Introduction to Operating Budgets

What you will learn to do: prepare an operating budget

A master budget consists of a projected income statement (planned operating budget) and a projected balance sheet (financial budget) showing the organization’s objectives and proposed ways of achieving them. In the diagram below, we depict a flowchart of the financial planning process that you can use as an overview of the elements in a master budget. The remainder of this section describes how a company prepares the operating budget portion of the master budget. We emphasize the operating budget because of its prime importance to financial planning and control in a business entity.

Flowchart of the Financial Planning Process is shown. From left to right connected by arrows are the following steps of the process: Sales budget (dollars), Projected cost of goods sold, Selling and administrative budget, Other expenses and taxes, Projected income statement (planned operating budget), and Projected balance sheet (financial budget).

The budgeting process starts with management’s plans and objectives for the next period. These plans take into consideration various policy decisions concerning selling price, distribution network, advertising expenditures, and environmental influences from which the company forecasts its sales for the period (in units by product or product line). Managers arrive at the sales budget in dollars by multiplying sales units times sales price per unit. They use expected production, sales volume, and inventory policy to project cost of goods sold. Next, managers project operating expenses such as selling and administrative expenses. Finally, they arrive at the bottom line: based on the planned sales and production costs, will the company make or lose money? If the result is a loss, it means going back to the drawing board, and the budgeting process starts all over again.

Thus, the starting point in preparing a master budget is the operating budget. Since the planned operating budget shows the net effect of many interrelated activities, management must prepare the supporting budgets, such as sales, production, and purchases, in a logical order before preparing the planned operating budget.

The operating budget consists of, in general:

  • Sales Budget
  • Production Budget
  • Direct Materials Budget
  • Direct Labor Budget
  • Manufacturing Overhead Budget
  • Cost of Goods Sold Budget
  • Selling, General, and Administrative Expense Budget

This chapter cannot cover all areas of budgeting in detail—entire books have been written on budgeting. However, the following video provides an overview of a budgeting procedure that many companies use.

You can view the transcript for “The Master Budget (Cost Accounting Tutorial #38)” here (opens in new window).

When you are done with this section, you will be able to:

  • Prepare a sales budget
  • Prepare a production budget
  • Prepare a direct materials budget
  • Prepare a direct labor budget
  • Prepare a manufacturing overhead budget
  • Prepare a cost of goods sold budget
  • Prepare a selling, general, and administrative expense budget
  • Prepare an operating budget for a manufacturing company
  • Prepare an operating budget for a merchandising company
  • Prepare an operating budget for a service company

Learning Activities

The learning activities for this section include the following:

  • Reading: Sales Budget
  • Self Check: Sales Budget
  • Reading: Production Budget
  • Self Check: Production Budget
  • Reading: Direct Materials Budget
  • Self Check: Direct Materials Budget
  • Reading: Direct Labor Budget
  • Self Check: Direct Labor Budget
  • Reading: Manufacturing Overhead Budget
  • Self Check: Manufacturing Overhead Budget
  • Reading: Cost of Goods Sold Budget
  • Self Check: Cost of Goods Sold Budget
  • Reading: Selling, General, and Administrative Expense Budget
  • Self Check: Selling, General, and Administrative Expense Budget
  • Reading: Operating Budget – Manufacturing
  • Self Check: Operating Budget – Manufacturing
  • Reading: Operating Budget – Merchandising
  • Self Check: Operating Budget – Merchandising
  • Reading: Operating Budget – Service
  • Self Check: Operating Budget – Service