Over the years, businesses have found measures to reduce costs and boost the overall efficiency of business processes. Traditional budgeting methods proved quite useful, but activity-based budgeting proved even more valuable. This is because it offers a more accurate way to budget and track product cost driver rates.
Now, business activity-based budgeting has become a widely adopted method that allows businesses to reduce costs without using historical data (such as the previous year's budget). This guide will discuss this golden method, how it works, why you can count on it, and an example of its usage.
What is activity-based budgeting?
Activity-based budgeting (ABB) is a process for analyzing business activities and costs to create budgets without taking historical data into account. It was born out of the sheer will to maximize efficiency while reducing costs.
The system comprises a series of steps involving recording, researching, and analyzing everything contributing to a company's cost driver. It doesn't require historical data like a traditional budgeting system.
The result is that each of the activities analyzed will allow the organization to find ways to cut costs without reducing performance. The company then creates its budget based on the insights from these results.
What are the features of activity-based budgeting?
Every business wants to improve its critical activities without incurring unnecessary costs. This can help increase profits when done right. Hence, activity-based budgeting is an important tool for avoiding unnecessary costs while focusing on high-value activities that help generate more sales.
For easier comprehension, the process can be split into three stages.
Step 1: Identify your business activities
The first and most important step to maximizing output is a deep understanding of the inputs. So, this step is where you evaluate all the activities that call the shots for your operational costs.
Each of these activities you consider doesn't have to impact revenue or profits directly. So, ensure you pay attention to every business activity regardless of how minute it might seem.
Once you've identified them, proceed to figure out the cost drivers, i.e., what factors determine the cost of each of these activities.
The final process is to begin making material operational changes to the activities. Remember, the sole aim is to reduce costs and unnecessary activities, so make sure your changes contribute to the company's goal.
Step 2: Calculate the unit of each activity
After figuring out the cost drivers, find the unit of each activity as well. Finding the unit will help you progress to the next activity-based budgeting step. The unit can be any figure that denotes the amount of workforce behind an activity.
For example, a unit could be the number of raw materials, the number of factory workers, and the number of transport vehicles or equipment in a production line that contributes to the normal function of the business activities.
Step 3: Compute the cost per unit
The final task is to multiply the units calculated in step 2 by the costs you identified in step 1. This value is the cost per unit of production.
You can then use the cost per unit value to create your monthly or annual budget by identifying all the tasks and multiplying them by the corresponding task. While doing this, ensure you keep track of the figures and find ways to cut the cost per unit of activity completed.
When optimizing any cost drivers, you can check how much reduction you achieve by recalculating the cost per unit. Compare the value to the initial value to see how much cost you could reduce without reducing the overall efficiency of the process.
What is an activity-based budgeting example?
To further understand the concept, we'll illustrate an imaginary company's activity-based budgeting process.
So, if Company A hopes to reach a net sale of 7,000 units of its products within a month, the company spends $3 to produce one unit. Since you can calculate the activity-based budgeting with the cost and the total number of units, then:
Activity-based budget = 7,000 units × $3 = $21,000
This means the business will have an activity-based budgeting estimate of $21,000 for that month.
Suppose Company A optimizes costs and manages to reduce them to $2 for the same number of units.
Activity-based budget = 7,000 × $2 = $14,000
Hence, the new business line can boost efficiency, reduce costs, and gain an additional $6,000 profit. This figure is more reliable for budgeting than that of a traditional budgeting method.
What is the benefit of activity-based budgeting?
As discussed earlier, activity-based budgeting can be quite helpful for businesses and operational managers at any stage. Below are some of the several advantages you should consider adopting this method.
Proper budget management
When you create an activity-based budget, you'll get the liberty of proper business operations management. There'll be a better evaluation of certain costs, more clarification of each process, and reasons for inefficiencies. With this knowledge, the accounting unit can draw up a straightforward calculation and plan to create a budget with minimum incurred costs and accurate results.
Offers competitive edge
Reducing your operational costs can give you an edge over competitors. The activity-based budgeting method can help you sell products at a lower price and keep operations at an optimal level. The extra profit can also help build your organization and improve overall performance.
Regardless of your type of business, there are limitations to the resources available. Hence, it's smart to incorporate a process that can help maximize your required resources.
Using activity-based budgeting, you can allocate resources effectively when necessary. So, you can focus more on relevant activities that create more cash inflow and meet the company goals.
More cost control insights
Activity-based budgeting helps reduce costs by using data and analytics of operational activities with costs. This insight allows any business or organization to easily track its operational costs and sales order processing expenses.
This budgeting method gives you more idea into the factors that affect your production costs and steps to take if you want to reduce them.
There is a chance to boost the overall profitability of company production processes with activity-based budgeting. Considering how well it deals with the production and associated costs, it's a simple process to optimize either of them, increase the earning capacity and reflect business growth.
What are the disadvantages of activity-based budgeting?
To effectively carry out activity-based costing, one must work at micro levels. Data collation and careful evaluation of various company activities and processes could be costly, especially compared to other budgeting methods like zero-based budgeting and traditional budgeting methods.
The activity-based budgeting methods are quite time-consuming. Of course, it's a simple process if you're dealing with a small business. But you might be surprised how time-consuming it can be if the company or organization has many sections and departments.
Can be complex
This method can be difficult if the budgeting team doesn't understand the technical details and factors that can help determine a cost driver. It might also be complex if it's your first time dealing with cost and unit calculations.