Introduction to operational budgets
The operating budget
As a critical component of the annual profit plan, the operating budget aligns production, labor, and resource allocations with expected sales, ensuring each department contributes effectively to overall profitability.
The operating budget is built in a sequence of steps, each producing a supporting schedule:
Notice how the pieces connect: the sales budget’s forecasted unit sales drive the production budget, the production budget’s required units drive the direct materials, direct labor, and overhead budgets, and those costs flow into the cost of goods sold budget. Sales volume also drives the selling and administrative expense budget, which adds the non-production costs. The budgeted income statement, the last schedule of the operational budget, brings all of these schedules together. In the following sections, each budget type will be explored in detail, starting with the sales budget and building toward the comprehensive operational budget.
1. Sales budget
The foundation of the operating budget, the sales budget forecasts expected sales volume and revenue, setting the target for subsequent production and cost-related budgets.
2. Production budget
Following the sales budget, the production budget determines the units required to meet sales targets, taking into account beginning inventory and desired ending inventory levels: units to produce equal budgeted unit sales plus desired ending finished goods inventory minus beginning finished goods inventory. Units to produce then drive the direct materials, direct labor, and overhead budgets.
3. Direct materials budget
This budget outlines the materials needed for production, linking production needs to material costs and inventory policies. Materials to purchase equal the materials needed for production plus desired ending materials inventory minus beginning materials inventory; the cost of materials used feeds the cost of goods sold budget, and the cost of purchases feeds the cash budget.
4. Direct labor budget
Estimating labor hours and costs required to meet production targets, this budget ensures the right workforce allocation to achieve production goals.
5. Overhead budget
The overhead budget captures all indirect costs associated with production, divided into variable and fixed components for better control and analysis.
6. Cost of goods sold (COGS) budget
Combining direct materials, direct labor, overhead and changes in finished goods inventory levels, this budget calculates the total cost of producing goods sold during the period.
7. Selling and administrative expense budget
This budget projects costs for non-production activities, including marketing, administrative salaries, and other operating expenses. Its variable portion, such as sales commissions and shipping, is driven by sales volume and reduces contribution margin; its fixed portion does not.
8. Contribution margin and operational budget
These final sections consolidate the budgets above into the budgeted income statement, the operational budget’s last schedule, which highlights anticipated profitability and guides managers in assessing the feasibility of meeting profit goals.
Contribution margin is sales minus all variable costs, including variable selling and administrative costs, so it does not come from the cost of goods sold budget alone. Sales minus cost of goods sold is gross margin, an absorption-costing figure that includes fixed manufacturing overhead and excludes all selling and administrative costs.
Example: Contribution margin vs. gross margin
Budgeted sales are $100,000, variable manufacturing costs $40,000, variable selling and administrative costs $10,000, and fixed manufacturing overhead $20,000. Every unit produced is sold. What are the budgeted contribution margin and gross margin?
Answer: Contribution margin is $100,000 − $40,000 − $10,000 = $50,000. Gross margin is $100,000 − ($40,000 + $20,000) = $40,000. The two differ because each deducts costs the other leaves out.