Operating Budgets

Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD

The four operating budgets answer one overarching question: what resources will a company need for the year? Each budget builds on the one before it, in a fixed order — sales, then production, then direct materials, then direct labor.

What is the sales budget?

The sales budget comes first, since everything downstream depends on how much the company expects to sell. Say a company expects to sell 200 airplanes at $1 million each:

Sales Budget = 200 airplanes × $1,000,000 = $200,000,000

What is the production budget?

Expecting to sell 200 airplanes doesn't mean the company needs to manufacture 200 — inventory levels matter. Say the company already has 50 airplanes in inventory, and needs to end the year with 25 in inventory as a required buffer:

Production Budget = 200 (sales) − 50 (beginning inventory) + 25 (required ending inventory) = 175 airplanes

What is the direct materials budget?

Once the company knows it needs to produce 175 airplanes, it can figure out how much raw material that requires. Say each airplane needs 1,000 pounds of aluminum:

175 airplanes × 1,000 lbs = 175,000 lbs of aluminum needed for production

That doesn't mean the company has to buy all 175,000 pounds, though — it already has some on hand. Say it starts the year with 50,000 pounds in inventory, and needs to end the year with 20,000 pounds as a required buffer:

Direct Materials to Purchase = 175,000 − 50,000 + 20,000 = 145,000 lbs

At $5 per pound:

Direct Materials Budget = 145,000 lbs × $5 = $725,000

What is the direct labor budget?

Unlike materials, there's no inventory to adjust for with labor — it's a straight calculation. Say each of the 175 airplanes takes 1,000 labor hours, at $20 per hour:

Direct Labor Budget = 175 × 1,000 × $20 = $3,500,000

Each operating budget adjusts for what the company already has on hand. Production adjusts sales for finished-goods inventory; materials purchases adjust production needs for raw-materials inventory. Only labor skips that adjustment, since you can't stockpile labor hours in advance.

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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.