In previous posts, we’ve discussed how budgeting is essential to managerial control and accounting. Preparing budgets is an important step for managers to plan finances. When it comes to preparing budgets, preparing the operating budgets is usually the first step. In this post, we will explore the different components of the operating budgets.
The sales budget is typically the first budget prepared. Every other budget depends on the sales budget. It shows management’s best estimate of sales revenue for the budget period. It’s important to forecast sales correctly when creating this budget using market trends, historical data, and good business sense. Poor estimates can lead to problems in other accounts. Inventory is one of the bigger accounts that could be hurt as a result of poor sales revenue estimates. For example, if management is overly optimistic about sales, inventory could be overstocked, leading to extensive inventory costs.
The sales budget is prepared by multiplying the expected unit sales volume for each product by its anticipated unit selling price.
The production budget shows the units to produce in order for a company to meet anticipated sales. This formula shows how to create production requirements:
Budgeted Sales Units + Desired Finished Goods Units – Beginning Finished Goods Units = Required Production Units
It’s important to note that a realistic estimate of ending inventory is essential in scheduling production requirements. Excessive inventory may lead to higher costs for the company, dramatically impacting resources, while too little inventory can have a large impact on sales and customer service. Also, the production budget provides the basis for the budgeted costs for each manufacturing cost element: direct materials, direct labor, and manufacturing overhead.
The direct materials budget shows the quantity and the cost of direct materials to be purchased. Ending inventory is a key component in the budgeting process. For example, inadequate inventories could result in temporary shutdowns of production. The formula for determining direct materials is:
Direct Materials Required for Production – Desired Ending Direct Materials Units – Beginning Direct Materials Units = Required Direct Materials Units to be Purchased
The direct labor budget contains the quantity (hours) and cost of direct labor necessary to meet production requirements. Direct hours are determined from the production budget. The formula is:
Units to be Produced X Direct Time per Unit X Direct Labor Cost per Hour = Total Direct Labor Cost
The Manufacturing Overhead Budget shows the expected manufacturing overhead costs for the budget period. This budget distinguishes between variable and fixed overhead costs.
The other two budget components are the selling and administrative expense budget and the budgeted income statement. The selling and administrative expense budget projects anticipated selling and administrative costs for the period. It also helps distinguish between variable and fixed costs. The budgeted income statement is an estimate of the expected profitability of the operations for the period.
*Learn more about Managerial Accounting or Accounting in general in our tutorial.