Purpose and types of budgets - Functional budgets and the co...

Learning Outcomes

By the end of this article, you will be able to explain why organisations set budgets and distinguish between different types, with a focus on functional budgets and the comprehensive budget. You will understand how these budgets support organisational planning, coordination, and control. You should also be able to outline the steps involved in preparing functional budgets and demonstrate how individual functional budgets are consolidated into a comprehensive budget for comprehensive financial planning.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand the reasons for budgeting and the practical process of budget preparation. This article will help you revise the following essential syllabus points:

• Explain the purpose of budgeting in organisational planning and control
• Distinguish between different types of budgets, including functional budgets and the comprehensive budget
• Prepare sales, production, material, labour, and overhead budgets
• Integrate functional budgets to create a comprehensive budget (including budgeted profit or loss, cash flow and financial position)
• Recognise the interrelationship between different budgets within an organisation

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which budget is usually prepared first, and why is its order important?
2. What information from the production budget is used to prepare the direct material usage budget?
3. True or false? The comprehensive budget always consists only of a budgeted statement of profit or loss.
4. In what ways do functional budgets help managers achieve organisational goals?

Introduction

Budgeting is a central tool for planning, coordinating, and controlling the activities of an organisation. Most businesses break down their overall financial plan into a range of specific budgets for each business function—these are known as functional budgets. Once the separate functional budgets are complete, they are consolidated into the comprehensive budget, which provides an integrated view of the expected financial performance and position for the entire organisation.

Key Term: budget
A quantitative plan of action prepared in advance, setting out expected income and expenditure for a set period.

THE PURPOSE OF BUDGETING

Budgets serve several core functions within an organisation:

• Planning: Setting measurable targets for income, costs, and activities in line with organisational objectives.
• Coordination: Aligning different departments to ensure they work towards the same goals.
• Communication: Communicating financial expectations and targets throughout the organisation.
• Control: Comparing actual performance with budgeted targets to highlight variances for management action.
• Motivation: Providing targets that can motivate managers and staff to achieve performance standards.

Budgets are forward-looking and provide the basis for both day-to-day operations and long-term strategic decisions.

Key Term: functional budget
A detailed budget prepared for a specific area or function of the business, such as sales, production, procurement, or marketing.

Key Term: comprehensive budget
The overall budget for the organisation, usually comprising the budgeted profit or loss account, cash budget, and budgeted statement of financial position, formed by consolidating all functional budgets.

TYPES OF BUDGETS

Organisations use a range of budgets to plan and manage activities. The most common are:

Functional Budgets

These are budgets prepared for each distinct area of the business. Typical examples include:

• Sales budget: Forecasts quantity and value of sales.
• Production budget: Plans production volumes, considering required inventories.
• Raw material usage and purchase budgets: Estimate the quantities and costs of materials required and purchased.
• Labour budget: Forecasts direct labour hours and their associated costs.
• Overheads budgets: Estimates variable and fixed overhead costs for production or other functions.
• Selling and distribution budget: Sets out planned sales, marketing and distribution expenses.
• Administration budget: Plans general running costs for the admin function.

Functional budgets form the building blocks for the overall comprehensive budget.

Comprehensive Budget

Once all functional budgets are prepared, they are consolidated into the comprehensive budget, which typically includes:

• Budgeted statement of profit or loss
• Cash flow budget
• Budgeted statement of financial position

The comprehensive budget demonstrates whether the organisation expects to meet its financial objectives and provides a summary for decision makers.

THE SEQUENCE OF BUDGET PREPARATION

The order in which budgets are prepared is important, as some budgets rely on information from others. In most organisations, the principal budget factor—the resource or constraint that most limits activity—dictates the starting point. Most commonly, this is sales demand.

A typical budget preparation sequence is:

1. Sales budget
   (often the principal budget factor)
2. Production budget
   (based on sales and desired inventory levels)
3. Material usage and purchases budgets
4. Labour budget
5. Overhead budgets
6. Other functional budgets (e.g., selling and administrative)
7. Cash budget
8. Comprehensive budget (Profit or loss, financial position)

This order ensures all dependent budgets are consistent and achievable.

Key Term: principal budget factor
The element that most restricts the activities of an organisation, often determining the order in which budgets are prepared.

STRUCTURE AND CONTENT OF FUNCTIONAL BUDGETS

Sales Budget

Estimates expected sales by product, region, or channel, often broken down by period.

Production Budget

Calculated as:

Budgeted sales

• Closing inventory of finished goods (target)
  − Opening inventory of finished goods (actual or planned)
  = Budgeted production

Material Usage and Purchases Budgets

• Material usage:
  Budgeted production × standard quantity of materials per unit

• Material purchases:
  Material usage

  • Closing raw material inventory (target)
    − Opening raw material inventory (actual or planned)
    = Purchases required

Labour Budget

Budgeted production × labour hours per unit × wage rate

Overhead Budgets

Based on expected activity levels, often separated into variable and fixed overheads.

Other Functional Budgets

Include selling, distribution, administration, and any other department-specific expenses.

Cash Budget

Forecasts the timing and amounts of cash receipts and payments to ensure liquidity.

Comprehensive Budget – Components

Combines the above to provide:

• Budgeted statement of profit or loss
• Cash flow budget
• Budgeted statement of financial position

RELATIONSHIPS BETWEEN FUNCTIONAL BUDGETS

Each functional budget depends on information from others. For example, the production budget needs the sales budget as its base. The material usage budget relies on the production budget, which then feeds into the purchases budget. The success of budgeting relies on recognising these interdependencies and coordinating the preparation of all budgets.

Key Term: interdependent budgets
Budgets that are linked such that the outputs of one become the inputs for another.

Key Term: limiting factor
The resource, such as sales demand, labour, or materials, that restricts the level of activity achievable by the organisation.

THE COMPREHENSIVE BUDGET IN PRACTICE

The comprehensive budget consolidates all expected results, allowing managers to:

• Assess whether targets are realistic and aligned with overall objectives
• Identify funding requirements or potential surpluses
• Make decisions about resource allocation, investment, and financing

A well-prepared comprehensive budget also facilitates effective monitoring and control throughout the financial period.

Worked Example 1.1

A company expects to sell 8,000 units of Product A in the next year. Each unit requires 3 kg of material X and 2 hours of direct labour. The opening inventory is 500 units; the desired closing inventory is 700 units. What is the budgeted production?

Answer:
Budgeted production = Budgeted sales + closing inventory − opening inventory
= 8,000 + 700 − 500 = 8,200 units

Worked Example 1.2

Given the production budget above, what is the required quantity of material X to be purchased if opening material inventory is 1,000 kg and desired closing inventory is 800 kg?

Answer:
Material usage = 8,200 units × 3 kg = 24,600 kg
Add closing inventory = +800 kg
Less opening inventory = −1,000 kg
Material to purchase = 24,600 + 800 − 1,000 = 24,400 kg

Exam Warning

Failure to use the correct order when preparing budgets can lead to inconsistent or unachievable results in the comprehensive budget. Always begin with the principal budget factor.

Revision Tip

Always check that opening and closing inventories are treated consistently across all relevant budgets.

Summary

Functional budgets are detailed forecasts for each major business area and are essential for organisational planning and control. The comprehensive budget brings these together in a consolidated view, allowing management to assess financial performance, make resource decisions, and monitor results. The correct preparation and combination of all functional budgets, following the right sequence, are critical for achieving organisational goals.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the main purposes of budgeting within organisations
• Identify and describe the range of functional budgets used in business
• Explain the typical order and process for preparing functional budgets
• Calculate sales, production, material, and labour budgets
• Understand how functional budgets are consolidated into a comprehensive budget
• Recognise the relationships and dependencies between different budgets
• Interpret a comprehensive budget’s role in organisational control and planning

Key Terms and Concepts

• budget
• functional budget
• comprehensive budget
• principal budget factor
• interdependent budgets
• limiting factor