Activity based budgeting

What Is Activity Based Budgeting?

Activity based budgeting (ABB) is a financial management approach that aligns an organization's expenditures with its activities and the costs associated with performing those activities. Unlike traditional budgeting methods that often rely on historical figures, ABB starts by identifying the activities necessary to produce goods or services and then estimates the resources required for each activity. This detailed approach falls under the broader category of financial planning and aims to improve accuracy in financial forecasts and enhance managerial control over costs. By focusing on activities, activity based budgeting helps businesses understand where and why costs are incurred, facilitating more informed decision-making and efficient resource allocation.

History and Origin

The conceptual foundations for activity based budgeting emerged from the development of activity-based costing (ABC) in the 1980s. As businesses became more complex and automation increased, traditional cost accounting methods, which primarily focused on direct labor and materials, struggled to accurately allocate growing overhead costs. Academics like Robert S. Kaplan and Robin Cooper of Harvard Business School were instrumental in articulating the need for a more sophisticated system to accurately measure costs and associate them with specific goods and services.⁷,⁶ The core idea was that activities consume resources, and products or services consume activities. This shift in perspective allowed for a more precise understanding of cost drivers, which then naturally extended to the budgeting process, leading to the adoption of activity based budgeting.

Key Takeaways

Activity based budgeting links expenditures directly to the activities that consume resources within an organization.
It emphasizes identifying and costing individual activities rather than simply adjusting prior period budgets.
ABB provides a more granular view of costs, aiding in precise cost allocation and identifying areas for efficiency improvements.
It supports strategic objectives by ensuring resources are directed towards value-adding activities.
Implementing activity based budgeting often requires significant time and effort due to its detailed analytical nature.

How Costs are Calculated in Activity Based Budgeting

While activity based budgeting itself does not have a single, overarching formula, its core involves the calculation of costs for individual activities, similar to the principles used in activity-based costing. The process involves identifying activities, pooling costs associated with those activities, and then determining cost drivers to allocate these costs to specific outputs or services.

The general approach to determine the cost per unit of an activity is:

$\text{Cost per Activity Unit} = \frac{\text{Total Cost of Activity Pool}}{\text{Total Activity Driver Volume}}$

For example, if a company's "customer support" activity pool has a total estimated cost of $500,000 per year (including salaries, software, and facilities related to support), and the activity driver is the number of customer inquiries, estimated at 25,000 inquiries annually, then:

$\text{Cost per Customer Inquiry} = \frac{\$500,000}{\text{25,000 inquiries}} = \$20 \text{ per inquiry}$

This calculated cost per activity unit then forms the basis for budgeting. If the company forecasts 30,000 inquiries for the next period, the budgeted cost for customer support would be ( $20 \times 30,000 = $600,000 ). This method allows for more accurate expense management based on projected activity levels rather than arbitrary percentage increases.

Interpreting Activity Based Budgeting

Interpreting activity based budgeting involves analyzing the granular cost data derived from activities to make informed operational and strategic decisions. By understanding the cost associated with each activity, managers can identify which activities are most resource-intensive and whether those activities add sufficient value to justify their costs. For example, if the cost of processing each sales order is high, management might look for ways to streamline the process or automate parts of it to reduce costs. The insights gained from ABB can highlight operational inefficiencies and areas where profitability can be improved. It also helps in setting realistic performance targets for departments and individual activities, thereby enhancing performance management across the organization.

Hypothetical Example

Consider a software development company, "Tech Innovations Inc.", planning its budget for the upcoming quarter. Instead of increasing last year's department budgets across the board, they opt for activity based budgeting.

Identify Activities: The company identifies key activities such as "Software Development," "Quality Assurance (QA) Testing," "Customer Onboarding," and "Marketing Campaign Execution."
Estimate Activity Costs:
- Software Development: Requires 5 developers, each at $15,000/month in salaries and benefits, plus $5,000/month in software licenses and tools. Total: ( (5 \times $15,000) + $5,000 = $80,000 ) per month.
- QA Testing: Requires 2 QA engineers at $12,000/month each, plus $2,000/month in testing tools. Total: ( (2 \times $12,000) + $2,000 = $26,000 ) per month.
- Customer Onboarding: Requires 1 onboarding specialist at $10,000/month, plus $1,000/month in CRM software fees. Total: ( $10,000 + $1,000 = $11,000 ) per month.
- Marketing Campaign Execution: Requires 1 marketing manager at $13,000/month, plus $3,000/month for ad spend and creative tools. Total: ( $13,000 + $3,000 = $16,000 ) per month.
Determine Activity Drivers and Forecast Volume:
- Software Development: Lines of code (LoC) produced. Expected: 50,000 LoC.
- QA Testing: Number of test cases. Expected: 2,000 test cases.
- Customer Onboarding: Number of new customers onboarded. Expected: 100 new customers.
- Marketing Campaign Execution: Number of campaigns. Expected: 4 campaigns.
Calculate Budgeted Cost per Driver:
- Software Development: ( $80,000 / 50,000 \text{ LoC} = $1.60 \text{ per LoC} )
- QA Testing: ( $26,000 / 2,000 \text{ test cases} = $13 \text{ per test case} )
- Customer Onboarding: ( $11,000 / 100 \text{ customers} = $110 \text{ per customer} )
- Marketing Campaign Execution: ( $16,000 / 4 \text{ campaigns} = $4,000 \text{ per campaign} )

Based on these calculations, Tech Innovations Inc. can construct a precise budget by multiplying the cost per activity driver by the forecasted volume for each activity. This allows them to see how changes in planned activities directly impact their total expenditures, offering a more dynamic approach to strategic planning.

Practical Applications

Activity based budgeting is particularly useful for organizations seeking to optimize operational efficiency and enhance cost control. It finds practical application in various sectors, from manufacturing to service industries. For instance, a manufacturing firm might use ABB to understand the true cost of producing different product lines by allocating manufacturing overhead, such as machine setup and quality control, based on specific activities rather than arbitrary percentages. In the service sector, a hospital could use ABB to determine the precise cost of different medical procedures by accounting for activities like patient admission, diagnostic testing, and nursing care.

Academic studies have demonstrated the utility of activity based budgeting in improving financial control. For example, a study on an industrial company found that activity based budgeting contributes significantly to determining and limiting costs and preparing budgets for each activity, thereby enabling more accurate control over costs.⁵ By providing a detailed and analytical view of activities and their associated costs, ABB facilitates a deeper understanding of where money is spent, leading to more effective cost reduction initiatives and better overall financial management. It enables businesses to distinguish between value-adding and non-value-adding activities, supporting efforts to streamline processes and enhance overall efficiency.

Limitations and Criticisms

Despite its advantages, activity based budgeting presents several limitations and has faced criticisms. One of the primary drawbacks is its complexity and resource intensity. Implementing ABB requires significant time, effort, and detailed analysis to identify all relevant activities, assign costs accurately, and determine appropriate cost drivers.⁴,³ This can be particularly challenging for large organizations with numerous activities or those lacking sophisticated financial systems.

Another common criticism is the subjectivity involved in activity allocation. Determining how to precisely assign certain shared costs to specific activities can be difficult and may lead to inconsistencies or inaccuracies if not managed with clear guidelines.² Furthermore, ABB is often more effective for managing variable costs directly tied to activities and may not adequately address [fixed costs](https://diversification.com/[¹](https://themba.institute/accounting-for-managers/limitations-of-activity-based-costing/)