Performance Management · Budgetary systems and types of budget

Budget Preparation Process and Principal Budget Factor in ACCA PM

Updated 11 October 2026 · Fact-checked

The principal budget factor is the resource or constraint that limits activity and so must be identified first. Budget preparation then builds the functional budgets around it, starting with the budget for that factor, and combines them into the master budget: budgeted income statement, statement of financial position and cash budget.

Understand Budget Preparation Process and Principal Budget Factor

A budget is a quantified plan for a future period. Preparing one is a process, not a single calculation. The organisation must decide who is responsible, what the limits are, and in what order the numbers are built.

Two supporting items matter. The budget committee coordinates the process. It usually has senior managers from each function, often chaired by the managing director. It sets guidelines, reviews draft budgets, resolves conflicts and approves the final version. The budget manual is a written set of instructions. It sets out responsibilities, timetables, forms, the planning assumptions and the procedures to follow.

The principal budget factor (also called the limiting budget factor or key factor) is the factor that limits the activity of the organisation. In most businesses it is sales demand. It can also be a scarce material, skilled labour, machine capacity or cash. You identify it first because every other budget depends on it. If demand is 10,000 units but capacity is only 8,000, you cannot plan to sell 10,000.

Once the principal budget factor is known, you prepare its budget first. If sales is the factor, the sales budget comes first. Then you work through the other functional budgets in a logical order. For a manufacturer this is usually: sales budget, finished goods inventory budget, production budget, then material usage and purchases, labour and overhead budgets. Each budget feeds the next.

The functional budgets are then combined into the master budget. This has three parts: the budgeted income statement, the budgeted statement of financial position and the cash budget. The cash budget is built after the other budgets because it needs their figures. Finally, the budgets are reviewed, adjusted if they do not fit together or do not meet targets, and approved.

Key rules to remember

Production budget (units): Sales units + closing inventory of finished goods − opening inventory of finished goods; Use units, not money. Closing inventory is the target level at the end of the period.
Material purchases budget (units): Material needed for production + closing material inventory − opening material inventory; Material needed for production = production units × material per unit. Allow for normal losses if told.
Principal budget factor test: Compare the maximum activity allowed by sales demand, materials, labour, machine capacity and cash; the lowest is the principal budget factor; Compare in the same unit, such as units of finished product.
Order of building budgets: Principal budget factor budget → other functional budgets → cash budget → master budget (income statement and statement of financial position); For most manufacturers the principal budget factor is sales, so the sales budget comes first.

How to solve Budget Preparation Process and Principal Budget Factor questions

Use this method for any question on preparing budgets or identifying the principal budget factor.

1Read the data and list each possible constraint: sales demand, materials, labour hours, machine hours, cash or finance.
2Convert each constraint into the maximum units of output it allows. Use the same unit for all of them.
3Pick the lowest. That is the principal budget factor. If the question asks only for this, state it and say why.
4Prepare the budget for the principal budget factor first. For sales, this is units × price.
5Build the other budgets in order: finished goods inventory, production, then materials, labour and overheads.
6Do each budget in units first, then convert to money using the standard costs or prices given.
7Feed the figures into the cash budget and the master budget, and check that the totals agree between statements.
8Where the question asks for a discussion, link your points to the process: committee, manual, coordination, review and approval.

Quickest way: Lowest-output test and units-first layout

When to use it: Use this in Section A and Section B objective questions where you must spot the limiting factor or work out production or purchases quickly.

For each resource, divide the amount available by the amount needed per unit. This gives maximum output.
The smallest answer is the principal budget factor. Circle it.
For production and purchases, write the formula as: needs + closing − opening. Fill in units only.
Check the direction of the inventory change. Rising inventory increases the amount to produce or buy. Falling inventory reduces it.
Multiply by cost or price only at the end.

Common mistakes in Budget Preparation Process and Principal Budget Factor

Assuming the principal budget factor is always sales demand.
Sales is the most common limiting factor, so students stop looking.
Fix: Always compare every constraint in the data. Sales is the factor only if it gives the lowest feasible output.
Preparing the production budget before the sales budget when sales is the limiting factor.
Students start with the factory data because it has the most numbers.
Fix: Begin with the budget for the principal budget factor. Production depends on sales and inventory targets.
Getting the inventory adjustment the wrong way round in the production budget.
Students add opening inventory instead of subtracting it.
Fix: Use sales + closing − opening. Opening inventory already exists, so you need to make less. Closing inventory must be made, so you add it.
Doing the cash budget before the other budgets.
Cash looks like an independent schedule.
Fix: The cash budget uses sales, purchases, wages and overhead figures, so it comes after the functional budgets.
Confusing the budget committee with the budget manual.
Both relate to organising the process, so the terms blur.
Fix: The committee is people who coordinate and approve. The manual is a document of instructions and timetables.
Mixing units and money in a budget schedule.
Students rush and multiply by price too early.
Fix: Finish the units schedule first. Convert to money at the end and label each line.

Worked examples

Example 1

A company makes one product. Next year's expected demand is 12,000 units. Each unit needs 3 kg of material and 2 labour hours. Available: 33,000 kg of material and 25,000 labour hours. Machine capacity is 14,000 units. Identify the principal budget factor and the budgeted production.

Show the solution

Demand allows 12,000 units.
Material allows 33,000 ÷ 3 = 11,000 units.
Labour allows 25,000 ÷ 2 = 12,500 units.
Machine capacity allows 14,000 units.
The lowest is 11,000 units, from material.
So material is the principal budget factor, and output cannot exceed 11,000 units.

Answer: The principal budget factor is material supply. Budgeted production is 11,000 units, so the company cannot meet all 12,000 units of demand unless it finds more material.

Example 2

Sales budget for a product is 8,000 units. Opening finished goods inventory is 1,500 units and the target closing inventory is 2,000 units. Each unit uses 4 kg of material. Opening material inventory is 3,000 kg and the target closing material inventory is 2,500 kg. Material costs ₹50 per kg. Calculate budgeted production, material purchases in kg and the purchases cost.

Show the solution

Production = 8,000 + 2,000 − 1,500 = 8,500 units.
Material needed for production = 8,500 × 4 = 34,000 kg.
Purchases = 34,000 + 2,500 − 3,000 = 33,500 kg.
Cost = 33,500 × ₹50 = ₹16,75,000.

Answer: Production is 8,500 units. Material purchases are 33,500 kg, costing ₹16,75,000.

Exam tips

In objective questions, check every constraint before you choose the principal budget factor. Examiners often make sales the obvious answer and hide a lower limit elsewhere.
Because objective questions are all or nothing, write the units schedule on your scrap paper and check the sign of each inventory change before you answer.
In written answers, name the stages in order and link each to a purpose: for example, the committee coordinates and the manual standardises the process.
Remember that the principal budget factor can change over time. If it is relieved, for example by buying more material, another factor may become the limit. Use this point in discussion answers.
State your assumptions clearly in Section C, such as which inventory targets you used, so you can earn method marks.

Practice questions from Budgetary systems and types of budget

Budget Preparation Process and Principal Budget Factor in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Budget Preparation Process and Principal Budget Factor: frequently asked questions

What is the principal budget factor in ACCA PM?

It is the factor that limits the organisation's activity, such as sales demand, materials, labour, machine capacity or cash. You identify it first because all other budgets must fit within it. It is also called the limiting budget factor or key factor.

What is the order of preparing a master budget?

Start with the budget for the principal budget factor, usually sales. Then prepare the other functional budgets, such as production, materials, labour and overheads. Finally prepare the cash budget and combine everything into the budgeted income statement and statement of financial position.

What does the budget committee do?

It coordinates the budget process. It sets guidelines, reviews the functional budgets, resolves conflicts between departments and approves the final budget. It usually includes senior managers from each function.

What is a budget manual?

It is a written document that sets out the procedures for preparing budgets. It usually covers responsibilities, timetables, standard forms and planning assumptions, so everyone prepares budgets in the same way.