Direct Materials purchase budget

Needles and Crosson (2013) describe direct materials as goods needed to manufacture directly and or indirectly the finished products that will ultimately be sold. For example, for a wood furniture manufacturing business, one of the direct materials is likely to be wood.

Drury (2015) recommends that figures included in the materials purchases budget should be variable costs only, such as raw materials components and packaging items that enter the work-in-process cycle to produce the final product.

38 As illustrated by Zimmerman (2014), the basic input required for SMEs to develop the direct materials purchase budget is the number of units to be produced according to the production budget. Thereafter, the number of units of materials required to manufacture each unit of finished goods is determined and brought into the budget. The required materials per unit are multiplied by the number of finished goods to be produced in order to derive the total units of materials required.

The SME owner/manager must make a decision as to the required levels of inventories of raw materials to be maintained (Bruwer et al., 2015). The required amounts of raw materials to be purchased will then be calculated.

Thereafter, the SME owner/manager must determine the planned unit purchase price for each unit of the materials. Jindrichovska (2013) explains that because the direct materials purchase budget is a complete bill of materials, small business managers should take into consideration the vendors’ or suppliers’ market price, increase in prices owing to inflation and effects of exchange rates on the price. Determining the planned purchase price involves selecting appropriate sources and suppliers (Xesha, Iwu &

Slabbert, 2014) and enhancing good business relationships with them, taking into consideration other environmental factors.

3.5.3.1 The importance of carrying sufficient raw materials

As the definition provides, manufacturing is the process of converting raw materials into finished products through the use of manpower machines and tools (Matsoso & Benedict, 2015). It is imperative for SMEs in the manufacturing industry to budget for and carry the right amount of raw materials (Olosola & Oluwaseun, 2014). Over-stocking of raw materials may lead to liquidity problems, while under-stocking may lead to loss of sales, as explained in Section 3.5.2 above.

Under stocking

Under-stocking occurs when the SMEs experience stock outs and sales are lost because the production process breaks down owing to unavailability of raw materials. This would mean that products are not available when asked for by a customer. As a result the SME loses income from potential sales. Even more damaging will be the perception of insecurity created in the minds of

39 both existing customers and potential customers. It is of vital importance for SME owners/managers to ensure at all times that both over-stocking and under stocking of raw materials occurs as seldom.

Equally, whenever the production process is halts because a required material or supplementary material is unavailable, there is loss of production time.

Such a loss of production time has negative effects, such as employee idle time, equipment and machinery laying idle and late delivery of products to the customer; which are costly to the small business (Drury, 2015; Hansen &

Mowen, 2016).

Stock-outs, as opined by Groover (2010), create crises as the required raw materials have to be urgently sourced to ensure that production continues. In this case owners/managers will be focusing on fire-fighting instead of on other more productive activities. Owing to the urgency, raw materials sourced during stock-outs are often purchased at a higher price per unit than budgeted.

Over stocking

Over stocking of raw materials would expose the SME to higher stock-keeping costs in terms of rent of storage space. Conradie and Fourie (2002) and Aulet, (2013) outline financing costs and opportunity costs as additional costs associated with over stocking of raw materials. The financing costs could be interest charged by a bank on the bank loan if the SME acquired the raw materials using borrowed funds. The opportunity costs could be the difference between the lower cash price and the higher credit price if the SME bought the raw materials on credit. Bruwer et al, (2014) observed that often SMEs may experience shortage of cash or additional capital because of over stocking and the cash is tied up in stock.

Bruwer (2010) found out that by using the raw materials purchases budget SMEs will be proactive in finding the most economical sources for materials, and avoiding costly, rushed, last-minute purchase decisions. This means that, without using a direct materials purchase budget, SMEs are likely to plan for excessively high or low cash requirements to fund material purchases. Agyei- Mensah (2011) and Berry (2011) affirm the latter when stating that by using the direct materials purchase budget, SMEs can minimise the negative effects

40 of raw materials price increases by anticipating the increases and planning for them, additional costs being incurred to source stock at short notice in order to meet demand. Groover (2010) advocates that optimum stock-keeping levels of raw materials will minimise the storage and other stock-keeping costs.