Chapter 6 - Budgeting
Summary :The Three Purposes of Budgeting
A budget is a detailed financial plan for a future period, prepared before that period begins, which means every figure in it is an estimate rather than an actual result. Organizations rely on budgets for three distinct purposes. Planning uses the budget, once complete, to schedule production, arrange purchasing, and guide capital investment decisions before the period starts. Controlling uses the budget during the period as a set of spending limits and targets - management is expected to keep actual raw material purchases, labor costs, and administrative spending within the amounts the budget authorized. Performance evaluation compares actual results against the budgeted figures after the period ends, which highlights which areas met their targets, which fell short, and whether the budget's own assumptions need to be revised going forward. Because unexpected events - a shift in demand, a supply disruption, a change in economic conditions - can occur mid-period, budgets are commonly revised rather than treated as fixed once finalized.
The Master Budget and Its Required Sequence
An organization's complete collection of individual budgets is called the master budget, and its components are interrelated: figures calculated in one budget feed directly into the next, so the budgets must be prepared in a specific order rather than all at once. The sales budget always comes first, because the number of units a company expects to sell drives nearly every other resource decision - how many units to produce, how much raw material to buy, how many labor hours to schedule, and how much manufacturing overhead and administrative spending to plan for. From the sales budget, a manufacturer proceeds through the production budget, the direct materials purchases budget, the direct labor budget, the manufacturing overhead budget, the cost of goods sold budget, the selling and administrative expenses budget, and finally the budgeted income statement, each one drawing inputs from the budgets completed before it.
The Sales Budget - A Worked Example
Consider LumaCandle Co., a scented candle maker whose owner, Priya, is preparing a quarterly master budget for the upcoming year. Each candle sells for $12.00, and Priya projects sales of 5,000 units in the first quarter based on prior-year trends and current order commitments. The sales budget for the quarter is simply budgeted units times selling price: 5,000 units times $12.00 equals $60,000 in budgeted sales revenue for the quarter - the single figure every later budget in the sequence will build from.
The Production Budget - A Worked Example
The production budget converts budgeted sales into the number of units that actually need to be manufactured, and it must also account for a desired cushion of finished goods inventory on hand at the end of the period, since running out of inventory is worse than holding a modest buffer. Priya wants ending finished goods inventory each quarter to equal 15 percent of the following quarter's budgeted sales, and she projects 6,200 units in sales for the second quarter, making the first quarter's desired ending inventory 15 percent of 6,200, or 930 units. The company begins the first quarter with 750 units already in finished goods inventory, carried forward from the prior year. Required production is budgeted sales plus desired ending inventory minus beginning inventory: 5,000 plus 930 minus 750, which equals 5,180 units that must be produced in the first quarter.
The Direct Materials Purchases Budget - A Worked Example
Once required production is known, the direct materials purchases budget determines how much raw material to buy, again building in a small buffer of ending raw materials inventory. Each candle requires 0.8 pounds of wax blend costing $2.50 per pound. Total material needed for this quarter's production is 5,180 units times 0.8 pounds, or 4,144 pounds. Priya wants ending raw materials inventory equal to 10 percent of the following quarter's material needs; with second-quarter production estimated at 6,320 units requiring 5,056 pounds, the desired ending inventory is 10 percent of 5,056, or 505.60 pounds. The company begins the quarter with 380 pounds already on hand. Required purchases are total material needed plus desired ending inventory minus beginning inventory: 4,144 plus 505.60 minus 380, which equals 4,269.60 pounds, costing 4,269.60 times $2.50, or $10,674.00 for the quarter.
Direct Labor and Manufacturing Overhead Budgets
The direct labor budget converts required production into labor hours and labor cost. Each candle takes 0.05 hours (three minutes) to pour, cool, and package, and workers are paid $16.00 per hour. Total direct labor hours needed are 5,180 units times 0.05 hours, or 259 hours, and total direct labor cost is 259 hours times $16.00, or $4,144.00 for the quarter. The manufacturing overhead budget separates overhead into its variable and fixed components: LumaCandle incurs $0.15 of variable manufacturing overhead per unit produced, plus $8,200 of fixed manufacturing overhead per quarter regardless of volume. Variable overhead for the quarter is 5,180 units times $0.15, or $777.00, and total manufacturing overhead is $777.00 plus $8,200.00, or $8,977.00.
Cost of Goods Sold, Selling and Administrative Expenses, and the Budgeted Income Statement
With direct materials, direct labor, and manufacturing overhead all budgeted, a per-unit product cost can be assembled: $2.00 of direct material per unit (0.8 pounds times $2.50), $0.80 of direct labor per unit (0.05 hours times $16.00), and $1.73 of manufacturing overhead per unit ($8,977.00 total overhead divided by 5,180 units produced), for a total product cost of $4.53 per unit. The cost of goods sold budget applies this per-unit cost to budgeted units in sales, not units produced, since only sold units flow through cost of goods sold: 5,000 units times $4.53 equals $22,650.00 in budgeted cost of goods sold for the quarter. The selling and administrative expenses budget separately projects $1.20 of variable selling and administrative cost per unit sold plus $14,500 of fixed selling and administrative cost per quarter, giving 5,000 times $1.20, or $6,000.00, plus $14,500.00, for a total of $20,500.00. The budgeted income statement then combines all of these: sales of $60,000.00 minus cost of goods sold of $22,650.00 gives a gross margin of $37,350.00, and subtracting the $20,500.00 in selling and administrative expenses produces budgeted net operating income of $16,850.00 for the quarter.
Quick Revision Summary
Budgets serve three purposes: planning before the period, controlling spending during the period, and evaluating performance after the period by comparing actual results to budgeted figures. The master budget's components must be built in sequence, starting with the sales budget, since each later budget depends on figures from the ones before it: sales, then production, then direct materials purchases, then direct labor, then manufacturing overhead, then cost of goods sold, then selling and administrative expenses, and finally the budgeted income statement. The production budget adds desired ending inventory and subtracts beginning inventory from budgeted sales to find required production; the direct materials purchases budget applies that same logic to raw materials. Cost of goods sold is calculated by applying a per-unit product cost (direct material plus direct labor plus applied manufacturing overhead) to budgeted units in sales, while the budgeted income statement subtracts cost of goods sold and selling and administrative expenses from sales, in that order, to reach net operating income.