Budgeting Basics: Types of Budgets and How to Prepare One
From the sales budget to the production and purchases budgets, with a fully worked example.
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Why do businesses budget?
- Planning: turning goals into numbers for sales, costs and cash.
- Coordination: making sure sales, production and purchasing plans fit together.
- Control: comparing actual results with the plan and acting on the differences. See variance analysis.
- Motivation and responsibility: giving managers clear targets.
The principal budget factor is the limit that restricts the business, most often sales demand, but sometimes materials, labour or cash. The budget process normally starts with that factor.
The main types of budgets
| Budget | What it shows |
|---|---|
| Sales budget | Expected sales units and revenue. Usually the starting point. |
| Production budget | Units to make = sales + closing inventory − opening inventory |
| Direct materials purchases budget | Materials to buy = materials needed + closing materials − opening materials |
| Labour and overhead budgets | Hours, wages and overhead costs needed for planned output |
| Cash budget | Expected cash receipts and payments, and the cash balance each month |
| Capital budget | Planned spending on long-term assets |
| Master budget | The combined plan: a budgeted income statement, budgeted balance sheet and cash budget |
Worked example: sales to purchases
A company expects to sell 5,000 units at 25 each. Opening finished goods inventory is 400 units and the company wants closing inventory of 600 units. Each unit needs 2 kg of material costing 3 per kg. Opening material inventory is 500 kg and the company wants 700 kg at the end.
1. Sales budget. 5,000 × 25 = 125,000 of revenue.
2. Production budget (units).
| Sales | 5,000 |
| Add: desired closing inventory | 600 |
| Less: opening inventory | (400) |
| Units to produce | 5,200 |
|---|
3. Materials purchases budget.
| Materials needed for production (5,200 × 2 kg) | 10,400 kg |
| Add: desired closing material inventory | 700 kg |
| Less: opening material inventory | (500 kg) |
| Materials to purchase | 10,600 kg |
|---|---|
| Cost of purchases (10,600 × 3) | 31,800 |
The same “needed + closing − opening” pattern works for both finished goods and materials. Practise it in Problem 1 and build a cash budget in Problem 2 or the cash budget template.
Fixed budgets and flexed budgets
A fixed budget is set for one level of activity. If actual activity differs, comparing actual results with a fixed budget is unfair, because variable costs naturally rise with volume. A flexed budget restates the budget for the actual level of activity, so you compare like with like. The flexed-budget method is worked through in Problem 3.
Budgeting methods
| Method | How it works | Main drawback |
|---|---|---|
| Incremental | Start from last year’s figures and add or subtract a percentage | Can carry forward waste and old habits |
| Zero-based | Every item must be justified from zero each period | Time-consuming |
| Rolling | Update the budget regularly, adding a new period as one ends | Needs ongoing effort |
Participation: budgets work best when the managers who must achieve them help to set them. Be aware of budgetary slack, where managers pad costs or understate sales to make targets easier.
Common mistakes
- Forgetting inventory changes. Production is not equal to sales unless opening and closing inventory are equal.
- Confusing profit and cash. A cash budget shows cash timing, so a credit sale appears when the cash is collected, and a purchase of equipment appears even though it is not an expense.
- Setting the budget and forgetting it. Budgets should be compared with actual results regularly.
Quick check
1. Sales are 8,000 units, opening inventory is 1,000 and desired closing inventory is 1,500. How many units must be produced?
8,000 + 1,500 − 1,000 = 8,500 units.
2. Production needs 20,000 kg of material, opening material is 2,000 kg, desired closing material is 3,000 kg. How much should be purchased?
20,000 + 3,000 − 2,000 = 21,000 kg.
Frequently asked questions
What is the principal budget factor?
The factor that limits the business’s activity, such as sales demand, materials or labour. Other budgets are prepared around it.
What is the difference between a budget and a forecast?
A budget is a plan and target. A forecast is a prediction of what is likely to happen and is usually updated more often.
What is a master budget?
The overall plan that combines the individual budgets into a budgeted income statement, balance sheet and cash budget.
Keep learning
This lesson is for general learning. Terminology and layouts vary by syllabus and country.
