The next step in the master budget process is to determine its cost of goods sold budget. The cost of goods sold (COGS) is a manufacturing expenses that a company incurs when finished inventory is sold.
To prepare the cost of goods sold budget, an accountant follows these steps:
1. Enter the beginning work in process inventory balance (from the beginning balance sheet).
2. Add the budgeted direct materials, budgeted direct labor, and budgeted manufacturing overhead used in production.
3. Subtract the budgeted ending work in process inventory balance to determine the budgeted cost of goods manufactured (COGM).
4. Add the beginning finished goods inventory balance (from the beginning balance sheet).5. Subtract the budgeted ending finished goods inventory balance.
Cost of Goods Sold Budget Steps
To complete the cost of goods sold (COGS) budget, budgeted ending inventory is needed. Heavenly Sleep Systems has chosen to maintain a stable ending inventory of 1,000 units. Another option some companies use is to maintain ending inventory equal to a percentage of the following month's sales. This helps reduce the amount of cash tied up in inventory and helps decrease inventory carrying costs.
Heavenly Sleep Systems uses information from its previous budgets to create its cost of goods sold budget. For Quarter 1, budgeted production is 11,500 units. The cost of cotton per unit is $5. The cost of labor per unit is $10. Management would multiply the number of units produced times the cost per unit to arrive at the total cost of cotton and the total cost for direct labor. The overhead for Quarter 1 is $574,250. To find the total cost of goods manufactured in Quarter 1, management would add the total cost of cotton $57,500, total cost of direct labor $115,000, and total manufacturing overhead $574,250.
Next, the change in inventory levels must be accounted for in order to arrive at cost of goods sold. What management just calculated was cost of goods manufactured. However, the number of units manufactured does not always equal the number of units sold.
The budgeted number of units in beginning and ending inventory is multiplied by the cost per unit to find the total value of beginning and ending inventory. The cost per unit is calculated by dividing the total cost of goods manufactured by the number of units manufactured . There are a variety of ways to track the value of inventory. For simplicity, Heavenly Sleep Systems has used the total cost of manufacturing for the entire year and divided by the total number of production units for the year to arrive at $65.72.
Finally, cost of goods sold is calculated by adding the value of beginning inventory and subtracting the value of ending inventory from the cost of goods manufactured.
|Heavenly Sleep Systems
Cost of Goods Sold Budget
For Year Ended December 31, 2019
|Quarter 1||Quarter 2||Quarter 3||Quarter 4|
|Total Cost of Cotton|
|Direct Labor Budget|
|Total Manufacturing Overhead|
|= Budgeted Cost of Goods Manufactured|
|= Budgeted Cost of Goods Sold|
After the COGS is determined, an accountant can calculate gross profit. An accountant figures out this preliminary profit number on the income statement by taking total net sales revenues and subtracting the cost of goods sold. The gross profit amount helps managers figure out production efficiency and estimate the overall profitability of a company.
After gross profit is determined, an accountant can layer in other items of the pro forma income statement, such as selling and administrative expenses, operating profit, and interest income and expense. This leads to the calculation of pro forma pretax income.
After this, the accountant estimates income taxes and subtracts them from pretax income. The result is the net income, or "bottom line," of the pro forma income statement.
Now that the operating budget is complete, the financial budget is created to finalize the master budget.