Section 3.) Production/Purchase Budget
The goal of this budget is to determine how many units we must produce to meet our expected sales, based on the inventory we currently had from prior months as well as any required ending inventory levels based on company policy. Most companies strive for a certain ending inventory level at the end of the month to assist with sales to made in the next month. In other words, a company doesn’t want to start the month out with zero inventories, because they run the risk of not being able to fill sales as they come in. On the other hand, a company does not want to have too much inventory on hand due to the risk of loss and obsolescence, as well as the cost of storing inventory.
Companies may express this requirement in terms such as 70% of expected sales for next month.
The purchases or production that we need to meet will equal:
Quantity Sold (or expected to be sold this month)
+ Ending Inventory (we want to build back to this level, so this adds to the amount we need to produce)
= Production Needs (one way or another, we need to have this total amount available throughout the year)
- Beginning Inventory (it is already available for us, so this subtracts from the amount we need to produce this month)
= Units Required to Produce (this is the quantity of units we actually must produce this year)
Note: In order to determine the desired ending inventory for one month, you must know the expected sales for the next month.
This below video goes through the Production Budget.
Section 4.) Raw Materials Purchases Budget
To support the level of production discussed in the production budget above, a company will also have to prepare a raw material purchase budget. This mathematical formula for this budget is the same as the production budget.
The raw material that we will have to purchase to meet the above production levels equal:
Quantity of parts needed for above production level (take the number of units to be produced times the quantity of each type of raw material needed for each unit.)
- Beginning Inventory (these materials are already available for us, so this subtracts from the amount we need to purchase this month)
= Material Needs (one way or another, we need to have this total amount of materials available throughout the year)
+ Ending Inventory (we want to build back to this material level, so this adds to the amount we need to purchase)
= Materials Required to be Purchased (this is the quantity of materials we actually must purchase this year)
Note that in reality most items manufactured are comprised of several parts and several types of raw material. This same calculation would need to be done for each type of raw material.
This below video goes through the Raw Materials Purchases Budget.
Section 5.) Direct Labor Budget
The direct labor budget is also part of the production budget, although it is much simpler than the raw materials budget due to the fact that you cannot keep “inventories” of direct labor or manufacturing overhead. Instead, both are allocated based on a number of units per product and a rate for each of those units. For example, it may take 10 direct labor hours per product at a rate of $25 per hour.
The direct labor budget must come after the production budget, as it supports it. To know how much labor you need, you need to know your production goals. One of the big differences between this and the direct materials budget is that labor has no desired ending inventory and no beginning inventory. You use whatever labor you need during that period. There is no connection to other months. This greatly simplifies the preparation of the labor budget. The labor budget is determined based on a number of units per product and a rate for each of those units. For example, it may take 10 direct labor hours per product at a rate of $25 per hour. In reality, there may be multiple levels of labor needed, though most textbook problems simplify it by using just one type of labor.
This below video goes through the Direct Labor Budget.
Section 6.) Manufacturing Overhead Budgets
The manufacturing overhead budget is the third of the budgets that support the production budget. Like the labor budget, there is no need to maintain beginning or ending inventories of this cost. One main difference with the manufacturing overhead budget is that there are both variable and fixed costs. In fact, some of them are indirect materials and indirect labor costs that wouldn’t be included in the direct materials and direct labor budgets. Manufacturing overhead costs are allocated based on a number of “units” per product (these units could include direct labor hours or machine hours.) Each type of cost will have a rate per “hour”. For example, it may take 10 machine hours per product at a rate of $5 per hour.
One important thing to note is that the depreciation expense is an expense that does not immediately relate to cash. In fact, the depreciation expense generally relates to a purchase that was paid for in a prior period. As a result, when calculating the cash budget later on we are going to need to be able to carve out the depreciation expense to arrive at the cash disbursement.
Below is an example of what the manufacturing overhead budget may look like.
This below video goes through the Manufacturing Overhead Budget.
Selling, General, and Administrative (Operating Expenses) Budget
This budget details all of the NON-PRODUCT expenses related to the company’s operation.
This budget is another type of overhead budget for costs outside of the manufacturing process. Like the manufacturing overhead budget, there are both variable and fixed costs. The budget may include detailed lines for each type of overhead, or it may be summarized into one line. Generally, the variable overhead costs will be applied based on a rate similar to the manufacturing overhead budget’s variable costs.
One important thing to note is that the depreciation expense is an expense that does not immediately relate to cash. In fact, the depreciation expense generally relates to a purchase that was paid for in a prior period. As a result, when calculating the cash budget later on we are going to need to be able to carve out the depreciation expense to arrive at the cash disbursement.
This below video goes through the Selling, General, and Administrative Budget.
Section 7.) Cash Budget
The cash budget is the budget that is most familiar to most people, due to the fact that a cash budget is what we use for our own personal finances. Of course, there are some differences, such as the fact that our cash inflow is usually related to a paycheck instead of sales.
To calculate the cash budget, we must calculate the expected cash receipts and the expected cash disbursements.
Cash Receipts Budget
The purpose of the cash receipts budget is to identify the amount of sales that we will be collecting in a given month. In some cases, a company may just be collecting cash for that same month. However, in other cases a company may allow the customer time to pay for the sale.
Some customers may pay within 10 days (possibly to get a discount), some may pay within 30 days, and some may be longer. Likewise, we may choose to pay some creditors earlier than others depending on their credit policy.
Based on all of this data we have to increase estimates on what percentage of cash we will receive or disburse each month related to prior period sales or purchases.
Below is an example of how the cash receipts budget may look. This budget is discussed further in the cash budget video.
Cash Disbursements Budget
The second part of the cash budget is the cash disbursements budget. The main difference with this budget is that there are many more reasons to pay money than receive it.
The first type of cash disbursement is that of material purchase payments. To start this budget, you need to use the amount from the material purchases and determine in what month they are paid. In the example below, the company pays 40% of its purchase amounts in the current month and 60% in the following month.
After the material purchases, the company needs to account for the cash spent on labor. Then, they need to account for cash spent on manufacturing overhead and selling, general, and administrative expenses (from their respective budgets.) With the two overhead budgets it is important to carve out any depreciation expense, since that is not an amount that will actually be paid in cash.
Overall Cash Budget
Finally, the overall cash budget is used to summarize the cash receipts and disbursements budget to determine the amount of cash expected to be available throughout the period. In some cases, a company may need to obtain financing to arrive at their minimum desired cash balance. This is because companies want to keep a cushion to ensure that they have enough money to continue their operations, even if things stray a bit from the plan. Of course, this also means that they will have to pay those loans off with interest when they have excess cash in later periods.
The below videos go through the cash receipts and disbursements budgets.
Wrap-Up
The first three sections of this week are largely informational. Although they are helpful as we begin the course, most of it is not necessary to build on in future weeks. However, you should at least retain an understanding of the difference between financial and managerial accounting.
Section 1.) Budgeting Overview
The process of budgeting is critical to companies, not only for the control of costs, but also for the establishment of goals and standards. This also allows the different departments of the company to align their goals.
Types of Budgets
Top-Down Budgeting- In this type of budget, top management uses the information they have available to them to dictate a budget to be followed by everyone underneath them. There is very little involvement by lower levels. Although this type of budgeting is very efficient, it may not represent the best data because top management may not have all of the details about some of the lower levels of the company. Although they will have reports on that data (i.e., historical results, etc.), there is some information that cannot be reflected in reports. The lower-level managers may be aware of this.
Participative Budgeting- In this type of budget, lower management gets more involved with the budget process, and as such will be more likely to be motivated to effectuate it with their staff. The drawback of this type of budget is that it takes a lot more time and effort to work out a budget that everyone agrees with.
Zero-Based Budgeting- In this type of budget, we do not start with the prior year results and make adjustments; instead, we start from scratch each year and have to add in amounts for each activity and each department, if they are determined to be a priority. Although this has a tendency to weed out the lower priority activities, the budget process itself is extremely time-consuming because of the amount of data that must be produced by everyone involved to try to properly set their budget and determine which activities have a higher priority.
Budget Timeframes
Single-Year Budget- As the name implies this type of budget is produced for one year at a time (sometimes broken into quarters as well.) Although we would generally start on the second year’s budget sometime before the first year is over, the two budgets are very distinct.
Rolling or Continuous Budget- In this type of budget, we always have four quarters for the current budget. Once one quarter has been completed, we add on another quarter (likely in a future year) so that the same timeframe is always able to be looked at. One drawback is that the company is always in budget mode, and the time and expense related to doing this extra work is high. In some cases, the increased efficiency and information derived from the budget process may be worth the extra cost though.
Operating or Master Budget
This is a term for a collection of the smaller budgets that the company creates and interlinks to establish the goals.
The overall budget of the company is broken into several pieces:
· Sales Budget
· Production/Purchases Budget (depending on whether the firm is manufacturer or merchandiser)
If the company is a manufacturer, this production budget is further broken down into the following budgets:
o Raw Materials Purchases Budget
o Direct Labor Budget
o Manufacturing Overhead Budget
· Cost of Goods Sold Budget
· Operating Expense Budget
· Budgeted Income Statement
· Cash Budget (further broken down into Cash Receipts and Cash Disbursements budgets)
· Budgeted Balance Sheet
It is important to note that all budgets are estimates or forecasts of expected activity in a given month. If those estimates prove to be off, the budget should be able to flex to accommodate the change. Most of these budgets interrelate with one another and it is important to create these budgets in the order given above. In many cases, one item from an early budget will be needed to calculate a later budget.
Section 2.) Sales Budget
This budget is a simple forecast of how many units we expect to sell in each given month and at what price. Although this is a simple budget in appearance, the detail is derived from historical data, as well as expectations about the company’s product, given advertising plans, and economic outlooks. This is a very important budget as it feeds directly and indirectly into all other budgets.
This budget is the first budget, and the easiest to prepare, once the market forecasts are actually available. The format of this budget is the number of expected sales for a month multiplied by the expected sales price per unit to arrive at an expected sales dollar total for each month. Although this is a simple budget in appearance, the detail is derived from historical data, as well as expectations about the company’s product, given advertising plans, and economic outlooks. This is a very important budget as it feeds directly and indirectly into all other budgets.
Both the quantity of sales and sales price are subject to change throughout the period, based on various market forces in place at the time. Based on economics, a price increase may be expected to reduce the expected sales demand and thus quantity.
As noted in the illustration below, even though we may only be preparing a sales budget for a quarter at a time, you will generally need sales from the next two months as well. This is needed for both the production budget and materials budget. To complete the production budget for the last month of a quarter, you need to know the sales budget for the next month. To complete the materials budget for the last month of a quarter, you need to know the production budget for the next month, which means you need to know the sales budget for the month after that. Both of these links will be discussed in the next two budgets.
This below video goes through the Sales Budget that is similar to the one we are doing for our assignment this week.
Comments
Post a Comment