Activity-Based Budgeting: Meaning, Benefits And How To Do It
Updated 25 September 2022
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Budgeting is an essential financial exercise that helps meet financial goals and offers an opportunity to examine costs and assess solutions. Specific types of budgeting, such as activity-based budgeting (ABB), help a business record, assess and reduce their expenses to improve efficiencies and lower the overall costs. Understanding this type of budgeting can help you decide if it can be helpful in a company's accounting. In this article, we define ABB, explore the businesses the benefit from it, list its benefits, highlight how to create an activity-based budget, provide tips for creating one and show an example for reference,
What Is Activity-Based Budgeting?
Activity-based budgeting is a budgeting system where the company records and analyses every activity that incurs a cost to them to identify areas for improving efficiencies. These activities are also called activity cost drivers and can be anything that triggers an expense, like facility rentals, manufacturing changes or labour hours. After analysing the costs, the accounts team creates a budget based on these findings.
Organisations often use this type of budgeting to lower costs, gain a competitive advantage, improve productivity and make the overall operations more cost-efficient. ABB is usually more rigorous than traditional budgeting processes. This is because traditional budgeting is more straightforward and usually tends to just adjust prior budgets to consider inflation or business development.
Which Organisations Benefit From ABB?
It is essential that companies analyse their requirements and goals to determine whether ABB makes sense to implement. For instance, new businesses and start-ups that may lack historical costing data can gain better insights utilising an ABB system than established businesses. It helps new companies to better analyse each cost driver and the corresponding activity levels to make accurate budgets without considering the previous year's budget.
Apart from new companies, an ABB system is also suitable for organisations undergoing material operational changes. This may include transformation in business lines, change in the customer base, a significant change in the geographical locations of prominent exporters, or expansion in a new business line. Companies may also adopt activity-based budgets to allocate required resources while establishing a subsidiary company.
Related: What Is Zero-Based Budgeting? (Advantages And How To Create)
Benefits Of ABB
There are several benefits of using an activity-based budget, which include:
Better budget management
An activity-based budget integrates accounting and operations management in the budgeting process. Employees from different backgrounds and teams are essential to the calculation, as activity-based budgets usually require their expertise to provide information about the analysis of activities. For instance, employees from operations management can help clarify the basis of specific costs and understand processes, including points of inefficiency. Similarly, accounting teams can use their experience to ensure the calculations are correct and validate the results.
Related: What Is Capital Budgeting? (Definition And Methods)
Better insights into operational costs
The primary goal of the activity-based budget is to reduce operational costs. With an in-depth analysis of expenses and how it impacts the entire company's performance, ABB budgets often offer better insight into specific and overall operational expenses. These evaluations are helpful information for several departments, as it helps them determine how to improve or make the individual process more efficient.
Related: How To Calculate Variable Cost In 3 Steps (With Examples)
Provide a competitive advantage
Using an activity-based budget allows a company to identify ways to improve production efficiency, reduce production costs and determine how to make cost-effective products. Using the budget to reevaluate activities may help leaders identify ways to lower costs, such as finding reduced shipping rates or negotiating a revised facility lease price. After implementing these changes, the company may deliver products at a lower cost than its competitors. This competitive advantage may also help them in the market.
Improve budget control
An activity-based budget allows companies to make budgetary decisions based on specific activity cost influences, their amounts and their significance to the company. An organisation may find it easier to gain actionable and specific budget control goals with an ABB. It can help them identify particular activities to adjust, determine a change and assess how that change impacts the budget.
Provide synergy support
Many activity costs involve several departments. This can create synergy across these departments. These departments can collaborate to identify unnecessary costs and find ways they can work together to create more efficiency.
An ABB system is also effective in reducing wastage. Because activity-based evaluations rank the importance of activities, the process helps identify certain unnecessary company activities that are redundant or obsolete. When an organisation attempts to minimise wasteful activities, production may become more efficient, and the company can better utilise its resources.
How To Create An Activity-Based Budget?
You can create an activity-based budget using the following steps:
1. Identify the cost drivers of different activities
Ensure to identify each activity cost driver thoroughly. Cost drivers are the components of an overall cost. This list is not only limited to activities associated with revenue generation and order fulfilment, but it includes all the business activities in the entire organisation. Some typical cost drivers include the amount of space required, number of vendors, number of hours worked by employees or number of machine hours. For instance, the cost drivers for a production facility can be the total labour hours and employee wages.
2. Calculate the number of units required within each cost driver
Next, calculate the baseline units associated with each cost driver. Examples of units include the number of production line employees required at a specific period, the number of office staff members, the amount of office space or warehouse space required, raw material purchasing activities, the number of vehicles required to conduct business operations and the number of vendors. For instance, a manufacturing facility may always require four people on the production line, which can result in 160 labour hours per week.
Related: What Is A Break-Even Point? Examples And How To Calculate It
3. Calculate the cost per unit of each activity relating to the particular cost driver
The output is a report that identifies every activity cost driver and divides it into its basic requirements. Companies use this output to determine future costs and profit margins and to identify how the business can earn revenue under specific scenarios. For example, in the example of the manufacturing facility, the company may estimate that the per-hour rate for each employee on the production line is ₹120.
Related: What Is Cost Unit? (Definition, Calculation And Examples)
Tips To Execute ABB
Here are some tips for practical activity-based budget calculation:
Utilise activity-based costing. Activity-based costing includes assigning indirect expenses, such as utilities and salaries, to products and services based on the consumption of each. Companies can use their activity-based budget to achieve a more comprehensive understanding of the firm's total incurred costs.
Clearly outline the objectives. Before starting the process, clarify with the senior leadership team how to align the company goals with the budget. Then, use this vision to set clear and specific targets for the company's activity-based budget.
Determine specific cost-cutting goals. Determine specific areas for cost reduction, like labour, operations, or technology costs. This can help you concentrate your evaluation on particular processes or teams that are inefficient.
Communicate with all involved employees. It is polite and essential to notify all employees who may get affected by an activity-based budget. It is essential to create awareness about the new rules, processes or methods they may follow or if there are any changes in the way they work in the future.
Related: What Is Cost Of Production? (With Factors That Affect It)
Example Of An ABB Calculation
Here is a sample of how an activity-based budget calculation works:
Shalini's Goods anticipates generating 20,000 sales orders in the next year. Each order individually costs ₹100 to process and complete. The activity-based budgeting for the processing expenditures for next year totals ₹20,00,000. You can calculate this amount by multiplying 20,000, the expected number of sales the business intends to generate in the following year, by ₹100, the processing fee associated with creating each order.
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