What is Activity based budgeting and how is it used?
Activity-based budgeting (ABB) is a planning system under which costs are correlated with activities, and expenses are then budgeted based on the planned activity level. It is a budgeting process in which budgets are developed using Activity Based Costing (ABC) after considering the overhead costs.
Meaning of Activity based budgeting
ABB analyses the resource input or cost for each activity. It gives you a guiding framework for estimating the amount of resources required in line with the budgeted level of activity.
Activity based budgeting is a planning and monitoring system that aims to help you achieve your continuous improvement goals. It involves planning and controlling the expected activities of an organization to arrive at a cost-effective budget that meets the agreed-upon strategic goals.
Actual results can be compared to budgeted results to highlight both, in financial and non-financial terms, those activities that show significant variances from budget so that a potential reduction in the supply of resources can be looked for.
Key elements of ABB
The key elements of activity-based budgeting are as follows:
- Estimating the type of work to be done
- Estimating the quantity of work to be done
- Estimating the cost of work to be done
Under ABB, every activity in an enterprise that incurs a cost is evaluated for possible ways to create efficiencies. Budgets are then generated based on these results.
Benefits of Activity-based budgeting
Some of the benefits offered by activity-based budgeting can be:
- Activity based budgeting (ABB) can enhance the accuracy of financial forecasts and increase management understanding.
- When automated, ABB can rapidly and accurately generate financial plans and models based on varying levels of volume assumptions.
- Every activity cost incurred by an organization is closely scrutinized to see whether efficiencies can be created and costs reduced. It may take the form of a decline in activity levels or the complete elimination of unnecessary activities.
Steps of ABB
To execute activity-based budgeting, the following steps must be performed:
- Identify the cost driver for each activity. For instance, the cost driver for a production facility can be the total labor hours or wages paid to employees. These are the items that are responsible for incurring expenditure in a company. Say, a company wants to assess the expenses relating to processing sales orders for the upcoming year. The number of sales orders would be the cost driver here.
- Project the number of units required under each activity. This number acts as the foundation for making calculations. Say, the company anticipates receiving 40,000 sales orders in the upcoming year.
- Compute the cost per unit of activity. This is called the activity cost driver rate and multiply that result by the activity level. Say, each single sales order costs Rs. 22 to process. The budget for expenditure relating to processing sales orders is, therefore, Rs. 8,80,000.
On the other hand, when the traditional budgeting process is applied in place of ABB, this figure might get distorted. Suppose the previous year’s budget called for Rs. 6,00,000 of sales order processing expenses and sales were expected to grow 10%. In that case, only Rs. 6,60,000 would have been budgeted.
ABB is more rigorous than traditional budgeting. Traditional budgeting tends to merely change prior period budgets to account for inflation or business growth. But rather than using past budgets as a base, ABB digs deeper into the cause.
Let’s take another example to see how ABB works.
Assume that XYZ Company has collected the following data for its two activities. It calculates activity cost rates based on the budgeted capacity of cost drivers.
| Activity | Cost Driver | Budgeted capacity | Budgeted Cost (in INR) |
| Power | Kilowatt hours | 50,000 kilowatt hours | Rs. 2,00,000 |
| Quality Inspections | Number of Inspections | 10,000 Inspections | Rs. 3,00,000 |
The factors that management considered in choosing a capacity level to compute the budgeted fixed overhead cost rates were:
- Effect on product costing & capacity management
- Effect on pricing decisions
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements
- Difficulties in forecasting
Suppose the company makes three products A, B, and C. For the year ended March 31, 2021, the following consumption of cost drivers was reported by the company’s management:
| Product | Kilowatt hours | Number of Inspections |
| Product A | 10,000 | 3,500 |
| Product B | 20,000 | 2,500 |
| Product C | 15,000 | 3,000 |
In this case, to implement activity-based budgeting using budgeted capacity and cost, the rate per unit of cost driver would be computed as below:
Activity 1 – Power = Rs. 2,00,000 ÷ 50,000 kilowatt hours = Rs. 4 per KWH
Budgeted activity cost is Rs. 2,00,000
Activity 2 – Quality Inspections = Rs. 3,00,000 ÷ 10,000 Inspections = Rs. 30 per inspection
Budgeted activity cost is Rs. 3,00,000
Thereafter, cost allocation to each product from each activity would be made using the budgeted cost driver rates:
| Activity | Product A | Product B | Product C | Total Product cost |
| Power | 10,000 KWH × Rs. 4 = Rs. 40,000 | 20,000 KWH × Rs. 4 = Rs. 80,000 | 15,000 KWH × Rs. 4 = Rs. 60,000 | Rs. 1,80,000 |
| Quality Inspections | 3,500 inspections × Rs. 30 = Rs. 1,05,000 | 2,500 inspections × Rs. 30 = Rs. 75,000 | 3,000 inspections × Rs. 30 = Rs. 90,000 | Rs. 2,70,000 |
The cost of unused capacity for each activity can now be computed by comparing the budgeted activity costs with the actual activity costs incurred for each product.
Unused capacity for Activity 1 is 50,000 kilowatt hours minus 45,000 kilowatt hours. (45,000 being the actual consumption of activity by the three products)
Unused capacity for Activity 2 is 10,000 inspections minus 9,000 inspections. (9,000 being the actual consumption of activity by the three products)
| Activity | INR |
| Power (Rs. 2,00,000 – Rs. 1,80,000) or 5,000 x Rs. 4 | 20,000 |
| Quality Inspections (Rs. 3,00,000 – Rs. 2,70,000) or 1,000 x Rs. 30 | 30,000 |
| The total cost of unused capacity | 50,000 |
Takeaway
ABB works to develop a more detailed and in-depth business budget based on various activities within the organization. This can be an efficient way, particularly for new or continuously evolving businesses that keep on changing their operations, to reduce costs and remove redundant functions that are detracting from overall profit generation.
Moreover, companies use ABB when they have minimal information regarding historical budgets. They should detail any potential activities that will be undertaken in the future. For this reason, start-ups are most suitable for this approach.
Read more:
What is activity-based costing? – Meaning and suitability
What is Activity-based management? How does it work?
Difference between traditional costing and activity-based costing – Which is better?
