This is the first article in our 3-part series on budgeting to support the MABU unit for level 4 students.
Study tips: Budgeting series
- Part 1 – Compiling the materials elements of a budget
- Part 2 – Labour, overheads and operating budget
- Part 3 – Production budget report (coming soon)
A budget is a financial plan which is compiled to enable an organisation to meet its strategic objectives, based on the company’s vision or aims. It gathers together all the relevant data, whether it is financial information in the form of forecasts, or non-financial in the form of strategic targets, and comes up with a monetary based blueprint. In this series we are going to look at the three main components of an operating budget; materials, labour and overheads, and some of the key planning assumptions behind them.
Let’s assume the role of the budget accountant for a food manufacturer that produces a range of dairy products. The company has recently been reviewing the product life cycle of some of its milkshakes as sales have been in decline. A PEST analysis indicated that changes in government policies about health choices and general shifts in consumer perceptions of milkshake as being healthy, might have contributed to the reduction in sales. This led the company to commission some market research which sampled a mixture of existing and target customers. The result of this combined research has been the development of a new fruit smoothie which will be launched with the support of a targeted marketing campaign. You are at the start of the process of compiling a draft operating budget for upcoming production.
After consulting with the marketing manager, the predicted sales targets have been agreed as 5,000 units in week 1 with a 10% weekly increase until the target volume of 10,000 units has been achieved. The production manager estimates that 8.5% of production could be rejected during quality control and because the product is perishable it has been agreed that large quantities of closing inventory are not desirable. Closing inventory has been calculated as 2% of the following week’s sales volume.
The variables above are therefore used to produce a production forecast:
Week 1’s calculations start with determining the closing inventory, which is 2% of week 2’s sales volume (5,500 ÷ 100 x 2). Closing inventory for one week will become the opening inventory for the next:
The good production is calculated as the week’s sales volume + the closing inventory – opening inventory. This is the quantity of units required, however, due to the 8.5% rejection rate we know that it is only 91.5% (100 – 8.5) of what needs to be manufactured. Therefore, the total manufactured units can be calculated by dividing the good production by the percentage it represents to calculate 1% (5,110 ÷ 91.5 = 55.8469) and then multiplying by 100 and rounding up to the nearest whole unit:
Finally, the rejected production is determined as 8.5% of the total manufactured units (5,585 ÷ 100 x 8.5):
The calculations can be sanity checked by thinking through the requirements. In other words, the opening inventory plus the total number of units manufactured, less the rejection allowance, must be sufficient to meet the sales target, and leave the closing inventory. For week 2 this would be 110 + 6,023 – 512 = 5,500 + 121
If you would like to complete the table you will be able to access the full forecast by selecting the link below. If you find calculating the total manufactured units challenging, further reading on margins and mark-ups would help as the skills are transferable once you understand the theory. Also remember that logically the total of manufactured units must be more than the good production to account for the units that are made and then rejected.
Based on the completed forecast (click to download) the production manager has compiled the following production budget for the first quarter. The link will enable you to see the source of the figures.
Each unit requires 0.2kg of fruit. As this is a perishable material a small buffer opening inventory is held and a daily delivery received on a just in time basis. The company has been buying berries to flavour milk shakes and found that wholesale prices have fluctuated over the last two year between £2.15 and £4.60. The chief buyer has been monitoring statistics published by the Department for Environment, Food and Rural Affairs, and has suggested it would be prudent to budget at £5.10 which is 15% more than this year’s actual average per kg.
In order to calculate the cost of raw materials to include in the operating budget, you need to calculate how much fruit will be required given the open and closing inventory (the opening inventory will be transferred from a product whose production will cease):
The working schedule is completed by calculating the required quantity to be used in production. This is based on the number of units to be produced multiplied by the raw material requirement per unit (106,426 units x 0.2kg). This can then be adjusted by the opening and closing inventory to calculate the quantity to purchase. The open inventory doesn’t need to be purchased again but we do need to buy enough so that we end up with the required closing inventory (21,285kg – 250kg + 300kg):
Now, the values can be added. The company works on the basis that purchases and closing inventory of raw materials should be valued at the budgeted cost of purchases, with usage being valued on a FIFO basis.
Therefore, the value of purchases and closing inventory can be calculated first by multiplying the quantity by the budget cost (21,335 x £5.10) and (300 x £5.10):
The value of the units used in production is the difference between the value of the opening inventory plus purchases less the value of the closing inventory (£110,009 – £1,530):
The value of materials used in production, in this case £108,479, is the figure that will be transferred to the operating budget.
In part 2 – labour, overheads and operating budget, we’ll go through the process of writing an email to submit the draft production budget to the budgetary committee for approval. Agreement at this stage will then allow us to continue preparing the operating budget by adding the labour and overheads elements, which we’ll cover in part 3.
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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.