A budget is a quantitative plan or forecast for a future period of a business. An activity-based budget is one of the types of budgets which is made based on an activity or different activities in a business.
In an activity-based budget, a business bases its costs on an expected activity level. The activity bases used for this type of budget are thoroughly analyzed by a business to predict the costs of the business.
In an activity-based budget, the business closely considers every cost incurred to determine if it can reduce these costs and create efficiencies.
Activity-based budgets are different from traditional budgets. Traditional budgets take the previous period’s budgets and adjust them for inflation or any other changes within the business.
Activity-based budgets take a different approach to budgeting as they allow the business to focus the budget on the volume or type of activities within the business.
How to make an Activity Based Budget?
A business that wants to operate an activity-based budget must use a three-step process to make these budgets. These are as below.
1) Identify cost drivers
The first step in making an activity-based budget is to identify the cost drivers of a business. Cost drivers are activities or items that are responsible for incurring expenses within a business.
For example, in modern manufacturing businesses, machine hours are the main cost drivers as the higher the machine hours of the business are, the more costs it will incur.
2) Estimate the number of units for each cost driver
Once a business identifies its different cost drivers, the business must estimate the number of units for the cost drivers. The business can use these units as a baseline for the calculation of the budget.
The number of units for each cost driver will depend on the level of planned activity of the business.
For example, the business may estimate it requires 2 machine hours per unit of product and will produce 100 units of the product per week. Thus, the number of total machine hours will be 200 hours per week.
3) Calculate the cost per unit of activity according to the cost driver
Once the number of units for each cost driver is determined, the business must calculate the cost per unit of the activity and multiply it with the activity level.
For example, if the business calculates the cost per unit of the activity to be $5, it can simply multiply the cost per unit with the number of machine-hours, which was 200 hours per week. This will bring the cost to $1,000 (200 hours x $5 per unit).
When should businesses use Activity Based Budget?
Before using an activity-based budget, businesses must first determine whether this budget can help the business. Therefore, businesses must first know when to use this type of budget before applying it.
Activity-based budgets should be used by startups and businesses going through significant changes that cannot implement a traditional budget.
This is because startups don’t have any historical data based on which they can calculate and implement a traditional budget.
On the other hand, while established businesses going through significant changes may have the required historical data, the data cannot be relied upon to produce traditional budgets.
Advantages of Activity Based Budgeting
There are many advantages of activity-based budgeting for businesses. These advantages are as below.
Provide a fresh start
As mentioned above, startups and businesses going through significant changes use activity-based budgets to set a base budget for the future.
However, it can also be used by businesses that want to have a fresh start to their budgeting process. Activity-based budgets can provide these businesses with a fresh start and provide a strong base for future budgets based on it.
Activity-based budgets do not rely on historical data to contemplate a budget. These budgets are more forward-looking and future-oriented rather than depending on data from past activities, as is the case in traditional budgets.
Help identify inefficiencies
Activity-based budgets are based on the activities of the business. Therefore, they can give a business better insight into any inefficiencies within the processes of the business.
This can help managers of the business find areas of improvement and make them more efficient. Bringing efficiency to the processes of the business can also decrease its costs and increase profits in the long-term.
Activity-based budgets are more goal-oriented as compared to traditional budgets. Activity-based budgets do not focus on individual departments within a business but focus on the business as a whole.
This makes activity-based budgets more goal-oriented than other types of budgets.
Since traditional budgets focus on allocating resources to individual departments within a business, they can create conflicts within the managers of different departments.
However, it avoids any interdepartmental conflicts because activity-based budgets, as mentioned above, focus on the activities of a business as a whole rather than individual departments.
Disadvantages of Activity Based Budgeting
Businesses using an activity-based budget may also face some disadvantages. These disadvantages are as below.
Activity-based budgets can be time-consuming as they involve a thorough examination of the activities of a business to identify cost drivers.
It can also be demoralizing for managers who have to prepare these budgets regularly as they have to spend most of their time on budgeting while also handling other responsibilities.
Require skills and knowledge
Only managers with skills and deep knowledge of the business can prepare activity-based budgets. As compared to traditional budgeting, which involves inflating historical budgets, activity-based budgets require technical knowledge.
As discussed in the above two points, activity-based budgets require a lot of time and require skilled and knowledgeable individuals to prepare them.
Furthermore, to successfully implement activity-based budgets, a business needs to have trained employees.
This means the business has to incur the costs of technical staff for the preparation of budgets and training employees for an activity-based budgeting system. It makes them costlier as compared to traditional budgets.
An activity-based budget is based on an activity or different activities of a business. It is different from a traditional budget because it focuses on the volume and type of activities in a business rather than historical results. It takes an easy three-step process to prepare an activity-based budget.
Activity-based budgets are more suited to businesses with no historical data or businesses that are going through significant changes.