Activity-Based Budgeting Definition, How it Works

Companies turn to activity-based budgeting when they need a better handle on spending. This type of budgeting exercise helps young companies manage their costs from the start and established companies bring expenses under control when needed. Activity-based budgeting also helps ensure that the most important activities allocate the right budget. It can help uncover opportunities for cost savings It helps managers to track actual spending versus budgeted amounts and compare spending across different departments or locations.

For a new business without historical info, you will have to dig a bit deeper. This can include digging into resources like the Consumer Product Index (CPI) for inflation or studying your competitors. You should look at your forecast results to ensure they make sense and summarize them in a way that works for your business. For example, if you are forecasting customers on a monthly basis, you may want to do quarterly and annual views.

At the national level, healthcare budgeting directly impacts access, delivery, staffing, and quality of care. In the United Kingdom, the National Health Service (NHS) is tasked with delivering care to the public. These drivers can be things like machine-hours, labor hours, or material costs.

  1. Revenue and expense planning occurs at a precise level that provides useful details regarding projections.
  2. You should look at your forecast results to ensure they make sense and summarize them in a way that works for your business.
  3. 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.
  4. In comparison, activity-based budgeting identifies critical activities and links them to their cost driver to calculate the required activity levels.

You may even want to look at trend views to ensure there aren’t any outliers. Once your model is set up, you simply need to run it and adjust the inputs as needed. You will want to do this on a regular basis, especially if your business is growing or changing.

I have scoured the internet and handpicked the best financial analysis courses for you. As discussed earlier, activity-based budgeting can be quite helpful for businesses and operational managers at any stage. Below are some of the several advantages you should consider adopting this method. To further understand the concept, we’ll illustrate an imaginary company’s activity-based budgeting process. Details derived from Activity Based Costing method are used as an input when calculating base rates of cost drivers under Activity Based Budgeting. However, the significant difference between the two budgeting methods is the basis of calculation.

Controlling costs is imperative to preserving revenue, so companies always look for creative ways to avoid overspending. This is why activity-based budgeting is such an effective budgeting approach. Breaking these processes down and identifying cost drivers  allows for greater control over financial decisions and better visibility into how funds are used.

Why do companies use activity-based budgets?

Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. On the other hand, a new start-up doesn’t have years of historical financial information at its disposal. It may be worthwhile for the newer start-up to inspect each cost driver and their corresponding activity levels to make more accurate financial projections. Activity-based budgeting (ABB) is a budgeting method where activities are thoroughly analyzed to predict costs.

So, ensure you pay attention to every business activity regardless of how minute it might seem. Further, the cost of a product includes two components – fixed costs and variable costs. Remember, a good business budget always helps forecast cash inflows and outflows and plan thoughtful allocation of resources. Hence, the company should carefully evaluate every possible way to reduce costs and then make an informed decision. But here’s a catch—unnecessary reduction in costs may force a company to compromise on the integrity and quality of business operations. While the process of making an ABB is time consuming and can be arduous, there are actually only a few steps in the process.

Also, assume Company ABC reported a cost of goods sold at $4,000 last month, with the rate of increase averaging 10% each month in the past. Under the traditional budgeting method, the company will estimate the cost of goods sold in the upcoming month to be $4,400 [$4,000 + ($4,000 x 10%)]. While other methods of budgeting look at the costs of inputs to perform activities, ABB looks at the outputs that drive costs. In doing so, management can better evaluate different business units relative to each other and allocate capital where they deem to be most profitable.

What are the benefits of activity-based budgeting?

An activity-based budget is a budget that scrutinizes every cost in a business. Like the name implies, an activity-based budget is created using the activities that drive costs. Activity-based budgeting (ABB) is a rigorous form of budgeting that is often used in conjunction with cost cutting efforts. It is a useful form of budgeting for fledgling organizations that need to keep a tight lid on costs and provides good insight into expenses that drive revenue. By breaking down spending in this granular manner, organizations more accurately determine their total budgets for each activity and adjust accordingly.

How Activity-Based Budgeting (ABB) Works

Suppose Company A optimizes costs and manages to reduce them to $2 for the same number of units. Fixed costs such as factory rent & lease, utility bills, etc., always remain the same, whereas, variable costs will vary based on activity. Organizations are often tempted to allocate most of their resources to operational activities that boost revenue and profitability. However, focusing on revenue-generation activities is not the only way to increase profits. Breaking down these costs is the first step in reducing the cost of producing goods or providing services. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.

Datarails’ FP&A software can help your team create and monitor budgets faster and more accurately than ever before. However, an ABB is a great option for new businesses that might not have historical information at their disposal. In addition, new businesses should heavily scrutinize every cost as they look to grow. From here, you can calculate the total and per-unit cost of producing your item. Join our exclusive, free Slack community for strategic finance professionals like you. Discover books, articles, webinars, and more to grow your finance career and skills.

When optimizing any cost drivers, you can check how much reduction you achieve by recalculating the cost per unit. Compare the value to the initial value to see how much cost you could reduce without reducing the overall efficiency of the process. After figuring out the cost drivers, find the unit of each activity as well.

What are the disadvantages of activity-based budgeting?

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. 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.

And there’s a budgeting method that helps reflect business growth while also giving you fine control over spending. Activity-based budgeting (ABB) systems allow for more control over the budgeting process. Revenue and expense activity based budgeting planning occurs at a precise level that provides useful details regarding projections. ABB allows for management to have increased control over the budgeting process and to align the budget with overall company goals.

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