What’s it: Activity-based budgeting is a budgeting method by quantifying only key business activities and their associated costs. In the process of allocating money, the company maps critical activities to achieve company goals. Then, the company calculates the costs and develops its budget based on these activities.
This method differs from the traditional method, where the company simply adjusts the previous period’s budget by considering factors such as sales growth and inflation.
When does the company use activity-based budgeting methods?
Generally, companies use activity-based budgeting when they have minimal information regarding historical budgets. They should detail any potential activities that will be undertaken. For this reason, startups are suitable for this approach.
Apart from new companies, this method is also appropriate for companies that are experiencing material operational changes. Examples are when there is a change in the customer base, a change in business lines, a shift in business locations, and business expansion in a new business line. When establishing a subsidiary, management usually adopts this method as well.
In contrast, for companies with minimal operational changes, traditional budgeting is more common. Under the traditional method, companies use data from the previous year, plus a certain percentage increase to reflect business growth and inflation. Traditional methods are faster and require less resources than activity-based budgeting methods.
Steps in building an activity-based budget
Activity-based budgeting is one way to improve the efficiency of business operations. Under this method, management should try to determine how well a particular activity contributes to its goal and explain the possible deviation from each activity’s budget.
To achieve company goals, management determines the activities to be carried out. They also estimate the costs for each activity.
Also, management maps the relationship between activities, whether they are following the objectives or not. From each activity, management then decides how much they should allocate resources.
In general, the activity-based budgeting process is divided into three stages, namely:
- Identify critical activities. Management breaks down the company’s goals into several activities to carry out. Next, management screens them and determines the main activities, i.e., those generating revenue or incur expenses.
- Determines the number of units associated with each activity. Management will use this figure to calculate costs. For example, for raw material purchasing activities, management considers purchasing personnel and warehouse leases.
- Calculates the cost per unit of activity and multiplies the result by the number of units in each activity. Say, the purchasing activity requires 5 personnel and a salary of IDR5 million each year. Meanwhile, the company only needs one warehouse with a lease of IDR100 million a year. So, the company will budget for a cost of IDR125 million from the purchasing activity, consisting of a personnel salary of IDR25 million (5 x IDR25 million) and a warehouse rental of IDR100 million.
The above case is a simple example. Companies will usually break down key activities in more detail, from purchasing raw materials to processing to product delivery activities. Each of these incurs costs or contributes to revenue.
Advantages of activity-based budgeting
Compared to traditional budgeting, activity-based budgeting has several advantages, including:
- Provides details of the main activities. Budgeting reflects the estimated workload and financial burden to achieve the company’s strategic goals. This method provides a more detailed list, particularly of overhead costs. This is important for future budget evaluations.
- Better budget control. The company identifies activities that add value and their driving factors. This kind of information is essential for decision making and better control of cash inflows and outflows. Management gets a clear picture of the cause-and-effect relationship between costs and activities. It can align the budget with the overall goals of the company.
- Empowering resources better and efficiently. Management can direct all personnel to focus on main activities. Management eliminates less critical activities. So, the staff has clear roles and targets during the fiscal year.
- Eliminates waste of money. Management designs budgets and activities based on causal relationships. Management filters various activities into several main activities and determines their cost consumption. So, this method eliminates all kinds of unnecessary costs.
- Achieve excellence while reducing workload. Before designing a budget, management should gain a deep understanding of how to create value for customers. Then, they determine various activities to fulfill the, from purchasing inputs, selling to providing after-sales service. So, every activity contributes to providing the best value for customers.
- Supports synergy. This method helps in viewing the business as a whole. Management maps the relationship between activities and tries to eliminate all kinds of bottlenecks that often occur in cross-division cooperation.
Disadvantages of activity-based budgeting
This method is not ideal for all companies. This method contains some drawbacks so that some companies do not adopt it. Among the disadvantages of activity-based budgeting are:
- More expensive and time-consuming than traditional budgeting. Management must collect and detail information about various operational activities. The details may not only take a page or two. They have to sort out and determine which activities are essential to arrive at a cost determination. The process will likely take a long time.
- Assumption inaccuracy. The disaggregation of critical activities is often biased. Determining what contributes to revenue and what doesn’t is difficult. Management may overspend on activities that contribute less to revenue and reduce budgets for activities that are actually more important.
- More complex. Management requires a deep understanding of every business activity before determining what is important and what is not. Misunderstanding will only result in an inaccurate budget.
- Requires more resources. Management may have to involve everyone to map the various activities that should be carried out. Why? Each of them has a duty and role in the company’s operations. Also, this method requires trained employees to know how vital their role is. So, ideally, management should question all of them. For this reason, activity-based budgeting is suitable for large companies with more structured operations and management.