Business — Banking — Management — Marketing & Sales

Direct material budget

Category: Budgeting Methodology

The objective of the direct material budget is to determine what direct material costs need to be incurred by the company when realizing the planned production programme. The purpose is twofold: The budgeted material cost number on the one hand permits generation of the forecast income statement. The prepared material planning data, on the other hand allows measurement of the efficiency of purchasing and of the material utilization. The latter depends on the planning detail which is applied and conserved in the budget. If the basic material costs are budgeted by adding to the previous year global numbers a certain percentage – e.g. raw material +5%, purchased parts +10%, consumables +2% — the use which can be made of this budget during the year is close to zero. The only information which can be drawn from the comparison of such a budget with the actual material consumption is the fact that the actual consumption is lower/higher than the percentages estimated.

To be useful, the material budget has to be established in some detail using material consumption standards denominated in quantities (i.e. so much g, kg, m, items etc. are needed to manufacture a certain quantity of product). These material consumption standards should be engineered and be realistic (i.e. reflect attainable performance under efficient operating conditions). The quantities so obtained are then multiplied by the purchase prices which the company, realistically, can expect to obtain on the market.

A material budget which is built up in this way lists, by month, the main materials, by item, the quantities needed and the purchase prices which the company wants to achieve to purchase them. The advantages which such a material budget offers to management are evident: because a material budget prepared in this way is a detailed simulation of the future purchase activity and of the future material consumption, the budget numbers can be directly used to measure during the year the performance of the purchasing function and the efficiency of manufacturing as far as material usage is concerned. The establishment of a material budget which fully covers the above mentioned two aspects – income forecasting and management controlling with regard to purchasing efficiency and material usage – however, is a relatively complex and time consuming task going beyond the immediate objective to obtain information as to the monthly balance sheet and cash flow data which prevails here. The methodology described, due to this, is not paying particular attention to the task to establish budget data for measuring the efficiency of purchasing and material utilization.

In the case of Eurotransform, all transformers are being planned as customer specific versions. The direct material lists (bills of material) compiled when working out the proposal for the customer, therefore can be used to budget the material requirements. These lists show the needed quantities and “LIFO” — purchase prices. This information, in accordance with the planned delivery dates, is collected by month, and classified in accordance with six raw material categories (2 types of copper wire, magnetic steel, oil, isolation paper, others). Direct materials are loaded with material acquisition cost which cover purchasing, incoming inspection, and the transportation to the workshop.

An further important material cost element of transformers are the purchased components, as they are often imposed by the customer. These components are planned specifically too, classified in accordance with the components type as listed below, and shown with the planned transformer type to which they belong.

In order to determine the points in time when materials, and components become due for payment during the production cycle (and, consequently, cause cash outflows), a consumption pattern has to be established. The scenario developed for this purpose links the payments for materials to the transformer size (2 classes: size II-III, and size IV-VII); to the types of raw materials, and purchased components, to the production cycle time (3 months for size II-III, 4 months for size IV-VI), and to an assumed typical payment pattern indicating at what point in time of the production cycle payments are made. The production cycle is counted backwards from the planned delivery date.

Essentially, the same methodology has been used to prepare the material budget for the tannery business. The material consumption standards are here related to the 15 planning units used for sales planning.

The following assumptions have been made with regard to raw material inventories and the cash out flows caused by material purchases:

  • material inventory at end of each month should be equal to the next month’s consumption;
  • 50% of the monthly purchases are paid in the same month, the remaining 50% in the following months.

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