Activity Based Budgeting

What is Activity Based Budgeting?

Activity-Based Budgeting is a budgeting process where the firm first identifies, analyzes, and researches the activities that determine the cost of the company and, after that, prepares the budget based on the results.

The formula is represented as follows,

Activity-Based Budgeting Formula = Cost Pool in the Designated Diver /Cost Driver in Units

Examples of Activity-Based Budgeting

You can download this Activity Based budgeting Excel Template here – Activity Based budgeting Excel Template

Example #1

Washington Inc. has decided to switch from a traditional budgeting system to activity-based budgeting. Based on the below information, you are required to compute the budgeted cost based on those drivers.

ActivityLast Year Actual Cost
Machine Set up400000
Inspection Cost280000
Number of Machine Setups700
Inspection Hours15500

Solution

The company has shifted from traditional based to activity budgeted way, and hence here we can see that there are two activities which are driving the cost

Using the ABC formula: Cost Pool total / Cost driver, we can calculate the overhead cost

 We have  = Machine setup cost / Number of Machine setups & Inspection cost / Inspection hours

Calculation of Machine Set-Up Per Unit

Activity Based Budgeting Example 1.1

=400000/700

  • =571.43

Calculation of Inspection Cost Per Unit

Activity Based Budgeting Example 1.2
  • = 280000 / 15500
  • = 18.06 per hour inspection cost

 Hence, in ABB, the cost is determined at the activity level and not an ad-hoc rate, which was done in a traditional method where only inflation was accounted for.

Example #2

Vista Inc was losing the auction due to its higher cost compared to peers. The management then decided to start budgeting the cost for their new orders by using Activity Based Budgeting.

Activity Cost DriverLast Year CostCost DriverLast YearExpected Activity
Purchasing900000Number of Purchase Orders4159
Production Steps1518750Number of Setups2530
Inspection1200000Inspection Hours150200
Assembling600000Assembly Hours400400
Machine Maintainance2250000Machine Hours25002600

Solution

The expected activity for the next order is given and based on it, you are required to estimate the total cost that can be provided as a bid.

In this example, we are given all the actual costs and drivers for the same, and we can use the below formula to compute the cost that was incurred in the last order, and the same is assumed to remain the same, and hence we can estimate for the new order as well.

Using the Activity Based Budgeting formula: Cost Pool total / Cost driver

Below are the calculations for each activity and are as per the last order.

Activity Based Budgeting Example 2.1

The total cost for the new order and budgeted cost will be –

Example 2.2

The above shall reflect true cost instead of a traditional way of doing the same.

Advantages

Disadvantages

  • The main disadvantage of Activity Based Budgeting is that it is more expensive to implement and comparatively more costly than the traditional way of budgeting.
  • Furthermore, technical details are required to maintain to capture costs at a particular level.
  • This process also involves a lot of assumptions to be made, which shall consume more time of management and can lead to inaccuracy of cost at certain times as well, which shall depict the incorrect cost of the product.
  • It also requires a deep understanding of the process.

Important Points

Most simply, Activity Based Budgeting shall follow below three stages:

Conclusion

The traditional way of assigning cost or budget was to take the overhead cost of last period and adjust the same for inflation and compute the total cost for the new order and hence it was ignoring the activities cost wherein one could lead to no involvement in the process, and still it was charged.

Hence, by implementing activity-based budgeting, the management can identify activities that are indeed involved in the production process and accordingly price the product and save cost and hence increase the revenue of the firm.

This article has been a guide to what is Activity-Based Budgeting. Here we discuss the formula of activity-based budgeting, its calculation with examples, advantages, and disadvantages. You can learn more about finance from the following articles –

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