Activity-based budgeting (ABB) is a rigorous form of budgeting that is often used in conjunction with cost cutting efforts. It is a useful form of budgeting for fledgling organizations that need to keep a tight lid on costs and provides good insight into expenses that drive revenue.
While it is more intense than a traditional budget, activity-based budgeting can be an incredibly useful practice. In this FAQ we will discuss what activity-based budgeting is, why it is important, and how to create an activity based budget.
What Is An Activity-Based Budget?
An activity-based budget is a budget that scrutinizes every cost in a business. Like the name implies, an activity-based budget is created using the activities that drive costs.
The process is agnostic to the type of costs or their importance to the organization. The ABB process demands that each cost is researched thoroughly and then justified before being included in the budget.
Because of the heavy emphasis placed on researching and justifying each expense, it takes far more time and resources than a traditional budget. It is important that you weigh the costs and benefits of devoting the time and resources required for a successful ABB.
Why Is An Activity-Based Budget Important?
Probably the most obvious benefit of creating an ABB is the process of examining, researching, and justifying every expense in the business.
This does two critical things for a business:
- It forces the enterprise to become intimately familiar with every cost associated with revenue generation
- It helps the organization unify to find ways to reduce and manage expenses.
The idea behind an ABB is to help the organization maintain its current level of revenue while simultaneously reducing its costs. In this way, an ABB can be a powerful tool that hypothetically should increase the bottom line.
Activity-Based Budgeting vs Traditional Budgeting
A traditional budget relies on prior-year expenses and revenues that are then projected into the future and adjusted for sales growth/decline or changes in economic conditions.
Typically, a traditional budget uses some percentage basis to adjust prior-year values. Because of this, traditional budgets tend to bloat unnecessarily over time and can result in relaxed cost management.
An activity-based budget differs from this in that it disregards prior year values entirely and instead focuses on identifying cost drivers. The process then eliminates unnecessary costs to develop a new budget independent of prior-year values.
Although every business can benefit from an ABB, it is not always the best approach for every business. Well-established businesses that have mature revenue generation and expense management might find an ABB overly time consuming and of little benefit.
However, an ABB is a great option for new businesses that might not have historical information at their disposal. In addition, new businesses should heavily scrutinize every cost as they look to grow.
An ABB is also a great budgeting approach for businesses that are experiencing some material change to their organizational structure. This might be a recent acquisition, an establishment of a new subsidiary, or major shifts in demand.
How To Make An Activity-Based Budget
While the process of making an ABB is time consuming and can be arduous, there are actually only a few steps in the process. Each of the steps is straightforward, with the most emphasis placed on the first step.
Step 1: Identify the Relevant Business Activities and Examine Cost
The first step is to identify all of the relevant business activities that support the organization and then to peel each one apart to scrutinize each of the cost drivers.
This list should not be limited to activities only associated with revenue generation and order fulfillment — they should include all of the business activities in the entire organization.
Once all of the activities are identified, begin the process of identifying the cost drivers of the activity. Remember to thoroughly review each expense and in the process justify its existence.
Once the base budget is created, begin the process of implementing changes in the business activities aimed at reducing costs.
Step 2: Calculate Units
Once you have determined the cost drivers behind your business activities, calculate the number of units related to each activity.
These values are used in the third step. An example of units would be: number of production line workers, number of administrative staff, or number of vehicles required to conduct normal business.
Step 3: Determine Cost Per Unit
Now multiply the number of units required for each of the respective business activities you identified in the step by the cost you identified for that task in the first step. This is your baseline cost per unit.
Use the cost per unit to build the budget from the ground up, first identifying each required unit for every task and multiplying it by the cost.
Remember to justify each additional dollar needed to operate the business and look for ways to reduce the cost per unit.
When you make changes to the cost drivers, simply recalculate the cost per unit and compare it to your baseline calculation to determine its value.
Using DataRails to Build Your Activity-Based Budget
Every finance department knows how challenging building an activity-based budget can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced FP&A solution that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.