OK - Castle cake - will be plenty as an 8" square - it's quite tall, and people only eat/take home small bits. The only reason I might consider making it into a rectangular castle is to have enough towers to match birthday age - when I did it DS was 4, conveniently! I would typically bake on Wednesday, decorate Thurs/Fri for a Saturday party, but madiera will keep for at least a week after that.
Food - I agree you don't need pizza, but if you have the means (and the manpower) to do it then it might be nice to have something warm, given the temperatures. My only other comment would be that you can never have too many mini sausages!
Craft activity - if you can afford it, would be good, as they won't all be on the bouncy castle all the time. Also if you print a load of random knight-and-princess related colouring sheets, there will generally be one or two DC who just want to do that.
I wouldn't bother decorating the bags - unless you fall across any suitable stickers. You're right - bag-decorating would mean you would have to have contents ready-bagged to just drop in, which would be a pain.
Pass the parcel - I would opt for 1 circle, 2-3 parcels, sweets in the layers and a stock to give to those who didn't get a go at the end. Books or paint sets sound fine to me for the prize in the middle.
Music - Disney CDs are guaranteed safe, if you can stand them!