Preparing Functional, Cash and Master Budgets (with What-Ifs)

Learning objectives

• Prepare functional budgets (sales, production, materials, labour, and overheads) from a consistent set of assumptions.
• Build a cash budget that correctly reflects the timing of receipts and payments.
• Compile a simple master budget, including a budgeted statement of profit or loss and a budgeted statement of financial position.
• Apply what-if analysis (scenarios, sensitivities, and goal seek) to test key assumptions and decisions.
• Perform internal consistency checks so that units, margins, and working-capital movements reconcile across budgets.

Overview & key concepts

Budgeting turns plans into numbers. A good budget model links operational drivers (units, hours, kilograms) to financial outcomes (profit, cash, working capital). The purpose is not perfect prediction, but a disciplined way to:

• state assumptions clearly,
• quantify the effect of those assumptions on profit and cash, and
• identify periods where cash pressure could arise even when forecast profit looks healthy.

Two perspectives run in parallel:

• theprofit view(accrual-based): records expected sales and the related costs for the period; and
• thecash view(timing-based): records when money is expected to be received and paid.

A master budget ties these together into forecast financial statements.

Functional budgets

Functional budgets are prepared for individual areas of activity and then combined.

Sales budget

The sales budget sets forecast units and selling price by period. It drives:

• revenue in the budgeted statement of profit or loss (accrual view), and
• cash receipts in the cash budget (timing view, adjusted for customer credit terms).

Production budget

The production budget converts sales demand into planned output, allowing for finished goods inventory targets.

Production units = Sales units + Closing finished goods units − Opening finished goods units

Materials budgets

Two linked budgets are usually required:

• Materials usage(materials needed for planned production), and
• Materials purchases(materials to be bought after adjusting for raw material inventory targets).

Materials purchases (kg) = Materials usage (kg) + Closing raw materials (kg) − Opening raw materials (kg)

Purchases drive payables (if bought on credit) and cash payments (based on supplier terms).

Labour budget

Direct labour is budgeted using hours per unit and wage rate.

Direct labour cost = Units to produce × Hours per unit × Rate per hour

Overhead budget

Overheads are commonly split into:

• variable overheads (vary with activity), and
• fixed overheads (largely time-based).

For cash budgeting, remove non-cash items (for example, depreciation) from cash payments.

Cash budget

The cash budget tracks when money is expected to come in and go out. It starts with the opening cash balance, adds expected receipts, deducts expected payments, and shows the expected closing cash position each period.

Closing cash = Opening cash + Cash inflows − Cash outflows

The cash budget is not a profit measure. A business may forecast profit and still run short of cash if collections are slow or too much cash is tied up in inventory and customer balances.

Master budget

The master budget consolidates functional budgets into forecast statements.

Budgeted statement of profit or loss

This schedule estimates profit using accrual principles rather than cash timing. Sales are included in the period they are expected to be made, even if customers pay later. Costs should be assigned on a basis that reflects the goods sold during the period, so inventory movements matter: some production cost may be carried forward in closing inventory instead of appearing immediately in cost of sales.

Where absorption costing is used, inventory is valued using both variable production cost and an allocated share of fixed production overhead.

Budgeted statement of financial position

This statement shows forecast assets, liabilities, and equity at the period end. Working-capital balances should be consistent with the cash budget logic:

• receivables reflect sales not yet collected,
• payables reflect purchases not yet paid, and
• inventories reflect the stated inventory policies.

A basic integrity test is:

Assets = Liabilities + Equity

What-if analysis

Scenario analysis

Compare outcomes under different internally consistent sets of assumptions (for example, base, downside, upside).

Sensitivity analysis

Change one input at a time (for example, selling price ±5%) while holding others constant to identify key drivers.

Goal seek

Work backwards from a target (for example, minimum closing cash) to find the required input (for example, sales volume).

Internal consistency checks

Budgets should be self-checking. Useful controls include:

Units reconciliation

Opening finished goods + Production − Sales = Closing finished goods

Inventory policy checks

Confirm closing inventory quantities match the stated policies (finished goods and raw materials).

Timing logic checks

Confirm that receivables and payables balances match the collection and payment assumptions used in the cash budget.

Margin checks

Confirm implied margins are plausible and consistent with the cost structure. A common error is mixing production-based costs into a sales-based profit calculation.

Worked example

Narrative scenario

BrightLite Co manufactures a single lighting product (BL-1) and is preparing budgets for the quarter January to March.

Sales forecast (all sales are on credit):

• January: 2,000 units
• February: 2,400 units
• March: 2,600 units
• Selling price: £50 per unit

Finished goods inventory policy: closing finished goods each month equals 20% of the next month’s sales (units).
Sales in April are expected to be 2,500 units.
Opening finished goods on 1 January are 400 units.

Direct materials: 3 kg per unit at £4 per kg.
Raw materials inventory policy: closing raw materials equals 10% of the next month’s usage (kg).
Opening raw materials on 1 January are 1,200 kg.

Direct labour: 0.5 hours per unit at £16 per hour.

Overheads (all treated as production overheads in this example):

• Variable overhead: £6 per unit produced
• Fixed overhead: £18,000 per month, including £3,000 depreciation (non-cash)

Credit terms:

• Customers: 70% collected in the month after sale and 30% in the second month after sale
• Suppliers: 100% paid in the month after purchase
• Trade receivables at 1 January are £70,000, all collected in January. There are no trade payables at 1 January.

Cash timing for costs:

• Wages and variable overheads are paid in the month incurred
• Fixed overhead cash payments are made in the month incurred (excluding depreciation)

Other information:

• Opening cash on 1 January is £12,000
• The carrying amount of plant and equipment on 1 January is £189,000
• No capital expenditure, financing transactions, tax, or dividends in the quarter

Required

1. Prepare the sales budget for January to March.
2. Derive the production budget for January to March.
3. Prepare the direct materials usage and purchases budgets for January to March.
4. Prepare the direct labour and overhead budgets for January to March.
5. Compile the cash budget for January to March.
6. Prepare the budgeted statement of profit or loss for the quarter.
7. Prepare the budgeted statement of financial position as at 31 March.

Solution

1) Sales budget (January to March)

January: 2,000 units × £50 = £100,000
February: 2,400 units × £50 = £120,000
March: 2,600 units × £50 = £130,000

Quarter revenue = £350,000

2) Production budget (January to March)

Finished goods policy: closing FG = 20% of next month’s sales (units)

Closing FG targets:

• January closing FG = 20% × 2,400 = 480 units
• February closing FG = 20% × 2,600 = 520 units
• March closing FG = 20% × 2,500 = 500 units

Production units = Sales units + Closing FG − Opening FG

January: 2,000 + 480 − 400 = 2,080 units
February: 2,400 + 520 − 480 = 2,440 units
March: 2,600 + 500 − 520 = 2,580 units

Total production (quarter) = 7,100 units

3) Direct materials usage and purchases budgets (January to March)

Materials usage (3 kg per unit produced):

January usage: 2,080 × 3 = 6,240 kg
February usage: 2,440 × 3 = 7,320 kg
March usage: 2,580 × 3 = 7,740 kg

Raw materials policy: closing RM = 10% of next month’s usage (kg)

Closing RM targets:

• January closing RM = 10% × 7,320 = 732 kg
• February closing RM = 10% × 7,740 = 774 kg

To set the March closing RM target, an estimate of April usage is required. The information given is not sufficient to derive April production strictly from the finished goods policy (because that would also depend on May sales). For raw-material planning only, assume April production equals April sales of 2,500 units.

April usage = 2,500 × 3 = 7,500 kg
March closing RM = 10% × 7,500 = 750 kg

Materials purchases (kg) = Usage + Closing RM − Opening RM

January purchases: 6,240 + 732 − 1,200 = 5,772 kg
February purchases: 7,320 + 774 − 732 = 7,362 kg
March purchases: 7,740 + 750 − 774 = 7,716 kg

Purchases value at £4/kg:
January: 5,772 × £4 = £23,088
February: 7,362 × £4 = £29,448
March: 7,716 × £4 = £30,864

4) Direct labour and overhead budgets (January to March)

Direct labour (0.5 hours per unit at £16/hour):

January: 2,080 × 0.5 × £16 = £16,640
February: 2,440 × 0.5 × £16 = £19,520
March: 2,580 × 0.5 × £16 = £20,640

Variable overhead (£6 per unit produced):

January: 2,080 × £6 = £12,480
February: 2,440 × £6 = £14,640
March: 2,580 × £6 = £15,480

Fixed overhead: £18,000 per month (includes £3,000 depreciation)

Fixed overhead (total): January £18,000; February £18,000; March £18,000
Fixed overhead cash payment each month:

Fixed overhead cash payment = Fixed overhead − Depreciation
Fixed overhead cash payment = £18,000 − £3,000 = £15,000 per month

Depreciation (non-cash) each month = £3,000

5) Cash budget (January to March)

Customer collections: 70% in month after sale; 30% in second month after sale.

Receipts:
January: collection of opening trade receivables = £70,000
February: 70% × £100,000 = £70,000
March: (70% × £120,000) + (30% × £100,000) = £84,000 + £30,000 = £114,000

Supplier payments: paid 100% in month after purchase.

Materials payments:
January: £0
February: pay January purchases £23,088
March: pay February purchases £29,448

Other payments (paid in month incurred):
Direct labour + variable overhead + fixed overhead cash

Payments:
January: £16,640 + £12,480 + £15,000 = £44,120
February: £23,088 + £19,520 + £14,640 + £15,000 = £72,248
March: £29,448 + £20,640 + £15,480 + £15,000 = £80,568

Net cash movement:
January: £70,000 − £44,120 = £25,880
February: £70,000 − £72,248 = −£2,248
March: £114,000 − £80,568 = £33,432

Opening cash (1 January) = £12,000

Closing cash:
January: £12,000 + £25,880 = £37,880
February: £37,880 − £2,248 = £35,632
March: £35,632 + £33,432 = £69,064

6) Budgeted statement of profit or loss (quarter)

This statement is accrual-based. Cost of sales must reflect units sold and inventory movements. Inventory is valued using absorption costing (variable production cost plus an allocated share of fixed production overhead).

The scenario does not provide a brought-forward value for opening finished goods. For illustration, use the same budgeted absorption cost per unit to value opening inventory, noting that in practice the opening figure would normally come from the prior period’s records. Because no opening finished goods valuation is given, the opening statement of financial position is completed using the same illustrative unit cost assumption.

Variable production cost per unit:
Direct materials £12 (3 × £4)
Direct labour £8 (0.5 × £16)
Variable overhead £6
Variable production cost per unit = £26

Total fixed production overhead (quarter) = £18,000 × 3 = £54,000
Total production units (quarter) = 7,100 units

Fixed overhead absorption rate:

Fixed overhead absorption rate = Total fixed production overhead / Total production units
Fixed overhead absorption rate = £54,000 / 7,100 = £7.6056 per unit (approx.)

Budgeted absorption cost per unit:

Absorption cost per unit = Variable production cost per unit + Fixed overhead absorption rate
Absorption cost per unit = £26 + £7.6056 = £33.6056 per unit (approx.)

Production cost of units completed (quarter):
Direct materials used: (6,240 + 7,320 + 7,740) kg × £4 = 21,300 × £4 = £85,200
Direct labour: £16,640 + £19,520 + £20,640 = £56,800
Variable overhead: £12,480 + £14,640 + £15,480 = £42,600
Fixed overhead: £54,000
Total production cost of units completed = £238,600

Opening finished goods value (illustrative valuation):
400 units × £33.6056 = £13,442 (approx.)

Closing finished goods value:
500 units × £33.6056 = £16,803 (approx.)

Cost of sales:

Cost of sales = Opening finished goods + Production cost of units completed − Closing finished goods
Cost of sales = £13,442 + £238,600 − £16,803 = £235,239 (approx.)

Budgeted statement of profit or loss (quarter):
Revenue: £350,000
Cost of sales: £235,239
Operating profit: £114,761

(No additional operating expenses are given. Depreciation is included within fixed production overhead.)

7) Budgeted statement of financial position (as at 31 March)

Plant and equipment:
Opening carrying amount £189,000 − depreciation (3 × £3,000) = £180,000

Current assets:
Cash (from cash budget): £69,064

Trade receivables at 31 March:

• 30% of February sales = 30% × £120,000 = £36,000
• 100% of March sales = £130,000
• Total receivables = £166,000

Inventories:
Finished goods: 500 units × £33.6056 = £16,803 (approx.)
Raw materials: 750 kg × £4 = £3,000

Current liabilities:
Trade payables: March purchases unpaid (paid in April) = £30,864

Equity presentation:
Using the stated opening balances and valuing opening finished goods at the illustrative unit cost assumption above, opening equity is the balancing figure. Closing equity equals opening equity plus the quarter’s profit (no dividends assumed).

Opening equity (balancing figure):
Opening assets:

• Plant and equipment £189,000
• Finished goods £13,442 (approx.)
• Raw materials £4,800
• Trade receivables £70,000
• Cash £12,000
• Total opening assets = £289,242 (approx.)
• Opening liabilities = £0
• Opening equity = £289,242 (approx.)

Closing equity:

Closing equity = Opening equity + Profit (assuming no dividends)
Closing equity = £289,242 + £114,761 = £404,003 (approx.)

Budgeted statement of financial position summary:

Non-current assets:
Plant and equipment: £180,000

Current assets:
Inventories: £19,803 (approx.)
Trade receivables: £166,000
Cash: £69,064

Total assets: £434,867 (approx.)

Current liabilities:
Trade payables: £30,864

Net assets: £404,003 (approx.)

Equity:
Total equity: £404,003 (approx.)

Interpretation of the results

The quarter ends with a strong cash balance (£69,064), although February shows a small net outflow. The pattern is driven by working-capital timing: receipts lag credit sales, and supplier payments lag purchases by one month. The cash budget therefore highlights month-by-month liquidity in a way that a profit forecast cannot.

At 31 March, trade receivables (£166,000) are high because March sales are still outstanding. This illustrates how growth can absorb cash through receivables and inventory, even when forecast profit remains positive.

Common pitfalls and misunderstandings

• Treating credit sales as immediate cash receipts.
• Building a cash budget from profit figures without adjusting for timing and working-capital movements.
• Using production volume to calculate cost of sales instead of units sold and inventory movement.
• Ignoring finished goods or raw materials policies when deriving production and purchases.
• Including depreciation (or other non-cash costs) as a cash payment.
• Forgetting that payables and receivables balances must reconcile to the stated payment and collection patterns.
• Mixing “cash-based” and “accrual-based” logic within the same schedule.

Summary

Functional budgets translate activity into operational schedules for sales, production, resources, and overheads. The cash budget then converts those schedules into timed receipts and payments, revealing liquidity risk. The master budget consolidates everything into forecast statements, where inventories, receivables, and payables must be consistent with the underlying assumptions.

A strong budgeting model is characterised by tight internal consistency: units reconcile, inventory policies are applied correctly, and working-capital balances match the cash timing logic.

FAQ

What is the primary purpose of a cash budget?

To forecast when cash will be received and paid so that the business can plan for shortages or surpluses and ensure obligations can be met as they fall due.

How does scenario analysis differ from sensitivity analysis?

Scenario analysis compares outcomes under different coherent sets of assumptions. Sensitivity analysis changes one input at a time to identify which variables most affect profit or cash.

Why is unit reconciliation so important?

Because a small unit mismatch in production or inventory targets will distort materials purchases, labour, overheads, payables, and ultimately the cash forecast.

What are common mistakes in a master budget?

Common errors include confusing sales with cash receipts, valuing inventory inconsistently, ignoring working-capital effects, and calculating cost of sales using production instead of sales.

How does goal seek help in budgeting?

It finds the input required to hit a target output (for example, the sales volume needed to achieve a minimum closing cash balance).

Why do credit terms matter so much in a cash budget?

Because they determine when cash moves. Profit can be forecast, but cash can still be tight if customer collections are slow or supplier payments fall due quickly.

Summary (Recap)

This chapter showed how to prepare functional budgets for sales, production, materials, labour, and overheads, and how to translate them into a timing-based cash budget. It then demonstrated how to compile a master budget through a budgeted statement of profit or loss and a budgeted statement of financial position, and how to strengthen reliability through what-if analysis and internal consistency checks.

Glossary

Functional budget
A detailed budget for a specific operational area (for example, sales, production, materials, labour, or overheads) that feeds into the overall budget.

Master budget
A consolidated financial plan combining functional budgets, typically including a budgeted statement of profit or loss, a cash budget, and a budgeted statement of financial position.

Sales budget
A schedule of forecast sales volumes and selling prices by period, forming the basis for other budgets.

Production budget
A schedule of units to be produced, derived from sales demand and finished goods inventory targets.

Direct materials usage budget
A schedule of materials required for planned production, expressed in physical units.

Direct materials purchases budget
A schedule of materials to be purchased, adjusted for raw material inventory targets, often extended into value for payables and cash planning.

Direct labour budget
A schedule of labour hours and labour cost based on production volume, labour standards, and pay rates.

Overhead budget
A schedule of indirect production costs split into variable and fixed elements, with non-cash items separated where required.

Cash budget
A forecast of cash inflows and outflows by period based on the timing of receipts and payments.

Working capital
The short-term investment in current assets (inventory, receivables) financed partly by current liabilities (payables).

Scenario analysis
A comparison of outcomes under different internally consistent sets of assumptions.

Sensitivity analysis
An assessment of how outcomes change when one input is varied while others are held constant.

Goal seek
A method of finding the input needed to achieve a target output (for example, sales volume required to keep closing cash above a set minimum).