What Is Activity-Based Budgeting?
Activity-based budgeting (ABB) is an accounting tool that works to create a more in-depth business budget based on specific activities within the organization. For new or changing companies, this can be an effective way to cut costs and eliminate unnecessary functions that are detracting from the overall profit generation.
This method of budgeting enables a higher level of efficiency by focusing on the activities that are driving forward movement, rather than falling back on a static budget.
In this blog post, we will talk a bit about how ABB works, how it differs from more traditional budgeting strategies, and who can benefit the most from it.
Want a dedicated team on your side to walk you through the implementation of your new activity-based budget? Contact the Redwood team today and let us help you connect the dots.
How does activity-based budgeting work?
Activity-based budgeting doesn’t look at last year’s budget in order to create this year’s, like most traditional methods. Rather, it takes an in-depth look at each of the individual activities of the business to budget according to each function. With ABB, after extensive research and analysis, managers have a deeper understanding of how many resources they’ll need to allocate to each activity.
- Fixed overhead costs are accounted for first and separately if they’ll remain consistent. For example, the manager likely knows how much they’ll pay in rent for their leased warehouse, so they can account for that without creating a separate budget.
- The manager will then identify all the relevant activities within the business. These are the cost drivers of the business, meaning they incur either revenue or expenses. For example, the number of shipments would be a cost driver.
- Next, the manager should determine the quantity of that activity. For example, the manager predicts 80,000 shipments for the upcoming year.
- Then they will delineate the cost per unit of activity. How much does each shipment cost to process? Let’s say it costs $3.
- Multiply the unit times the cost per unit to determine how much that activity will cost. 80,000 units times $3 for shipment processing means that the cost to ship those orders for the year would be $240,000.
To break it down in simpler terms… Figure out what activities your business needs in order to run. Then, determine how much that activity will cost.
In the case of logistics, ABB looks at each individual operations activity to see what your business needs in terms of funding for each function.
How is activity-based budgeting different than traditional budgeting?
Traditional budgeting processes look at last year’s budget and move it to this year’s, adjusting for inflation and basic business development.
Using the example above, if their shipping processing costs last year were $200,000 and they expected shipments (and sales) to grow 10%, they would budget for $220,000 [$200,000 + (10% of $200,000)]. This is $20,000 less than they might budget for using ABB. This is a fast and easy way to figure out a budget, but it might not always be directly related to the business’s true needs.
Activity-based budgeting takes longer than traditional budgeting, as it requires a deeper level of analysis and business evaluation. However, for a lot of businesses, especially for those that are restructuring, this kind of deep evaluation is the most effective way to minimize loss and expand profit margins.
Who can benefit from this type of budgeting?
Any organization can benefit from ABB if approached with care, time, and expertise. However, it’s especially useful for companies that don’t have historical budgeting information, like new organizations or those undergoing a lot of changes.
For large firms with an established history of annual budgets, the traditional method can work well. They already have a good idea of what has worked in the past and how their business will grow or shrink based on other factors, so they can often use historical data to create their financial plan. Still, we often recommend doing an ABB audit every few years for all businesses to ensure there aren’t any extraneous activities that could be slowly eating away at profits.
What are the advantages?
- Control: ABB allows for greater control over budgeting. You are budgeting based on activities that are in alignment with your company goals, which gives the freedom to allocate funds in accordance with what your business needs to grow.
- Cost reduction: You’re not over-budgeting on functions that your business doesn’t actually need. The purpose of ABB is to spend just the right amount in just the right places, which can save a vast amount of resources.
- Streamlining: You’re eliminating all unnecessary activities that aren’t relevant to generating revenue. Removing these bottlenecks ensures functions are handled smoothly, effectively, and cost-efficiently.
- Organizational unity: ABB requires that you view your business on the whole based on activities, not based on individual departments. This creates a more comprehensive sense of financial unity.
Activity-based budgeting helps you allocate money to activities that push your business forward. If your business doesn’t have historical data, budgeting based on activities can be a highly effective way to determine a financial plan that will work for your business.
What are the disadvantages?
ABB takes a lot of time and resources to research, evaluate, and analyze each activity individually. This sort of research is complicated and consumes a lot of resources. It’s time and cost-intensive to complete, and managers need to have a comprehensive understanding of the different areas of the business. Furthermore, not accomplishing ABB analysis correctly could result in budgeting inaccuracies, which can be especially problematic for businesses that don’t have any profit leeway.
In a lot of cases, ABB is also more focused on the short-term goals of the business. It doesn’t always consider long-term objectives and budgeting. It’s important to consider how each activity plays into the overall scope of the business in order for ABB to work most effectively.
Is ABB right for my business?
Activity-based budgeting can be a useful financial planning tool for businesses that are looking to have a better handle on where and how they spend their money. ABB is especially useful for logistics teams to evaluate and analyze each operational activity for a value-driven spending account.
Talk to your accounting team and 3PL partner to see if activity-based budgeting could be right for your business for the upcoming quarters. We’d love to chat with you about the best financial and tech solutions for your business.