The activity-based method (ABB) is a top-down approach that thoroughly analyzes activities to predict operating budgets and future costs. In this context, “activity” refers to anything that incurs a cost and that accountants can examine for different ways to create efficiencies.
The current year’s budget is formed based on this information.
There are three main steps to determining the new budget under the ABB approach:
1. Identify cost drivers and relevant activities, which are the items responsible for revenue and expenses for the company.
2. Determine the projected total units for these activities, which is the baseline for calculating the following year’s budget.
3. Estimate the cost per unit of activity, which gets multiplied by the activity level.
In other words, under ABB, a new budget is determined by a simple formula:
Who it’s for…
Large companies generally use this type of budgeting method. It’s popular in major industries, such as manufacturing, construction, and healthcare. ABB is ideal for companies with large budgets and considerable revenue that are undergoing material changes as well as new companies looking to start on the right foot.
An example of activity-based budgeting
ABB requires plenty of research. Management must determine which activities the company needs to take to meet specific goals and then evaluate the costs of carrying out those activities.
Say that Company A anticipates receiving 80,000 sales orders (X) in the upcoming fiscal year, with each order costing $3.00 to process (Y). The ABB for these expenses (Z) is then determined by multiplying those two numbers:
80,000 * $3.00 = $240,000
If this budget calls for $240,000 of sales order processing expenses and sales are expected to grow 10%, $264,000 is budgeted. Here’s the formula for determining how much money to allocate depending on expectant growth:
$240,000 + ($240,000 * 10%) = $264,000
Advantages of activity-based budgeting
ABB is an excellent budgeting method because you can see the exact costs for every operational activity, which provides a clear lens into where every dollar goes. This makes it easier to reduce costs and obtain profits from sales.
Plus, ABB is a useful method for businesses that prioritizes a forward-looking view rather than looking at previous activities rather than just allocation of costs according to previous activities. Using this method, you can eliminate unnecessary activities and offer services and products for a lower price.
Drawbacks of activity-based budgeting
ABB can be very expensive to implement and highly time-consuming compared to traditional budgeting. A team of analysts needs to identify the company’s activities and the costs of each. Then, they have to determine the appropriate budget for each department accurately.
And you can’t just hire anybody to analyze your business records: You need experienced accountants who have a deep understanding of this type of budgeting process.
Is ABB budgeting right for my business?
Activity-based budgeting is an effective method for identifying the exact cost of activities and expenditures so that businesses can better manage their money and eliminate unnecessary expenses. In turn, eliminating these costs can increase profits while strengthening relationships with customers.
However, ABB is a time-consuming method that requires accountants of particular expertise, which can be costly. It is suitable for companies looking to restructure their material output or newer businesses that need to reduce spending.