Budget: Definition, Classification and Types of Budgets

what is budget?A budget is a quantitative plan for acquiring and using resources over a specified period. Individuals often create household budgets that balance their income and expenditures for food, clothing, housing, and so on while providing for some savings.

Once the budget is established, actual spending is compared to the budget to make sure the plan is being followed. Companies similarly use budgets, although the amount of work and underlying details involved far exceed a personal budget.

In an organization, the term master budget refers to a summary of a company’s plans including specific targets for sales, production, and financing activities.

The master budget—which culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet— formally lays out the financial aspects of management’s plans for the future and assists in monitoring actual expenditures relative to those plans.

Budgets are used for two distinct purposes planning and control.

Planning involves developing goals and preparing various budgets to achieve those goals.

Control involves the steps taken by management to increase the likelihood that all parts of the organization are working together to achieve the goals set down at the planning stage.

To be effective, a good budgeting system must provide for both planning and control. Good planning without effective control is a waste of time and effort.

One of the management major responsibilities is planning. Planning is the process of establishing en wide objectives. A successful organization makes both long term and short-term plans. These plans s the objectives of the company and the proposed way of accomplishing them.

A budget is a formal statement of management’s plans for a specified method of communicating the agreed-upon objective of the organization.

Companies usually propose a budget to plan for and their control their revenues (inflows) expenses (outflows), failure to prepare a budget could lead to significant cash flow problems or even f disaster for a company.

Once adopted a budget becomes important in strong instruments for performance. We consider the role of budgeting as a control device.

A budget is a blueprint of the plan of action to be followed during a specific time for attaining some decided objective.

According to CIMA Official Terminology, budget is “a plan quantified in monetary terms prepared and approved before a defined time usually showing planned income to be generated and or expenditure to be incurred during that period and the capital to be employed to attain a given objective.”

The analysis of the above definition shows the following elements in the budget:

  1. It is a plan expressed in financial-terms for attaining some objective.
  2. It is prepared and approved before a defined time.
  3. It shows the planned income to be generated.
  4. It shows probable expenditure to be incurred.
  5. It indicates the capital to be employed during the period.

Classification of Budget

Budgets classified according to 4 bases;

  1. Based on Time;
  2. Based on Condition;
  3. Based on Functions; and,
  4. Based on Flexibility.

These are explained below;

classification and types of budgets

Types of Budget Based on Time

Based on time factor budgets can be classified into two types;

  1. Long-term Budget, and
  2. Short-term Budget.

Long-term Budget

This budget is related to the planning operations of an organization for a period of 5 to 10 years. The long-term budget may be adversely affected due to unpredictable factors. Therefore, from a control point of view, the long-term budget should be supplemented by short-term budgets.

Example: Research and Development Budget, Capital Expenditure Budget, etc.

Short-term Budget

This budget is drawn usually for one year. Sometimes a budget may be prepared for a shorter period (like monthly budget, quarterly budget, etc.). Short­term budgets are prepared in detail and these budgets help to exercise control over day-to-day operations.

Example: Material Consumption Budget, Labor Utilization Budget, Cash Budget, etc.

Types of Budget Based on Condition

Based on conditions prevailing, a budget can be classified into 2 types;

  1. Basic Budget, and
  2. Current Budget.

Basic Budget

A budget that is established for use as unaltered over a long period is called Basic Budget.

This budget does not take into consideration changes occurring from the external environment which are beyond the control of management. This budget is more useful for top-level management for formulating policies.

Current Budget

A budget that is established for use over a short period and is related to the current conditions is called the Current Budget. This budget is adjusted to the current conditions prevailing in the business.

Types of Budget Based on Functions

Based on activities or functions of a business, budgets can be classified into 2 types

  1. Master Budget, and
  2. Functional Budgets.

Master Budget

The final integration of all functional budgets by the Budget Officer provides the Master Budget. When functional budgets have been completed, the Budget Officer prepares the Master Budget.

Master Budget is the summary budget incorporating its component functional budgets, which is finally approved, adopted and employed. [C. I. M. A. (London)l.

Master Budget shows the operating profit of the business for the budget period and budgeted balance sheet at its close. This Budget portrays the overall plan for the budget period.

The master budget consists of several separate but interdependent budgets. The first step in the budgeting process is the preparation of the sales budget, which is a detailed schedule showing the expected sales for the budget period. An accurate sales budget is the key to the entire budgeting process.

If the sales budget is inaccurate, the rest of the budget will be inaccurate. The sales budget is based on the company’s sales forecast, which may require the use of sophisticated mathematical models and statistical tools.

We will not go into the details of how sales forecasts are made. This is a subject that is most appropriately covered in marketing courses.

The sales budget helps determine how many units need to be produced.

Thus, the production budget is prepared after the sales budget. The production budget, in turn, is used to determine the budgets for manufacturing costs including the direct materials budget, the direct labor budget, and the manufacturing overhead budget.

These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget.

A cash budget is a detailed plan showing how cash resources will be acquired and used. After the cash budget is prepared, the budgeted income statement and then the budgeted balance sheet can be prepared.

Functional Budgets

Functional Budgets relate to functions of the business such as product sales etc. In other words, Functional Budgets are prepared in respect of various functions performed in a business.

Functional Budgets which are commonly found in a business concern are as follows;

  1. Sales Budget;
  2. Production Budget;
  3. Material Budget;
  4. Labor Budget;
  5. Production Overhead Budget;
  6. Administration Overhead Budget;
  7. Selling & Distribution Overhead Budget;
  8. Plant Utilization Budget;
  9. Cash Budget
  10. Research & Development Budget and more.

Sales Budget

The sales budget is the starting point in preparing the master budget. The sales budget is constructed by multiplying budgeted unit sales by the selling price.

A schedule of expected cash collections is prepared after the sales budget. This schedule will be needed later to prepare the cash budget.

Cash collections consist of collections on credit sales made to customers in prior periods plus collections on sales made in the current budget period.

Production Budget

The production budget is prepared after the sales budget. The production budget lists the number of units that must be produced to satisfy sales needs and to provide for the desired ending inventory.

Production needs can be determined as follows:

Budgeted unit sales……………… XXXX

Add the desired ending inventory… XXXX

Total needs………………………….. XXXX

Less beginning inventory……….. XXXX

Required production……………… XXXX

Note that production requirements are influenced by the desired level of the ending inventory. Inventories should be carefully planned. Excessive inventories tie up funds and create storage problems.

Insufficient inventories can lead to lost sales or last-minute, high-cost production efforts. At Hampton Freeze, management believes that an ending inventory equal to 20% of the next quarter’s sales strikes the appropriate balance.

Cash Budget

The cash budget is composed of four major sections:

  1. The receipts section.
  2. The disbursements section
  3. The cash excess or deficiency section.
  4. The financing section.

The receipts section lists all of the cash inflows, except for financing, expected during the budget period. Generally, the major source of receipts is from sales.

The disbursements section summarizes all cash payments that are planned for the budget period.

These payments include raw materials purchases, direct labor payments, manufacturing overhead costs, and so on, as contained in their respective budgets.

Also, other cash disbursements such as equipment purchases and dividends are listed.

The budget is the forecast of expected cash receipts and cash disbursement during the budget period. The importance of cash budget need not be overemphasized. Cash is the lifeblood of the business. Without sufficient cash, a business can not be run smoothly.

Cash is required for the purchase of raw material, payment of wages and other expenses, acquisition of assets, fulfillment of commitment to investors and so on.

The preparation of functional budgets will be a useless job unless the requisite amount of cash is made available to implement them.

That is why; the cash budget has assumed enormous importance. It reflects possible receipts of cash from various sources and the expected requirement of cash for meeting various obligations.

In this way, it highlights well in advance neither the need for taking necessary measures to streamline the cash flows so that there is neither any cash shortage nor the surplus of cash.

A cash budget is prepared for the budget period, however, for effective cash management, it is generally divided monthly, weekly or even daily.

Purpose of Cash Budget

The principal purposes of the cash budget may be outlined as follows:

  • It indicates the probable cash position as a result of planned operations.
  • Indicates cash excess or shortages.
  • It indicates the need to arrange for short-term borrowing, or the availability of idle cash for investment.
  • It makes provision for the co-ordination of cash about (i) total working capital (ii) sales, (iii) investment, and debt.
  • It establishes a sound basis for obtaining credit.
  • It establishes a sound basis for current control of the cash position.

Difference Between Cash Budget and Cash Flow Statement

A cash flow analysis may be made based on past data or estimated data of a forthcoming period. When the cash flow analysis is done based on past data the statement of such analysis is usually called the cash flow statement.

On the other hand, if the cash flow analysis is done based on estimated data about a forthcoming period, it is called the cash budget. The differences between the cash budget and cash flow statement are discussed as:

Point of DifferenceCash BudgetCash Flow Statement
1. NatureThe cash budget is futuristic. It reflects expected receipts and payments of cash under different heads during the budget period.The cash flow statement is a post-mortem analysis revealing inflows and outflows of cash having taken” place during a past period.
2. PurposeThe purpose of the cash budget is to indicate whether there will be any deficiency or surplus of cash.The purpose of the cash flow statement is to indicate how the cash position of the firm.
3. PeriodA cash budget can be prepared for a short period says, monthly, weekly, or even daily and also for a long period says, half-yearly, yearly.The cash flow statement is prepared for a longer period usually coinciding with the past accounting year.
4. UsesExercise control over important activitiesIt helps management and external parties like shareholders, bankers, auditors.
5. UsesWith the help of cash budget management exercises control over important activities.The cash flow statement helps the management as well as external parties like shareholders, bankers, auditors, etc.

Difference between Budget and Forecast

The terms ‘budget’ and forecast’ are often used interchangeably. But they are not the one and same things. The difference can be discussed as follows:

Types of Budget based on Flexibility

Based on flexibility budgets can be classified into two types;

  1. Fixed Budget, and
  2. Flexible Budget.

Fixed Budget (or Static Budget)

Fixed Budget is a budget which is designed to remain unchanged irrespective of the level of activity attained. This type of budget is most suited for Fixed expenses, which have no relation to the volume of output. Fixed -Budget is ineffective as a tool for cost control. Fixed Budget is based on the assumption that the volume of output and sales can be anticipated with a fair degree of accuracy.

Flexible Budget (or Sliding Scale Budget)

Flexible Budget is a budget which is designed to change by the level of activity attained.

This budget recognizes the difference in behavior between fixed and variable costs about fluctuations in output. This budget serves as a useful tool for controlling costs. It is more realistic, practical and useful than Fixed Budget.

A flexible budget that can be used to estimate what costs should be for any level of activity within a specified range. A flexible budget shows what costs should be for various levels of activity.

The flexible budget amount for a specific level of activity is determined differently depending on whether a cost is variable or fixed.

If a cost is variable, the flexible budget amount is computed by multiplying the cost per unit of activity by the level of activity specified for the flexible budget. If a cost is fixed, the original total budgeted fixed cost is used as the flexible budget amount.

Characteristics of a Flexible Budget

Flexible budgets take into account how changes in activity affect costs. A flexible budget makes it easy to estimate what costs should be for any level of activity within a specified range.

When a flexible budget is used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period rather than to the budgeted costs from the original budget.

This is a very important distinction— particularly for variable costs. If adjustments for the level of activity are not made, it is very difficult to interpret discrepancies between budgeted and actual costs.

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