Budget – Definition, Explanation, Classification with Examples

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What is Budget? – Definition

In business, a budget may be defined as a formal expression of the expected income and expenditure for a definite future period.

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 pre-determined statement of management policy during a given period which provides a standard comparison with the result actually achieved.” George R. Terry has defined 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 has defined 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

The three main functions of management are planning, operating and control. Planning relates to the future, operating to the present and control to the past. For assisting the management in the functions of planning and control, two techniques are applied viz., budgetary control and standard costing systems. Budgetary control system is usually operated with a system of standard costing since both systems are inter-related but it should be remembered that these two systems are not inter-dependent.


In the context of the budgetary control system, we should now discuss the main term “Budget”. The term Budget has been derived from the French word ‘Bougette’ which means a leather bag from which the Minister of the Government would take out his proposals regarding the expenditure and revenue of the Government during the coming financial period. Now-a-days, the budget is not restricted to Government affairs only. It covers domestic, business and institutional affairs as well.

Features of a Budget

A careful study of the above discussion brings out the following features of a budget:

(i). A budget is a plan. A budget is an expression of the plan of the operations of an enterprise. The operations of an enterprise are affected by a number of factors-both external (such as general business conditions, government policy and size and composition of the population) and internal (such as manufacturing processes, promotional programs). The budget covers both external and internal factors and expresses partly what the management expects to happen and partly what the management intends to happen.

(ii). It is comprehensive. A budget is comprehensive which means that it covers the activities and operations of all the segments or divisions of an organization. Budgets are prepared for each segment or division of an organization and all these are integrated into a Master Budget.

(iii). It provides for a co-ordinated plan: The budgets are prepared for the various segments or division of an organization after considering the conditions and problems of each segment. The budgets for all the components are prepared in harmony with one another.

(iv). It is prepared in advance. A budget is prepared in advance and denotes the future course of action. Thus, a budget is forward-looking in approach.

(v). It relates to a specific future period. A budget always relates to a specified future period. A budget becomes meaningless if it is not related to a time horizon. Thus, budgeted output, sales, profits, etc., are planned to be achieved in a pre-determined time framework.

(vi). it is a plan for Operations and Resources. A budget is a mechanism to plan for the operations and resources of an organization. The operations are expressed in terms of revenues and expenses. The plan also covers the planning of the resources of the organization. Resources refer to the various assets and the sources of capital available to finance these operations.

(vii). It is expressed in Financial and/or Quantitative Terms. A budget is always expressed in financial or monetary terms. It is due to the fact that the monetary unit is a common denominator. The various activities and operations of a business concern may be expressed in different units e.g., Material Budget is expressed in terms of weight, Labour budget in terms of labor hours, Sales budget in terms of sales territories. But for the purpose of integration into a plan, all these budgets have to be expressed in terms of some comparable unit of measurement. This comparable unit is provided by monetary unit.

(viii). It provides a yardstick for the comparison of actual performance. A budget provides for the comparison of actual achievements with the specified goals. This comparison is of utmost importance for exercising effective control over the business operations since it helps in fixing the responsibility for variances between actual performance and budgeted performance.

Classification of Budgets

Budgets may be classified on the basis of:

(A) Functions involved;
(B) Conditions (on which these are based);
(C) Periods; and
(D) Activity levels.

(A) Classification of Budgets on the basis of functions

On the basis of functions, budgets may be divided into:

(i) Functional Budgets and (ii) Master Budget.

A functional budget refers to a budget which relates to any of the functions of an undertaking, e.g., sales, production, finance, purchases, administration, etc.

Functional Budgets:

In a manufacturing concern, generally the following detailed functional budgets are prepared:

(1) Sales Budget

Under the system of budgetary control, the starting point is the preparation of Sales Budget. Sales budget is the forecast of sales during a given period, both in quantity and value. It is said to be the most difficult budget to prepare since it is not easy to estimate consumer’s demand, especially in case a new product is being introduced in the market. The responsibility for the preparation of the sales budget lies with the Sales Manager. This budget is classified under a number of headings, namely—product or product group, territories, areas and countries, type of customer, e.g., National Govemment, State Governments, export, country customers, salesman and period, etc. The specimen of a Sales Budget has been given below:

Specimen of Sales Budget

Example

C. Bros, sells two products which are manufactured in one plant. During the year 2019-20 it plans to sell the following quantities of each product:

Sales Budget Example

Each of these two products is sold on a seasonal basis. Product 1 tends to sell better in summer months, while product 2 sells better during the winter. C. Bros. plan to sell product 1 throughout the year at a price of $10 a unit and product 2 at a price of $20 a unit.

A study of the past experiences reveals that C. Bros. has lost about 3% of its billed revenue each year because of returns (constituting 2% of loss of revenue), allowances and bad debts (1% loss).

Prepare a budget incorporating the given information.

Sales Budget Example Solution

(2) Selling and Distribution Cost Budget

This budget shows the cost of selling and distribution for the quantities shown in the sales budget. The main factors which affect the selling and distribution cost budget are the channels through which sales are to affect, the sales promotion plan to be pursued, the sales territories to be covered and the mode of despatch of products to the customers.

Selling and distribution cost budget is drawn up by the Sales Manager and in the compilation, he is assisted by Distribution Manager, Advertising Manager, Sales Office Manager and the Accountant. For compiling this budget, the expenses are grouped according to elements e.g., direct selling expenses, sales office expenses, distribution expenses and advertising expenses.

Example

The following table shows the selling and distribution expenses of X Ltd., incurred during the year ended on 31st March, 2019.

Selling and Distribution Cost Budget Example

The following additional information are also given to you for next year:

1. Management decided to participate in ‘The International Trade Fair’ to be held in February 2020 and it was estimated that an expenditure of $40,000 will be incurred in this connection which will be met by head office.

2. It was estimated that to increase the sales in North Division 4 additional salesmen will be appointed next year. They will be paid $300 per month each.

3. Management also decided to promote sales in the South through an independent sales division (South). This will increase the expenditure as follows:

Salesmen Salaries $5,000, Travelling Expenses $2,000, Sales Depot and Showrooms Expenses $5,000, Advertisement $10,000, Misc. Expenses $7,000, Sales Manager’s Salaries $9,000.

4. Extensive advertisement programs will be adopted for which $20,000 will be spent by head office.

5. The commission will be given @ 5% on sales.

6. There will be an expenditure for credit collection @ 1% on sales.

7. Customers will be allowed 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 and South: $3,00,000.

Prepare the Selling and Distribution Cost Budget for the year ending on 31st March 2020 from the above details.

Solution:

Selling and Distribution Cost Budget Example Solution

(3) Production Budget

A Producüon Budget is defined as an estimate of the quantity of goods that must be produced during the budget period. This budget is prepared by the Production Manager keeping in view the following factors:

(a) Estimated sales.
(b) Expected opening stock and desired closing stock of each article.
(c) Available physical resources of plant, power, factory space, materials and machines.
(d) The policy of the management regarding manufacture or purchase of components.

The Production Budget may be classified under the following heads:

(i) Products
(ii) Manufacturing Departments
(iii) Months, Quarters etc.

Example

Prepare ‘Production Budget’ from the following particulars for the year ended 31st March, 2019:

Solution:

Production Budget Example

(4) Production Cost Budget

This budget is also known as Factory Cost Budget and it shows the cost of carrying out the production plan given in the Production BUdget. production cost includes direct materials cost, direct labour cost, direct expenses and factory overheads.

Production Cost Budget is generally classified under the following headings:

(i) Products
(ii) Manufacturing Departments
(iii) Months, Quarters, etc.
(iv) Elements of Costs.

Example

Your company manufactures two 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:

Production Cost Budget Example

It is anticipated that (i) there will be no work-in-progress at the end of any month, (ii) 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:

Production-Cost-Budget-Example-1

Prepare for the six months period ending 30th June, a production budget for each month and a summarised production cost budget.

Solution:

(a).

Production-Cost-Budget-Solution

(b).

Summarized-Production-Cost-Budget

(5) Purchases Budget

The purchases budget represents the total purchases to be made during the budget period. These purchases represent the requirements of direct and indirect materials, fixed assets, services and finished goods for resale but the most important item is that of raw materials. The requirements of the items to be purchased are expressed in terms of quantities as well as money.

This budget is prepared on the basis of Sales, Production Cost, Capital Expenditure, Research and Development Cost Budgets. Purchases budget facilitates the management of finances by defining the cash requirements in respect of the purchases to be made during the budget period and enables the Purchases Department to plan its purchases in time so that long-term forward contracts may be made when advantageous.

Example

The Sales Director of a manufacturing company reports that next year he expects to sell 54,000 units of a certain product. The production manager consults the storekeeper and casts his figures as follows:

Two kinds of raw materials, A and B are required for manufacturing the product. Each unit of the product requires 2 units of A and 3 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.

Solution:

Production-Budget-Example-2

Raw-material-purchase-budget

(6) Labour Cost Budget

The Labour Cost Budget represents in terms of money, number and grades of personnel, number of working hours or other appropriate units, the direct and indirect labour required to carry out the program laid down in the Sales, Production, Capital Expenditure and Research and Development Expenditure Budgets. Thus, this budget is a forecast of planned outlay on direct and indirect labour of a concern during the budget period.

(7) Plant Utilisation Budget

Plant Utilisation Budget forecasts the plant and machinery requirements to meet the Production Budget. This budget is expressed in terms of working hours or other convenient units and it indicates the machine load on each manufacturing department, machine or group of machines and the extent of over-loading or under-loading so that the management may take corrective action.

(8) Administration Cost Budget

This budget is a forecast of general administration costs of the undertaking during the budget period. General administration cost includes the cost of formulating the policy, directing the organization and controlling the operations of an undertaking. Most of the items of administration cost are fixed in nature but a clear distinction shall have to be made between ‘fixed’ and ‘variable’ items.

(9) Capital Expenditure Budget

This budget expresses in detail the anticipated expenditure to be incurred on fixed assets during the budget period e.g., plant and machinery, land, buildings, patents, etc. Capital Expenditure Budget is normally a long-term budget providing for the acquisition of the assets necessitated by the replacement of existing assets, additions to the existing assets, or by the installation of an improved type of machinery to take the advantage of new production techniques.

(10) Research and Development Cost Budget

This budget is a planned outlay on research and development activities of an undertaking and expresses in terms of money, the permissible limits within which the research and development activities are to be pursued and the directions for the same.

(11) Cash Budget

The cash budget is a forecast of the cash position for a period and represents the cash receipts and payments and the estimated cash balance each month of the budget period. This budget is practically the nerve center of the whole budgetary control system since the most carefully prepared budgets are incapable of fulfillment if adequate cash is not available at the proper time. The main functions of this budget may be summarised as follows:

  • It ensures that sufficient cash is available to meet the requirements of the organisation.
  • It reveals any expected shortage of cash so as to enable the management to arrange for cash in time by means of bank overdraft or loan etc.
  • It 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.

Cash Budget of a business concern can be prepared by Receipts and payments Method, Adjusted Profit and Loss Method and Balance Sheet Method. But the Receipts and Payments Method is the most popular method and is commonly used by business concerns. Under this method, cash budget is prepared just like a summarised cash book. For the purpose of preparing cash budget, all types of ‘Cash Receipts’ or ‘Cash Inflows’ (including opening balance of cash/bank) are to be estimated in a logical manner period-wise, keeping in view the past figures, existing trends and expected changes in future.

Similarly, all types of ‘Cash payments’ or ‘cash outflows’ are also estimated period-wise. Thereafter, a comparison of total estimated cash receipts and total estimated cash payments is made to ascertain the amount of excess or shortage of cash. In case of expected shortage or shortfall, arrangements shall be planned to raise funds by means of short-term loans or bank overdraft, etc.

Example

Estimate the cash requirement of Meerut Fruit Co. Ltd. for June, 2019 on the basis of data given:

(i) Sales

February, 2019: $25,000
March, 2019: $20,000
April to June 2019: $30,000 per month.

Half the sales are for cash. 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 of cash to avail 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)

Solution:

Cash flow statement Solution

Working Notes:

(i) As the opening cash balance for the month of April has not been given in the question, it has been assumed to be nil.
(ii) Closing cash balance of a month becomes the opening balance of the
next month.
(iii) Cash collections from debtors have been calculated as follows:

Working-Note

Master Budget:

A Master Budget is a summary of all the functional budgets. It is defined as the Summary Budget, incorporating its components functional budgets, which is finally approved, adopted and employed. When the Master Budget is complete, its details shall be considered by the Budget Committee and if approved, it will be submitted to the Board of Directors.

However, once it is finally approved, it becomes the target for the organization during the budget period. The master budget is usually prepared in the form of a Budgeted Profit and Loss Statement. It begins with the sales budget figures, from which Production Cost Budget figures and overheads are deducted in order to arrive at the figure of budgeted profit.

Example

Glass manufacturing company requires you to calculate and present the budget for the next year from the following information:

Example

Administration, Selling and Distribution expenses $14,000 per year.

Solution:

Solution

(B) Classification on the basis of conditions

On the basis of conditions on which they are based, budgets may be divided into:

(i) Basic Budgets, and (ii) Current Budgets.

Basic budget is a budget which is established for use unaltered over a long period of time while a current budget is one which is established for use over a short period of time and is related to current conditions.

(C) Classification on the basis of period

On the basis of period for which they are prepared, budgets may be divided into: \

(i) Shon Term Budgets and (ii) Long Term Budgets.

A short term budget is one which is prepared for a period of one year or less than one year. Such budgets cover those expenses or activities, the trend in which is difficult to be foreseen over longer periods. Cash Budget and Materials Budget are examples of short term budgets.

A long term budget is that which is prepared for a period longer than a year. Long term budgets normally help in business forecasting and future planning. Capital Expenditure Budget and Research and Development Expenditure Budget are examples of long term budgets.

(D) Classification on the basis of Activity Levels

On the basis of activity levels or capacity, the budgets may be classified as:

(i) Fixed Budgets and (ii) Flexible Budgets.

The Institute of Cost and Management Accountants has defined fixed budget as “a budget which is designed to remain unchanged irrespective of the level of activity actually attained.”

The fixed budget shows an inflexible or rigid plan. There is one set of conditions, one volume of output, and a simple collection of costs and the management expects all conditions etc., to operate without any variation.

On the other hand, flexible budget is a budget which is designed to change in accordance with the level of activity actually attained. The figures used in this type of budget are made adaptable to any given set of operating conditions. The compilation of flexible budgets requires the classification of all costs or expenses into fixed, variable and semi-variable. Fixed costs remain fixed or constant at all levels of activity, semi-variable costs vary with different levels of activity while variable costs vary directly in proportion to changes in the volume of output or sales.

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