- Activity Based Budgeting | Need, Advantages, and Disadvantages — eFM
- Need of Activity Based Budgeting
- Competitive Edge:
- Business as a Unit
- Elimination of Bottlenecks
- Improves Relationship
- Disadvantages of Activity Based Budgeting
- Requires Understanding
- Resource Consumption
- Cost Involved
- Short Term
- Activity Based Budgeting (Definition, Example)| Advantage / Disadvantage
- Example #1
- Example #2
- Important Points
- Recommended Articles
- 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
Activity Based Budgeting | Need, Advantages, and Disadvantages — eFM
Activity based budgeting is a budgeting method in which budgets are prepared using Activity Based Costing after considering the overhead costs.
In simple words, activity based budgeting is management accounting tool which does not consider the past year’s budget to arrive at current year’s budget.
Instead, the activities that incur the cost are deeply analyzed and researched. the outcome of the study, the resources are allocated to an activity.
Need of Activity Based Budgeting
Activity based budgeting is carried out to bring efficiency in the activities of an organization. Budgets are prepared after justifying the cost drivers. Thus, activity based budgeting is activity oriented and not function oriented.
Let us now have a look at the benefits of activity-based budgeting method.
Activity based budgeting method evaluates each and every cost driver. It takes into consideration all the steps involved in an activity. The irrelevant activities are eliminated and only the necessary activities form a part of the business.
Activity based budgeting system eliminates all sorts of unnecessary activities, which helps the business to save its costs. The saved cost results in the production of goods and services at lower cost than that of competitors. It also helps the organization to gain a competitive edge in the market.
Business as a Unit
This budgeting technique helps in viewing the business as a single unit and not in the form of departments. The managers or the top management prepare the budget for the business unit as a whole and not keeping in mind any single department as done in the case of other methods of budgeting.
Elimination of Bottlenecks
Budgets under activity based budgeting are prepared after deep research and analysis. This study removes all the unnecessary activities of the business. By doing so, the business eliminates all sorts of bottlenecks associated with an activity and business functions are carried out more smoothly.
Activity based budgeting system helps in improving the relationship between the organization and its customers. The main aim of this budgeting method is to eliminate unnecessary activities and serve the customers with the best quality at best price.
This enforces (indirectly) the employees of the company to serve the customers in the best way possible and ensure customer satisfaction. In turn, the relationship between the organization and the customers improves.
Let us have a look at disadvantages of activity-based budgeting.
Disadvantages of Activity Based Budgeting
Activity-based budgeting offers many advantages. However, every process, this too has its disadvantages as listed below:
Activity-based budgeting requires a deep understanding of various functional areas of the business. If the manager preparing the budget is incapable of understanding and evaluating the areas of business, it would lead to inaccurate budget preparation.
Activity-based budgeting system is complex in nature. It requires research and analysis of various factors. This budgeting method comprises of estimation of demand and that, it does the estimation of resources to be employed in various activities.
The process of budgeting in this method consumes a lot of resources of an organization. It needs to employ top officials for conducting numerous analyses. It is a very time-consuming task too. If these resources are employed in other operational activities, they can give better returns.
Implementation of activity-based budgeting requires trained employees. An employee, who is not trained enough, cannot handle the budgeting exercise effectively. So business needs to incur extra costs to train its employees. Moreover, the process requires the involvement of top management, so proves to be costly too.
Activity-based budgeting focuses on short-term goals of the business. It does not take into account the long-term scenario of the business. Focusing more on short-term goals rather than long-term goals can prove to be very fatal for the organization.1–4
Liberto D. Activity-Based Budgeting (ABB) Definition. Investopedia. August 2019. [Source] Activity-Based Budgeting (ABB). CGMA . June 2013. [Source] What are the Key Benefits of Using Activity Based Budgeting (abb) in Businesses? Benefits Of. March 2014. [Source] What are the Disadvantages of Activity-Based Budgeting? brighthub. August 2019. [Source] Last updated on : August 31st, 2019
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.
- The budgeting process can have more control when Activity-based budgeting (ABB) systems are used in the company instead of a traditional way of budgeting.
- Expenses and Revenue planning will occur at an accurate level, which shall provide meaningful details regarding the estimated and future financial projections.
- Last but not the least company can have better control and can align its annual budget with the overall firm’s goals by implementing Activity Based Budgeting.
- It helps to improve the business process by identifying unnecessary activities, which leads to an increase in cost as a lot of research is done here.
- The main disadvantage of Activity Based Budgeting is that it is more expensive to implement and comparatively more costly than the traditional way of budgeting.
- Furthermore, technical details are required to maintain to capture costs at a particular level.
- This process also involves a lot of assumptions to be made, which shall consume more time of management and can lead to inaccuracy of cost at certain times as well, which shall depict the incorrect cost of the product.
- It also requires a deep understanding of the process.
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?
The traditional way of assigning cost or budget was to take the overhead cost of last period and adjust the same for inflation and compute the total cost for the new order and hence it was ignoring the activities cost wherein one could lead to no involvement in the process, and still it was charged.
Hence, by implementing activity-based budgeting, the management can identify activities that are indeed involved in the production process and accordingly price the product and save cost and hence increase the revenue of the firm.
This article has been a guide to what is Activity-Based Budgeting. Here we discuss the formula of activity-based budgeting, its calculation with examples, advantages, and disadvantages. You can learn more about finance from the following articles –
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:
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.