Activity-Based Budgeting - Explained
What is Activity-Based Budgeting?
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What is Activity-Based Budgeting (ABB)?
Activity Based Budgeting, or ABB, is a system used to research, record and then analyze the activities leading to costs in a business. This method works by distributing costs according to the activities the company carries out and is used in cost accounting. The basis of ABB is that the company's activities are the ones consuming resources and originating costs.
Back to: ACCOUNTING, TAX, & REPORTING
How is Activity-Based Budgeting Used?
Since the company's activities consume resources, the ABB model uses physical and monetary indicators. This model has been made possible by the evolution and advancement of computing for carrying out the company's services. By allowing the monetary and non-monetary measures to be carried out, this system provides the whole view of the company's costs and ensures better utilization of resources. This method assumes a split variation of the total cost model that indicates that all the costs in a company have to be distributed among its products. This method, which appeared in the mid-80s, is one of the most reliable models of allocating costs to activities.
Activity Based Budgeting Activities
The first task of the ABB system is to identify all the activities developed in the company and consuming resources. These activities are classified as:
- Main activities: These are those activities directly related to the company's purpose and cannot be eliminated.
- Secondary activities: These are those generating added value from the customer's viewpoint. They usually involve too many costs which are sometimes subcontracted.
This way the company knows the resources that each activity consume and analyzes the cost of this in the product. The ABB method offers:
- An extension of the management's conception, control, and the costs' analysis while paying attention to the planning and design of the product.
- A measure of quality and delivery times, flexibility, innovation, and after-sales service while also discerning the traditional cost systems which are less developed compared to it.
- Obtaining a detailed analysis of the resources used in the case of the base of the costs by activities.
Distribution of costs through inducers
After the tasks in the company have been defined, it is essential to determine how to distribute the costs among the activities. In this situation, the inducers are used since they are factors whose purpose is influencing the level of consumption in different activities. There are three types of inductors:
- Transaction inductors. The number of activities an activity is repeated has to be taken into account to calculate the average cost per activity.
- Inductors of duration. This is the time necessary to carry out each activity.
- Inductors of intensity: These are the resources consumed each time that the activity occurs.
The ABB system is an excellent element of analysis for obtaining the information needed to make decisions and assessing the activities and actions related to the product. It is, however, more complex and difficult to implement compared to others. It emphasizes on the cost of activities unlike other more traditional systems of cost quantification. The ABB model emphasizes on the added value that activities bring to the product.
Steps Applied in Activity-Based Budgeting
There are three steps involved in activity-based budgeting. They are as follows:
- Identify relevant activities cost drivers. These cost drivers account for the revenue or expenses incurred by a company.
- Determine the cost drivers number of units needed for each activity level.
- Compute the rate of the cost drivers (cost per activity unit).
How Activity-Based Budgeting Works (Example)
The following is an example of activity-based budgeting where office sales scenario has been used. Note that the cost driver here is represented by the number of sales order. Now lets assume that the company's anticipated sales orders in the coming year are $100,000. Then, the cost for processing one order is $4. In this case, the ABBs expenses related to processing in the coming years sales order will be $40,000 ($100,000 x $4).
Importance of Activity-Based Budgeting
Activity-based budgeting has one importance. It brings about efficiency in an organizations activities. This is because activities are scrutinized for the purpose of adjusting cost drivers. Budget is prepared based on the identified productive activities. This saves the company from costs related to unnecessary activities.
Advantages and Disadvantages of Using Activity-Based Budgeting
There are several advantages and disadvantages related to the use of activity-based budgeting. They are as follows: Advantages
- The ABB enables the management to avoid wasting resources on irrelevant activities. Using ABB, activities are properly scrutinized and then resources aligned to more efficient activities. These cuts down the activities costs and resources are used to maximize sales which lead to higher profits.
- The ABBs is done after intensive research and analysis. This enables the management to do away with bottleneck related activities. It ensures that the business operations run smoothly.
- Also, the ABB budget ensures that operational requirements are balanced. It is able to point our sources of inefficiencies and imbalances. It also highlights areas of improvement which allows the management and the employee to be able to amend the inefficiencies.
- It increases the managements agility as far as the following functions are concerned:
- Decision-making process
- Activity contingency planning
- Activity performance measurement
- Activity evaluation
- Since it improves the resources and activities flow, it becomes easier for the management to evaluate activity performance. The management is able to hold employees accountable. This is because, through ABB, it is easier to tell who is responsible for particular activities in various departments.
- Activity-based budgeting is expensive in terms of cost. This is so because the budget requires more resource allocation compared to other types of budgets.
- It is time-consuming. The management will require more time and information in order to develop an activity-based budget.
- The ABB requires deep knowledge (competence) to be able to develop and implement it in various business functional areas. In this case, if the management is not able to understand it well, it may result in inaccuracy in budget preparation.
- The ABB has much workload which requires activity tracking. The tracking comes at a cost, meaning that the company will have to allocate funds for this operation. Also, besides costs, setting up activity tracking is, on the other hand, a complex job.
- The activity-based budgeting is used in business to account for short-term goals. It is not, therefore, applicable to business long-term goals. Note that a budget which doesnt focus on helping the business to achieve its long-term goals is detrimental to the entire organization.
- The activity-based budgeting is a budgeting system whereby cost related activities are researched, recorded, and analyzed.
- The activity-based budget is mostly used by emerging organizations which are going through material changes.
- The activity-based budget helps firms to cut down activity related costs and generate more returns from sales.
- Job Costing vs Process Costing
- Assign Overhead Costs to Products
- Plantwide Cost Allocation
- Department Cost Allocation
- Activity-Based Costing
- Weighted-Average Cost of Products
- Production Cost Report
- Fixed, Variable, and Mixed Cost Estimations
- Contribution Margin Income Statement
- Cost-Volume-Profit Analysis
- Margin of Safety
- Contribution Margin per Unit of Constraint
- Absorption Costing vs Variable Costing
- Differential Analysis and Decisions
- Cost Decisions for Joint Products
- Capital Budgeting
- Life Cycle Costing
- The Master Budget
- Activity-Based Budgeting
- Standard Costs
- Imputed Value
- Variance Analysis for Product Costs
- Absorption Pricing
- Price Variance
- Absorption Variance
- Responsibility Centers
- Comparing Segmented Income
- Using ROI to Evaluate Performance
- Using Residual Income to Evaluate Performance
- Use Economic Value Added to Evaluate Performance
- Transfer Pricing