Prepare Operational Budgets Textbook Pdf

[Kenya Ahyet]

Budgetingis a powerful tool that is widely used for planning, executing, and evaluating organizational operations. A budget is a detailed financial plan for future time periods. Budgets are typically prepared before the budgeted period begins. For this reason, budgeted amounts are estimates and not actual amounts. Most organizations use historical data and current operating plans to estimate budgeted amounts. In an established organization, an effective manager can make these estimates with remarkable accuracy. For example, if the lease payment is $2,000 per month it is easy to project in the upcoming budget that yearly rent expense will be $24,000. However, budgets are not static. Budgets are frequently revised during the period due to unforeseen circumstances such as a change in economic conditions, changes in sales demand, or other factors that affect the organization.

Planning. The budget is created prior to the time period covered by the budget. The completed budget is then used by management to help plan operations including activities like scheduling production, purchasing materials, and making capital investments.

Controlling. The budget is used to control operations during the time period covered by the budget. It sets forth expected targets and limitations. The budget projects sales and revenue targets, production targets, and spending limitations for budgeted expenditures. For example, the budgets establishes the amount to be spent on raw materials; direct labor; and selling, general, and administrative expenses. It is the responsibility of management to ensure that actual expenditures are within the budgetary guidelines.

Performance evaluation. The budget is also used to evaluate the actual results achieved during the time period covered by the budget. Performance evaluation involves comparing the actual results to the results projected in the budget. Comparing budgeted activities to actual results is a widely used method for performance evaluation at all levels of the organization. For example, management can evaluate various departments or activities to see if they met expected targets or stayed within budgeted spending limitations. This feedback can be used to correct organizational inefficiencies or in some cases to justify adjusting budgeting projections and assumptions going forward.

As demonstrated in Exhibit 6-1, the budgets are interrelated with some budgets feeding into other budgets. For this reason, budgets must be completed in a specific order. The sales budget is the first budget completed in the master budget. The estimated sales number drives many organizational decisions such as how many units to produce, how many people to employ, and what kind of facilities are necessary to support that level of sales activity.

The sales budget is the first budget prepared in the master budget. Estimated sales is the basis for the individual budgets within the master budget. Estimating sales is a fundamental part of the budgeting process. Estimated sales are used to project everything else, such as sales revenue collected, production needs, and organizational expenditures.

The example of Wonderball, Inc. is used to illustrate the individual budgets. The Wonderball is a unique stress ball made from crushed crystals. Due to innovative social media marketing, Wonderball is trending on nearly every social media platform. Sofia, the creator and owner of Wonderball, Inc. is preparing a master budget for her second year of operations. Sofia decided to prepare the master budget by quarter.

The first budget she needs to prepare is the sales budget. The sales budget is provided in Exhibit 6-2. First, Sophia estimated the number of units she believes the company will sell in the upcoming period. She looked at past sales data to project the number of units sold in each quarter. She projects a sharp increase in sales in quarter 4 (Q4) due to holiday gift-giving. Each unit sells for $15. The sales budget is calculated by multiplying the budgeted units in sales by the selling price per unit to get total sales dollars. Total sales dollars for her second year of operations is estimated to be $3,915,000.

Stephanie Shuck invented a revolutionary new product called the Water Wiz. The Water Wiz can be programmed to deliver the perfect amount of water and nutrients to virtually any type of potted plant. The company experienced a profitable first year of operations. In the final quarter of the first year, Stephanie decided to compile a master budget to plan for the second year of operations.

For this illustration, assume that Stephanie only sells one product, the Water Wiz. The Water Wiz sells for $20 per unit. For the upcoming year, she expects to sell 20,000 units in the first quarter, 24,000 units in the second quarter, 33,000 units in the third quarter, and 40,000 units in the fourth quarter. In the first quarter of year 3, she expects to sell 21,000 units. Prepare the sales budget.

The production budget is prepared after the sales budget. The production budget estimates the number of units that need to be produced to meet sales demand and to maintain a desired level of finished goods inventory on hand. Normally making and storing a large quantity of excess inventory is not recommended. However, producing a small amount of excess inventory or a desired level of ending finished goods inventory is standard practice. The excess inventory serves as a buffer in case sales demand is more than expected, production issues occur, or the organization needs additional inventory for another reason. Maintaining a small amount of excess inventory is preferable to running out of inventory.

After the production budget is completed, the direct materials purchases budget is prepared. The direct materials purchases budget estimates the amount of direct raw materials purchases needed to produce the units scheduled for production plus the desired level of raw materials ending inventory. Purchasing a small quantity of excess raw materials, referred to as the desired amount of ending raw materials inventory, acts as a buffer in case additional raw materials are needed due to unexpected supply chain issues, production issues, or sales demand.

Continuing with the Wonderball, Inc. example, the direct materials purchases budget is prepared after the production budget. Finely crushed quartz crystal is the only direct material used to produce the Wonderball. The crushed crystal is poured into a specialized machine with a small amount of proprietary chemical additives. The chemical additives are accounted for as indirect materials or manufacturing overhead. The crushed crystal mixture is pressurized, causing the particles to form a bond. Each unit requires 1.2 pounds of crushed crystal. The crushed crystal costs $3.00 per pound.

After the production budget is prepared the direct labor budget is prepared. The direct labor budget calculates the total number of labor hours and the total cost of direct labor needed to satisfy production.

It is common for the number of direct labor hours needed to produce one unit to be more or less than one hour of direct labor. Continuing with the Wonderball, Inc. example, assume that a worker can load and process one Wonderball every 6 minutes. The direct labor hours needed to produce a single unit is 0.10 of an hour (6 minutes / 60 minutes in an hour). The worker is paid $15 per hour.

The direct labor budget for Wonderball, Inc. is provided in Exhibit 6-8 below. The direct labor budget starts with the required production in units taken from the production budget. The formula for calculating the costs of direct labor starts by taking the required production in units (from the production budget) times direct labor hours required to complete one unit to get the total number of direct labor hours required. Next, take total direct labor hours times the direct labor rate per hour to get total direct labor costs. The direct labor costs per unit is calculated at the bottom of the direct labor budget.

The final budget to determine product costs is the manufacturing overhead budget. The manufacturing overhead budget calculates the total manufacturing overhead that will be incurred to satisfy production needs.

Manufacturing overhead includes indirect materials used in production, such as glue, screws, and nails; indirect labor used in production, such as wages for the production supervisor or quality control; and all other costs incurred to manufacture a product, such as rent, insurance, taxes, and utilities incurred on the manufacturing facilities.

Manufacturing overhead is classified as variable or fixed. Variable manufacturing overhead costs are the same per unit, but total costs depend on the quantity produced. Fixed manufacturing overhead costs are the same in total regardless of the quantity produced.

After carefully classifying all indirect product costs as variable, fixed, or mixed, Sophia determined that each unit of Wonderball consumes $0.12 of variable manufacturing overhead and total fixed manufacturing overhead is $21,500. The manufacturing overhead budget is presented in Exhibit 6-10.

The cost of goods sold budget is prepared after the raw materials budget, direct labor budget, and manufacturing overhead budgets are prepared. The cost of goods sold budget determines the estimated cost for the inventory sold during the period. Cost of goods sold is the total manufacturing costs, or product costs, incurred to make the products that were sold. Product costs include the costs for direct material, direct labor, and manufacturing overhead.

Cost of goods sold per unit is the sum of direct materials per unit, direct labor per unit, and manufacturing overhead per unit. These numbers are taken from the direct materials budget, direct labor budget, and manufacturing overhead budget. The estimated number of sales in units is taken from the sales budget. The cost of goods sold budget for Wonderball, Inc. is provided in Exhibit 6-12.

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