6.3 Operating Budget: Production, Direct Material, Direct Labor, Manufacturing Overhead

There are three costs that go into every product: direct materials, direct labor, and manufacturing overhead.  The production budget determines how much you need to produce.  The direct materials budget determines how much you need to buy to meet your production goals.  It is important to note these two schedules (production and direct materials) will have different numbers!

Production Budget

Estimating sales leads to identifying the desired quantity of inventory to meet the demand. Management wants to have enough inventory to meet production needs, but they not too much in ending inventory which would result in using cash resources and paying for unnecessary storage. Management often uses a formula to estimate how much should remain in ending inventory. Management wants to be flexible with its budgeting, wants to create budgets that can grow or shrink as needed, and needs to have inventory on hand. So the amount of ending inventory often is a percentage of the next week’s, month’s, or quarter’s sales.

In creating the production budget, a major issue is how much inventory should be on hand. Having inventory on hand helps the company avoid losing a customer due to the product not being available. However, there are storage costs associated with holding inventory as well as having a lag time between paying to manufacture a product and receiving cash from selling that product. Management must balance these two issues to determine the amount of inventory that should be available.

When determining the number of units needed to be produced, start with the estimated sales plus the desired ending inventory to derive the maximum number of units that must be available during the period. Since the number of units in beginning inventory are already produced, subtracting the beginning inventory from the goods available results in the number of units that need to be produced.

After management has estimated how many units will sell and how many units need to be in ending inventory, it develops the production budget to compute the number of units that need to be produced during each quarter. The formula is the reverse of the formula for the cost of goods sold.

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

Goods Sold (Sales) + Ending Inventory – Beginning Inventory = Number of Units Produced

The number of units expected to be sold plus the desired ending inventory equals the number of units that are available. When the beginning inventory is subtracted from the number of units available, management knows how many units must be produced during that quarter to meet sales.

The number of units needed to be produced each quarter was computed from the estimated sales and is used to determine the quantity of direct or raw material to purchase, to schedule enough direct labor to manufacture the units, and to approximate the overhead required for production. It is also necessary to estimate the sales for the first quarter of the next year. The ending inventory for the current year is based on the sales estimates for the first quarter of the following year. From this amount, the production budget and direct materials budget are calculated and flow to the operating and cash budget.

In a merchandising firm, retailers purchase, rather than produce, their inventory. Therefore, stores such as Walmart do not have raw materials.  Instead, merchandisers substitute the number of units to be purchased in place of the number of units to be produced; the result is the amount of merchandise inventory to be purchased.

To illustrate the steps in developing a production budget, recall that Big Bad Bikes is introducing a new product that the marketing department thinks will have strong sales. For new products, Big Bad Bikes requires a target ending inventory of 30% of the next quarter’s sales. Unfortunately, they were unable to manufacture any units before the end of the current year, so the first quarter’s beginning inventory is 0 units.  Sales in quarter 2 are estimated at 1,000 units; since 30% is required to be in ending inventory, the ending inventory for quarter 1 needs to be 300 units. With expected sales of 1,000 units for quarter 2 and a required ending inventory of 30%, or 300 units, Big Bad Bikes needs to have 1,300 units available during the quarter. Since 1,300 units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units.

The ending inventory from one quarter is the beginning inventory for the next quarter, and the calculations are all the same. In order to determine the ending inventory in quarter 4, Big Bad Bikes must estimate the sales for the first quarter of the next year. Big Bad Bikes’ marketing department believes sales will increase in each of the next several quarters, and they estimate sales as 3,500 units for the first quarter of the next year and 4,500 units for the second quarter of the next year. Thirty percent of 3,500 is 1,050, so the number of units required in the ending inventory for quarter 4 is 1,050 units.

The number of units needed in production for the first quarter of the next year provides information needed for other budgets such as the direct materials budget, so Big Bad Bikes must also determine the number of units needed in production for that first quarter. The estimated sales of 3,500 units and the desired ending inventory of 1,350 units (30% of the next quarter’s estimated sales of 4,500) determines that 4,850 units are required during the quarter. The beginning inventory is estimated to be 1,050 units, which means the number of units that need to be produced during the first quarter of year 2 is 3,800 units.

Direct Materials Budget

From the production budget, management knows how many units need to be produced in each budget period. Management is already aware of how much material is needed to produce each unit and can combine the direct material per unit with the production budget to compute the direct materials budget. This information is used to ensure the correct quantity of materials is ordered and the correct amount is budgeted for those materials.

For the direct material budget, it is important to note that we use Required Production.  Similar to the production budget, management wants to have an ending inventory available to ensure there are enough materials on hand. The direct materials budget illustrates how much material needs to be ordered and how much that material costs. The calculation is similar to that used in the production budget, with the addition of the cost per unit.  It is normal for the direct materials budget to have a different percentage than the production budget.

If Big Bad Bikes uses 3.2 pounds of material for each trainer it manufactures and each pound of material costs $1.25, we can create a direct materials budget. Management’s goal is to have 20% of the next quarter’s material needs on hand as the desired ending materials inventory.  Therefore, the determination of each quarter’s material needs is partially dependent on the following quarter’s production requirements. The desired ending inventory of material is readily determined for quarters 1 through 3 as those needs are based on the production requirements for quarters 2 through 4. To compute the desired ending materials inventory for quarter 4, we need the production requirements for quarter 1 of year 2. Recall that the number of units to be produced during the first quarter of year 2 is 3,800. Thus, quarter 4 materials ending inventory requirement is 20% of 3,800.

Management knows how much the materials will cost and integrates this information into the schedule of expected cash disbursements.  The cash payments schedule shows when cash will be used to pay for Accounts Payable. One such example are direct material purchases, which originates from the direct materials budget. When the production budget is determined from the sales, management prepares the direct materials budget to determine when and how much material needs to be ordered. Orders for materials take place throughout the quarter, and payments for the purchases are made at different intervals from the orders. A schedule of cash payments is similar to the cash collections schedule, except that it accounts for the company’s purchases instead of the company’s sales. The information from the cash payments schedule feeds into the cash budget.

Big Bad Bikes typically pays half of its purchases in the quarter of purchase. The remaining half is paid in the following quarter, so payments in the first quarter include payments for purchases made during the first quarter as well as half of the purchases for the preceding quarter.

This information will also be used as cost of goods sold on the budgeted income statement and as accounts payable on the budgeted balance sheet.  Additionally, the balance of purchases in Accounts Payable can be reconciled by using information from the cash payment schedule as follows:

Direct Labor Budget

Management uses the same information in the production budget to develop the direct labor budget. This information is used to ensure that the proper amount of staff is available for production and that there is money available to pay for the labor, including potential overtime. Typically, the number of hours is computed and then multiplied by an hourly rate, so the total direct labor cost is known.

If Big Bad Bikes knows that they need 45 minutes or 0.75 hours of direct labor for each unit produced, and the labor rate for this type of manufacturing is $20 per hour, the computation for direct labor simply begins with the number of units in the production budget. The number of units produced each quarter multiplied by the number of hours per unit equals the required direct labor hours needed to be scheduled in order to meet production needs. The total number of hours is next multiplied by the direct labor rate per hour, and the labor cost can be budgeted and used in the cash disbursement budget and operating budget.

The direct labor of $105,750 will be apportioned to the budgeted income statement and the budgeted balance sheet. With 0.75 hours of direct labor per unit and $20 per direct labor hour, each unit will cost $15 in direct labor. Of the 7,050 units produced, 6,000 units will be sold, so $90,000 represents the labor portion of the cost of goods sold and will be shown on the income statement, while the remaining $15,750 will be the labor portion of ending inventory and will be shown on the balance sheet.

Manufacturing Overhead Budget

The manufacturing overhead budget includes the remainder of the production costs not covered by the direct materials and direct labor budgets. In the manufacturing overhead budgeting process, producers will typically allocate overhead costs depending upon their cost behavior production characteristics, which are generally classified as either variable or fixed. Based on this allocation process, the variable component will be treated as occurring proportionately in relation to budgeted activity, while the fixed component will be treated as remaining constant. This process is similar to the overhead allocation process you learned in studying product, process, or activity-based costing.

For Big Bad Bikes to create their manufacturing overhead budget, they first determine that the appropriate driver for assigning overhead costs to products is direct labor hours. The overhead allocation rates for the variable overhead costs are: indirect material of $1.00 per hour, indirect labor of $1.25 per hour, maintenance of $0.25 per hour, and utilities of $0.50 per hour. The fixed overhead costs per quarter are: supervisor salaries of $15,000, fixed maintenance salaries of $4,000, insurance of $7,000, and depreciation expenses of $3,000.

The total manufacturing overhead cost was $131,863 for 7,050 units, or $18.70 per unit (rounded). Since 6,000 units are sold, $112,200 (6,000 units × $18.70 /unit) will be expensed as cost of goods sold, while the remaining $19,663 will be part of finished goods ending inventory.