L3 - Operating Budget

8/9/2019 L3 - Operating Budget

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Operating Budget

M.Sc. Elham Safari

[email protected]

Based on the lecture slides by

Senior Lecturer Jukka Sirki


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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


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Basic Operating

Budget Steps1. Prepare the revenues

budget.

2. Prepare the production

budget (in units).3. Prepare the direct materials

(usage and purchases)budget.

4. Prepare the directmanufacturing labor budget.

5. Prepare the manufacturingoverhead costs budget.


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Basic Operating

Budget Steps6. Prepare the endinginventories budget.

7. Prepare the cost of goods

sold budget.8. Prepare the operating

expense budget.

9. Prepare the budgeted

income statement.


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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 tooutput products (e.g. wages and benefits paid to assembly-line workers whoconvert direct materials to finished goods)

Manufacturing Overhead / Indirect Manufacturing Costs

All manufacturing costs that are indirectlyrelated 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)


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Remark2: Types of Inventory

Manufacturing-sector companies usually have one or more of thefollowing types of inventories:

Finished Goods (FG) Inventoryincludes products that are ready to

be sold (but not sold yet).

Direct Materials (DM) Inventoryincludes direct materials that willlater be used in production.

Work-in-Process / Work-in-Progress (WIP) Inventoryincludesgoods that are not complete yet (for example, mobile phones that areat different stages of completion, but are not finished yet).


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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 ofresources needed for the operations

When this estimation is done, other budgets can be developedbased on it.


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Sales Budget / Revenues Budget

Number of units to be sold

x Sales price per unit= Total Sales Revenue


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Example 1: XYZ company

XYZ company is preparing budgets for the quarter ending inJune 30, 2014. (a)The budgeted sales for the months April toAugust are as follows: 10000, 20000, 30000, 35000, and

40000(all in units) respectively. Prepare a Sales Budget.

Selling price is10/unit.April May June Quarter

Budgeted Sales (in units) 60000

Selling Price(per unit)

10000 20000 30000

10 10 10 10

Total Budgeted Sales () 600000100000

x

=

200000

x

=

300000

x

=

+ + =x

=


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Production Budget

A detailed plan which shows the number of units a companymust produce to meet budgeted sales and budgetedinventory levels

Expressed in terms of units

Production managers use this information to plan for thematerials and human resources that production activities willrequires

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 thebudget year


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Production Budget

In inventory accounts, there are two items onthe debit side, and two items on the credit side

Beginning

Inventory

Additionsto

Inventory

Withdrawals(Desired)Ending

Inventory= ++

Beginning

Inventory

(BI)

Additions to

Inventory

(To be produced)

Withdrawals(To be sold)

Ending

Inventory

(EI)= -+


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Production Budget

Units needed for sales

+ Desired ending inventory= Total units needed

- Beginning inventory

= Required Production

(or: To Be Produced)


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Example 1b: Production Budget

(b) Suppose that the management of XYZ company wants theending inventory to be equal to 20% of the following monthsbudgeted sales in units. Prepare a Production budget. OnMarch 31, 2000 units were on hand.

April May June Quarter

Budgeted Sales (in units) 10000 20000 30000 60000

ADD: DesiredEnding Inv. 4000 6000 7000 7000

Total Needs 14000 26000 37000 67000

LESS: BeginningInv. 2,000 4000 6000 2000

Required Production 12000 22000 31000 65000

+ + =+

=-

=


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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 budgetedproduction as well as inventory needs, and the costsassociated 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


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Direct Material Usage Budget

Quantity of Finished Goods Production

x Quantity of Materials needed per unit of FG

= Quantity of DM to be used for production

x Cost of direct material per (its) unit

= Total cost of (DM) to be used


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Direct Material Purchases Budget

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

x Cost of direct material per (its) unit

= Total direct material (DM) cost

Purchasing managers prepare this budget to know theamount of purchases in each period.


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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 8000

Required Production 12000 22000 31000 36000

REMINDER:

Additions to Inv. = WithdrawalsEI + BITo be Purchase = To be Sold + Desired EIBI

= 35000 + 80007000= 36000


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Example 1c: DM Purchases Budget

(c)At XYZ company, 5 Kg of materials are required per unit ofproduct. Management wants materials on hand at the end ofeach month equal to 10% of the following months production.

On March 31, 10000 Kg of material are on hand. Material cost

is0.50 per Kg. Prepare the Direct Materials Purchasesbudget 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)


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Example 1c: DM Purchases Budget (cont.)The DM needs for July: 36000units * 5 Kg/unit = 180000 KgJunes ending inventory is equal to 10% of this, or 18000 Kg.


Production(in units)

Material needs (Kg per unit)ProductionNeeds (of DM, in Kg) 60000 110000 155000 325000

Cost (per Kg)

12000 22000 31000 65000

5 5 5 5

0.50 0.50 0.50 0.50

DM Usage Cost () 30000 55000 77500 162500

TargetEnding Inv. of DM (in Kg) 11000 15500 18000 18000

Total Material Needed (Kg) 71000 125500 173000 343000

Beginning Inv. of DM (in Kg) 10000 11000 15500 10000

Materials to be Purchased (Kg) 61000 114500 157500 333000

Direct Material PurchasesCost () 30500 57250 78750 166500

x

=

x

=

-

=

x

=


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Example 3

Marina company makes and sells dresses. Three metersof silk are needed to make one dress. Budgetedproductions for the next four months are as follow:

The company wants to maintain monthly endinginventories of material equal to 20% of the following

months production needs. On March 31, this requirementwas not met since only 2500 meters of silk were on hand.

The cost of silk is0.60 per meter.

April May June JulyProduction in units 14000 14500 15500 12600


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Example 3 (cont.)

(a)What is the desired ending inv. of material for May?

We have to calculate Junes needs for materials.

Production for June 15500

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


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Example 3 (cont.)

(b) What is the total cost of material to be purchased inApril?

April May

Production (units) 14000 14500Materials (per unit) (meters) 3 3

Production Needs 42000 43500

ADD: Targeted Ending Inv. 8700

Total Material Needed 50700

LESS: Beginning Inv. 2500

Mater ials to be purch ased (meters) 48200

Cost per meter 0.60

Material Cost 28920


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Example 3 (cont.)

(b) What is the total cost of material to be purchased inApril?

SECOND APPROACH (without using the table):

We can directly use the formula to solve for the material neededand then multiply it by the cost per unit of use the statementmethod.

Additions to Inv. = WithdrawalsEI + BI

Purchases of materials = Needed for production + Desired EIBI

= (14000 units * 3 meters) + 8700 2500

= 42000 8700 + 2500 = 28920


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Direct (Manufacturing) Labor budget

A detailed plan that estimates the direct labor hours needed in anaccounting 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.

Accountantsuse 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.


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Direct Manufacturing Labor Budget

Required production

x Direct labor hours per unit of production

= Total direct labor hours needed

x Cost of direct labor per hour

= Total direct labor (DL) costs


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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 of10. Prepare the Direct Labor budgetfor 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 thequarter in Euros)


600 1100 1550 3250

12000 22000 3100065000

0.05 0.05 0.05 0.05

10 10 10 10

Production(in units)Direct Labor Hours (perunit)

Total Hours Required

Hourly Wage Rate (per hour)

Total Labor Costs () 6000 11000 15500 32500

x

=

x

=


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Example 4

Lubriderm corporation (specialized in daily skin careproducts) goes through two department in the productionprocess. Each bottle requires two direct labor hours indept. A and one hour in dept. B. Labor cost is20 perhour in dept. A and15 per hour in dept. B. (a)Assumingthe 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 thebudgeted direct labor cost for January, assuming abudgeted production of 30000 units?


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Example 4 (cont.)

(a) Production units: 30000

Dept. A Dept. B Total

Production in units 30000 30000Direct Labor Hours per unit 2 1

Total Hours Required 60000 30000

Hourly Wage Rate 20 15

Total Labor Costs 1200000 450000 1650000


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Example 4 (cont.)

(b) Labor Capacity : 50000

Dept. A Dept. B Total

Production in units 30000 30000Direct Labor Hours per unit 2 1

Total Hours Required 60000 30000

Hourly Wage Rate 20 15

Regular Labor Costs 1000000 450000 1450000

Overtime (10000 hrs @ 30) 300000 - 300000

Total Labor Costs 1300000 450000 1750000


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Manufacturing Overhead (Costs) Budget

The manufacturing overhead budget contains all manufacturingcosts other than the costs of direct materials and direct labor.

The total of all costs in this overhead budget are converted into aper-unit overhead allocation, which is used to derive the cost of

ending finished goods inventory, and which in turn is listed on thebudgeted balance sheet.

It may also be divided into fixed and variable (and maybe evenmixed) groups.

Examples: indirect materials (e.g. lubricants for machinery),

indirect labor (e.g. administrative salaries: wages paid tomanufacturing supervisors, the purchasing staff, production clerks,and logistics planning staff), rent, utilities (e.g. electricity and heat),factory insurance, factory taxes, etc.


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Example 1e: MOH Budget

(e)At XYZ company, manufacturing overhead is applied tounits of products on the basis of direct labor hours. The variablemanufacturing overhead is20 per direct labor hour. The fixedmanufacturing overhead is30000 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 previousmultiplication to get total MOH costs.


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Example 1e: MOH Budget (cont.)


LaborNeeded (hours) 600 1100 1550 3250

Variable MOH Rate (per hour) 02 20 20 20Variable MOH Costs () 12000 22000 31000 65000

Fixed MOH Costs () 30000 30000 30000 90000

TotalMOH Costs () 42000 52000 61000 155000

x

=

+

=


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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 inventoriesthe company posses.

We do not consider the Ending Work-in-Processinventory.


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Ending DM Inventory Budget

For Ending DM inventory, it is easy! Just write theamount of direct materials that are planned to be onhand at the end of the period along with their costs.

At the end, the (cost of) EI of all direct materials shouldbe added together!

Target DM ending inventory

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


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Ending FG Inventory Budget

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

The ending finished goods inventory budgetcontains per unit values of three main costs that

are required to be included in the inventoryasset: direct material, direct labor, & overhead.


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Ending FG Inventory Budget

For DM part, multiply the cost of direct material by thequantity of direct material needed for the production ofone unit of FG.

For DL part, multiply the cost of DL (per hour) by thenumber of hours needed for production of one unit ofFG.

For MOH, it depends on the thing the cost is associatedwith (we will see an example). NOTE:total MOH costs divided by the required amount of

production gives the per unit MOH cost.


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Example 1f: Ending (FG) Inv. Budget

Production Costs

(perunit)Quantity of

Input (per unit)Cost of Input

(per unit)Total

Direct Materials 5 Kg 0.50 (per Kg) 2.50

Direct Labor 0.05 hrs 10 (per hour) 0.50TotalMOH Costs 0.05 hrs 47.69 (per hour) 2.385

PerUnit Production Cost 5.385

Ending Inv.(in units) 7000

Total Ending FG Inv. Costs 37695

Input

from MOH budget:

Cost per unit of input = Total MOH

costs / Total labor hours needed

=155000 / 3250 hrs = 47.69

from production budget

(EI at the quarter)


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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 equalto the FG cost)


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Cost of Goods Sold (CGS) Budget

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

Cost of Beginning FG inventory

x 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)


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Example 1g: Cost of Goods Sold Budget

Suppose the cost of beginning inventory at XYZ company is5.00per unit. Prepare the Cost of Goods Sold Budget for the quarter.

Units Rate (/unit) Total ()

Beginning Inv. 5.00 10000

ADD: Cost ofGoods Manufactured

Direct Materials Used 2.50 162500

Direct Labor 0.50 32500

TotalMOH Costs 2.385 155000

Cost of Goods A vai lab lefor Sale 360000

LESS: Cost of Ending Inv.

2000

65000

65000

65000

7000 5.385 37.695

Cost of Goods Sold 322.305


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Operating Expenses

Includes all non-manufacturing costs (for example,R&D costs, design costs, marketing costs, distributioncosts, customer service costs, labor costs of sales floorpersonnel, distribution costs: costs of shipping productsto customers)

For service companies, this includes all costs that arenot directly related to the service offered

Similar to MOH, this cost can also have fixed andvariable parts (we will see an example!)


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Example 1h: Operating ExpensesApril May June Quarter

Budgeted Unit Sales (in units) 10000 20000 30000 60000

VARIABLE OPERATING EXPENSES

Sales Commission Exp.(0.5/unit sold) 5000 10000 15000 30000

Shipping Expenses (0.40/unit sold) 4000 8000 1200024000

Bad-creditCustomers (1% *10) 1000 2000 3000 6000

Total Variable Operating Expenses 10000 20000 30000 60000

FIXED OPERATING EXPENSES

Office Rent 10000 10000 10000 30000

Advertising 5000 5000 5000 15000

Non-manufacturing Staff Salaries 35000 35000 35000 105000

Total Fixed Operat ing Expenses 50000 50000 50000 150000

Total Operating Expenses 60000 70000 80000 210000


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Income Statement

Sales Revenue

- Cost of Goods Sold (CGS)

= Gross Prof i t

- Operating Expenses= Operat ing Pro f i t

- Depreciation & Amortization

= Trading Prof i t

- Interest & Tax expenses

= Net Profit


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Example 1i: Budgeted Income Statement

Total Sales Revenue 600000

LESS: Cost of Goods Sold 322305Gross Margin (Gross Profit) 277695

LESS: Operating Expenses 210000

Operating Income (Operating Profit) 67695

L3 - Operating Budget

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