There are many different kinds of budgets businesses may rely on including a master budget, a financial budget, a cash flow budget and the direct materials purchases budget. This is a budget needed by any business that makes its own inventory.
Before we look at how to calculate and come up with one, it's important to know what a direct materials purchase budget is.
What Is a Direct Materials Purchases Budget?
A direct materials purchases budget calculates how much material is required for purchase to satisfy the production budget. This is calculated for each period of production — usually monthly or quarterly.
Because the direct materials budget can be a significant portion of all costs — both direct and indirect — you should make sure you prepare the budget carefully to ensure your company is successful. If you're careless with the preparation of your budget or if you don't calculate it properly, it can lead you to overestimate or underestimate your costs. Either mistake can lead to serious cash-flow problems.
How to Calculate the Direct Materials Purchases Budget
To calculate your direct materials purchases budget, you'll need the following information — which we'll use in a real-life example below:
- Your production level: This can be found in your production budget.
- Beginning direct materials inventory: You'll find this in the production budget of the most recent period that was completed.
- Ending direct materials inventory: This will ensure you have enough materials for the next production period.
- Direct materials that go into production.
- Cost of direct materials.
Real Life Example Background Information
Let's use the materials budget for ArtCraft Pottery — a small pottery business — as our example. We can use the following information to develop a direct materials purchases budget:
The budgeted units of pottery are to be produced in each of the following four quarters:
- Q1: 1,060
- Q2: 1,260
- Q3: 1,600
- Q4: 1,800
In the ArtCraft Pottery example, plain pottery is $3 per unit and the material used to color the pottery — here abbreviated to "color" — is $0.20 per ounce. On a per-unit basis, the factory needs one pound of clay and five ounces of color to produce the final piece.
ArtCraft Pottery's policy is to have 10% of the following quarter's production needs in ending inventory. This policy changes your material needs because this 10% ending inventory must be taken into account in the budget. The factory has 58 pounds of clay and 390 ounces of color on hand on January 1. At the end of the year, the desired ending inventory is 106 pounds of clay and 530 ounces of color.
Ending Inventory for Clay and Color for Q2 and Q3
The first step in preparing the direct materials budget is to use the information above to calculate the ending inventory of clay and color for quarters 2 and 3. The second step is to prepare the direct materials purchases budget for both clay and color.
- Ending Inventory clay, Q2 = 0.10 (1,600 units X 1 unit clay) = 160
- Ending Inventory clay, Q3 = 0.10 (1,800 units X 1 unit clay) = 190
- Ending Inventory color, Q2 = 0.10 (1,600 units X 5 ounces) = 800
- Ending Inventory color, Q3 = 0.10 (1,800 units X 5 ounces) = 900
You now have the units of each component to manufacture the pottery you need. You can see, however, if a product was more complicated and needed a lot of different raw materials, this calculation would be massive. In this simple example, we have the information to calculate the direct materials purchases budgets, which is presented below in table form.
ArtCraft Pottery Direct Material Purchases Budget*
The following table was developed from two simple accounting equations you may be familiar with:
1. Raw Materials Required for Production + Ending Inventory = Total Raw Materials Required
2. Total Raw Materials Required - Beginning Raw Materials Inventory = Raw Materials to Be Purchased
|Quarter 1||Quarter 2||Quarter 3||Quarter 4||Year|
|Units to be Produced||1,060||1,260||1,600||1,800||5,720|
|Direct Materials Per Unit||x1||x1||x1||x1||x1|
|Desired Ending Inventory||126||160||180||106||542|
|Less: Beginning Inventory||(58)||(126)||(160)||(180)||(524)|
|Direct Materials to be Purchased||1,128||1,294||1,620||1,726||5,768|
|Cost of clay||x$3||x$3||x$3||x$3||x$3|
|Total Purchase Cost of Clay||$3,384||$3,882||$4,860||$5.178||$17,304|
*Table Developed Compliments of Cornerstones of Managerial Accounting, 3rd ed.
The Bottom Line
A direct materials budget is an important budgeting tool for businesses that make their own inventory. Drafting one will help you determine how much material is required to satisfy the production budget. But you must be sure you prepare it carefully with precise calculations. Failure to do so will result in overestimating or underestimating your costs.