What is an 'Activity-Based Budgeting - ABB'

Activity-based budgeting is a method of budgeting in which the activities that incur costs in every functional area of an organization are recorded and their relationships are defined and analyzed. Activity-based budgets do not simply adjust prior budgets to account for inflation or business development. Instead, activity-based budgets search for efficiencies in business operations and develop budgets based on these activities.

BREAKING DOWN 'Activity-Based Budgeting - ABB'

Activity-based budgets are more likely to be utilized by newer companies without historical budgeting information on which to rely. In addition, activity-based budgets are more useful for companies undergoing material changes, such as those with new subsidiaries, major customers, business locations or products. Because traditional budgeting processes simply adjust previous year budgeted amounts, established firms with minimal change are more likely to use traditional growth budgeting approaches. A flat rate is typically applied to previous year data to reflect business growth and inflation.

Basic Calculation Process

The activity-based budgeting process can be simplified into a three-step process. First, relevant activities are identified. These cost drivers are the items responsible for incurring revenue or expenses. Second, the number of units related to each activity is determined as the baseline for the calculation. Finally, the cost per unit of activity is determined and multiplied against the activity level.

Example of Activity-Based Budgeting

A company anticipates receiving 50,000 sales order in the upcoming year. The cost to process a single order is $2. Therefore, the activity-based budget for the expenses relating to processing sales orders for the upcoming year is $100,000 ($50,000 * $2). This figure may be contrasted to a traditional approach to budgeting. If last year’s budget called for $80,000 of sales order processing expenses and sales were expected to grow 10%, only $88,000 ($80,000 + ($80,000 * 10%)) is budgeted.

Benefits of Activity Based Budgeting

Activity-based budgeting systems allow for a greater degree of control over the budgeting process. Revenue and expense planning occurs at a finer level that provides useful details regarding projections. Activity-based budgeting allows for management to have more control over the budgeting process and to align the budget with overall company goals.

Disadvantages of Activity-Based Budgeting

Activity-based budgeting is more costly when compared to traditional budgeting techniques. It requires more information and more time from management in order to be developed. Activity-based budgets require more assumptions and insight from management that result in potentially greater opportunities for budgeting inaccuracies. Finally, the ongoing maintenance and analysis of budget variances require more resources than other budgeting techniques.

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