Activity Based Budget (ABB)
The activity based budget is the method which management prepares annual budget base on next year’s activity. It is depended on the activities based costing, which analyzes all variable and overhead costs associate with activities, the non-value added cost will not be included.
It is the management accounting tool that does not consider the history data in prior years. The budget needs to build from scratch, the cost will be changed base on the activities.
It includes the usage of activities level to determine the appropriate amount of resource need, how the resource is managed, and the proper explanation of any different from the budget.
Example of Activity Based Budget
Company A produces product X which involves setup and assembling process. The detailed cost can see as below:
- Direct material $ 5 per unit
- Direct Labor $ 10 per unit.
Based on the activity based costing, the cost driver of setup and assembling process can identify as follows:
The setup drive by the number of setup time, base on experience the one setup cost $ 2,000, and it requires one setup after 5,000 units of production. The assembling process will depend on the number of batches. It cost $ 3,000 per batch that consists of 1,000 units.
The company plan to produce 500,000 units of products next year, please use the activity base budget to prepare the budget.
First, we need to calculate the overhead cost which requires to produce a unit of product X.
- Setup cost = $ 2,000/5,000 units = $ 0.4 per unit
- Assembling cost = $3,000 /1,000 units = $ 3 per unit
The budget for both variable and overhead cost:
|Cost per unit
Note: sometimes, the cost driver cannot separate into the individual unit as it needs to complete as one-time work. So we can calculate the number of cost drivers require to achieve the target. Then we can multiply the number of cost drivers with its cost.
|Principle of Activity Based Budget
|Control cost driver, not cost
|ABB tries to control the cost driver rather than the cost itself. A cost driver is a factor that limits the cost, so if we can manage it mean we can manage the total cost. It helps the company to understand deeply in each cost category and be able to reduce. The manager also aware of the impact when each cost driver change.
|Reduce non-value-added activities
|Not all activities have the same value to the company and customer. We need to rank them based on their value, non-value-added activities should be decreased.
|Beyond control of each department
|The activities will be driven by the need of a whole company, so it is not under the control of each department.
|Each activity and cost driver will analyze every year in order to respond to any change which aims to reduce cost without impact on quality.
What are the advantages of Activity Based Budget?
|Advantages of Activity Based Budget
|Focus on company objective
|The budget will start from target net income, and lead to required activities, and the resource need to implement. The budget will focus on the company goals rather than the department goals. It will prevent the conflicts of interest between company and each department.
|Strengthen the critical success factor
|We already know the level of activities requires to archive a certain output. Each activity’s cost will depend on the cost driver. All of them provide different value to the company, and some components differentiate us from competitors. These are the factors which we must perform the best and maintain the value.
|Straight to the result
|As the budget starts from the target, the whole process has ensured that the result is achieved. It differences from the traditional budget where all departments follow the top management. And we are not sure if all activities can archive a certain level of outcome.
What are the Disadvantages of Activity Based Budget?
|Disadvantages of Activity Based Budget
|The nature of this method is very complicated. Analyzing require activities for a certain level is not as easy as it sounds. Some activities are not directly linked to the outcome. It requires the expert with enough experience to make a proper estimate. Moreover, all activities will need to define the cost driver which impacts to total cost.
|This process requires top management involvement along with all heads department. They need to do a lot of research and data analysis to come up with the best solution. They need to spend time with operation in order to prepare the budget for next year.
|Require a full understanding of company operation
|Top management needs to have a complete understanding of the company operation and the relationship between departments. It will be hard to find someone who fully understands the whole process.
|Require Activity Base Costing
|This budgeting will not work if the company does not use Activity Based Costing.