As a business owner, having a solid budgeting process is crucial to your company’s success. One of the most important budgets you need to prepare is the cost of goods sold (COGS) budget. This budget determines the direct costs associated with producing your products and is a key component of your overall operating budget.
In this comprehensive guide we will walk through the steps to prepare a COGS budget for your business.
What is a COGS Budget?
The COGS budget captures all the direct costs involved in manufacturing your products. This includes:
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Direct material costs – Raw materials and components used to produce the product.
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Direct labor costs – Wages paid to employees who work directly on production.
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Manufacturing overhead costs – Indirect production costs like utilities, equipment maintenance, etc.
The COGS budget does NOT include operating expenses like marketing, administration, etc. It isolates just the expenses directly tied to making your products.
Knowing your COGS allows you to properly value your inventory and determine an accurate gross profit margin on sales. It is a vital number for effective financial management.
Why Prepare a COGS Budget?
Here are some key reasons you need a well-prepared COGS budget:
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Accurately value inventory – COGS allows you to assign a proper dollar value to your inventory of manufactured goods.
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Determine pricing – Knowledge of your product COGS helps you intelligently set pricing to achieve target gross margins.
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Control costs – The budget provides a spending plan and helps you identify opportunities to reduce direct production costs.
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Manage production – With expected COGS, you can plan manufacturing levels and inventory needs accurately.
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Forecast profitability – COGS budgeting improves your ability to forecast gross profits based on projected sales.
How to Prepare Your COGS Budget
Follow these steps to develop a comprehensive COGS budget for your business:
1. Understand your manufacturing costs
First, you need a clear understanding of all your direct manufacturing costs.
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Direct material costs: This includes raw materials, component parts, packaging supplies, etc. used to produce the finished product. Analyze your product designs and process to identify all direct materials.
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Direct labor costs: Wages, salaries, and benefits paid to employees who directly work on production. This includes machine operators, assemblers, production supervisors, etc.
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Manufacturing overhead: Indirect production costs like plant utilities, equipment maintenance, quality control, indirect materials, etc.
Analyze how each of these costs behave – are they fixed or variable? Unit-based or time-based? Understanding cost behavior is key.
2. Identify cost drivers
For variable manufacturing costs, identify the key activity that drives the cost. Common cost drivers:
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Units produced – For direct material and labor costs.
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Machine hours – For plant utilities, maintenance.
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Direct labor hours – For production supervision.
The cost driver is essential for budgeting variable production costs accurately.
3. Determine cost rates
Next, calculate cost rates for each manufacturing cost element:
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Material costs: Cost per unit of direct materials.
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Labor costs: Hourly direct labor wage rate.
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Overhead costs: Overhead per unit, labor hour, machine hour, etc. based on cost behavior.
Historical data can provide initial estimates, but you should validate them.
4. Define production levels
You need budgeted production quantities to build your COGS budget. The main options for estimating production are:
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Sales forecast: Base your production budget on projected sales demand. This ensures you don’t over or under-produce.
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Capacity-based: Build your budget based on maximum production capacity. This approach aims to maximize output.
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Combination approach: Use projected sales to set base production level but add capacity buffer for flexibility. This balanced approach is often best.
Once you define production quantities, document planned levels by product and time period.
5. Calculate budgeted costs
With your rates and production plan in place, you can calculate budgeted COGS:
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Material costs: Multiply units to be produced by the material cost per unit
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Labor costs: Multiply planned production labor hours by the hourly labor rate
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Overhead: Apply appropriate overhead driver (e.g. units produced, labor hours) to estimate overhead costs
The total is your overall budgeted manufacturing cost for the budget period.
6. Compare to actuals
Once your budget is complete, compare it to actual results to identify variances. Investigate any significant deviations to determine the cause – this helps improve future budgeting accuracy.
7. Update the budget
Review and update your COGS budget periodically based on the latest projections. This keeps it aligned with your current operating plan.
COGS Budget Example
Let’s look at a sample COGS budget for a fictional manufacturer, Acme Furniture Company.
Acme plans to manufacture 5,000 chair units in March 20xx. Here are their budgeted manufacturing costs per unit:
- Materials: $30
- Direct labor: $20 (2 hours @ $10 per hour)
- Variable overhead: $5 per direct labor hour
- Fixed overhead: $100,000 or $20 per unit (evenly allocated)
Acme Furniture COGS Budget
| Cost Element | Total Budget |
|---|---|
| Direct material | $150,000 ($30 x 5,000 units) |
| Direct labor | $100,000 ($20 x 5,000 units) |
| Variable overhead | $50,000 (10,000 DL hrs x $5 per hr) |
| Fixed overhead | $100,000 ($100k / 5,000 units) |
| Total budgeted COGS | $400,000 |
This budget provides Acme’s management with a clear expected COGS for the month, which can now be used for financial planning and production management.
Key Takeaways
- The COGS budget is vital for quantifying the direct costs of manufacturing your products.
- Carefully identify all cost components including direct materials, direct labor, and manufacturing overhead.
- Use cost drivers like units produced or labor hours to budget variable costs accurately.
- Tie your production plan directly to projected sales demand or capacity constraints.
- Compare actual COGS regularly to the budget to improve insights over time.
- Update the budget frequently based on changing business conditions.
Accurately budgeting COGS is crucial for operational control and profitability management. Follow the steps outlined to develop a dynamic COGS budget tailored to your manufacturing process. With the budget in place, you gain key insights to manage margins and make sound decisions.
CPA explains how to stop dreading and start understanding how cost of goods sold actually works!
How to prepare cost of goods sold budget?
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.
How do you calculate cost of goods sold?
The first step on the cost of goods sold budget is to list and total the three manufacturing costs: direct materials, direct labor, and factory overhead. Their amounts are taken from their respective cost budgets and appear in the left column. Total manufacturing costs for the year is the sum of the three, entered in the middle column.
How do I prepare a budget for cogs?
Collect financial information When you prepare a budget for COGS, you want to find the amount of money you spend on each of the individual costs. Common costs for COGS include the direct cost of materials, production staff and additional materials or staff you gain during the accounting period.
Do service companies need a cost of goods sold budget?
A cost of goods sold budget would not be necessary for a service company since they do not sell a product. Management must now prepare a schedule to forecast the cost of goods sold, the next major amount in the planned operating budget.
