What is it?
CIMA Official Terminology describes activity-based budgeting (ABB) as a method of budgeting based on an activity framework, using cost driver data in the budget setting and variance feedback processes.
The most basic form of ABB uses cost drivers (identified through activity-based costing, ABC) to help derive budgets. As its name suggests, ABB focuses on activities rather than functions.
In simple terms, ABB follows three stages:
1. Identify activities and their cost drivers
2. Forecast the number of units of cost driver for the required activity level
3. Calculate the cost driver rate (cost per unit of activity).
The following simple example uses a sales office scenario, where the cost driver is number of sales orders.
Calculate the forecast cost of processing a single sales order using ABC, adjusting for inflation if necessary ($5)
Forecast the number of sales orders for the budget period (40,000)
Finally, calculate the total sales office budget (40,000 x $5 = $200,000)
This example assumes that costs incurred by the sales office are mostly variable – in practice, they would also include elements of fixed and semi-fixed costs, such as accommodation, heating and salaries. Further analysis would be required to determine how much staff time is spent processing sales orders.
What benefits does ABB provide?
Like activity-based costing, activity-based budgeting draws attention to overhead activities and their associated costs. It emphasises that activity costs may be controllable if activity volume is controlled. Where traditional budgeting tends to focus on input costs, ABB takes an outputs-based approach, recognising that activities drive costs. ABB views the business as a collection of activities, a perspective that links well with organisational strategy.
Questions to consider when implementing ABB
Like ABC, ABB requires significant time to implement. Do we have the required support and time?
Do we have the required resources and software?
Like ABC, ABB is expensive to implement. Will the costs of implementation outweigh the benefits?
Can we easily identify all of our activities and costs?
Can we get buy-in from operational managers?
|Actions to take / Dos||Actions to Avoid / Don'ts|
|Consider using ABB if overhead costs are a significant proportion of total operating costs||Don’t try and implement ABB unless you are using activity-based costing (ABC) as it is only suited to organisations that are also using ABC|
|ABB is particularly useful in a Total Quality Management (TQM) environment, to help identify the cost-effectiveness of activities||Do not ignore the need to engage with operational managers, or they may struggle with the concept of ABB, making the process more time-consuming|
Calculating the purchases budget at GS
GS has budgeted sales for the next two years of 24,000 units a year spread evenly throughout both years. The estimated opening inventory of finished goods at the start of the next year is 500 units but GS now wants to maintain inventory of finished goods equivalent to one month’s sales.
Each unit uses 2 kg of material. The estimated opening raw material inventory at the start of the next year is 300 kg but GS now wants to hold sufficient raw material inventory at the end of each month to cover the following month’s production.
The change in the policy for inventory holding for both raw materials and finished goods will take effect in the first month of next year and will apply for the next two years. The budgeted material cost is $12 per kg.
GS uses the following approach to calculate the material purchases budget:
|Budgeted sales||24,000 units|
|Plus closing inventory||2,000 units|
|Less opening inventory||-500 units|
|Budgeted production||25,500 units|
|Raw material required||25,500 units x 2 kg = 51,000 kg|
|Plus closing inventory||2,000 units x 2 kg = 4,000 kg|
|Less opening inventory||(300) kg|
|Raw material purchases||= 54,700 kg|
|Raw material purchases budget||54,700 kg x $12 = $656,40|
Related and similar practices
Activity-based management (ABM)