estimate of the organization’s

profit for a given period. Most organizations, prepare the budgeted
income statement using the accrual basis of accounting: revenues are
recorded when earned and expenses are recorded when incurred.

How do companies use the budgeted income statement to improve

operations?

The budgeted income statement is perhaps the most carefully scrutinized

component of the master budget. The management and employees
throughout the organization use this information for planning purposes
and to evaluate company performance. The board of directors and budget
committee are responsible for approving the budget and often review
periodic reports comparing actual net income to budgeted net income to
determine if profit goals are being achieved. Lenders and owners often
review the budget to ensure the organization is on track to meet its goals.
The budgeted income statement answers the question: what profits does
the organization expect to achieve?
 ABC Company

Budgeted Income Statement

YEAR Qtr 4 Qtr 3 Qtr 2 Qtr 1

from
Sales 4,000,000 1,000,000 800,000 1,600,000 $600,000 Sales (in dollars)
budget

from
Cost of
Goods 1,975,000 493,750 410,000 745,000 326,250 Less: Cost of goods sold
Sold
budget

(Sales –
Cost of
2,025,000 506,250 390,000 855,000 273,750 Gross Profit
good
sold)

Operating Expenses:

from 200,000 50,000 40,000 80,000 30,000 Selling Expenses

Selling
and
Admin 400,000 100,000 100,000 100,000 100,000 Administrative Expenses
budget

(Gross
Profit –
Selling
and $1,425,000 356,250 250,000 675,000 $143,750 Income from operations
Admin
expense
)

Less: Income tax expense

570,000 142,500 100,000 270,000 57,500
(40%)

$855,000 $213,750 $150,000 $405,000 $86,250 Net Income

After completing the budgeted income statement, only three

budgets remain: the capital expenditures budget, the cash
budget, and the budgeted balance sheet.
Second Illustration:

Royal Company is preparing budgets for the quarter ending June 30.

Budgeted sales for the next five months are:

April 20,000 units

May 50,000 units

June 30,000 units

July 25,000 units

August 15,000 units

The selling price is $10 per unit. Prepare the sales budget for the quarter
April – June.

Royal Company wants ending inventory to be equal to 20% of the

following month’s budgeted

sales in units. On March 31, 4,000 units were on hand valued

at $20,000. Prepare the production budget for the quarter.

At Royal Company, 5kilograms of material input are required

per unit of product.

Management wants materials on hand at the end of each

month (i.e. ending materials Inventory) equal to 10% of the following
month’s production requirement. On March 31, 13,000 kilograms of
material are on hand with a total value of $5,200. The budgeted materials
cost is$0.40/kg.

Royal pays $0.40 per kg for its materials and this is expected to continue.
Assumed payment schedule: One-half of a month’s purchases are paid for
in the month of purchase; the other half is paid in the following month.
The March 31 accounts payable balance is $12,000.

At Royal, each unit of product requires 0.05 hours of direct labour. The
company has a “no layoff” policy so all employees will be paid for 40
hours of work each week (Note: this is a
unique requirement to this example it mirrors the fact that labour in most
organizations is not often truly variable). In exchange for the no layoff
policy, workers agreed to a wage rate of $10per hour regardless of the
hours worked (i.e., no overtime paid). For the next 3 months the direct
labour workforce will be paid for a minimum of 1,500 hours per month.

Royal Company uses a predetermined variable overhead rate of $1 per

unit produced. Fixed overhead is $50,000 per month. The total
overhead includes $20,000 of non-cash costs (depreciation of
plant assets). For simplicity here we will assume OH will be
allocated to products based on units - the practical capacity for the year
is 400,000 units or 100,000 units per quarter.

At Royal, variable selling and administrative expenses are expected to be

$0.50 per unit sold.

Fixed selling and administrative expenses are expected to be $70,000 per

month. The fixed

selling and administrative expenses include $10,000 in depreciation that

is not a cash outflow of the current month

Royal maintains an open line of credit for $75,000. The interest rate is
16% p.a. (overdraft).

The company wants to maintain a minimum cash balance of $30,000.

If funds are borrowed, it is assumed they are borrowed on the first day of
the month required and are repaid on the last day of the month when cash
is available to pay off the debt.

Royal pays a cash dividend of $49,000 in April.

Purchases of $143,700 of equipment in May and $48,300 in June are paid

in cash

Cash balance April 1: $40,000

Royal Company is preparing budgets for the quarter ending June 30th .
Budgeted sales for the next five months are:

April 20,000 units

May 50,000 units

June 30,000 units

July 25,000 units

August 15,000 units

The selling price is $10 per unit.

The Sales Budget The individual months of April, May, and June are
summed to obtain the total budgeted sales in units and dollars for the
quarter ended June 30th

April May June Quarter

Budgeted sales in units 20,000 50,000 30,000 100,000

Selling price per unit $ 10 $ 10 $ 10 $ 10

Total budgeted sales $ 200,000 $ 500,000 $ 300,000 $ 1,000,000

Expected Cash Collections

All sales are on account. Royal’s collection pattern is: 70% collected
in the month of sale, 30% collected in the month following sale, In
April, the March 31st accounts receivable balance of $30,000 will be
collected in full.

April May June Quarter

Accounts Receivable $ 30,000 $ 30,000
3/31
April Sales
70% × $200,000 140,000 140,000
30% × $200,000 60,000 60,000
May Sales
70% × $500,000 350,000 350,000
30% × $500,000 150,000 150,000
June Sales
70% × $300,000 210,000 210,000
$ $ 410,000 $ 360,000 $ 940,000
170,000
The Production Budget

The production budget must be adequate to meet budgeted sales

and to provide for the desired ending inventory.
The management at Royal Company wants ending inventory
to be equal to 20% of the following month’s budgeted sales
in units. On March 31st, 4,000 units were on hand. Let’s
prepare the production budget.
April May June Quarter
Budgeted Sales 20,000 50,000 30,000 100,000
Add: Desired ending 10,000 6,000 5,000 5,000
inventory
Total needs 30,000 56,000 35,000 105,000
Less Beginning (4,000) (10,000) (6,000) (4,000)
inventory
Required production 26,000 46,000 29,000 101,000

Prepare a direct materials budget, including a schedule of

expected cash disbursements for purchases of materials.
The Direct Materials Budget
At Royal Company, five pounds of material are required per unit of
product. Management wants materials on hand at the end of each month
equal to 10% of the following month’s production. On March 31, 13,000
pounds of material are on hand. Material cost is $0.40 per pound. Let’s
prepare the direct materials budget.

April May June Quarter

Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
(pounds)
Production needs 130,000 230,000 145,000 505,000
Add: Desired 23,000 14,500 11,500 11,500
ending inventory
Total needs 153,000 244,500 156,000 516,500
Less Beginning (13,000) (23,000) (14,500) (13,000)
inventory
Required 140,000 221,500 142,000 503,500
production

Expected Cash Disbursement for Materials

Royal pays $0.40 per pound for its materials. One-half of a

month’s purchases is paid for in the month of purchase; the
other half is paid in the following month. The March 31
accounts payable balance is $12,000. Let’s calculate expected
cash disbursements.
Expected Cash Disbursement for Materials - Calculations
April May June Quarter
Accounts payable 3/31 $ $ 12,000
12,000
April Purchases
50% × $56,000 28,000 28,000
50% × $56,000 28,000 28,000
May Purchases
50% × $88,600 44,300 44,300
50% × $88,600 44,300 44,300
June purchases
50% × $56,800 28,400 28,400
Total cash $ 40,000 $ 72,300 $ 72,700 $ 185,000
disbursement

Prepare a direct labor budget.

At Royal, each unit of product requires 0.05 hours (3 minutes) of direct
labor. The labor can be unskilled because the production process is
relatively simple and formal training is not required.  Royal pays its
workers at the rate of $10 per hour.

Let’s prepare the direct labor budget.

The Direct Labor Budget – Direct Labor Costs

April May June Quarter

Production 26,000 46,000 29,000 101,000
Direct labor time per unit 0.05 0.05 0.05 0.05
Labor hours required 1,300 2,300 1,450 5,050
Hourly wage rate $ 10 $ 10 $ 10 $ 10
Total direct labor costs $ 13,000 $ 23,000 $ 14,000 $ 50,500

Prepare a manufacturing overhead budget.

Manufacturing Overhead Budget

At Royal, manufacturing overhead is applied to units of product on the

basis of direct labor hours.
The variable manufacturing overhead rate is $20 per direct labor hour. 
Fixed manufacturing overhead is $50,000 per month, which includes
$20,000 of noncash costs (primarily depreciation of plant assets).

Let’s prepare the manufacturing overhead budget.

April May June Quarter

Budgeted direct labor 1,300 2,300 1,450 5,050
hours
Variable mfg. OH Rate $ 20 $ 20 $ 20 $ 20
Variable mfg. OH costs $ $ 46,000 $ 29,000 $ 101,000
26,000
Fixed mfg. OH costs 50,000 50,000 50,000 150,000
Total mfg. OH 76,000 96,000 79,000 251,000
costs

Total mfg. OH for quarter $251,000 /Total labor hours required 5,050 =
$49.70 per hour * rounded

Manufacturing Overhead Budget – Noncash Costs (Depreciation)

April May June Quarter

Budgeted direct labor hours 1,300 2,300 1,450 5,050
Variable mfg. OH Rate $ 20 $ 20 $ 20 $ 20
Variable mfg. OH costs $ 26,000 $ 46,000 $ 29,000 $ 101,000
Fixed mfg. OH costs 50,000 50,000 50,000 150,000
Less: noncash costs (20,000) (20,000) (20,000) (60,000)
Cash disbursement for mfg. 56,000 76,000 59,000 191,000
OH

Depreciation is a noncash charge.

Selling and Administrative Expense Budget

What is a selling and administrative budget, and how is it prepared?

The selling and administrative budget is an estimate of all

operating costs other than production. Although many
organizations may have variable and fixed costs in this budget
many exercises assumes for simplicity that all selling and
administrative costs fixed costs. Depreciation is deducted at the
bottom of this budget to determine cash payments for selling and
administrative costs, which we use later in the next chapter for the
cash budget.
 At Royal, the selling and administrative expense budget is divided into
variable and fixed components.

The variable selling and administrative expenses are $0.50 per unit sold. 
Fixed selling and administrative expenses are $70,000 per month.

The fixed selling and administrative expenses include $10,000 in costs –

primarily depreciation – that are not cash outflows of the current month.

Let’s prepare the company’s selling and administrative expense budget.

Selling and Administrative Expense Budget – Computations

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Variable S&A 0.50 0.50 0.50 0.50
rate
Variable expenses $ 10,000 $ 25,000 $ 15,000 $ 50,000
Fixed S&A 70,000 70,000 70,000 210,000
expenses
Total S&A 80,000 95,000 85,000 260,000
expenses
Less: noncash (10,000) (10,000) (10,000) (30,000)
expenses
Cash S&A 70,000 85,000 75,000 230,000
expenses