Budgeting | ICSE Class 10 Commercial Studies Notes

This note covers the meaning and utility of budgeting, the comparison between budgeting and forecasting, and the meaning of the main types of budgets: sales, production, cash, purchase and master budgets.

What is a budget and what is budgeting?

A budget is a financial plan prepared in advance for a definite future period. It sets out, in figures, what a business expects to earn, spend, produce or receive over that period. A budget is expressed in money terms or in physical units such as units of output or hours of labour.

Budgeting is the whole process of preparing, coordinating and controlling budgets. It begins with estimating future figures, continues with drawing up the budget, and ends with comparing actual results against the plan and taking corrective action.

Definition: budget. A budget is a financial plan prepared in advance for a definite future period, showing expected income, expenditure, production or receipts in figures.

Definition: budgeting. Budgeting is the process of preparing budgets for a future period, coordinating them with one another, and using them to control actual performance.

What are the main features of a budget?

Three features follow from these definitions. First, a budget is always forward looking: it deals with a period that has not yet begun. Second, it is quantitative: it is stated in numbers, not in vague intentions. Third, it is a plan of action: it tells each department what it is expected to do.

A fourth feature is that a budget is period bound. It is prepared for a fixed length of time, called the budget period, which may be a month, a quarter or a year. When the period ends, a fresh budget is prepared for the next one.

How is budgeting related to planning and control?

Budgeting is closely tied to planning and control. Planning decides what should be done; budgeting puts that plan into figures. Control then compares what was actually done with the budget, so that differences can be investigated.

The difference between the budgeted figure and the actual figure is called a variance. A variance may be favourable or unfavourable. Budgeting is useful only when the variance is examined and the reason for it is found, so that the next budget is better.

What is the utility of budgeting?

Budgeting is useful to a business in several ways. It states objectives in figures, so that every department knows exactly what target it must reach. It coordinates the work of different departments: the sales budget tells the production department how much to make, and the production budget tells the purchase department how much material to buy.

Budgeting also helps in planning and control. Because a standard is set in advance, actual performance can be compared with it, and variances can be found and explained. This makes performance evaluation possible, since each department can be judged against its own budget.

How does budgeting help in controlling costs and using resources?

Budgeting helps to control costs by fixing limits on expenditure before it is incurred. It improves communication, because the budget is circulated to those responsible for carrying it out. It also helps in the optimum use of resources, since scarce funds and materials are allocated where they are most needed.

Finally, budgeting motivates managers and workers by giving them clear targets, and it helps the business to anticipate future needs such as cash requirements, so that borrowing or investment can be arranged in good time.

Note: utility of budgeting. Budgeting states objectives in figures, coordinates departments, aids planning and control, allows performance evaluation, controls costs, improves communication, promotes optimum use of resources, motivates staff and helps anticipate future needs.

How does budgeting differ from forecasting?

Forecasting is the process of estimating what is likely to happen in the future on the basis of past data and present conditions. A forecast is a prediction. Budgeting, by contrast, is a plan that the business intends to carry out.

The two are related: a forecast usually comes first, and the budget is then built on it. But they are not the same thing. A forecast may be made without any intention of acting on it, while a budget is always meant to be followed.

What are the points of difference between budgeting and forecasting?

Note: budgeting and forecasting. Forecasting estimates what is likely to happen; budgeting plans what the business intends to do and then controls performance against that plan. A budget is usually based on a forecast, but a forecast need not lead to a budget.

What is a sales budget?

A sales budget is an estimate of the quantity and value of sales expected in a future period. It is usually the starting point of the whole budgeting process, because the level of sales decides how much the business must produce and purchase.

The sales budget is prepared after considering past sales, market conditions, the capacity of the business, seasonal changes and the sales targets set by management. It is usually stated both in units and in money value.

Definition: sales budget. A sales budget is an estimate, in units and in value, of the sales expected during a future period.

Why must the sales budget be prepared carefully?

Because it drives the other budgets, the sales budget must be prepared carefully. If it is set too high, the business may produce and buy more than it can sell; if it is set too low, it may lose sales it could have made.

The sales budget also gives the value side of the plan. Multiplying the expected units by the expected selling price per unit gives the budgeted sales revenue, which is the figure carried into the master budget. A firm expecting to sell 5,000 units at ₹40 each, for example, plans sales revenue of ₹2,00,000.

Sales estimates are usually built from the records of earlier periods and from the judgement of the sales staff, who know the market closely. Where sales are seasonal, the annual sales budget is often broken into monthly or quarterly figures so that production and cash needs can be planned month by month.

What is a production budget?

A production budget states the quantity of goods that must be produced in a future period. It is prepared from the sales budget, after adjusting for the opening and closing stock of finished goods.

The quantity to be produced is found by adding the desired closing stock to the expected sales and subtracting the opening stock. The production budget is usually expressed in units of output.

Definition: production budget. A production budget is an estimate of the quantity of goods to be produced in a future period, prepared from the sales budget after adjusting for opening and closing stock.

What factors does the production budget take into account?

The production budget must take account of the capacity of the plant, the availability of labour and materials, and the time needed for production. It is the basis on which the purchase budget is prepared.

The stock adjustment matters because the business does not produce exactly what it sells. Some goods sold in the period come out of stock held at the beginning, and some goods produced are kept back as closing stock for the next period. Producing too little would leave orders unmet; producing too much would lock up money in unsold stock.

Where the plant cannot produce the quantity the sales budget demands, management must either arrange extra capacity or revise the sales budget downwards. The production budget therefore acts as a check on whether the sales plan is physically possible.

What is a purchase budget?

A purchase budget states the quantity and value of materials or goods that must be purchased in a future period. It is prepared from the production budget, after adjusting for the opening and closing stock of materials.

The quantity to be purchased is found by adding the desired closing stock of materials to the materials needed for production and subtracting the opening stock of materials.

Definition: purchase budget. A purchase budget is an estimate of the quantity and value of materials or goods to be purchased in a future period, prepared from the production budget after adjusting for opening and closing stock.

How is the purchase budget calculated and used?

The purchase budget helps the business to buy at the right time and in the right quantity, so that production is not held up for want of materials and money is not tied up in excess stock.

The materials needed for production are found by multiplying the quantity to be produced by the material requirement per unit. If each unit needs 2 kg of material and 5,300 units are to be made, the materials needed are 10,600 kg; the purchase budget then adds closing stock and deducts opening stock from this figure.

The purchase budget is also stated in money value, by multiplying the quantity to be purchased by the expected price per unit of material. This value is what the cash budget uses when it plans the payments to suppliers.

What is a cash budget?

A cash budget estimates the cash receipts and cash payments of a business over a future period. It shows the expected cash balance at the end of each period, and so reveals in advance the periods in which cash will be short or in surplus.

The cash budget records only actual cash movements. It does not record credit sales until the cash is received, and it does not record credit purchases until the cash is paid.

Definition: cash budget. A cash budget is an estimate of the cash receipts and cash payments of a business over a future period, showing the expected cash balance at the end of each period.

Why is a cash budget useful to a profitable business?

The cash budget is useful because a business may be profitable and still run short of cash. By showing the shortage in advance, it allows the business to arrange an overdraft or loan in good time, or to plan a short-term investment of surplus cash.

The cash budget is usually laid out in three parts: the opening cash balance, the receipts and payments during the period, and the closing cash balance. The closing balance of one period becomes the opening balance of the next, so a series of monthly cash budgets can be linked together.

Receipts usually include cash sales, collections from debtors and any loans received. Payments usually include cash purchases, payments to creditors, wages, rent, taxes and the purchase of fixed assets. Depreciation does not appear in a cash budget, because no cash moves when an asset is depreciated.

What is a master budget?

A master budget is the summary budget of the whole business. It brings together all the individual budgets, such as the sales, production, purchase and cash budgets, into one coordinated plan for the period.

The master budget usually includes a budgeted income statement and a budgeted balance sheet, along with the supporting budgets. It is the final stage of the budgeting process and is usually approved by top management.

Definition: master budget. A master budget is the summary budget of the whole business, combining all the individual budgets into one coordinated plan for the period.

What does the master budget show management?

The master budget gives management an overall picture of the expected results of the business. It also shows whether the individual budgets fit together, for example whether the cash budget can support the level of production planned.

Because it is a summary, the master budget is usually shorter than the budgets it combines. Its value lies in showing the expected profit and the expected financial position of the business as a whole, rather than the details of any one department.

If the master budget shows an unacceptable result, such as a cash shortage or a low expected profit, management goes back and revises the individual budgets before the plan is finally approved.

How are the budgets linked together?

The individual budgets are not prepared in isolation. They form a chain, and each budget feeds the next. The usual order of preparation is as follows.

1. The sales budget is prepared first, because sales decide the level of activity.
2. The production budget is prepared from the sales budget, after adjusting for opening and closing stock of finished goods.
3. The purchase budget is prepared from the production budget, after adjusting for opening and closing stock of materials.
4. The cash budget is prepared from the expected receipts and payments arising from all the other budgets.
5. The master budget is prepared last, combining all the individual budgets into one summary plan.

Draw five boxes in a row, labelled Sales budget, Production budget, Purchase budget, Cash budget and Master budget, with arrows running from each box to the next, and a final arrow from all four earlier boxes into the Master budget box.

The chain shows why an error in the sales budget spreads through the whole plan. If sales are overestimated, the production budget will call for too much output, the purchase budget will order too much material, and the cash budget will plan payments the business may not be able to meet.

What does each budget hand on to the next?

The table below sets out what each budget takes as its starting point and what it hands on to the next stage.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it. The unit asks only the meaning of each budget; the examples below show how the figures in them are worked out.

Worked examples on budgets

Worked example 1. A firm expects to sell 5,000 units in the coming year. It wants to keep 800 units as closing stock of finished goods and already has 500 units in opening stock. What quantity should it produce?

Answer: Production = Sales + Closing stock − Opening stock = 5,000 + 800 − 500 = 5,300 units. The production budget should be set at 5,300 units.

Worked example 2. To produce 5,300 units, the firm needs 2 kg of material per unit. It wants 1,000 kg as closing stock of material and has 700 kg in opening stock. What quantity of material should it purchase?

Answer: Material needed for production = 5,300 × 2 = 10,600 kg. Purchases = 10,600 + 1,000 − 700 = 10,900 kg. The purchase budget should be set at 10,900 kg.

Worked example 3. A trader starts a month with ₹20,000 cash. Cash sales are expected to be ₹50,000 and cash purchases ₹30,000. Wages of ₹8,000 and rent of ₹5,000 are to be paid in cash. Prepare the cash budget for the month.

Answer: Total receipts = ₹20,000 + ₹50,000 = ₹70,000. Total payments = ₹30,000 + ₹8,000 + ₹5,000 = ₹43,000. Closing cash balance = ₹70,000 − ₹43,000 = ₹27,000. The cash budget shows a surplus of ₹27,000.

Worked example 4. A firm's sales budget is 4,000 units at ₹50 each. Its production budget is 4,200 units, and each unit needs material costing ₹20. Should the firm approve the master budget if it expects a cash balance of only ₹10,000 and must pay ₹80,000 for materials in cash during the period?

Answer: Sales value = 4,000 × ₹50 = ₹2,00,000. Material cost = 4,200 × ₹20 = ₹84,000. Cash available is ₹10,000, which is less than the ₹80,000 cash payment due. The firm should not approve the master budget as it stands; it should arrange additional finance or reschedule the material payments before approving it.

Glossary

• Budget: a financial plan prepared in advance for a definite future period, stated in figures.
• Budgeting: the process of preparing, coordinating and controlling budgets for a future period.
• Forecasting: estimating what is likely to happen in the future from past data and present conditions.
• Sales budget: an estimate of the quantity and value of sales expected in a future period.
• Production budget: an estimate of the quantity of goods to be produced in a future period.
• Purchase budget: an estimate of the quantity and value of materials to be purchased in a future period.
• Cash budget: an estimate of cash receipts and cash payments over a future period.
• Master budget: the summary budget of the whole business, combining all individual budgets.
• Opening stock: the stock of goods or materials held at the beginning of a period.
• Closing stock: the stock of goods or materials held at the end of a period.
• Variance: the difference between the budgeted figure and the actual figure.
• Budget period: the future period for which a budget is prepared.

Common errors and misconceptions

• Misconception: A budget and a forecast are the same thing. Correct: A forecast estimates what is likely to happen; a budget is a plan the business intends to follow.
• Misconception: A cash budget shows profit. Correct: A cash budget shows only cash receipts and payments, not profit.
• Misconception: The production budget is prepared before the sales budget. Correct: The sales budget is usually prepared first, and production is planned from it.
• Misconception: The master budget is just another name for the sales budget. Correct: The master budget combines all the individual budgets into one summary plan.
• Misconception: A budget is prepared after the period is over. Correct: A budget is prepared in advance for a future period.
• Misconception: Credit sales appear in the cash budget when the sale is made. Correct: They appear only when the cash is actually received.
• Misconception: Budgeting guarantees that the plan will be achieved. Correct: Budgeting sets targets and helps control, but actual results may differ from the budget.

Exam-style questions with model answers

Q1. Define a budget. [2 marks]

1. A budget is a financial plan prepared in advance for a definite future period.
2. It is stated in figures, in money terms or in physical units, and shows what the business expects to earn, spend, produce or receive.

Q2. State any two points of difference between budgeting and forecasting. [2 marks]

1. Budgeting is a plan of action that the business intends to follow, while forecasting is only an estimate of what is likely to happen.
2. Budgeting includes control, by comparing actual results with the budget, while forecasting has no control element.

Q3. Explain any three points of utility of budgeting. [3 marks]

1. It states objectives in figures, so that each department knows exactly what target it must reach in the budget period.
2. It coordinates departments, since the sales budget decides how much to produce and the production budget decides how much material to buy.
3. It aids control and performance evaluation, because actual results can be compared with the budget and the variances explained.

Q4. Explain the meaning of a cash budget and state two of its uses. [4 marks]

1. A cash budget estimates the cash receipts and cash payments of a business over a future period.
2. It shows the expected cash balance at the end of each period.
3. It reveals a cash shortage in advance, so the business can arrange an overdraft or loan in time.
4. It shows a cash surplus in advance, so surplus cash can be invested for a short period.

Q5. Distinguish between a production budget and a purchase budget. [4 marks]

1. A production budget states the quantity of goods to be produced in a future period, while a purchase budget states the quantity and value of materials or goods to be bought.
2. The production budget is prepared from the sales budget, while the purchase budget is prepared from the production budget.
3. The production budget adjusts for the opening and closing stock of finished goods, while the purchase budget adjusts for the opening and closing stock of materials.
4. The production budget is usually expressed in units of output, while the purchase budget is expressed both in quantity and in money value.

Q6. Explain the meaning of the sales, production, purchase and master budgets, and show how they are linked. [5 marks]

1. A sales budget estimates the quantity and value of sales expected in a future period.
2. A production budget states the quantity of goods to be produced, prepared from the sales budget after adjusting for opening and closing stock of finished goods.
3. A purchase budget states the quantity and value of materials to be purchased, prepared from the production budget after adjusting for opening and closing stock of materials.
4. A master budget is the summary budget of the whole business, combining all the individual budgets into one coordinated plan.
5. The budgets are linked in a chain: sales decides production, production decides purchases, and all of them are combined in the master budget.

Key takeaways

• A budget is a financial plan for a definite future period, stated in figures.
• Budgeting is the process of preparing budgets, coordinating them with one another and controlling actual performance against them.
• Forecasting estimates what is likely to happen; budgeting plans what the business will do.
• A budget is usually based on a forecast, but a forecast need not lead to a budget.
• The sales budget is usually prepared first, because sales decide the level of activity.
• The production budget is prepared from the sales budget after adjusting for stock of finished goods.
• The purchase budget is prepared from the production budget after adjusting for stock of materials.
• A cash budget shows expected cash receipts, cash payments and the closing cash balance, not the profit of the business.
• The master budget combines all the individual budgets into one coordinated summary plan for the whole business.

Test yourself

What is budgeting?

Budgeting is the process of preparing budgets for a future period, coordinating them with one another, and using them to control actual performance.

Which budget is usually prepared first?

The sales budget, because the expected level of sales decides how much the business must produce and purchase.

What does a cash budget record?

It records the expected cash receipts and cash payments over a future period, and shows the expected cash balance at the end of each period.

How is the quantity to be produced calculated?

Production = Sales + Closing stock of finished goods − Opening stock of finished goods.

What is a master budget?

It is the summary budget of the whole business, combining all the individual budgets into one coordinated plan for the period.

Does a forecast bind the departments of a business?

No. A forecast is only an estimate and is not binding, while a budget, once approved, is meant to be followed by the departments.

Why is a cash budget useful to a profitable business?

Because a business may be profitable and still run short of cash; the cash budget shows the shortage in advance so that finance can be arranged in time.