Activity-Based Budgeting: Understanding the Concept and How it Works
Activity-based budgeting is a powerful tool for companies looking to optimise their spending and improve their bottom line. With the increasing complexity of businesses, traditional budgeting methods are becoming obsolete, leading many organisations to adopt activity-based budgeting as a more effective solution. The process of activity-based budgeting can be challenging. However, its benefits, such as improved cost control and better decision-making, make it a valuable tool.
Activity-Based Budgeting (ABB) is a sophisticated budgeting method, considering activities that result in costs for the company. It aims to provide an accurate picture of how the company spends its monetary resources on individual activities or projects.
ABB follows a bottom-up approach to budgeting in that the company gathers and analyses the cost of every activity. This information is then used to identify inefficiencies and optimise them to improve operational efficiency, thereby reducing costs. Now, based on these results, the company creates a budget.
While traditional budgeting methods rely on a broad, aggregate categorisation of expenses, ABB gives a more accurate picture of the costs associated with individual activities.
Businesses strive to minimise their expenditure, and ABB lets them take a step in the right direction. If done effectively, ABB helps companies grow revenues and maximise profits. But how, let’s see:
Identify the activity cost drivers — activities that affect expenses and revenues. These activities are generally divided into two parts — main and secondary.
Main activities cannot be eliminated as they are directly related to their purpose. Secondary activities generate value for the customers but are not the main ones. If they are costly, they can be subcontracted.
For simplicity, let’s take an example of a keyboard company. In this company, the main activity cost drivers could be making, packaging, and advertising keyboards, among others.
Now, determine or identify the number of units associated with each activity.
The keyboard company needs to determine how many keyboards they make and sell in a month in a certain period. Let’s say they sell 1,000 keyboards per month – this is the number of units related to the activity ‘making and selling keyboards’.
You need to determine the cost of making and selling one unit. If it costs £10 to make and sell one keyboard, you need £10,000 for 1,000 units. This is one simplistic example, though.
Usually, companies are involved in multiple activities, and to split the costs of doing those activities between different things, they can consider these three inductors:
- Transaction: Number of times they do a particular thing.
- Duration: How long does it take to do the said thing?
- Intensity: What are the resources required?
Since the company knows the cost of creating one keyboard, it can identify inefficiencies and eliminate unnecessary costs, boosting profitability.
ABB provides a systematic approach to budgeting, enabling firms to make informed decisions and improve operational efficiency. Let’s understand this further using a simple activity-based budgeting example.
The keyboard company expects to receive 5,000 keyboard orders from ABN Technologies next year, and processing every order is expected to cost £3. Therefore, the ABB budget for this order is £15,000 (= £5,000 * 3).
In contrast, using traditional budgeting models, the company might have arrived at a different number. For example, if the last year’s budget was £20,000 and sales were expected to grow 10%, it would have set aside an amount of £22,000.
ABB provides valuable insights into business operations and enables better resource allocation. It comes with higher costs, a longer implementation time, and requires specialised knowledge.
Businesses must weigh the benefits against the disadvantages before deciding if ABB is the right fit. Following are some activity-based budgeting pros and cons:
It ensures that resources are aligned to more efficient activities, reducing costs and maximising sales, leading to higher profits, and preventing resource wastage.
Undertaken after intensive research and analysis, allowing the management to eliminate bottleneck-related activities, ensuring smooth business operations.
Provides valuable insights into operational inefficiencies and imbalances, enabling the management to make more informed decisions.
This makes it easier for the management to evaluate activity performance, hold employees accountable and track progress.
Improves decision-making efficiency, contingency planning, performance measurement, and evaluation.
It is expensive compared to other types of budgeting due to the additional resources required for research, analysis, and tracking.
ABB requires more time and information to develop and implement, making it a slower process.
Developing and implementing ABB requires a deep understanding of the business processes, making it a complex task for those without the necessary skills.
ABB is primarily used for short-term goals, making it less suitable for businesses with long-term objectives.
ABB aims to identify and allocate costs to specific activities that cause an organisation’s costs. It is particularly useful for complex operations with multiple products or services.
Zero-based budgeting (ZBB) is a traditional approach in which the budget is created from scratch for each budget period. In this approach, each expense must be justified for each new budget period, regardless of whether it was included in the previous budget.
The idea behind ZBB is to ensure that the budget is based only on current needs and that all expenses are justified on a current basis. This approach is particularly useful for organisations that want to control costs, increase efficiency, and improve decision-making.
Activity-based budgeting considers the costs of individual activities that result in costs for a company. It provides an accurate picture of how the company spends its resources, enables better resource allocation and operational efficiency, and enhances decision-making. By improving resource allocation, reducing costs and maximising sales, ABB can positively impact cash flow.