BUDGETING FOR PRODUCTION COSTS
Overview
This lesson continues the Sunbird Boat Company example from the previous lesson to describe how to build cost budgets for direct materials, direct labor, and
manufacturing overhead.
Upon completion of this lesson, candidates should be able to:
• Demonstrate an understanding of the relationship between the direct materials budget, the direct labor budget, and the production budget.
• Explain how inventory levels and procurement policies affect the direct materials budget.
• Prepare direct materials and direct labor budgets based on relevant information and evaluate the feasibility of achieving production goals on the basis of these
budgets.
• Demonstrate an understanding of the relationship between the overhead budget and the production budget.
• Separate costs into their fixed and variable components.
• Prepare an overhead budget.
Study Guide
I. The Master Budget “Big Picture”
A. This lesson continues the example from the previous lesson on Sunbird Boat Company's
operational budget.
B. This lesson focuses on building the production cost budgets that eventually form budgeted cost of
goods sold for the pro forma income statement.
C. Typically, the production cost budgets represent the three product costs: direct materials, direct
labor, and manufacturing overhead. Be sure to keep in mind the position of these three budgets
within the big picture of the overall master budget. You can visually position these three budgets in
the illustration below.
II. Direct Materials Budget
A. The direct materials budget, like all of the production cost budgets, is a function of the production budget. The direct materials budget can be
described in three parts.
1. First, beginning with budgeted production volume, the direct materials budget uses the standard input quantity to determine the total
direct materials needed to support production.
2. Second, if the organization maintains an inventory of direct materials, then the budgeted production needs will not equal the quantity of
direct materials that will need to be purchased. As a result, the relationship between production needs and materials to be purchased
is: Production needs + Ending inventory − Beginning inventory = Materials to purchase
3. Finally, by multiplying the materials to be purchased by the standard price of materials, the cost budget for direct materials purchases
can be established.
B. Let's carry forward from the previous lesson the budgeting example for the Sunbird Boat Company. In the previous lesson, we determined a
budget for quarterly production of custom wood-built rowboats. That production volume is used below to build the direct materials budget for
Sunbird based on a standard quantity of 80 board feet of wood per boat and a standard price of $10 per board foot.
1. Sunbird's budget policy follows a practice of maintaining inventory equal to 30% of next
quarter's production needs. Hence, the Q1 planned ending inventory of 1,248 feet is computed
by the 4,160 feet needed for Q2 production multiplied by 30%. Note that the 960 feet of
inventory planned for the end of Q4 indicates that Sunbird management plans to produce 40
boats in the following quarter (40 boats × 80 feet × 30% = 960 feet).
2. Notice that the beginning inventory planned for Q1 is 600 feet. This amount is different
from Sunbird's 30% budget policy, which would be 816 feet (Q1 production needs 2,720
feet × 30%). Please understand that this budget is following the final results of the current
year. It appears that while Sunbird may have originally planned to end the current year with
816 feet of wood in inventory, it is actually ending the year with 600 feet.
3. After the materials needed for production are adjusted by Sunbird's inventory policy, the
budgeted quantity of wood to be purchased each quarter is multiplied by the standard price to
determine the final direct material purchases budget.
III. Direct Labor Budget
A. The direct labor budget is obviously uncomplicated by any kind of inventory policy. The
budgeted production volume is multiplied by the standard quantity of hours (which for Sunbird
Boat Company is 50 hours per boat) to establish the direct labor hours needed to support
production.
B. The direct labor hours needed to support production are multiplied by the standard price (i.e.,
wage rate) for labor to determine the budgeted direct labor payroll. Using Sunbird's standard
wage rate of $28 per hour, the organization's direct labor budget is presented.
IV. Manufacturing Overhead Budgets
A. Manufacturing overhead (sometimes called production overhead, factory overhead, or plant
overhead) is composed of many different kinds of costs necessary for the organization's
production process.
1. In the budgeting process, manufacturing overhead is separated into variable
costs and fixed costs. This distinction is important since variable costs have a
constant cost rate per unit that results in a varying total cost based on changing
levels of production volume. Conversely, fixed costs are fixed at the total
amount, but will have a varying cost rate based on changing levels of
production volume.
2. Note that direct materials and direct labor costs are traditionally assumed to be
variable (though this may or may not be the case for particular organizations).
On the other hand, the manufacturing overhead budget is effectively managing
two different types of costs, variable costs and fixed costs.
B. In the Sunbird Boat Company example, management has identified three sources of variable manufacturing overhead costs (indirect materials, indirect labor,
and utilities). Management has also identified four sources of fixed manufacturing overhead costs (property taxes, insurance, depreciation, and supervisor's
salary). The budgeted costs for each quarter are presented in the MOH budget in the right.
C. Building the MOH budget involves two aspects. The first aspect of this budgeting process is determining MOH costs. Note that the depreciation of plant
assets is included in MOH costs. However, remember that depreciation is a non-cash expense, which is why depreciation expense needs to be deducted to
determine the budgeted MOH payments. (We'll come back to MOH payments in a later lesson on cash budgets.)
D. The second aspect is building standard cost rates in order to apply MOH costs to units produced. This is necessary in order to establish the budgeted cost of
goods sold for the pro forma income statement (which we'll cover in the next lesson). The math involved in budgeted overhead application rates is simple:
Overhead allocation rate = Budgeted annual MOH costs ÷ Budgeted annual activity volume
The standard MOH cost rates for Sunbird are computed below
1. It must, however, be understood that it is a significant challenge for
management to build these rates accurately based on the appropriate activity volume
or volumes. [You'll study this important topic in Section D, Topic 1.]
2. In our example, Sunbird is using direct labor hours as the activity basis to
allocate overhead costs. If it turns out that direct labor hours are not the right cost
driver for these overhead costs, the MOH budget is not going to be accurate for
planning, controlling, and evaluation purposes.
V. The Budgeted Standard Cost Sheet
A. With the production cost budgets completed and standard cost rates established, the
standard cost sheet can be developed. This cost sheet is necessary for the pro forma
income statement (i.e., budgeting operating statement). It is also a valuable management
tool for building cost variances in order to control and evaluate performance in the
organization. [You'll study this important topic in Section C, Topic 1.]
B. The Sunbird Boat Company standard cost sheet is provided below. Note that this cost
sheet stipulates the standard input quantity and standard input price of each production
cost for a single boat product.
C. This standard cost sheet carries forward into the pro forma income statement, which we
will study in the next lesson.
Summary
• Once the production budget has been built, the budgets for all the production costs can commence.
• Traditionally, there are three basic production cost budgets: direct materials, direct labor, and manufacturing overhead.
• Remember that the direct materials budget will need to be adjusted based on the organization's inventory management policies.
• On the other hand, the direct labor budget simply combines the standard input quantities and standard input prices to compute the labor costs that need to
be scheduled for production.
• The manufacturing overhead (MOH) budget should be separated into its variable cost and fixed cost components.
• Once the MOH budget has been built, it can be used to establish the standard MOH costs per unit of output, which are needed to build budgeted costs of
goods sold.
