02_part 2 - budget preparation

(PART 2) - BUDGET PREPARATION (Manufacturing Organisation) INTRODUCTION

• With manufacturing industries raw materials are purchased and converted into a finished product ready for sale by employing labour and incurring other production costs

• When budgeting for these costs we need to consider certain aspects. These are as follows:

Direct Materials This is referred to as Direct materials, because it can be identifiable to the product and

varies in proportion to the number of products produced e.g. one product uses 2 metres of steel, therefore if we would use 6 metres to produce 3 of the product

Things we need to know for budget setting are:

- How many units are to be produced? This will depend on our budgeted sales and the amount of inventory we wish to have on hand.

- What quantity of raw material do we need to produce each product? - What quantity of raw materials do we need to purchase? We need to calculate what

we need to buy in so that production would not cease due too a temporary short supply. The amount we need to purchase is determined by the amount we need on hand in case of shortcomings (closing inventory) plus what we need to meet our production requirements less what we already have on hand (opening inventory)

- What is the cost of the raw materials and is there any change likely? - When will we pay for the materials purchased? This is necessary for the cash budget

as we may buy now and pay later

Direct Labour This is referred to as direct labour because it can be identified directly to the production

of a product. As with materials, it also varies in proportion to the number of products produced e.g. if it takes 1 hour to produce I product, it takes 3 hours to produce 3 of the product.

Things we need to know for budget setting are:

- How many hours it takes to make each finished product? - Total amount of hours needed to produce the required production? This will help us

determine if we need to expand or reduce our work force? - The cost of the labour required and any likely changes in pay conditions? - When wages will be paid so we can include this in our cash budget?

Other Production Costs This includes any other costs incurred in producing the product other than those included

above i.e. foreman's wages, production manager's wages, factory rent, indirect materials, etc

2 BUDGETING FOR A LARGE MANUFACTURING ORGANISATION

When budgeting for a large manufacturing organisation we need to prepare certain budgets in a particular order because the information to be included in one budget could depend on the information included or calculated in another budget

Sales Budget (units & dollars) This is the first budget prepared because it will determine what happens in other parts of

the business i.e. the amount of units we need to produce, the revenue we have to meet our expected expenditure. It will determine how many units we need to produce and what materials we may need to buy in

Information included in the sales budget is:

- The estimated quantity to be sold - The selling price/unit - The total sales value - Value Added Tax (VAT) charged (Assuming a rate of 10% on VAT for all questions)

Refer Example Fresco Ltd

Production Budget (units only) After we know what our expected sales will be, our next budget is the production budget This budget shows us the quantity to be produced each month to ensure there is

sufficient finished goods in the warehouse to cover both expected sales and the required levels of inventory

To prepare this budget, we take our budgeted sales add required closing inventory and subtract the opening inventory already on hand


Materials Budget (or Direct Materials Budget)

The direct materials budget shows the quantity and the cost of materials required to complete the units to be produced as calculated in our production budget

Before this budget can be produced the following information must be available:

- The production budget to get the number of units to be produced - The type and quantity of material necessary to produce one complete unit of finished

product - The estimated cost of each unit of direct material used and any estimated changes - The VAT paid

Refer Example Fresco Ltd Direct Labour Budget

The direct labour budget shows the direct labour hours and the cost of labour hours required to complete the units to be produced from our production budget


- The production budget to get the number of units produced - The amount of labour hours necessary to produce one complete unit of finished

product - The estimated cost of each direct labour hour used and any estimated changes

Refer Example Fresco Ltd Other Variable Costs Budget Sometimes referred to as variable factory overheads or variable indirect costs These are other variable costs budget shows all other costs that vary directly with the

volume of production other than material and direct labour. Note that costs that do not vary with production and stay constant are known as fixed costs e.g. factory rates and rent

Note that these other variable costs may vary directly with the product but are not of a significant nature or size to isolate them be e.g. nails or glue


- The production budget to get the number of units produced - The amount of other variable costs and any estimated changes to produce one

complete unit of finished product


Costs of Goods Sold Budget (COGS) This budget shows the cost of the finished goods actually sold (as distinct from items

produced) Before this budget can be produced the following information must be available:

- The sales budget to get the number of units sold - The cost of producing a unit sold


Budgeted Profit & Loss Statement (or income & expense statement) The Profit & Loss Statement shows the total sales, the cost of goods sold, gross profit,

other running expenses of the business and the net profit made for the period Before this budget can be produced the following information must be available:

- The sales budget to get the dollar value of sales revenue - The cost of goods sold budget - Budgeted selling and administration costs for the period

Refer Example Fresco Ltd Schedule of Collections from Debtors This budget shows when the business collects its money from the people to whom it sells

goods i.e. its debtors Not all customers pay cash when they buy the goods i.e. the sale may have taken place in

May, but the customer does not pay until June This schedule is required so we can prepare our cash budget (refer following budget) Before this budget can be produced the following information must be available:

- The sales budget to get the dollar value of sales - The profile on how the customers pay for their accounts - VAT collected

Refer Example Fresco Ltd Cash Budget The cash budget shows:

- A detail summary of the cash received for each month (from the schedule of

collections) - A detailed summary of the expected cash payments for each month - Any surplus or deficit in cash for the each month - The estimated closing cash/overdraft bank balance for each month. This gives us

fair warning if we have to borrow to meet future commitments or have surplus to invest. This way we can seek out the best alternatives


- The schedule of collections - Details of payments made

- The offset of any VAT paid to supplies against that collected from debtors - The balance of our bank account at the beginning of the period


CLASS EXAMPLE – FRESCO Fresco Ltd manufactures a product called Tables out of steel. The products are sold to retailers throughout the country. The budget for the next three months is being prepared from the following information received from the various section managers:

• SALES FORECAST The sales manager has forecast sales for the 3 months as follows:

July 8,000 Tables August 10,000 Tables September 12,000 Tables The product will sell for $800 per unit The company plans to have 40% of next month’s sales in closing stock at the end of the

previous month. Closing stock at the end of September is expected to be 6,000 Tables.

Opening July stocks will be 7,000 Tables.

• COLLECTION FROM DEBTORS All sales are made on credit and according to the credit manager, the money is expected to be collected as follows:

20% in the month of Sale 60% in the month following sale 20% in the second month following sale Amounts to be collected in July and August in respect of previous months’ sales are

$2,000,000 and $600,000 respectively.

• PRODUCTION, MATERIALS, DIRECT LABOUR AND OTHER VARIABLE COSTS The Production manager and Accounts Payable Manager provide you with the following

details:

- Each Table requires 20 square meters of steel @ $16 per square metre - Direct labour costs $30/hour and 5 hours are needed to produce one Table - Other variable costs are expected to be $80 per Table - Fixed manufacturing costs are $26 000 per month but are charged into production at

$50 per Table. - Fixed selling and administration costs are $80 000 per month.

- All expenses, apart from labour, are paid for at the end of the month after the month of purchase. Labour is paid in the month it is incurred. Amounts paid in July in respect of costs (excluding VAT) from the previous quarter are:

Materials $100,000 Other variable costs $190,000 Fixed manufacturing costs $26,000 Fixed selling and administration costs $40,000

• CASH BUDGET

- The balance of VAT collected and paid for in a particular month is forwarded to, or refunded by, the tax department in the following month. The balance of VAT owing from June is $300,000

- The opening July bank balance is expected to be $120,000 overdrawn.

You are required to prepare the master budget for the three months ending September i.e.

• Sales Budget • Cost of goods sold budget • Production budget • Schedule of collection from debtors • Materials budget • Cash budget • Direct labour budget • Profit & loss Statement for the quarter • Other variable costs Materials

budget

Activities Activity 1 XYZ Ltd produces dining tables out of wood. Prepare a budget for the 3 months from April to June. The sales manager has forecast sales for the 3 months as follows: April 1 500 Tables May 1 650 Tables June 1 800 Tables - Each Table will sell for $150 - The manager plans to have 50% of next month’s sales in closing stock at the end of the previous

month. Opening April stocks will be 800 tables and closing stocks at the end of June are expected to be 1000 tables.

- All sales are made on credit and the money is expected to be collected in the following manner Month of Sale 40% Month following sale 40% Second month following sale 20% - Amounts to be collected in April and May in respect of previous sales are $180,000 and $70,000

respectively. - Each table requires 10 pieces of wood at $5 per piece. - Direct labour costs $20/hour and 1 hour is required to produce 1 table. - Other variable costs are expected to be $10 per table - Fixed manufacturing costs are $8 500 per month but are charged into production at $5 per

table. - Fixed selling and administration costs are $50 000 per month. - All expenses, apart from labour, are paid for at the end of the month after the month of

purchase. Amounts paid in April in relation to March are: Materials $95 000 Other variable costs $21 000 Fixed manufacturing costs $8 500 Fixed selling and administration costs $50 000 - The balance of VAT collected and paid for in a particular month is forwarded to, or refunded by,

the tax department in the following month. The balance of VAT owing from March is $9 000 - The opening April bank balance is expected to be $120 000 overdrawn.

Activity 2 ABC Ltd produces fine glass lamp bases. Prepare a budget for the 3 months from April to June. The sales manager has forecast sales for the 3 months as follows: April 500 bases May 400 bases June 450 bases - Each base will sell for $3 000 - The manager plans to have 45% of next month’s sales in closing stock at the end of the previous

month. Opening April stocks will be 170 bases and closing stocks at the end of June are expected to be 210 bases.

- All sales are made on credit and the money is expected to be collected in the following manner Month of Sale 30% Month following sale 60% Second month following sale 10% - Amounts to be collected in April and May in respect of previous sales are $1,100,000 and

$200,000 respectively. - Each base requires 30 units of glass at $30 per unit. - Direct labour costs $20/hour and 40 hours are required to produce 1 base. - Other variable costs are expected to be $300 per base. - Fixed manufacturing costs are $45 000 per month but are charged into production at $100 per

base. - Fixed selling and administration costs are $500 000 per month. - All expenses, apart from labour, are paid for at the end of the month after the month of

purchase. Amounts paid in April in relation to March are: Materials $600 000 Other variable costs $170 000 Fixed manufacturing costs $45 000 Fixed selling and administration costs $500 000 - The balance of VAT collected and paid for in a particular month is forwarded to, or refunded by,

the tax department in the following month. The balance of VAT owing from March is $23 000 - The opening April bank balance is expected to be $380 000 in funds.

Activity 3 KLM Ltd produces wooden cubes. Prepare a budget for the 3 months from April to June. The sales manager has forecast sales for the 3 months as follows: April 5 000 cubes May 7 500 cubes June 6 500 cubes - Each cube will sell for $50 - The manager plans to have 55% of next month’s sales in closing stock at the end of the previous

month. Opening April stocks will be 3 000 cubes and closing stocks at the end of June are expected to be 3 700 cubes.

- All sales are made on credit and the money is expected to be collected in the following manner Month of Sale 20% Month following sale 60% Second month following sale 20% - Amounts to be collected in April and May in respect of previous sales are $270,000 and $25,000

respectively. - Each cube requires 5 pieces of wood at $3 per piece. - Direct labour costs $20/hour and .5 of an hour is required to produce 1 cube. - Other variable costs are expected to be $5 per cube. - Fixed manufacturing costs are $14 000 per month but are charged into production at $2 per

cube. - Fixed selling and administration costs are $125 000 per month. - All expenses, apart from labour, are paid for at the end of the month after the month of

purchase. Amounts paid in April in relation to March are: Materials $100 000 Other variable costs $32 000 Fixed manufacturing costs $14 000 Fixed selling and administration costs $125 000 - The balance of Value Added Tax (VAT) collected and paid for in a particular month is forwarded

to, or refunded by, the tax department in the following month. The balance of VAT owing from March is $4 000

- The opening April bank balance is expected to be $50 000 in funds.

02_part 2 - budget preparation

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