Preparing Functional Budgets

Once the principal budget factor is known, the real work of budgeting starts: turning a sales target into a production plan, the production plan into materials and labour needs, and the materials needs into a shopping list for the purchasing department. Each of these is a functional budget, and each is built from the one before it. Get the first wrong and every later one is wrong too.

This topic shows how to prepare the sales budget, the production budget, the materials usage and purchases budgets, the direct labour budget and the expenditure (overhead) budgets, and how they combine into a budgeted profit statement. One company runs through the whole topic, so you can see how the budgets link and where the numbers come from.

The syllabus asks for simple functional budgets with materials budgets prepared without losses, and that is the standard used here.

The order of preparation

When sales demand is the principal budget factor, the budgets follow this chain. Each needs the figure from the one above it.

A manufacturing process with several departments (for example machining, finishing and assembly) can have a separate production budget for each, which are then added to make the total.

The company used in this topic

Maiduguri Leather Ltd makes two products, Bag (B) and Wallet (W). Next year’s plans and standards are:

The sales budget

The sales budget is the plan for the volume and value of sales in the budget period. It is prepared product by product, in units and in revenue, then in total. Revenue is units × budgeted selling price.

Preparing the sales budget from this year’s sales

Often the budget starts from current sales, with adjustments. If a company expects this year’s sales to total ₦48 million, plans to raise prices by 4% and expects volume to grow by 10%, next year’s sales budget is ₦48 million × 1.04 × 1.10 = ₦54.9 million. Price and volume changes are multiplied, not added: 4% + 10% = 14% would give ₦54.7 million, which is wrong.

The production budget

The production budget is first set in units. For each product: sales budget in units + budgeted closing stock − opening stock.

The logic: if 100 units are to be sold and none are in stock, 100 must be made. If 20 can be taken from stock, only 80 need to be made. If stock is to be built up by 20, 120 must be made. Once production quantities are known, budgets can be prepared for the resources.

The materials usage budget

The materials usage budget states the quantities of direct materials needed for the production budget and their cost. It is prepared for each material separately, with a total cost. It uses the production units, not the sales units.

Total materials usage cost = ₦14,784,000 + ₦2,730,000 + ₦2,730,000 = ₦20,244,000.

The materials purchases budget

What is used in production is not the same as what must be bought. The materials purchases budget is the plan for the purchase cost of materials bought in the period, and it differs from usage by the planned change in material stocks. Quantities come first.

Purchases = usage + closing stock − opening stock, for each material. Then convert to naira at the budgeted purchase price.

Total purchases budget = ₦15,384,000 + ₦2,670,000 + ₦2,700,000 = ₦20,754,000. This is ₦510,000 more than the usage cost of ₦20,244,000 because leather stock is being built up (500 m² × ₦1,200 = ₦600,000) while fabric and zips are being run down (₦90,000 less in total: 200 m × ₦300 = ₦60,000 and 200 zips × ₦150 = ₦30,000). Net: ₦600,000 − ₦90,000 = ₦510,000. ✓

The purchases budget can be prepared for all materials, direct and indirect, or for direct materials only. Following the syllabus, the budgets here ignore losses of materials in production.

The labour usage budget

The direct labour usage budget is prepared in the same way as the materials usage budget. It states the hours of each grade of labour needed for the production budget and their cost. It is prepared separately by grade, with a total cost. Each grade’s hours are multiplied by its budgeted rate per hour.

Total direct labour budget = ₦13,125,000 + ₦7,280,000 = ₦20,405,000. The labour budget can be prepared before the materials budget, if preferred, since both depend only on the production budget. A budget of hours also shows whether the workforce can deliver the plan.

Indirect labour is budgeted too, but it is normally included in the budget of the overhead cost centre where the people work.

Overhead expenditure budgets

A budget is prepared for each production overhead cost centre, for administration and for selling and distribution. Each lists the expected costs, such as indirect labour, power, depreciation and maintenance. Variable items move with activity, and fixed items are set from commitments such as rent and salaries.

The budgeted profit statement

The functional budgets combine into a budgeted profit statement, the first part of the master budget. Cost of sales is built from opening stock, purchases and labour, less closing stock. We need the value of stocks, using the unit cost of materials and labour per product:

(To keep the illustration simple, production overhead is charged in full as an expense and not absorbed into stock values.) Check: gross profit by product = Bag: 4,000 × (₦9,000 − ₦6,050) = ₦11,800,000. Wallet: 10,000 × (₦3,000 − ₦1,555) = ₦14,450,000. Total ₦26,250,000, which agrees. ✓

Budgets by month: phasing and stock smoothing

The annual budget is divided into control periods. Sales are often seasonal, but a factory prefers to produce at an even rate, because changing output is costly. The production budget and the stock plans must then agree: stock rises in slack months and is used up in busy ones.

Example. A firm expects to sell 4,000 bags in the year, phased by quarter as 800, 1,200, 1,100 and 900. It starts the year with 300 bags in stock, wants to end with 300, and prefers to produce 1,000 bags every quarter.

Production equals sales over the year (4,000), and stock ends where it started. The lowest stock (200 in Q3) is the figure to check against the minimum safe level. If the minimum is 250, the plan must change, for example by raising Q2 production.

Checking the budgets against capacity

The resource budgets show what the plan demands. The committee compares them with what is available. In the Maiduguri budget, 8,750 skilled hours are required. If only 8,500 are available, there is a shortfall of 250 hours, about 2.9% of the requirement. Options include overtime (at a premium), hiring more skilled staff, training unskilled staff, buying in some work, or reducing the planned increase in finished stock.

The budget cannot be approved until it is feasible. This is the “feasibility” review of stage 4 of the budget process.

From the overhead budget to the absorption rate

The overhead expenditure budgets feed the absorption rates used in costing. The production overhead budget of ₦6,300,000, together with the labour hours budget of 8,750 + 9,100 = 17,850 hours, gives a budgeted absorption rate of ₦6,300,000 ÷ 17,850 = ₦352.94 per direct labour hour. A bag needing 2.5 labour hours (1.5 skilled + 1.0 unskilled) would then absorb 2.5 × ₦352.94 = ₦882 of production overhead. The budget and the costing system are therefore connected: a more accurate overhead budget gives a more accurate product cost.

Overhead budgets are also split into fixed and variable parts. Fixed items (rent, supervisors’ salaries, depreciation) do not change with activity. Variable items (power for machines, consumables) do. A flexible overhead budget can then be recalculated for the actual level of activity when results are compared with the budget in the control stage.

Where the sales budget figures come from

The sales budget is only as reliable as the estimates behind it. Typical sources are:

• Orders in hand and contracts, which give firm sales for the early months.
• Past sales, adjusted for trend and seasonal variation (using the time series methods of the previous topics).
• Market research and customer surveys, particularly for new products.
• Sales staff estimates, which are close to the market but can be biased.
• Economic factors such as inflation, exchange rates and competitors’ prices.
• Management decisions, such as a planned price change or promotion.

Because every other budget depends on the sales budget, an over-optimistic sales figure flows through to excess production, purchases and borrowing. A careful committee tests the sales budget against capacity, the economy and past accuracy.

Other items to budget

• Indirect materials such as cleaning materials and small tools are budgeted within the overhead cost centres, not in the direct materials budget.
• Machine hours budget where output depends on machines. It is built the same way as the labour budget: production × machine hours per unit.
• Capital expenditure budget for the purchase of non-current assets. It affects depreciation, cash and the statement of financial position.
• Research and development and other discretionary spending, which management may increase or cut.

The ideas in more depth

Production units, not sales units

The commonest error is to calculate materials and labour from sales units. The factory uses materials to make goods, and what it makes is the production budget. If stock is to rise, production exceeds sales, and usage must be higher than the sales units imply.

Usage versus purchases

Usage tells the factory how much material it will consume. Purchases tell the purchasing department what to order. If closing stock is higher than opening stock, purchases exceed usage. If lower, purchases are less. A simple check: purchases − usage must equal closing stock − opening stock.

Setting the stock policies

Stock levels in the budget reflect management’s policy: holding finished goods to meet demand, or materials to protect against delays. A higher closing stock raises production and purchases (and ties up cash). A lower one does the reverse. The cash budget will show the effect of these choices.

Budget for a service business

A service business has no finished goods stock and often no production budget. Its budgets are the sales budget (hours billed or customers served), the labour budget (staff hours and cost) and the overhead budgets. The same logic applies.

Using standard costs

Materials and labour quantities per unit come from standards (specifications and time studies), and prices from purchasing agreements and pay scales. Using realistic standards makes the budget more reliable, and the same standards are used later to calculate variances.

Limiting factors and the budget

If a resource is the principal budget factor, its budget is prepared first. For example, if skilled labour is limited to 8,000 hours, the production budget is set by those hours. The Maiduguri budget needs 8,750 skilled hours, so if only 8,000 are available the company must cut production, hire more staff or reduce the mix. Checking resource budgets against capacity is part of the committee’s review.

Worked example: a second company

1. Sales.
   Sandals 6,000 × ₦4,500 = ₦27,000,000.
   Slippers 9,000 × ₦1,800 = ₦16,200,000.
   Total ₦43,200,000.
2. Production.
   Sandals: 6,000 + 800 − 500 = 6,300.
   Slippers: 9,000 + 700 − 1,000 = 8,700.
3. Rubber usage.
   Sandals 6,300 × 1.2 = 7,560 kg.
   Slippers 8,700 × 0.6 = 5,220 kg.
   Total 12,780 kg × ₦250 = ₦3,195,000.
4. Strap usage.
   Sandals 6,300 × 2 = 12,600.
   Slippers 8,700 × 2 = 17,400.
   Total 30,000 × ₦80 = ₦2,400,000.
5. Purchases.
   Rubber: 12,780 + 1,200 − 1,500 = 12,480 kg × ₦250 = ₦3,120,000.
   Straps: 30,000 + 3,500 − 3,000 = 30,500 × ₦80 = ₦2,440,000.
   Total ₦5,560,000.
6. Labour.
   Sandals 6,300 × 0.8 = 5,040 hours.
   Slippers 8,700 × 0.4 = 3,480 hours.
   Total 8,520 hours × ₦900 = ₦7,668,000.
7. Check.
   Purchases (₦5,560,000) − usage (₦3,195,000 + ₦2,400,000 = ₦5,595,000) = −₦35,000.
   Stock change: rubber −300 kg × ₦250 = −₦75,000; straps +500 × ₦80 = +₦40,000; net −₦35,000. ✓

Common mistakes in the exam

• Using sales units instead of production units for materials and labour.
• Adding the opening stock and subtracting the closing stock in the production budget, which is the reverse of the correct treatment.
• Mixing up usage and purchases, or forgetting to convert quantities into naira.
• Applying the cost of the next material or labour grade to the wrong product.
• Adding percentage changes for price and volume instead of multiplying.
• Missing a grade of labour or a material from the totals.
• Forgetting that indirect labour belongs in the overhead budgets.
• Not checking that the budgets balance with the profit by product.

Quick revision

• Sales budget = units × price. Production units = sales + closing stock − opening stock.
• Materials usage = production × usage per unit × price. Materials purchases = usage + closing stock − opening stock.
• Labour budget = production × hours per unit, by grade, × rate.
• Overhead budgets by cost centre. Indirect labour goes with overhead.
• Functional budgets feed the budgeted profit statement and the master budget.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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