Study tips: Budgeting part 2 – Labour, overheads and operating budget

This is the second article in our 3-part series on budgeting to support the MABU unit for level 4 students.


Study tips: Budgeting series


In part 1 of this series on budgeting we focused on the raw materials element of an operating budget and set out some key planning assumptions based on our scenario. We are now in a position to look at the labour and overheads elements and compile the draft budget for the upcoming production of the new fruit smoothie.

Let’s resume our role as the budget accountant. The production budget for quarter 1 shows that 106,426 units are due to be manufactured. The process is highly automated and the production lines for similar existing products are supervised by three members of staff who work 40 basic hours per week. Production is expected to occur at the rate of 60 units per labour hour. Staff are paid £12 per basic hour and overtime is paid at time and a half.

Looking at labour costs

The labour hours needed are 1,774 (106,426 units ÷ 60 units per hour) however, there are only 1,440 hours available (40 hours per week x 12 weeks x 3 staff). This means that 334 hours are as yet unaccounted for.

The hours could be offered to the existing members of staff as overtime. However, the basic cost would be £17,280 (1,440 hours x £12) and the overtime £6,012 (334 hours x £18). Therefore, overtime would be 26% of the overall labour cost (£6,012 ÷ £23,288 x 100) and would mean each member of staff working for just over an extra 9 hours per week (334 hours ÷ 3 staff ÷ 12 weeks).

An alternative could be to bring in temporary workers or subcontractors. It would also be worth considering employing another member of staff as an extra 28 hours per week are required (334 ÷ 12 weeks). The labour hours required will build up over the period as production increases from 5,000 units per week to 10,000 units per week so a flexible solution is required.

After consulting with the human resources manager it has been agreed an existing member of staff, currently working in another area of the company, can be redeployed for 20 hours a week and temporary workers may be bought in later in the quarter. Therefore, the revised labour hours available are 1,680 (1,440 original hours + 20 hours per week x 12 weeks) which leaves 94 hours to be found from overtime or temporary staff (1,774 required hours – 1,680 basic hours). We will assume overtime for our calculations.

The working schedule for the operating budget is therefore:

As the manufacturing process is highly automated, overheads are recovered on the basis of machine hours. The production lines are expected to run for 2 hours for each labour hour worked, and variable production overheads are recovered at the rate of £20 per machine hour. Fixed production overheads of £5,000 have been allocated to the production budget.

The working schedule for the operating budget is therefore:

Now all the schedules have been completed the operating budget can be compiled. Why not have a go yourself before reading further?  A reminder of the information from part 1 is shown below.

Note that the company values closing finished goods inventory at the budgeted production cost per unit, rounded to two decimal places.

Workings:

The quantity of sales in units is taken from the production budget and multiplied by the cost per unit given to calculate the sales revenue.

The cost of production consists of the ‘Used in production’ figure taken from the materials schedule, the total cost of labour from the labour schedule and the total from the production overhead schedule. These three figures are then totalled to calculate the total cost of production.

The total cost of production is then divided by the number of production units in the production budget (£206,277 ÷ 106,426 units) to calculate the budgeted production cost per unit, rounded to two decimal places as per the policy. The quantity of closing inventory of finished goods is shown in the production budget and multiplied by the budgeted cost of production (200 units x £1.94).

The cost of goods sold is calculated as opening inventory plus cost of production less closing inventory. Gross profit is sales less cost of sales and the operating loss is gross profit less overheads.

The budget is now complete and needs to be submitted to the budget committee for approval. Let’s consider what we would want to communicate to the committee in order for the budget to be given due consideration, especially as it is forecasting such a small profit. 

Communicating the budget

Firstly, we could give reassurances that new products rarely make an initial operating profit at all and that this budget just covers the first quarter. Sales are based on weekly increases and only reach the target volume at the start of the third month. Whilst this won’t affect the variable costs it will mean that the fixed overheads, included the fixed element of the production overheads, will reduce on a per unit basis once the full sales volume is being produced and sold, and that will increase profits.

Secondly, we can point out the marketing cost is the result of the launch campaign and not representative of the on-going overhead. Once this reduces to normal operational levels the expense will reduce and profitability will improve.

Lastly, we can remind the committee of the high levels of product rejection. This is an area where major savings could be realised if the causes can be established and addressed so that rejection rates decrease and the cost of production lowered by reducing the quantity of raw materials required.

In the final part of this series we’ll respond to the budgeting committee’s decision and feedback.

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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.

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