A business's finished goods inventory includes products that are complete and ready for sale but have not been sold. A budget for these goods can be developed after the direct materials, direct labor, and overhead budgets are developed.
Why This Is Needed
The ending finished goods inventory budget is important because it assigns a value to every unit produced based on raw materials, direct labor, and overhead. This information is used to complete the cost of goods sold budget, and both budgets are needed to complete a balance sheet.
Additionally, this information is one of the factors necessary to establish prices for goods being sold. In order to cover all costs and make a profit, it obviously is important to know how much money it costs to produce each item in a business's inventory.
Its Role in the Operating Budget
Small businesses need an operating budget, one of the two parts of the master budget, to describe the firm's revenues and expenses, which includes sales and the finished goods inventory. The other part of the master budget is the financial budget, which shows the inflows and outflows of cash and other elements of the firm's financial position. Operating budgets are prepared first as information from the operating budgets is needed for the financial budgets.
A Sample Budget
Consider a product manufactured by a small pottery business as an example. While the business may produce several products, it will attempt to break down the cost of each product. This example looks at one product.
The pottery business is manufacturing a small product that includes two materials: clay and coloring for the clay. The cost of the clay for each product is $3.00, and the cost of the coloring for each product is $0.20.
Total cost of direct materials per unit: $3.20
Each unit requires 0.12 hours of labor at $10.00 per hour.
Total cost of direct labor per unit: $1.20
The business has fixed overhead costs that amount to $9.59 per hour and variable overhead costs that amount to $5.00 per hour for a total of $14.59 per hour. Multiply this number by the 0.12 hours it takes to produce each unit.
Total cost of overhead per unit: $1.75
Those three numbers add up to $6.15 per unit. So, if you have 200 of these finished units that have not been sold, your ending finished goods inventory budget would be $1,230.00.
How Volume Impacts This Cost
The figures in the example above are impacted by volume. In terms of materials, the cost typically will be lower, by volume, the more that a business purchases. Labor also is impacted by volume. In many cases, workers can be more efficient, up to a point, when producing a larger number of items.
While this means it makes financial sense to produce as many products as possible, it's also important for businesses to balance that against realistic sales goals. Whatever savings can be had by dealing in larger volumes will not increase profits if production outpaces demand or the ability of the sales staff to sell the product.