- Activity Based Budgeting | Components, Advantages and Diasdvantages
- Components and Process of Activity Based Budgeting
- Example of Activity Based Budgeting
- Advantages and Disadvantages of Activity-Based Budgeting
- Important Points of the Activity-Based Budgeting
- Recommended Articles
- Activity Based Budgeting (Definition, Example)| Advantage / Disadvantage
- Example #1
- Example #2
- Important Points
Activity Based Budgeting | Components, Advantages and Diasdvantages
Activity-Based Budgeting is a process of creating a blueprint or financial plan in advance which will act as a yardstick by addressing individual activities which are to be carried out given the limited amount of resources in an organization using research tools and allocating the resources accordingly as per their priority in form of a budget specifying expected costs that are required to be spent.
Components and Process of Activity Based Budgeting
Components and Process of Activity Based Budgeting are given below:
- It starts with identifying activities which revolve around resource consumption and these activities are mainly classified as main activities and secondary activities which denotes to the degree of involvement and importance of an activity to the organization as per their priority, therefore, main activities are activities which are directly related with the objectives and are essential.
- Secondary activities are those activities that create added value to the customer and change its preference in the organization’s favor which may involve a significant amount of resources.
- After defining the activities the next task is to identify how to distribute the costs or resources accordingly among the activities which are done with the help of inducers which are factors defining the level of consumption in different activities.
- Mainly three such inducers influence such decisions which are time which depicts the duration for the processes, amount of resources required by each activity and lastly the number of times an activity is repeated after getting all these facts the appropriate costs can be calculated.
Example of Activity Based Budgeting
Following is the example budget for the first quarter of the year 2020 of company A ltd the activity:
Advantages and Disadvantages of Activity-Based Budgeting
Advantages and Disadvantages are mentioned below:
The various different advantages related to the Activity-Based budgeting are as follows:
- Activity-Based Budgeting takes up a forward-looking view rather than looking at previous activities which a common feature under traditionally based budgeting i.e. it asks questions what needs to be performed and where can we make improvement rather than what was done earlier and sort of just allocation of costs according to that.
- Activity-Based Budgeting sources its budgets activities and resources allowing better insight on inefficiencies in processes and sources of imbalances which will help the managers find areas of improvements making them more efficient in their jobs.
- Activity-Based Budget has a more practical approach in a dynamic environment and makes it easier for the employees and managers to communicate and execute the activities in a time-bound manner as well as to evaluate performances of the same by fixing accountability of specific activities.
- Activity-Based Budget leaves scope for making changes as per the changes in the climate and current situation as opposed to what was initially planned as it allows tools to trace resource consumption which allows identifying capacity issues so they can adjust in a timely manner.
The various disadvantages related to the Activity-Based budgeting are as follows:
- Activity-Based Budgeting is a lengthy and comprehensive process that requires a considerable amount of time and resources on an entity and spending too much on analyzing may prove to be counterproductive.
- It requires a well-groomed talented team of individuals who are experts in finding gaps and are equally competent in reporting and use of the necessary software as it is a complex process on which the direction of the company is dependent.
- While preparing an Activity Based Budget it is possible that the axis of focus may shift to immediate and short term results and the bigger picture may be ignored causing damage in the long term.
- It is forecasting with the use of historical data and future expectations which may sometimes prove to be unreliable if the situations or scenarios planned do not come out to be what was expected to lead to problems that can hamper the entity and its resources.
- Activity-Based Budgeting provides only supplemental information.
Important Points of the Activity-Based Budgeting
- It is simply put getting a detailed analysis of all the costs associated with activities. A tool that enables the managers to gain control ensuring timely and quality delivery while cushioning them for an unforeseen future as it is a flexible approach and promotes innovation which is a great advantage to have compared to the traditional system of budgeting. However, it is a much more complex and difficult to manage as compared to traditional systems as its emphasis is on the added values that activities bring to the product.
- Activity-Based Budgeting has helped not just private institutions to run smoothly but also has its impact on drawing major public policies and government spending. Various institutions schools, universities and non-governmental organizations have also been using this technique to make decisions, enable transparency and fix accountability of work creating a better environment overall of efficiency and brilliance. The format and syntax of the budget may vary for different organizations there is no uniform format.
It is a detailed, lengthy, complex and continuous process that requires a significant amount of resources and time which an entity may not necessarily have. Further Activity Based Budgeting may cause more confusion rather than becoming a solution if not handled properly.
It is a very unique approach to look at things from a different perspective enabling better decision making hence improving the internal processes within the organization.
Therefore Activity Based Budgeting is better suited to those who are willing to innovate and want to be quick to make changes, identify and correct mistakes in a time-bound manner which are those organizations that have a significant amount of resources and a resolution to excel at any cost.
This is a guide to Activity-Based Budgeting. Here we discuss the introduction and components and process of activity-based budgeting along with advantages and disadvantages. You may also look at the following articles to learn more –
Activity Based Budgeting (Definition, Example)| Advantage / Disadvantage
Activity-Based Budgeting is a budgeting process where the firm first identifies, analyzes, and researches the activities that determine the cost of the company and, after that, prepares the budget the results.
The formula is represented as follows,
Activity-Based Budgeting Formula = Cost Pool in the Designated Diver /Cost Driver in Units
Washington Inc. has decided to switch from a traditional budgeting system to activity-based budgeting. the below information, you are required to compute the budgeted cost those drivers.
The company has shifted from traditional based to activity budgeted way, and hence here we can see that there are two activities which are driving the cost
Using the ABC formula: Cost Pool total / Cost driver, we can calculate the overhead cost
We have = Machine setup cost / Number of Machine setups & Inspection cost / Inspection hours
Calculation of Machine Set-Up Per Unit
Calculation of Inspection Cost Per Unit
- = 280000 / 15500
- = 18.06 per hour inspection cost
Hence, in ABB, the cost is determined at the activity level and not an ad-hoc rate, which was done in a traditional method where only inflation was accounted for.
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Vista Inc was losing the auction due to its higher cost compared to peers. The management then decided to start budgeting the cost for their new orders by using Activity Based Budgeting.
The expected activity for the next order is given and it, you are required to estimate the total cost that can be provided as a bid.
In this example, we are given all the actual costs and drivers for the same, and we can use the below formula to compute the cost that was incurred in the last order, and the same is assumed to remain the same, and hence we can estimate for the new order as well.
Using the Activity Based Budgeting formula: Cost Pool total / Cost driver
Below are the calculations for each activity and are as per the last order.
The total cost for the new order and budgeted cost will be –
The above shall reflect true cost instead of a traditional way of doing the same.
Most simply, Activity Based Budgeting shall follow below three stages:
- Identify the activities by conducting detailed research, and along with that also one needs to identify their cost drivers, which again requires proper knowledge of the process.
- Now, either forecast the number of units which shall be produced for the next period or there could be new order coming up and also at this stage compute the overhead per driver.
- In the final stage, one needs to Calculate the cost driver rate and multiply the same for the new order or the new production units, and that shall give one the total estimated or budgeted cost.
- But before the above, one needs to determine whether the required time and cost are adequately available with the management or the company.
- Does the company has required resources and software and workforce to capture the same daily?
- Cost-benefit analysis needs to be done before implementation of the same, as the management should be that benefits shall out weight the cost.
- Can operational managers be recruited at reasonable remuneration?