6 The Operating Budget

The Theory

Firms prepare budgets for several reasons: to plan for production needs, to set motivational goals, to provide a benchmark for evaluating actual results, to facilitate communication across departments and divisions, and many others.

The operating budget is a component of the master budget, which is essentially a set of budgeted financial statements. The operating budget is a budgeted income statement from revenue through operating income. It consists of several subsidiary budgets:

• The revenue budget: How much sales revenue the firm plans to earn, measured in dollars
• The production budget: How many units the firm plans to produce, measured in output units
• The direct materials usage budget: How much direct materials the firm plans to use in production, measured in units of direct materials such as pounds or gallons as well as dollars, and prepared separately for each type of material used in production
• The direct labor budget: How much direct labor the firm plans to use in production, measured in hours and dollars
• The manufacturing overhead budget: How much the firm plans to spend on manufacturing overhead, measured in dollars, and the predetermined overhead rate, measured as a rate per unit of cost allocation base, or if the cost allocation base is a dollar amount, as a percentage of the cost allocation base
• The ending finished goods inventory budget: The value of ending finished goods inventory, measured in dollars
• The cost of goods sold budget: The cost of the goods the company plans to sell, measured in dollars
• The period expense budget: The amount of nonmanufacturing costs the company plans to incur, measured in dollars
• The budgeted income statement: A summary of the other budgets

The operating budget for a manufacturing company reflects the costing system used to assign costs to manufactured goods for the purpose of valuing inventories and cost of goods sold. Recall that in a manufacturing company, all the costs of manufacturing goods are attached to products. Therefore, the three categories of manufacturing costs—direct materials, direct labor, and manufacturing overhead—are what make up the budgets for ending finished goods inventory and cost of goods sold.

Because manufacturing overhead is not traceable, it must be allocated or applied to products using a predetermined overhead rate. A firm chooses a cost allocation base that they believe varies with the overhead they assign to products, and calculates a rate based on that cost allocation base. The company then uses this rate throughout the year to apply manufacturing overhead costs to products.

The Method

A company prepares nine budgets as part of the master budgeting process. They are presented below, numbered in the order in which they should be prepared. Numbers in parentheses indicate an item that appeared on a previous budget.

• Revenue budget: Budgeted sales in units multiplied by budgeted selling price equals budgeted revenue.
• Production budget: Budgeted sales in units (from step 1) plus budgeted ending finished goods units minus budgeted beginning finished goods units equals budgeted production.
• Direct materials usage budget: Budgeted production (from step 2) multiplied by budgeted direct materials per unit equals budgeted direct materials usage. Budgeted direct materials usage multiplied by budgeted direct materials cost equals the budgeted cost of direct materials usage.
• Direct labor budget: Budgeted production (from step 2) multiplied by budgeted direct labor per unit equals budgeted direct labor hours. Budgeted direct labor hours multiplied by budgeted wage rate equals budgeted cost of direct labor.
• Manufacturing overhead budget: Budgeted cost allocation base multiplied by budgeted variable overhead rate equals budgeted variable overhead. Budgeted variable overhead plus budgeted fixed overhead equals total budgeted manufacturing overhead. Total budgeted manufacturing overhead divided by budgeted cost allocation base equals the budgeted manufacturing overhead rate.
• Ending finished goods inventory budget: Budgeted cost of direct materials (from step 3) plus budgeted cost of direct labor (from step 4) plus budgeted cost of manufacturing overhead (from step 5) equals total manufacturing cost. Total manufacturing cost divided by production (from step 2) equals budgeted cost per unit. Budgeted cost per unit multiplied by budgeted ending finished goods units equals budgeted ending finished goods inventory value.
• Cost of goods sold budget: Budgeted beginning finished goods inventory value plus budgeted cost of direct materials (from step 3) plus budgeted cost of direct labor (from step 4) plus budgeted cost of manufacturing overhead (from step 5) equals total manufacturing costs. Total manufacturing costs minus budgeted ending finished goods inventory value (from step 6) equals budgeted cost of goods sold.
• Period expense budget: Period expenses are either given in total or determined using a formula. All period expenses are added together to get the total period expense.
• Budgeted income statement: Budgeted revenue (from step 1) minus budgeted cost of goods sold (from step 7) equals budgeted gross margin. Budgeted gross margin minus budgeted period expense (from step 8) equals budgeted operating income.

Illustrative Example

Muschup Corporation produces wooden rocking horses. In the upcoming year, the sales department estimates the firm will be able to fill demand for their product, which should be 10,000 units. The firm tries to keep an inventory of 500 finished horses on hand at all times, but at the end of this year, inventory has dropped to 200 horses, valued at $35,000.

Each unit sells for $200 and uses 20 board-feet of wood that costs $2.50 per board-foot and a quart of paint that costs $20 per quart.

Each horse requires 3.2 hours of direct labor, paid at $20 per hour. Muschup estimates that variable overhead costs $5 per direct labor hour. Fixed overhead is estimated at $247,200, and selling, general, and administrative costs are estimated at $100,000.

 

1. Revenue Budget

Budgeted sales in units	10,000
Budgeted selling price	× $200
Budgeted revenue	2,000,000

2. Production Budget

Budgeted sales in units	10,000
Budgeted ending FG units	+ 500
Budgeted beginning FG units	− 200
Budgeted production units	10,300

3. Direct Materials Budget: Wood

Budgeted production units	10,300
Budgeted DM per unit	× 20 board-feet
Budgeted DM usage	206,000 board-feet
Budgeted DM cost	× $2.50
Budgeted cost of DM usage	515,000

3. Direct Materials Budget: Paint

Budgeted production units	10,300
Budgeted DM per unit	× 1 quart
Budgeted DM usage	10,300 quarts
Budgeted DM cost	× $20
Budgeted cost of DM usage	206,000

4. Direct Labor Budget

Budgeted production units	10,300
Budgeted DL hours per unit	× 3.2 hours
Budgeted DL hours	32,960 hours
Budgeted wage rate	× $20
Budgeted cost of DL	659,200

5. Manufacturing Overhead Budget

Budgeted cost allocation base	32,960 direct labor hours
Budgeted variable MOh rate	× $5 per DL hour
Budgeted variable MOh	164,800
Budgeted fixed MOh	+ 247,200
Budgeted total MOh	412,000
Budgeted cost allocation base	÷ 32,960 direct labor hours
Budgeted MOh rate	12.50 per DL hour

6. Ending FG Inventory Budget

Budgeted cost of wood usage	515,000
Budgeted cost of paint usage	206,000
Budgeted cost of DL	659,200
Budgeted MOh	412,000
Total manufacturing cost	1,792,200
Production units	÷ 10,300
Budgeted cost per unit	174
Budgeted ending FG units	× 500
Budgeted ending FG value	87,000

7. Cost of Goods Sold Budget

Budgeted beginning FG value	35,000
Budgeted cost of DM usage	+ 721,000
Budgeted cost of DL	+ 659,000
Budgeted cost of MOh	+ 412,000
Budgeted ending FG value	− 87,000
Budgeted cost of goods sold	1,740,200

8. Period Expense Budget

Budgeted SG&A expenses	100,000

9. Budgeted Income Statement

Budgeted revenue	2,000,000
Budgeted cost of goods sold	− 1,740,200
Budgeted gross margin	259,800
Budgeted period expense	− 100,000
Budgeted operating income	159,800

Lecture Example

Your business manufactures sofas, and charges $2,000 per unit. You are expecting to sell 20,000 units this month, 30,000 next month, and 25,000 the following month. Each unit requires 40 board-feet of wood, 10 yards of padding, and 20 yards of upholstery material. Wood costs $6 per board-foot, padding costs $30 per yard, and upholstery material costs $25 per yard. Each sofa requires 12 labor hours to assemble at a cost of $10 per hour. Variable manufacturing overhead is estimated at 150% of direct labor costs. Fixed manufacturing overhead is $4,800,000 per month. Selling costs are 10% of revenues, and general and administrative costs are $2,100,000 per month. Ending finished goods inventories are 10% of the following month’s sales. Beginning finished goods inventory will be valued at the current cost of $1,500 per sofa.

1. Prepare a revenue budget for this month.
2. Prepare a production budget for this month and next month.
3. Prepare a direct materials budget for this month.
4. Prepare a direct labor budget for this month.
5. Prepare a manufacturing overhead budget for this month.
6. Prepare an ending finished goods inventory budget for this month.
7. Prepare a cost of goods sold budget for this month.
8. Prepare a period expense budget for this month.
9. Prepare a budgeted income statement for this month.