Budget | Definition, Explanation, and Classification With Examples
Definition of a Budget
According to J. Fred Meston, “a budget is the expression of a firm’s plan in financial form for a period of time in the future.”
According to J.L. Brown and L.R. Howard, “a budget is a predetermined statement of management policy during a given period which provides a standard comparison with the result actually achieved.”
George R. Terry defines a budget as “an estimate of future needs arranged according to an orderly basis, covering some or all the activities of an enterprise for a definite period of time.”
The Institute of Cost and Management Accountants defines a budget as “a financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.”
Explanation of a Budget
The three principal functions of management comprise planning, operating, and control. Planning refers to the future, operating to the present, and control to the past.
Two techniques, namely, budgetary control and standard costing systems, assist planning and control.
A budgetary control system tends to operate with a system of standard costing since both systems are interrelated. However, the two systems are not interdependent.
The term “budget” derives from the French word “bougette”: a leather bag from which the Minister of the Government would take out his proposals regarding governmental expenditure and revenue during the coming financial period.
Nowadays, the term also encompasses domestic, business, and institutional affairs.
Features of a Budget
1. A budget is a plan. A budget expresses an enterprise’s operations affected by external and internal factors. External factors include business conditions, government policy, and population size; internal factors include manufacturing processes and corporate governance.
2. It is comprehensive. A budget covers all activities and operations of an organization. Each segment or division has a budget integrated into a master budget.
3. It provides for a coordinated plan. Budgets consider the conditions and problems of each segment and are prepared in harmony with one another.
4. It is readied in advance. A budget is prepared in advance and denotes the future course of action.
5. It relates to a specific future period. A budget relates to a specified period. Thus, the budgeted output, sales, and profits aim to meet a predetermined time framework.
6. A budget includes operations and resources. Such operations are expressed in terms of revenues and expenses. Resources refer to the various assets and the sources of capital available to finance these operations.
7. A budget is expressed in financial and/or quantitative terms. A business concern’s activities and operations are expressible in different units.
For instance, the material budget is expressed in terms of weight, the labor budget in terms of labor hours, and the sales budget in terms of sales territories. All budgets have to include a comparable unit of measurement.
8. A budget provides a yardstick for the comparison of actual performance. This comparison exercises effective control over the business operations since it helps fix the responsibility for variances between actual and budgeted performance.
Classification of Budgets
Budgets may be classified on the basis of:
(A) Functions involved
(B) Conditions (on which these are based)
(D) Activity levels
(A) Classification of Budgets on the Basis of Functions
Budgets may be split according to their function:
(i) Functional budgets and (ii) a master budget.
A functional budget relates to any of the functions of an undertaking, e.g., sales, production, finance, purchases, and administration.
In a manufacturing concern, the following detailed functional budgets are prepared:
(1) Sales Budget
Forecasts sales during a given period, both in quantity and value. Tricky to prepare due to the difficulties estimating consumer’s demand. The responsibility for this budget’s preparation lies with the sales manager.
This budget is classified under numerous headings: product or product group, territories, areas, countries, type of customer, export, customers, salesman, period, and more
The specimen of a Sales Budget has been given below:
C. Bros sells two products manufactured in one plant. During the year 2019-20 it planned to sell the following quantities of each product:
These products are sold on a seasonal basis. Product 1 tends to sell better in the summer, while product 2 sells better during the winter.
C. Bros. plans to sell product 1 throughout the year at $10 a unit and product 2 at $20 a unit.
A study of previous experiences reveals that C. Bros. has lost approximately 3% of its billed revenue each year because of returns (constituting a 2% revenue loss), allowances, and bad debts (1% loss).
Prepare a budget incorporating the given information.
(2) Selling and Distribution Cost Budget
This budget shows the cost of selling and distributing the quantities shown in the sales budget. The primary factors affecting the budget include the sales channels, the sales promotion plan, the sales territories, and the dispatch of products.
The sales manager, with the aid of the distribution manager, advertising manager, sales office manager, and accountant, draws up the budget. Compiling this budget involves grouping the expenses according to the elements: direct selling expenses, sales office expenses, distribution expenses, and advertising expenses.
The following table shows the selling and distribution expenses of X Ltd., incurred during the year ended on 31 March, 2019:
The following additional information applies for the following year:
1. Management decided to participate in ‘The International Trade Fair’ in February 2020. Estimates suggest an expenditure of $40,000: the head office will meet this connection.
2. Four additional salesmen will be appointed next year to increase sales in north division 4. They will each receive $300 per month.
3. Management also decided to promote sales in the south through an independent sales division. This will increase the expenditure as follows:
- Salesman salaries: $5,000
- Travelling expenses: $2,000
- Sales depot and showroom expenses: $5,000
- Advertisement: $10,000
- Misc. expenses: $7,000
- Sales managers salaries: $9,000
4. Extensive advertisement programs will be adopted for which the head office will spend $20,000.
5. The commission will be given @ 5% on sales.
6. There will be an expenditure for credit collection @ 1% on sales.
7. Customers will receive a discount and rebate @ 10% on sales. Other expenses will remain unchanged.
8. Estimated sales for the next year will be as follows:
- West: $5,00,000
- East: $8,00,000
- North: $6,00,000
- South: $3,00,000
Prepare the selling and distribution cost budget for the year ending 31 March 2020 from the above details.
(3) Production Budget
A production budget estimates the number of goods requiring production during the budget period. The production manager prepares the budget given the following factors:
- Estimated sales
- Expected opening stock and desired closing stock of each article
- Available physical resources of plant, power, factory space, materials, and machines
- The management policy regarding the manufacture or purchase of components
The production budget may be classified under the following heads:
- Manufacturing departments
- Months, quarters, and so on
Prepare a production budget from the following particulars for the year ended 31 March 2019:
(4) Production Cost Budget
This budget, also known as the factory cost budget, shows the cost of carrying out the production plan given in the production budget. The production cost includes the direct materials cost, direct labor cost, direct expenses, and factory overheads.
The production cost budget is generally classified under the following headings:
- Manufacturing departments
- Months, quarters, and so on
- Elements of costs
Your company manufactures products A and B. A forecast of the number of the units to be sold in the first seven months of the year is given below:
According to estimations:
- No work-in-progress will take place at the end of any month
- Finished units equal to half the sales for the next month will be in stock at the end of each month (including the previous December)
Budgeted production and production costs for the whole year are as follows:
Prepare for the six-month period ending 30 June, a production budget for each month, and a summarised production cost budget.
(5) Purchases Budget
The purchases budget represents the total purchases during the budget period. These purchases comprise direct and indirect materials, fixed assets, services, finished goods for resale, and, most importantly, raw materials.
Remember to express the prospective purchases in terms of quantities as well as money.
This budget’s preparation reflects sales, production costs, capital expenditure, research, and development cost budgets. Purchase budget facilitates the management of finances by defining the cash requirements during the budget period and enables the purchases department to plan its acquisitions.
The sales director of a manufacturing company reports that next year he expects to sell 54,000 units of a product.
The production manager consults the storekeeper and finds that manufacturing the product requires two raw materials: A and B. Each unit of the product requires two units of A and three units of B.
The estimated opening balances at the commencement of the next year are:
- Finished product: 10,000 units
A: 12,000 units
B: 15,000 units
The desirable closing balances at the end of the next year are:
- Finished product: 14,000 units
A: 13,000 units
B: 16,000 units
Draw up a quantitative chart showing the material purchase budget for the next year.
(6) Labor Cost Budget
The labor cost budget represents the number and grades of personnel, working hours or other appropriate units, and labor required to carry out the program laid down in the sales, production, capital expenditure, and research and development expenditure budgets.
Thus, this budget forecasts planned outlay on direct and indirect labor during the budget period.
(7) Plant Utilization Budget
The plant utilization budget forecasts the plant and machinery requirements to meet the production budget. This budget, expressed in terms of working hours or other convenient units, indicates the machine load on each manufacturing department, machine, or group of machines and the extent of over- or underloading so that the management may take corrective action.
(8) Administration Cost Budget
This budget forecasts the general administration costs of an undertaking during the budget period. The general administration costs include formulating the policy, directing the organization, and controlling operations.
Many administration cost items are fixed, but a clear distinction is required between ‘fixed’ and ‘variable’ items.
(9) Capital Expenditure Budget
This budget details the anticipated expenditure on fixed assets during the budget period, e.g., plant and machinery, land, buildings, and patents. This long-term budget provides for the acquisition of assets replacing existing assets, additions to the existing assets, or installing improved machinery to take the advantage of new production techniques.
(10) Research and Development Cost Budget
A planned outlay on research and development activities. This budget expresses the permissible limits of research and development activities and the directions for the same.
(11) Cash Budget
The cash budget forecasts cash positions and represents the cash receipts and payments and the estimated cash balance each month of the budget period.
This budget acts as the nerve center of the budgetary control system since the most carefully prepared budgets are incapable of fulfillment if adequate cash is not available at the proper time.
- Ensures the availability of sufficient cash
- Reveals any expected shortage of cash to enable arrangement of money in time through bank overdrafts or loans
- Reveals any expected surplus of cash available for investment outside the business
This budget is prepared after all the functional budgets have been drawn up.
The preparation of a cash budget can involve the receipts and payments method, the adjusted profit and loss method, and the balance sheet method.
Many business concerns use the receipts and payments method, which prepares the cash budget like a summarised cash book. All types of cash receipts or cash inflows are to be estimated logically period-wise, keeping in view the past figures, existing trends, and expected changes in the future.
Similarly, all cash payments or cash outflows are estimated period-wise. A comparison of total estimated cash receipts and total estimated cash payments then takes place to ascertain the excess or shortage of cash.
In case of expected shortage or shortfall, arrangements shall be planned to raise funds utilizing short-term loans, bank overdrafts, and so on.
Estimate the cash requirement of Meerut Fruit Co. Ltd. for June 2019 on the basis of data given:
- February 2019: $25,000
- March 2019: $20,000
- April to June 2019: $30,000 per month
Half the sales are for cash. Additionally, 90% of credit sales are collected in the month following the month of sale and the balance one month later.
(ii) Fruits are always bought with cash to avail of a cash discount of 5%. The purchase budget for the second quarter (April to June) was 15,000 baskets per month at $1 per basket.
(iii) Wages and salaries for the second quarter were budgeted at $5,000 per month.
(iv) Manufacturing and other expenses for the quarter were:
- Cash expenses: $4,500
- Depreciation: $7,500
- Selling expenses: $3,000
- Administrative expenses $2,000 (equally in April and May only)
(i) Since the question has not provided the opening cash balance for April, it has been assumed to be nil.
(ii) The closing cash balance of a month becomes the opening balance of the following month.
(iii) Cash collections from debtors have been calculated as follows:
A master budget summarises all the functional budgets. It is defined as the summary budget. Upon the master budget’s completion, the budget committee considers its details, and if approved, it will be submitted to the Board of Directors.
However, upon approval, the budget becomes the target for the organization during the budget period.
The master budget tends to take the form of a budgeted profit and loss statement. It begins with the sales budget figures, from which the production cost budget figures and overheads are deducted to calculate the budgeted profit figure.
Calculate and present the budget for the next year from the following information:
Administration, selling and distribution expenses are $14,000 per year.
(B) Classification on the Basis of Conditions
According to conditions, budgets may be divided into:
- Basic budgets
- Current budgets
The basic budget is established for unaltered use over a long period, while the current budget is established for use over a short period and is related to current conditions.
(C) Classification on the Basis of Period
Budgets may be divided into:
- Short-term budgets
- Long-term budgets
A short-term budget is prepared for one year or less. Such budgets cover expenses or activities with trends that are difficult to forecast over longer periods. Examples include the cash budget and the materials budget.
A long-term budget covers a period longer than a year and helps business forecasting and future planning. Examples include the capital expenditure budget and the research and development expenditure budget.
(D) Classification on the Basis of Activity Levels
Based on activity levels or capacity, the budgets may be classified as:
- Fixed budgets
- Flexible budgets
The institute of cost and management accountants has defined a fixed budget as “a budget which is designed to remain unchanged irrespective of the level of activity actually attained.”
Fixed budgets operate an inflexible or rigid plan with one set of conditions, one volume of output, and a simple collection of costs.
Flexible budgets can change according to the level of activity and operating conditions.
The compilation of flexible budgets requires classifying all costs or expenses into fixed, variable, and semi-variable.