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,
Examples of Activity-Based Budgeting
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.
|Activity||Last Year Actual Cost|
|Machine Set up||400000|
|Number of Machine Setups||700|
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
Calculation of Inspection Cost Per Unit
- = 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.
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 Driver||Last Year Cost||Cost Driver||Last Year||Expected Activity|
|Purchasing||900000||Number of Purchase Orders||41||59|
|Production Steps||1518750||Number of Setups||25||30|
|Machine Maintainance||2250000||Machine Hours||2500||2600|
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.
The total cost for the new order and budgeted cost will be –
The above shall reflect true cost instead of a traditional way of doing the same.
- The budgeting process can have more control when Activity-based budgeting (ABB) systems are used in the company instead of a traditional way of budgeting.
- Expenses and Revenue planning will occur at an accurate level, which shall provide meaningful details regarding the estimated and future financial projectionsFinancial ProjectionsFinancial projection is a statistical forecast of a company's future revenue and expenditure based on historical market patterns, internal factors, data interpretation, anticipated market developments, and experiences. To meet production or sales targets, both short-term and long-term financial estimates are sometimes evaluated..
- Last but not the least company can have better control and can align its annual budget with the overall firm’s goals by implementing Activity Based Budgeting.
- It helps to improve the business process by identifying unnecessary activities, which leads to an increase in cost as a lot of research is done here.
- 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.
Most simply, Activity Based Budgeting shall follow below three stages:
- Identify the activities by conducting detailed research, and along with that also one needs to identify their cost driversCost DriversA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity., which again requires proper knowledge of the process.
- Now, either forecast the number of units which shall be produced for the next period or there could be new order coming up and also at this stage compute the overhead per driver.
- In the final stage, one needs to Calculate the cost driver rate and multiply the same for the new order or the new production units, and that shall give one the total estimated or budgeted cost.
- But before the above, one needs to determine whether the required time and cost are adequately available with the management or the company.
- Does the company has required resources and software and workforce to capture the same daily?
- Cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc. needs to be done before implementation of the same, as the management should be that benefits shall out weight the cost.
- Can operational managers be recruited at reasonable remuneration?
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 –