What is Activity-based Budgeting?
Definition: Activity-based budgeting is most often found in cost accounting. Managers prepare budgets and spending propositions based on past production activities. In other words, management examines the costs of performing certain activities, like bending a fender for a car, to budget the overall costs of producing a product.
Activity-based budgeting (ABB) is a system that records, researches, and analyzes activities that lead to costs for a company. Every activity in an organization that incurs a cost is scrutinized for potential ways to create efficiencies. Budgets are then developed based on these results.
Activity-based budgeting (ABB) is more rigorous than traditional budgeting processes, which tend to merely adjust previous budgets to account for inflation or business development.
Activity based budgeting is a budgeting method in which budgets are prepared using activity based costing after considering the overhead costs. In simple words, activity based budgeting is management accounting tool which does not consider the past year’s budget to arrive at current year’s budget. Instead, the activities that incur the cost are deeply analyzed and researched. Based on the outcome of the study, the resources are allocated to an activity.
This might be a little hard to think about without an example. Let’s assume there are two different setup stages to make a cell phone: machining and assembling. A managerial accountant would look at the total amount of cell phones that need to be produced, the number of cell phones in each batch, the setup time for both machining and assembling, as well as the hourly rate of each machinists and assemblers.
By looking at all of these different activities, the managerial accountant could come up with efficiencies in the production process that would save the company money.
What Does Activity Based Budgeting Mean?
Depending on the two activities, the company might be able to save money by increasing the batch production, reducing the production time, or even combining these two activities. As you can see, activity-based budgeting not only helps the company save money, it also forces management to examine every activity. By doing this, management can become extremely familiar with the production process as a whole. This kind of knowledge can lead to much more than cost savings.
Manufacturing and product innovations often result from knowing and understanding the production process. It only takes one person to look at the process differently. As you can see, activity-based budgeting should be important to any manufacturer.
How Activity-Based Budgeting (ABB) Works?
Keeping costs to a minimum is a crucial part of business management. When done effectively and not too excessively, companies should be able to maintain and keep growing their revenues, while squeezing out higher profits from them.
Using activity-based budgeting (ABB) can help companies to reduce the activity levels required to generate sales. Eliminating unnecessary costs should boost profitability.
The activity-based budgeting (ABB) process is broken down into three steps:
- Identify relevant activities. These cost drivers are the items responsible for incurring revenue or expenses for the company.
- Determine the number of units related to each activity. This number is the baseline for calculations.
- Delineate the cost per unit of activity and multiply that result by the activity level.
Activity-Based Budgeting (ABB) Vs. Traditional Budgeting Processes
Activity-based budgeting (ABB) is an alternative budgeting practice. Traditional methods are more simplistic, adjusting prior period budgets to account for inflation or revenue growth. Rather than using past budgets to calculate how much a firm will spend in the current year, activity-based budgeting (ABB) digs deeper.
Activity-based budgeting (ABB) is not necessary for all companies. For example, established firms that experience minimal change typically find that applying a flat rate to data from the previous year to reflect business growth and inflation is sufficient.
In contrast, newer companies without access to historical budgeting information cannot consider this an option. Activity-based budgeting (ABB) is also likely to be implemented by firms undergoing material changes, such as those with new subsidiaries, significant customers, business locations, or products. In these types of cases, historical information may no longer be a useful basis for future budgeting.
Components and Process of Activity Based Budgeting
Components and Process of Activity Based Budgeting are given below:
- It starts with identifying activities which revolve around resource consumption and these activities are mainly classified as main activities and secondary activities which denotes to the degree of involvement and importance of an activity to the organization as per their priority, therefore, main activities are activities which are directly related with the objectives and are essential.
- Secondary activities are those activities that create added value to the customer and change its preference in the organization’s favor which may involve a significant amount of resources.
- After defining the activities the next task is to identify how to distribute the costs or resources accordingly among the activities which are done with the help of inducers which are factors defining the level of consumption in different activities.
- Mainly three such inducers influence such decisions which are time which depicts the duration for the processes, amount of resources required by each activity and lastly the number of times an activity is repeated after getting all these facts the appropriate costs can be calculated.
Advantages of Activity-Based Budgeting
The various different advantages related to the Activity-Based budgeting are as follows:
- Activity-Based Budgeting takes up a forward-looking view rather than looking at previous activities which a common feature under traditionally based budgeting i.e. it asks questions like what needs to be performed and where can we make improvement rather than what was done earlier and sort of just allocation of costs according to that.
- Activity-Based Budgeting sources its budgets based on activities and resources allowing better insight on inefficiencies in processes and sources of imbalances which will help the managers find areas of improvements making them more efficient in their jobs.
- Activity-Based Budget has a more practical approach in a dynamic environment and makes it easier for the employees and managers to communicate and execute the activities in a time-bound manner as well as to evaluate performances of the same by fixing accountability of specific activities.
- Activity-Based Budget leaves scope for making changes as per the changes in the climate and current situation as opposed to what was initially planned as it allows tools to trace resource consumption which allows identifying capacity issues so they can adjust in a timely manner.
Disadvantages of Activity-Based Budgeting
The various disadvantages related to the Activity-Based budgeting are as follows:
- Activity-Based Budgeting is a lengthy and comprehensive process that requires a considerable amount of time and resources on an entity and spending too much on analyzing may prove to be counterproductive.
- It requires a well-groomed talented team of individuals who are experts in finding gaps and are equally competent in reporting and use of the necessary software as it is a complex process on which the direction of the company is dependent.
While preparing an Activity Based Budget it is possible that the axis of focus may shift to immediate and short term results and the bigger picture may be ignored causing damage in the long term.
- It is based on forecasting with the use of historical data and future expectations which may sometimes prove to be unreliable if the situations or scenarios planned do not come out to be what was expected to lead to problems that can hamper the entity and its resources.
- Activity-Based Budgeting provides only supplemental information.
Important Points of the Activity-Based Budgeting
- It is simply put getting a detailed analysis of all the costs associated with activities. A tool that enables the managers to gain control ensuring timely and quality delivery while cushioning them for an unforeseen future as it is a flexible approach and promotes innovation which is a great advantage to have compared to the traditional system of budgeting. However, it is a much more complex and difficult to manage as compared to traditional systems as its emphasis is on the added values that activities bring to the product.
- Activity-Based Budgeting has helped not just private institutions to run smoothly but also has its impact on drawing major public policies and government spending. Various institutions like schools, universities and non-governmental organizations have also been using this technique to make decisions, enable transparency and fix accountability of work creating a better environment overall of efficiency and brilliance. The format and syntax of the budget may vary for different organizations there is no uniform format.
- Activity-based budgeting (ABB) is a method of budgeting where activities that incur costs are recorded, analyzed and researched.
- It is more rigorous than traditional budgeting processes, which tend to merely adjust previous budgets to account for inflation or business development.
- Using activity-based budgeting (ABB) can help companies to reduce costs and, as a result, squeeze more profits from sales.
- This method is particularly useful for newer companies and firms undergoing material changes.