WRAPPING UP OPERATIONAL BUDGETING

Overview
This lesson continues the Sunbird Boat Company example from the previous two lessons. In this lesson, we build the budgeted statement of operations, which is the
foundation of the pro forma income statement. We also explore how to build a budgeted contribution margin statement. Reconciling these two statements (statement of
operations and contribution margin statement) requires working with inventory and the fixed manufacturing overhead cost rate.

Upon completion of this lesson, candidates should be able to:

• Identify the components of the cost of goods sold budget and prepare a cost of goods sold budget
• Demonstrate an understanding of contribution margin per unit and total contribution margin, identify the appropriate use of these concepts, and calculate
both unit and total contribution margin
• Identify the components of the selling and administrative expense budget
• Explain how specific components of the selling and administrative expense budget may affect the contribution margin
• Prepare an operational (operating) budget

I. The Statement of Operations and the Income Statement

A. When managers refer to the income statement in the budgeting process, they'll often describe it as the
“statement of operations” or the “operating statement.” However, this description isn't referencing the entire income
statement as stipulated by financial reporting regulation.

B. The operating statement is focused on the profit generated by the organization's primary business. It reports on
the product cost (i.e., cost of goods sold) and period costs (i.e., selling and administrative expense), but it does not
include the non-operating expenses such as interest and taxes. The operating statement and the income statement
are compared on the left side.

II. Computing COGS

A. Computing the budget for cost of goods sold can be done using the traditional income statement
formula, which is used below to depict the computation for our continuing example of budgeting
operations for the Sunbird Boat Company.

1. The traditional cost of goods sold (COGS) formula begins with direct materials purchases, which are
adjusted for beginning and ending inventory to compute the cost of direct materials used in production.
This cost is combined with direct labor and manufacturing overhead costs used in production. The total
production costs (i.e., total manufacturing costs) are adjusted for the beginning and ending inventory of
finished goods to determine the COGS computation.

B. Total production costs, finished goods inventory levels, and cost of goods sold can all be computed directly from the volumes and inventory levels for
finished goods using the total standard cost per boat. Consider the final COGS computation in the budget above. Pulling forward the standard cost sheet and
production budget from the last two lessons, we can compute all the key COGS numbers as shown below.

1. Based on a standard cost of $3,075 per boat, Sunbird management should be able to compute the budgeted cost of total production by multiplying the
production volume by the standard cost (156 × $3,075 = $479,700). The cost of beginning and ending inventory can be computed in a similar manner, which
provides all the numbers needed to compute budgeted COGS.

2. However, there is a shortcut computation available. Notice above that budgeted COGS can be computed more directly by simply multiplying the sales volume
by the standard cost (150 × $3,075 = $461,250).

3. It is important you realize that a crucial assumption is being made in putting together the budgeted COGS for Sunbird Boat Company. The crucial assumption
is that total standard costs ($3,075) are the same for the upcoming year being budgeted and for the current year of operations. This is important because
beginning inventory is coming from the current year while production volume and ending inventory is being planned for the upcoming year. As a result, sales
volume will contain boats from both years. If standard costs shift between these two operating years, then Sunbird must separately compute the effect of
beginning inventory and ending inventory. In other words, using the shortcut computation above depends on standard costs to be unchanged between the
two years.

III. Completing the Statement of Operations

A. With the budgeted amount of cost of goods sold in hand, we can return to the operating statement to compute gross margin (sales revenue – cost of goods sold).

B. Before completing the operating statement, we need to budget for selling and administrative expense. Hence, in the exhibit below we are introducing some new
numbers for our Sunbird Boat Company example.

1. Selling and administrative (S&A) expense is another form of overhead for the organization. And like manufacturing overhead, these expenses typically have
variable and fixed cost components. Sunbird Boat Company has two variable S&A expenses, which are the costs of delivering boats ($100 per boat), and the
sales commissions paid ($110 per boat). Based on budgeted sales of 150 boats, Sunbird expects to spend $31,500 for these S&A expenses.
 2. There are also fixed S&A expenses at Sunbird. These yearly fixed expenses include an executive salary ($96,000), depreciation on non-production assets
($4,400), and advertising ($5,200). Hence, regardless of the number of boats sold, Sunbird is planning to spend $105,600 for fixed S&A expenses.

3. The budgeted variable and fixed S&A expense totals to $137,100. When combined with the $461,250 in cost of goods sold, Sunbird's budgeted operating
income can be established as $31,650. Later, when Sunbird management has prepared estimates for interest expense and tax expe nse, the complete pro
forma income statement can be prepared using this budgeted operating statement.

IV. The Contribution Margin Statement

A. It is important that managers are able to budget for operating income in a manner that allows preparation of pro forma income statements based on financial
reporting requirements such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). However, an operating statement
structured according to GAAP or IFRS is not always how managers want to use their budget to manage operations.
B. For many kinds of decisions, managers need to understand the contribution margin provided by
operations. Contribution margin represents the difference between revenue and all variable costs (both
variable production costs and variable S&A expense). The exhibit below contrasts the operating
statement with the contribution margin statement.

1. The main difference between the two statements is the repositioning of costs above and below the
“margin” line. All product costs (material, labor, overhead) are positioned above the gross margin line
in the operating statement, and non-production costs (selling and administrative) are below. In
contrast, all variable costs (whether related to production or to sales and administration) are above the
contribution margin line in the contribution margin statement.

C. While building the operational budget for Sunbird Boat Company, we have been classifying production costs and S&A expenses as variable or fixed according to the
volume of sales activity. This classification allows us to build a budgeted contribution margin statement for Sunbird, as shown below.

1. The original standard cost sheet includes four separate cost calculations for direct materials, direct labor, variable overhe ad (manufacturing overhead), and
fixed overhead. The variable production costs include only the first three cost items, which total up to $2,575 per boat. When multiplied by 150 boats planned
to be sold, the budgeted variable production costs for the year are $386,250. When combined with the variable S&A expense ($31,500), total variable costs at
Sunbird are budgeted to be $417,750.

2. In the previous lesson, we identified the fixed production costs that the Sunbird management team is budgeting for the year. These four costs (property
taxes, insurance, depreciation, and the supervisor's salary) total $78,000. Combined with the fixed S&A expense ($105,600), Sunbird's total fixed costs are
budgeted to be $183,600.

D. As an alternative view of operating profit, the contribution margin statement supports a number of important management decision processes, including cost-volume-
profit analysis (i.e., break-even analysis), relevant cost analysis for operating decisions, and pricing analysis.

V. Reconciling the Operating Statement and the Contribution Margin Statement

A. With all budgeted costs classified according to their behavior (variable vs. fixed), Sunbird is budgeting its operating income to be $28,650. This operating
income from the contribution margin statement is different from budgeting operating income based on a traditional financial reporting view that separates
costs into product and period expense classifications, and computes the operating income to be $31,650. The two statements are compared below. Why is
there a $3,000 difference in operating income

B. Reconciling operating income on the operating statement with operating income on the
contribution margin statement is a function of the change in inventory and the allocated
fixed costs of production. Recall from the previous lesson that total fixed manufacturing
overhead ($78,000) was divided by total budgeted production volume (156 boats) to
establish a fixed overhead rate of $500 per boat, and was included as a cost item in
Sunbird's standard cost sheet. This cost rate will be used to allocate fixed manufacturing
overhead cost to each boat produced. If inventory is budgeted to increase at Sunbird
(which it is), then some of the fixed manufacturing overhead will not be expensed to the
traditional operating statement, but will be instead listed an increase to inventory on the
pro forma budget sheet.

C. As shown in the exhibit below, this fixed manufacturing cost per unit can be combined with the increase in inventory to explain why the operating statement
is budgeted to be $3,000 higher than the contribution margin statement.
1. Recall at the beginning of this lesson, when we were computing the shortcut for budgeted cost of goods sold, that we assumed that standard
costs per unit at Sunbird are the same for the upcoming year as for the current year. We're making the same assumption here.

2. If the standard cost per unit for fixed manufacturing overhead is different between the two years, then the reconciliation for operating income is a
little more involved. Specially, the beginning inventory would need to be multiplied by the current year's standard cost per unit, and ending
inventory multiplied by next year's standard cost per unit, to complete the reconciliation between the two statements.
Summary
• The traditional operating statement is the foundation of the pro forma income statement.
• The operating statement reports only cost of goods sold along with selling and administrative expense.
• The pro forma income statement includes other expense items not related to the organization's operation.
• When computing cost of goods sold for the operating statement, the standard cost per unit at the organization can be multiplied by the budgeted sales
volume (so long as standard costs per unit are constant between years).
• Revenue minus cost of goods sold is gross margin.
• Reducing gross margin by planned selling and administrative expense provides the budgeted operating income.
• Managers can also use a contribution margin approach to compute operating income.
• This approach entails separating all budgeted costs into variable or fixed costs, subtracting variable costs from revenue to compute contribution margin, and
then subtracting fixed costs to compute operating income.
• Reconciling income on the operating statement with income on the contribution margin statement is a function of the change in inventory multiplied by the
fixed manufacturing cost per unit