Operating Budgets

Four Operating Budgets:

1. Sales Budget
2. Production Budget
3. Direct Materials Budget
4. Direct Labor Budget

First are the four operating budgets, which are all about what resources we will need for the year. It’s going to focus on how many units we expect to sell, how many units we expect to manufacture, how much in direct materials we’re going to need, and how much direct labor we’re going to need.

Within the operating budgets, the first budget that we have to create is the sales budget. Let’s say that we expect to sell 200 airplanes at $1 million each. Our sales budget is $200 million. After we figure out how many units we expect to sell, we need to figure out how many units we need to produce, therefore creating the production budget. Does the fact that we estimate sales of 200 airplanes mean that we need to manufacture 200 airplanes?

Well, not necessarily because of our inventory levels. Maybe we already have 50 airplanes produced in inventory, and therefore we only need to manufacture 150 more airplanes. And then maybe we have a required balance for our end-of-year inventory. Let’s say that we need to keep 25 airplanes in our end-of-year inventory.

We’re creating 150 airplanes for the current year needs, and then 25 more airplanes for our end-of-year inventory. We’re going to have to produce 175 airplanes.

Once we figure out the number of units we need to produce with the production budget, we need to figure out how much in resources we need. How much indirect materials are we going to need, and how much in direct labor are we going to need?

Therefore, now we create the direct materials budget and the direct labor budget. For example, let’s say that each airplane requires 1,000 pounds of aluminum, we’re producing 175 planes, for a total of 175,000 pounds of aluminum. Does that mean that we need to actually buy 175,000 pounds of aluminum? Not necessarily because of our beginning of -year inventory balance.

Let’s say that we already have 50,000 pounds of aluminum in our beginning-of-year raw materials balance, then we only need to buy 125,000 pounds of it. And then let’s say that we’re required to keep an end-of-year inventory balance of 20,000 pounds. Therefore, we’re going to need to buy a total of 145,000 pounds of aluminum.

And let’s say that costs $5 per pound of aluminum, we’re going to expect to pay $725,000 for our raw materials.

Now when we get to the direct labor budget, there’s no inventory that we have to worry about. We know that we need to produce 175 planes, and let’s say each plane takes 1,000 labor hours. Each labor hour costs $20. Therefore our direct labor budget is going to be $3,500,000 (175 X 1,000 X $20)