What is Activity Based Budgeting?
Activity based budgeting (ABB) is a method for detailed budgeting needs. This method develops a budget based on the activities and does not take into account historical costs. The ABB method aims to be the more accurate method of budgeting compared to other methods by analyzing activity.
Other methods usually take historical costs and increase the budget by inflation or some other increment. Simplicity of the traditional method of budgeting is tempting for business as it requires less work compared to ABB. ABB requires that every cost to be included is analyzed to determine if there are any cost reductions that can be achieved.
ABB requires that cost drivers are identified such as labour hours drive wages or material required in the production of a product.
In a simplified example, when budgeting for production costs of a product, ABB will identify labour hours and material required to produce one unit of a product. In reality there will be other costs in the production of a product, such as setup of machinery and assembly cost. ABB requires each of these costs to be analyzed to achieve per unit cost.
ABB dives down to per unit cost for accuracy which can then be scaled to the forecasted number of units to be produced, for example.
Drawbacks of using ABB
ABB is a resource intensive activity. It requires detailed information gathering for this method to provide value. Gathering information can take a significant amount of time and resources depending on the size and complexity of a business.
It also assumes that managers have a good understanding of the business processes and know which information is required for ABB. If there are communication issues between the department in the company then information will not flow efficiently and make it difficult to obtain sufficient data to make ABB viable.
Advantages of using ABB
Advantages of using ABB are clear. It can lead to accurate budgets that are built based on activities that add value to the company and minimize activities that add little or no value to the company. This allows that company to efficiently allocate resources to value-adding activities.
If there are significant overhead costs related to production then activity based budgeting can identify activities driving overhead costs and in turn help understand how to reduce the overhead costs.
If executed properly, switching from traditional budgeting to ABB can lead to significant cost savings that may not have been identified under traditional budgeting.
Each business needs to weigh the costs of implementing activity based budgeting against the potential benefits of this method.