Activity-Based Budgeting

A budgeting approach that calculates expenditures based on the potential activities to arise and their intensity. 

Budgeting for activities in organizations of any size can be a complex process. Nonetheless, it's a crucial process that must be undertaken to ensure the achievement of goals, whether short or long-term.

Activity-Based Budgeting

Accounting and finance professionals often find budget deficits rising as they monitor organizational activities; hence a better approach is needed. 

Activity-based budgeting is a budgeting approach that calculates expenditures based on the potential activities to arise and their intensity. 

In other words, this approach calculates budgets based on actions or activities conducted by organizations rather than mere estimations. 

The basis of this approach is that the company's activities are responsible for consuming resources and creating costs. This differs from other bases of other budgeting approaches where products and services are the sources of these elements. 

ABB enables organizations to have a clear understanding of their costs and expenses. As a result of this better understanding, enhanced budgeting can be conducted. Sound budgeting leads to the achievement of goals and objectives. 

Activity-based budgeting vs. Traditional based budgeting

The traditional-based budgeting is the most recognizable, adopted, and cheapest approach to budgeting for organizations, whether of small or large sizes. This traditional approach relies on the previous year's costs.

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This approach considers previous recurring costs and adjusts them for inflation changes or activities changes in the organization, then calculates or conducts the budgeting for the coming year. This approach is easy to perform and doesn't require an in-depth analysis of activities' intensity. 

Traditional budgeting relies on historical costs. On the other hand, the activity-based budgeting process conducts a three-part process. 

This three-part process begins with analyzing multiple cost generators within the organization and tries to identify approaches to minimize these costs by business optimization.

It is one of the most suitable budgeting approaches for new businesses with a set of operations that can change frequently. In addition, it's an appropriate approach for these new businesses as they lack historical data collection. 

For new businesses, knowing their level of activities is more efficient in terms of expenses and costs. This allows them to save up on their initial capital and funds and ensure that the burn rate is predicted reasonably. 

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However, this approach can be deemed unneeded and costly for organizations and businesses that can be considered at maturity. This is because they have many sets of historical data, which is the basis for traditional budgeting. Also, their activities at this stage seldom change. 

Nonetheless, whether for a new or a mature business, budgeting should be considered a need-to-change tool to align with the organization's activities and goals. 

Even for mature businesses, as long as they operate in competitive markets, there will be frequent changes in their activities and goals.

Activity-based budgeting vs. Zero-based budgeting 

While both ABB and zero-based budgeting are often confused due to their similarities, these approaches have different bases they operate on and bring in different final results. 

Zero-based budgeting relies more on identifying expenses, analyzing expenses, justifying costs, and discontinuing expenses if needed. 

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For instance, a corporation might be planning or setting one of its current goals to pay off its debts during the current year. Hence, any amounts identified or saved in the zero-based budgeting will be allocated to this justified and transparent spending. 

The confusion between activity-based and zero-based budgeting occurs due to their similarities in identifying expenses. Still, ABB is more concerned with identifying essential costs and increasing profitability. In contrast, zero-based budgeting is more concerned with identifying costs and finding justifications. 

As we have mentioned, the action of identifying costs and expenses creates the misconception that these two approaches are the same. 

But we need to realize that activity-based budgeting is more involved in optimizing activities, which drive costs and expenses and increase profitability through this optimization action. 

We can put the differences between these two approaches in a table to understand the differences clearly. 

Activity-Based Budgeting and Zero-Based Budgeting
Activity-based budgeting Zero-based budgeting
  • Define activities that directly contribute to costs 
  • Calculate the minimum required to conduct these activities 
  • Based on this minimum this will be the budget needed next year if activity X is conducted 
  • Define every cost and expense 
  • Analyze if this cost is necessary
  • If this cost or expenses is not necessary then if it is not needed to be continued. 

This table shows that ABB and Zero-based budgeting might be similar in identifying costs. Still, the differences emerge once it goes beyond the identifying stage. Hence they are both used for different results. 

As a reminder, one element is concerned with justifying costs or expenses. If not justifiable, it will omit these expenses. The other element is concerned with optimizing activities and cost drivers so it can increase productivity and profitability. 

How to conduct activity-based budgeting? 

Before we conduct this action, we need to remember that the primary goal of this approach to budgeting is to identify, analyze and optimize cost drivers to make activities more efficient or more cost-effective to drive up profitability.

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It is crucial to conduct this budgeting approach with a new mentality. Access to enhanced data analysis tools will significantly change the efficiency level in identifying and cost driver optimization. 

This budgeting approach is a process with three parts:

1. Identify all activities in correlation with a specific cost.

They are called "cost drivers." Be exact in identifying all cost drivers carefully. Cost drivers can be presumed as the elements of an overall cost. 

For instance, some general cost drivers are the number of hours conducted by employees, number of providers, number of machinery working hours, or amount of premises needed.

2. Calculate the benchmark of units needed for every activity.

For instance, how many individuals are needed to conduct activities or tasks at any given period? Who are these individuals? What are their duties and job descriptions? 

Do the activities need a set amount of warehouse or premises space? Is there a special requirement for custom elements or products? Keep in mind that the calculation of benchmark units has to be looked upon from the perspective of "barebones" necessity.

3. Determine the cost per unit of every activity and then multiply it by the number of times it will be performed.

The result is an analysis that identifies all cost drivers of business activity and crumbles it down into its minimum requirements. 

After that stage, the outcome is used to determine coming or future costs and margins and to identify the break-even for the business during specific situations.

Advantages and disadvantages 

Many advantages and disadvantages are correlated to the utilization of activity-based budgeting. They are as follows: 

Advantages

  • It allows management to pass on wasting resources on unrelated and irrelevant activities. Utilizing this budgeting approach, activities are correctly examined, and then activities alignment is conducted to ensure more efficient activities. 
    This will cut down on costs of the activities and resources used to maximize sales, which can translate to higher profits.
  • This budgeting approach is made after thorough research and analysis are conducted. This commissions the management to omit bottleneck-related activities. It guarantees that business operations are conducted smoothly.
  • In addition, it guarantees that operational obligations are balanced. It can point to our sources of inefficiencies and unevenness. Moreover, it highlights points of improvement which let the management and the employee be able to adjust the inefficiencies.
  • It boost-up the managements agility as far as the following functions are concerned:
    • Their decision-making ability.
    • To conduct contingency planning.
    • To have performance measurement.
  • To conduct an evaluation.
  • Since it enhances the resources and activities surge, it is simpler now for the management to conduct or evaluate activity performance. 

The management can now hold employees accountable based on their actions or activities. This is because, through ABB, it is easier to tell who has done what or is in charge of particular activities in different departments.

Disadvantages

  • It is considered to be expensive to conduct. This is because the budget will require more resource allocation as it is more complex than other budgeting approaches. 
  • It requires time to be conducted and requires more effort by the conducting personnel. 
  • It requires experienced personnel with knowledge about businesses and their different departments to apply it to the various business sectors. The results may be inaccurate if not conducted with this profound knowledge.
  • It has a hefty workload that will need careful monitoring and activity observation. So naturally, this will incur costs and means companies have to allocate funds for this specific activity and not forget this is a complex activity. 
  • The activity-based budgeting is designed to assist companies in achieving their short-term goals. This means that after these complex and cost-driver activities, you may only use the results in a short-term manner. 

Importance & Final take

Efficiency is one of the most noticeable and essential things in this budgeting approach. Therefore, it carefully examines cost drivers and their importance, ensuring that only relevant and high-priority activities to the company's success exist.  

Activity-based budgeting is an approach to estimating next year's costs and eliminating activities based on their importance and priority. It allows you to lower your burn rate and increase profitability. 

Compared to other budgeting approaches, it may be more expensive and complex. Still, the result is accurate and relevant to your expenditure in a way that allows significant savings for you and your organization. 

Focusing on cost drivers and activities that create high costs will make organizations' operations more efficient and cost-effective. Efficiency in any organization is much needed as it means fewer expenses and less wasted resources. 

Budgeting should be a tool used to allow companies of any size to foresee their needed resources and capital needs so they can plan accordingly and achieve their short- or long-term goals. 

One of the significant downsides of this approach is that it doesn't enable those who conduct it to plan for the long-term goals as it only assists them in reaching short-term goals, but does this mean it's not a suitable tool?

ABB is still a valuable tool as it allows increased efficiency within organizations, even if it incurs costs, yet it saves other hefty costs. A hybrid approach can exist for short-term and long-term goals. 

We should always be aware of the budgeting tool we are planning to use and understand the nature of the results of these budgeting methods. In addition, we need to understand our goals and what type of budgeting will assist us in reaching these goals. 

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Researched and Authored by Ahmed FagiryLinkedIn

Reviewed and Edited by Savan Sabu | LinkedIn

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