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What is activity-based budgeting and how it can help trim costs

What is activity-based budgeting and how it can help trim costs

Activity-based budgeting (ABB) is an innovative approach to managing your company’s finances. As a data-driven process, the ABB system scrutinizes every cost incurred to uncover ways to create efficiencies.

Activity-based budgeting (ABB) definition

The activity-based budgeting process is a budgeting method businesses use to measure and analyze their activities to predict costs. In the business world, “activities” are the ones consuming resources and originating costs (products and services).

Using a traditional budgeting method like incremental budgeting, you would start from the previous year’s numbers and slightly adjust as needed for the current year. In contrast, activity-based budgeting uses a top-down approach to determine how to use the budget to reach critical company goals.

The activity-based budgeting method is laser-focused on cost reduction. This makes it a good fit for young businesses and those going through material changes. Let’s look at how this budgeting technique works.

On a budget, activity-based budgeting evaluates cost drivers relative to the activities, the number of activities, and how much it costs to do each of those activities:

activity-based diagram

You can see how each cost driver is analyzed, followed by the cost per unit, number of units, and total overhead costs required to meet these needs.

This method is ideal for companies with at least a year of financial information, which can help you create the next fiscal period’s budget. Activity-based budgeting may also work well for companies undergoing major changes, such as launching new products or business locations.

Activity-based budgeting steps

To understand how the activity-based budgeting process works, you’ll need to become familiar with its three-step process:

  • Identifying relevant activities and their cost drivers
  • Determining the number of activities related to each activity
  • Estimating the cost per activity and multiply that cost by the activity level

Step #1: Identify the relevant activities and their cost drivers

Cost drivers, or activities, are any item on your budget that incurs revenue or expenses for a business.

The first step is to identify all the relevant business activities that support the business and then analyze each cost driver associated with the activity. More specifically, a relevant activity refers to an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products.

Step #2: Determine the number of units per activity

Determining the amount of money spent per unit per activity helps you figure out the baseline for your calculations when determining your final budget. It also makes it easier to cut any unnecessary costs.

In our example, a small family business is open eight hours a day, six days a week. That’s 48 working hours a week, and at least two people are required to be on the floor at all times, which translates to 96 labor hours each week.

Step #3: Estimate the cost per unit per activity

Lastly, you have to estimate the cost per unit per activity and multiply that number by the activity level. So the formula would read:

activity based costing formula

Activity based costing formula

Overhead cost per activity x number of activities = Allocated overhead

Per the example and formula, assume that these small family business employees get paid $13 an hour. You would then calculate:

96 labor hours per week * $13.00 per hour = $1,248 weekly labor costs

Broken down, you can see the 96 labor hours per week (the activity level, X) is multiplied by $13 an hour (the cost per unit per activity, Y), which means that your labor costs every week are $1,248 (allocated overhead, Z).

Activity-based budgeting method vs. Zero-based budgeting method

The activity-based budget is similar to zero-based, as they both identify activities and consider whether they’re worth the cost.

However, there’s a distinct difference: activity-based budgeting exclusively identifies cost drivers. Then business owners work to find the minimum budget needed to meet those costs. In contrast, zero-based budgeting determines every expense, and business owners allocate income to each.

There’s a lot more to these processes that may influence how you determine your budget. So, when choosing your business’s approach, take time to learn about other business budgeting methods and find the one that works best for you.

When is activity-based budgeting used?

ABB is typically used in situations where there is a need to allocate resources based on the activities performed rather than using traditional budgeting methods.

Here are some scenarios where activity-based budgeting may be used:

  1. Complex cost structures: ABB is useful when an organization has complex cost structures, with costs distributed across multiple activities or processes.
  2. Resource optimization: ABB helps organizations optimize their resource allocation by aligning budgeting decisions with the activities that generate value.
  3. Process improvement: ABB is often employed when organizations are looking to improve operational efficiency and streamline processes.
  4. Service-based industries: Industries that provide services, such as consulting firms, law firms, or healthcare organizations, can benefit from ABB.
  5. Project-based organizations: ABB can be valuable for organizations that undertake projects with unique activities and varying resource requirements.
  6. Resource-intensive operations: Industries that rely heavily on resources, such as manufacturing or construction, can leverage ABB to allocate resources more effectively.

Implementing activity-based budgeting requires a strong understanding of the organization’s activities, cost drivers, and resource consumption patterns. Organizations considering activity-based budgeting should evaluate the potential benefits, downfalls, and resource requirements involved in implementing this approach before adopting it.

Reach your business goals using activity-based budgeting

Activity-based budgeting is an excellent method for analyzing business activities and goals and then budgeting around those goals.

It’s a practical budgeting technique for businesses that want to find a way to pay for specific company goals in the upcoming financial period, whether hiring trained employees, upgrading a department’s equipment, or purchasing raw materials for a new product.

No matter what type of budgeting method you choose for your business, you need an expense management system that can help you predict future costs based on past and present activities.

BILL Spend and Expense provides just about everything you need, whether that’s business crediting, AP automation, or a simple-to-read income and expense management analyzer so that you’re never left in the dark. Learn more today.

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