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

Activity based budgeting or ABB is a budgeting approach or budgeting method 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 and a better understanding of their costs and expenses, as a result of this clear and 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.

This approach takes into account 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 it doesn’t require an in-depth analysis of activities intensity conducted.

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 analyses of multiple cost generators within the organization and tries to identify approaches to minimize these costs by business optimization.

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

For new businesses, it is actually more efficient in terms of expenses and costs to know exactly their level of activities in order to be able to save up on their initial capital and funds and to ensure that the burn rate is predicted to be a reasonable extent.

However, for organizations and businesses that can be considered at their maturity phase, this approach can be looked upon as an unneeded action and a costly one, this is because they have many sets of historical data which is the basis for traditional budgeting and also their activities at this stage are seldom to change.

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

Even for mature businesses as long as they operate in competitive markets this means 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, both these approaches have different bases they operate on and both bring in different final results.

Zero-based budgeting relies more on identifying expenses, analysing expenses, then justifying expenses and finally discontinuing expenses if needed.

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

The confusion between Activity-based budgeting and zero-based budgeting occurs due to their similarities in identifying expenses, but ABB is more concerned with identifying key costs and increasing profitability while 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 are driving costs and expenses and driving up the profitability through this optimization action.

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

This table makes it clear to realize that ABB and Zero-based budgeting might be similar in identifying costs, but the differences start to merge 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 and if not justifiable it will omit these expenses, and 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 in order to make activities more efficient or more cost-effective to drive up profitability.

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

Activity-based budgeting is a process with three parts:

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

They are called “cost drivers”. Be exact to carefully identify all cost drivers. 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 tasks 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 the activity will be performed.

The result is an analysis that basically 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, margins, and assists 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 not related and irrelevant activities to be conducted. Utilizing this budgeting approach, activities are properly examined and then activities alignment is conducted to ensure more efficient activities.

This will cut down on costs of the activities and resources are used to maximize sales which means or can be translated to higher profits.
– This budgeting approach is done after thorough research and analysis are conducted. This commissions the management to omit bottleneck related activities. It guarantees that the business operations are conducted smoothly.
– In addition the ABB budget 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 ability in decision-making

* To conduct contingency planning

* To have performance measurement

* To conduct evaluation
— Since it enhances the resources and activities surge, it is simpler now for the management to conduct or evaluate activity performance.

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

Disadvantages

– Activity-based budgeting is considered to be expensive to conduct. This is due to the fact that the budget will require more resource allocation as it is more complex compared to other budgeting approaches.
– It requires time to be conducted and requires more effort by the conducting personnel
– It requires experienced personnel with the know-how knowledge about businesses and their different departments in order to be able to apply it to the different business sectors. If it’s not conducted with this deep knowledge the results may be inaccurate.
– It has a hefty workload which will need attentive monitoring and activities observation. This will incur costs and means companies have to allocate funds for this specific activity and not to forget this is a complex activity as well.
-The activity-based budgeting is designed to be used to assist companies to achieve their short-term goals. This means that after these complex and cost driver activities you may use the results in a short-term manner only.

Importance & Final take

Efficiency is one of the most noticeable and important things in this budgeting approach. As it carefully examines cost drivers and their importance it will ensure that only relevant and high-priority activities to the success of the company exist. 

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

When compared to other budgeting approaches it may be more expensive and complex, but the result is accurate and relevant to your expenditure in a thorough way that allows major saves for you and your organization.

As it focuses on cost drivers and activities that create major costs, it will make operations in organizations more efficient and more cost-effective. Efficiency in any organization is much needed as it means less 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 become able to achieve their goals whether short or long term.

One of the major 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 to reach short-term goals, but does this mean it’s not a suitable tool?

ABB is still a very valuable tool as it allows increased efficiency to exist 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 which will be provided by these budgeting methods. In addition, we need to understand our goals and what type of budgeting will assist us to reach these goals.

Having a deep or a basic understanding of these tools is crucial and we at wall street oasis understand the importance of budgeting and many other business topics, hence through our informative library, we provide a set of courses to assist you in your financial journey.

Researched and Authored by CEO of NeuralWize Ahmed Fagiry