Budgeting in Practice: Building Budgets and Flexing for Control

Learning objectives

By the end of this chapter, you should be able to:

• Prepare key functional budgets (sales, production, materials, labour and overheads) using stated assumptions and inventory policies.
• Build a cash budget that reflects timing of receipts and payments, including VAT effects.
• Identify the principal budget factor (the binding constraint) and explain how it shapes the budget.
• Produce a flexed budget for an actual activity level and use it as the benchmark for control.
• Communicate budget outcomes clearly, highlighting practical next steps for management.

Overview & key concepts

Budgeting converts intentions into numbers. It takes expected activity levels and turns them into targets for sales, resource usage, spending, and cash. Budgets are internal benchmarks used to coordinate departments and evaluate performance once actual results are known.

Budgets and control

A budget is an internal plan expressed in numbers. It turns expectations (how much you intend to sell and produce) into targets for resources, spending, and cash.

Budgetary control is what happens after the period starts: you compare what actually happened with the right benchmark, work out why any gaps arose, and decide what to change. For variable items, fairness requires flexing to the activity achieved; fixed costs normally remain unchanged within the relevant range unless capacity steps, contracts, or policy changes apply.

Principal budget factor

The principal budget factor is the constraint that prevents the organisation from doing “as much as it would like”. Typical constraints include market demand, machine capacity, skilled labour hours, materials supply, or available cash/working capital. The constraint determines the planning sequence:

• Ifdemandlimits activity, start with the sales budget and build production and resources from it.
• Ifcapacitylimits activity (machine hours or labour hours), start with available capacity, derive output, and then set feasible sales targets.
• Ifcashlimits activity, the cash budget becomes central and may force changes to credit terms, inventory levels, or spending.

Functional budgets and the master budget

Functional budgets focus on a single area (for example, production or labour). Together they form the master budget, which summarises expected profitability and cash position for the period.

Flexible budgets

A flexible budget is the original plan recalculated for the activity level that actually occurred. Think of it as resetting the measuring tape: once the tape matches the real volume, any remaining differences are more likely to reflect spending discipline, efficiency, or operational issues rather than “we sold more/less than expected.”

Cash budgeting

Cash budgeting is about timing, not profit. Profit can be reported while cash is tied up in inventories and receivables. A cash budget shows when cash will arrive and when it must be paid out, highlighting funding needs and surplus cash periods.

Core theory and frameworks

Building functional budgets

Functional budgets are typically prepared in a logical sequence:

1. Sales budget(units and value)
2. Production budget(units to make)
3. Materials usage and purchases budgets(quantities and cost)
4. Labour budget(hours and cost)
5. Overhead budgets(variable and fixed)
6. Cash budget(timing of receipts and payments)

Each step answers a practical question: what will we sell, what must we make, what resources does that require, what will it cost, and when will cash move?

Sales budget

The sales budget sets expected sales volumes and selling prices. Where a sales tax such as VAT applies, keep two figures:

• net sales value(excluding tax) for profitability and margin analysis
• gross invoice value(including tax) for cash receipts, because customers pay the tax-inclusive amount

Production budget

Production must cover sales demand and the planned change in finished goods inventory.

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

The inventory policy (for example, “closing inventory is 10% of next month’s sales”) must be applied consistently.

Materials budget (usage and purchases)

Start with material usage driven by production:

• Materials to use (kg) = Production units × kg per unit

Purchases then adjust for raw material inventory:

• Purchases (kg) = Materials to use + Closing raw materials − Opening raw materials

For cash budgeting, supplier payments are based on purchases, not usage, and usually include sales tax where applicable.

Labour budget

• Direct labour hours = Production units × hours per unit
• Direct labour cost = Direct labour hours × hourly rate

If overtime premiums or efficiency assumptions exist, state them explicitly.

Overhead budgets

Separate variable and fixed overheads:

• variable overheads flex with activity (often per unit)
• fixed overheads remain constant within the relevant range (unless step-changes apply)

Flexing budgets for control

A flexed budget should reflect the activity driver that causes the item:

• Revenue is usually driven bysales units(or sales value), so it is flexed using actual sales volume.
• Manufacturing costs are often driven byproduction units, so they are flexed using actual output when inventories change.

In this example, sales revenue is flexed to actual sales units, while manufacturing costs are flexed to actual production units.

A practical point about inventory policies: a flexed budget uses actual activity for the chosen driver, but it may keep inventory policy at the budget basis unless the policy itself changed in reality. If actual closing inventory differed materially from policy, the flex should be based on the actual inventory movement (and therefore actual production), not a policy-based proxy.

Linking budgets to working capital and sales taxes

Timing assumptions in the cash budget imply balances in receivables, payables and tax control accounts:

• Credit salescreate a closing receivable balance equal to the unpaid portion of gross invoices. For example, if customers pay 40% in the month of sale and 60% next month, the month-end receivable is the 60% not yet collected.
• Credit purchasescreate a closing payable balance equal to unpaid gross purchases.
• Sales taxes collectedfrom customers are not income; they are amounts collected on behalf of the tax authority and become a liability until settled. Input tax on purchases typically offsets output tax, producing a net tax payable or receivable.

Tax rules and settlement timing vary by jurisdiction; the approach here illustrates the principle using a one-month settlement lag.

Worked example

Narrative scenario

XYZ Ltd sells a single product (Product A) and prepares monthly budgets for the next quarter (three months). The following information applies:

• Forecast sales volumes (units):
  • Month 1: 10,000
  • Month 2: 12,000
  • Month 3: 11,000
• Selling price: £30 per unit (excluding sales tax). Sales tax is 20%.
• Opening finished goods inventory (start of Month 1): 1,000 units.
• Finished goods policy: closing finished goods each month is10% of next month’s forecast sales.
• Forecast sales for Month 4 are 10,000 units (used only for Month 3 closing inventory).
• Each unit requires2 kgof Material X at£3 per kg(excluding sales tax).
• Opening raw materials inventory (start of Month 1): 5,000 kg.
• Raw materials policy: closing raw materials inventory at each month-end is6,000 kg.
• Direct labour:0.5 hours per unit producedat£15 per hour.
• Variable production overhead:£2 per unit produced.
• Fixed overhead:£25,000 per month.
• Customer receipts:40% in the month of sale, 60% in the following month(based on tax-inclusive invoices).
• Supplier payments:one month after purchase(based on tax-inclusive purchase invoices).
• Wages and overheads are paid in the month incurred.
• Sales tax is paidone month in arrearsbased on the prior month’s net tax position (output tax less input tax on material purchases).
• Opening cash balance at the start of Month 1: £15,000.
• For cash-budget purposes, assumeno opening trade receivables, trade payables, or sales tax balance.

After Month 1, actual results were:

• Actual sales in Month 1: 9,500 units
• Actual costs in Month 1 (manufacturing costs incurred for the month, not cash payments):
  • Materials: £59,000 (net of tax)
  • Labour: £73,500
  • Variable overhead: £19,800
  • Fixed overhead: £25,400

Required

1. Prepare the sales, production, materials, labour and overhead budgets for Month 1.
2. Construct a cash budget for Months 1–3.
3. Flex the Month 1 budget for actual sales of 9,500 units and prepare a flexed cost benchmark.
4. Compare Month 1 actual costs to the flexed budget and interpret the results.

Solution

1) Month 1 functional budgets

Sales budget (Month 1)

Units: 10,000
Net selling price: £30

Sales value (net of tax)
= 10,000 × £30
= £300,000

Sales invoices (gross, tax-inclusive)
= £300,000 × 1.20
= £360,000

Production budget (Month 1)

Closing finished goods (units)
= 10% × Month 2 forecast sales
= 10% × 12,000
= 1,200 units

Production (units)
= Sales + Closing FG − Opening FG
= 10,000 + 1,200 − 1,000
= 10,200 units

Materials budget (Month 1)

Usage (kg)
= Production × kg per unit
= 10,200 × 2
= 20,400 kg

Purchases (kg)
= Usage + Closing RM − Opening RM
= 20,400 + 6,000 − 5,000
= 21,400 kg

Purchases cost (net)
= 21,400 × £3
= £64,200

Purchases cost (gross)
= £64,200 × 1.20
= £77,040

Labour budget (Month 1)

Hours
= 10,200 × 0.5
= 5,100 hours

Cost
= 5,100 × £15
= £76,500

Overhead budget (Month 1)

Variable overhead
= 10,200 × £2
= £20,400

Fixed overhead
= £25,000

Total overhead
= 20,400 + 25,000
= £45,400

2) Cash budget for Months 1–3

All receipts and payments below are cash amounts.

Step 1: Supporting schedules

(a) Sales invoices (gross, tax-inclusive)

• Month 1: 10,000 × £30 × 1.20 =£360,000
• Month 2: 12,000 × £30 × 1.20 =£432,000
• Month 3: 11,000 × £30 × 1.20 =£396,000

(b) Customer cash receipts (40% current month, 60% next month)

• Month 1 receipts = 40% × 360,000 =£144,000
• Month 2 receipts = 60% × 360,000 + 40% × 432,000
• = 216,000 + 172,800 =£388,800
• Month 3 receipts = 60% × 432,000 + 40% × 396,000
• = 259,200 + 158,400 =£417,600

Closing receivables at end of Month 3 = 60% of Month 3 invoices
= 0.60 × 396,000
= £237,600

(c) Material purchases (gross, tax-inclusive) and supplier payments

Finished goods closing inventories:

• End of Month 1: 10% × 12,000 = 1,200 units
• End of Month 2: 10% × 11,000 = 1,100 units
• End of Month 3: 10% × 10,000 = 1,000 units

Production units:

• Month 1: 10,000 + 1,200 − 1,000 =10,200
• Month 2: 12,000 + 1,100 − 1,200 =11,900
• Month 3: 11,000 + 1,000 − 1,100 =10,900

Material purchases (kg), with closing raw materials of 6,000 kg each month:

• Month 1 purchases = 10,200×2 + 6,000 − 5,000 =21,400 kg
• Month 2 purchases = 11,900×2 + 6,000 − 6,000 =23,800 kg
• Month 3 purchases = 10,900×2 + 6,000 − 6,000 =21,800 kg

Purchases cost (gross):

• Month 1: 21,400 × £3 × 1.20 =£77,040
• Month 2: 23,800 × £3 × 1.20 =£85,680
• Month 3: 21,800 × £3 × 1.20 =£78,480

Supplier payments (one month after purchase; no opening payables assumed):

• Month 1:£0
• Month 2: pay Month 1 purchases =£77,040
• Month 3: pay Month 2 purchases =£85,680

Closing payables at end of Month 3 = Month 3 purchases outstanding
= £78,480

(d) Sales tax payments (one month in arrears on net tax)

Net tax for each month:

• Output tax = Sales (net) × 20%
• Input tax = Material purchases (net) × 20%
• Net tax payable = Output tax − Input tax

Month 1:

• Output tax = 300,000 × 20% =£60,000
• Input tax = 64,200 × 20% =£12,840
• Net tax payable =£47,160

Month 2:

• Output tax = 360,000 × 20% =£72,000
• Input tax = 71,400 × 20% =£14,280
• Net tax payable =£57,720

Month 3:

• Output tax = 330,000 × 20% =£66,000
• Input tax = 65,400 × 20% =£13,080
• Net tax payable =£52,920

Tax cash payments (one month in arrears; no opening tax balance assumed):

• Month 1:£0
• Month 2: pay Month 1 tax =£47,160
• Month 3: pay Month 2 tax =£57,720

Closing tax payable at end of Month 3 = Month 3 net tax unpaid
= £52,920

Step 2: Cash budget (Months 1–3)

Opening cash (start of Month 1): £15,000

Month 1

• Receipts:£144,000
• Payments:
  • Suppliers: £0
  • Wages: £76,500
  • Overheads: £45,400
  • Sales tax: £0
  • Total payments =£121,900
• Net cash flow = 144,000 − 121,900 =£22,100
• Closing cash = 15,000 + 22,100 =£37,100

Month 2

• Receipts:£388,800
• Payments:
  • Suppliers: £77,040
  • Wages: 11,900×0.5×£15 =£89,250
  • Overheads: 11,900×£2 + £25,000 =£48,800
  • Sales tax:£47,160
  • Total payments =£262,250
• Net cash flow = 388,800 − 262,250 =£126,550
• Closing cash = 37,100 + 126,550 =£163,650

Month 3

• Receipts:£417,600
• Payments:
  • Suppliers: £85,680
  • Wages: 10,900×0.5×£15 =£81,750
  • Overheads: 10,900×£2 + £25,000 =£46,800
  • Sales tax:£57,720
  • Total payments =£271,950
• Net cash flow = 417,600 − 271,950 =£145,650
• Closing cash (end of quarter) = 163,650 + 145,650 =£309,300

3) Flexed budget for Month 1 (actual sales 9,500 units)

Revenue is driven by sales units, so sales revenue is flexed to actual sales. Manufacturing costs are driven by production units, so variable manufacturing costs are flexed to actual output.

In this example, sales revenue is flexed to actual sales units, while manufacturing costs are flexed to actual production units.

Manufacturing output for the flex is based on actual sales and the inventory policy (closing finished goods 1,200 units), assuming the policy remained in place:

Flexed production (Month 1) = Actual sales + Closing FG − Opening FG
= 9,500 + 1,200 − 1,000
= 9,700 units

If the actual closing inventory differed from 1,200 units, flexed production should be based on the actual inventory movement (and therefore actual production), not the budget policy.

Flexed budget benchmark (Month 1)

Sales (net of tax)
= 9,500 × £30
= £285,000

Flexed manufacturing costs (based on 9,700 units produced)

• Materials: 9,700 × 2 kg × £3 =£58,200
• Labour: 9,700 × 0.5 hr × £15 =£72,750
• Variable overhead: 9,700 × £2 =£19,400
• Fixed overhead:£25,000

4) Comparison of Month 1 actual costs to the flexed budget

Actual costs are assumed to be manufacturing costs incurred for the month (materials used, labour worked, overheads incurred), not cash payments and not material purchases.

Variances (Actual − Flexed)

• Materials: 59,000 − 58,200 =£800 adverse
• Labour: 73,500 − 72,750 =£750 adverse
• Variable overhead: 19,800 − 19,400 =£400 adverse
• Fixed overhead: 25,400 − 25,000 =£400 adverse

Total cost variance: £2,350 adverse

Interpretation and follow-up actions

A flexed budget removes the volume effect by resetting variable manufacturing costs to the actual output level (9,700 units). The remaining differences point to cost control or efficiency issues.

To sharpen diagnosis, variances are often split into standard components:

• Materials: price (rate per kg) and usage (kg per unit), and where relevant, mix and yield.
• Labour: rate (hourly cost) and efficiency (hours per unit).
• Variable overhead: spending (cost per variable driver) and efficiency (driver usage).
• Fixed overhead: expenditure (overspend/underspend against the period allowance).

Practical next steps for management:

1. Materials: check supplier price changes, discount loss, and wastage/scrap reports; review issuing controls and production losses.
2. Labour: reconcile to overtime logs, grade mix, absenteeism, training time, and rework; compare actual hours per unit to standards.
3. Variable overhead: identify which indirect items increased (energy, consumables, maintenance); link movements to machine running time or rework.
4. Fixed overhead: confirm whether overspend is recurring (e.g., contractual increases) or one-off; check whether a capacity step was triggered.

Common pitfalls and misunderstandings

• Building a plan that ignores bottlenecks: if a constraint exists (capacity, materials supply, cash), the plan must start there.
• Flexing on the wrong driver: production-driven costs should be flexed on output, not sales, when inventories change.
• Blurring net and gross figures: use tax-exclusive figures for margins and cost analysis, but tax-inclusive amounts for customer receipts and supplier payments.
• Forgetting opening balances in cash budgets: opening receivables/payables/tax balances change Month 1 cash flows immediately.
• Using purchases when you need usage (or vice versa): usage drives production costing; purchases drive supplier cash flows and payables.
• Assuming fixed costs are always fixed: stepped fixed costs can apply when capacity thresholds are crossed.
• Treating budgets like postings: budgets are benchmarks; working capital balances follow from timing assumptions, not from “budget entries”.
• Explaining variances too broadly: move from general comments (“inefficient”) to specific causes (rate vs efficiency, price vs usage).

Summary

Budgeting translates plans into coordinated targets for sales, production, resources, spending, and cash. Functional budgets build logically from sales through production into materials, labour, and overhead requirements. Cash budgets then convert those plans into expected receipts and payments by applying timing assumptions, including sales tax, revealing the working-capital consequences (receivables, payables, and tax balances). For performance control, flexed budgets reset variable items to the activity level actually achieved, so variances can be interpreted as spending or efficiency issues rather than volume effects.

FAQ

What is the principal budget factor and why does it matter?

It is the tightest constraint that caps what can be achieved in the short term. Once identified, it determines the planning sequence and prevents targets being built on unrealistic activity levels.

Why is a flexible budget a better benchmark than the original budget?

Because it recalculates variable items for the activity actually achieved. That makes the comparison fairer and directs attention to controllable causes (spending, efficiency, waste), not volume changes.

Why can an organisation be profitable but still short of cash?

Because profit and cash move on different timelines. Credit sales delay receipts, inventory absorbs cash, and some cash payments (such as tax settlements) occur after the related sales period.

How should sales tax be handled in budgets?

Use tax-exclusive figures for profitability analysis, but tax-inclusive amounts for customer receipts and supplier payments. Then calculate net tax (output less input) and schedule settlement based on the assumed payment timing.

When should manufacturing costs be flexed on production rather than sales?

When those costs are driven by output and inventories change. In that case, sales and production volumes differ, and flexing on sales produces a misleading cost benchmark.

Glossary

Budget
A forward-looking numerical plan used to coordinate activities and set targets for a period.

Budgetary control
A routine for running the business: set targets in advance, compare performance to a fair benchmark, explain what drove the differences, and adjust actions or assumptions.

Principal budget factor
The tightest constraint limiting achievable activity, which therefore drives the rest of the plan.

Functional budget
A detailed budget for a specific area (such as sales, production, materials, labour, overheads, or cash) that feeds into the overall plan.

Master budget
The combined budget package formed from functional budgets, typically summarising expected profit and cash position.

Flexible (flexed) budget
A budget recomputed using the actual activity level, so the comparison with actual results focuses on efficiency and cost management rather than volume.

Incremental budgeting
Budgeting that starts from the current position and adjusts for expected changes, often quicker but less challenging of existing spending.

Zero-based budgeting
Budgeting that requires activities and costs to be justified from a zero starting point, encouraging scrutiny of value and necessity.

Rolling budget
A budget updated regularly so the planning horizon stays constant (for example, always budgeting the next 12 months).

Cash budget
A time-based schedule of expected cash receipts and payments, used to anticipate liquidity needs and manage short-term finance.

Budget slack
Deliberately building in easier targets (for example, by understating revenue or overstating costs), often arising from incentive pressures.