Activity-Based BudgetingDefined with Steps and More

Patrick Louie
Last Updated: February 1, 2022
Date Published: February 1, 2022

The main purpose of running a business is to generate profit.

The higher the profit, the better.

You usually do this by generating the most revenue that you can.

However, that’s not the only way for you to increase your profitability.

Managing costs is another way to increase the profitability of your business.

By keeping costs to a minimum, you’d have more gross profit available at your discretion.

Running a business comes with costs and it’s in your best interest to control them as much you can.

If your total cost exceeds your revenue, you’d be incurring a loss instead of generating a profit.

Unless you are running a non-profit business, it makes no sense to run a business that constantly generates losses.

Minimizing costs is an important aspect of business management.

If done correctly, you’d be able to squeeze higher profits from your revenue.

I said correctly because just literally decreasing costs won’t cut it.

You need to minimize costs without compromising the integrity and quality of your business operations.

If decreasing costs does more harm than good for your business, you may have to review how you manage costs.

To help with the management of costs, you can always prepare a budget.

By preparing a budget, you’ll be able to gauge if you’re going over your budgeted cost.

If you are, you might want to review why that is so.

It could be a case of underestimating costs, which should prompt a readjustment to your budget.

There are many ways to approach budgeting.

There’s the traditional method in which you base the new budget on your current one.

However, we won’t be discussing that approach in this article.

Instead, we’ll be learning about another method of budgeting: Activity-Based Budgeting.

Cash budget

Activity-Based Budgeting: What is it?

Activity-based budgeting is an approach to budgeting.

It is a more involved process of budgeting where activity cost drivers are analyzed to arrive at a budget for costs vis-à-vis activity levels.

For example, your budget for the cost of direct labor will be based on its cost driver: the number of direct labor hours.

The higher the perceived direct labor hours will be, the higher the budget for the cost of direct labor should be.

Under this approach, you scrutinize every activity cost driver to create the most cost-efficient budget possible.

By the way, activity cost driver refers to an activity or set of activities that affect the rise or fall of business costs.

This no-nonsense approach minimizes costs by only budgeting for those that are absolutely necessary.

If you cannot trace a cost to an activity, it may be unnecessary.

As you can see so far, activity-based budgeting is a more complex process compared to traditional budgeting.

The process is simple under traditional budgeting.

You usually only need to apply a flat rate to the previous year’s budget.

Whereas under activity-based budgeting, you’d have to justify your budgeted costs via their activity costs drivers.

If an activity is unnecessary or does not ultimately contribute to the generation of revenue, you may want to reconsider assigning a budget for such activity.

By removing unnecessary costs, you will be able to squeeze more profits out of your revenue.

Activity-based budgeting is much more practical for businesses that have only started.

This is because they don’t have a previous budget to base on, hence, they can’t go with the traditional method.

By preparing a budget based on perceived activity levels instead, the newer business can have a clearer guideline on the costs that it’ll incur.

The Steps of Activity-Based Budgeting

Zero-based budgeting

There are four steps in activity-based budgeting:

  • Identify your activity cost drivers
  • Identify the costs associated with your activity cost drivers
  • Determine your projected activity level for each activity cost driver (e.g. number of units)
  • Prepare your budget by calculating total costs

1. Identify your activity cost drivers

The first step is to identify the activities that incur costs for your business, or those that we refer to as activity cost drivers.

A tip: classify these activities according to their involvement and/or importance to the overall operations of your business.

You may want to prioritize budgeting for activities that have high importance or involvement in your business’s operations.

You can also classify these activities as major activities and secondary activities.

Major activities are those that are absolutely necessary for your business.

An example of this is the production of goods (which has the activity cost drivers: the units of materials consumed, the number of labor hours expended, etc.).

If you don’t produce goods, you won’t have any products to sell. That’s why the production of goods is a major activity.

Secondary activities are those that aren’t strictly necessary but they create value for your business.

For example, doing product promotions isn’t necessary for your business operations, but it adds value by offering incentives to customers who avail of your products.

This paints a good picture of your business, which may encourage potential customers to finally take the plunge and purchase your products.

Also in this step, you may be able to identify activities that are neither necessary nor value-adding. These activities are of the least priority, and you may even opt to not assign a budget for them.

2. Identify the costs associated with your activity cost drivers

The next step is to identify the costs associated with your identified activities.

If you can identify it on a per-unit basis, do so as it makes the whole budgeting process easier.

Do so for each of your identified activities.

For example, we identified the production of goods as an activity.

Let’s break it down to more specific activities: the start-up, the actual production of goods, and the wrapping-up process.

All of these activities have something in common: they all require the involvement of direct labor.

As such, to budget for each of these activities, you would want to know the cost of direct labor on an hourly basis.

Another activity cost driver involved in the above activities is the machine hours expended.

Machinery and equipment are depreciable assets.

With continued use, they will eventually reach a point where they need maintenance.

If you can identify the number of machine hours that necessitates maintenance, you’ll be able to assign the maintenance cost on a per machine hour basis.

3. Determine your projected activity level for each activity cost driver

Now that you know your activities and their associated costs, the next step is to determine your project activity level for each of them.

This is best stated in units. For example, for the cost of direct labor, you would want to project the number of direct labor hours needed to satisfy your desired output.

The units will depend on the activity cost driver.

You can start by determining the level of revenue or output that you want to achieve for the upcoming period.

From there, you can project the units needed for each activity cost driver.

How many units of raw materials do I need? How much labor hours will it take? Will I need to acquire additional space to accommodate my desired output level?

These are some of the questions that can guide you in determining your projected activity levels.

Do so for each of your identified activities and their corresponding cost drivers.

4. Prepare your budget by calculating total costs

Now that you have your projected activity level and the cost for each activity cost driver, you can finally prepare your budget.

Calculate your projected revenue, as well as the total cost per activity cost driver.

You can then arrange these items in a way similar to that of an income statement (revenue first, cost of sales next, then operating expenses, and finally, non-operating income and expenses).

After completing your budget, review it.

Are you sure that you accounted for all necessary costs and expenses?

Can you identify if there are unnecessary costs?

Do you think that your prepared budget is doable?

Prepare to make adjustments as necessary so that you can create the most accurate and relevant budget plan that you can.

Advantages and Disadvantages of Activity-Based Budgeting

Types of Budgets

Advantages of Activity-Based Budgeting

Activity-based budgeting allows a business to have a high degree of control in cost planning.

It also gives importance to the types of activities involved in the operations of the business, as well as their activity levels.

With activity-based budgeting, you are more likely to find the minimum required activity level to attain your desired revenue.

Or you can trim out unnecessary costs by identifying activities that are not necessary or not value-adding.

Both of these result in more profits due to the lower total cost.

Activity-based budgeting also requires management and those involved in the budgeting process to have a deeper understanding of the operations of the business.

This results in more competent management personnel.

If they know how the business works, they can better identify which costs are necessary and which ones aren’t.

They can also think of ways to make the whole operation to be more cost-efficient.

Another advantage that activity-based budgeting provides is the prioritization of costs vis-à-vis company goals.

By identifying which activities are necessary to reach the goals of the business, management can identify which activities should be allocated more funds to, and which ones can take a cut.

For example, if the goal of the business is to roll out new products, management may decide to allocate more funds for the research, development, production, and distribution of a new product.

Activity-based budgeting encourages a forward-looking view instead of looking at past activities.

Unlike traditional budgeting which only bases costs on what is proven and done, activity-based budgeting begs to answer the questions:

Which activities are necessary for this business?

How can we improve the whole process?

Which activities can we cut out to minimize costs?.

Disadvantages of Activity-Based Budgeting

Unfortunately, the benefits provided by activity-based budgeting come at a cost, or rather, costs.

Unlike the simplistic approach of traditional budgeting, activity-based budgeting is more complex.

Meaning that it requires more time and effort to prepare.

You’ll need to analyze the various activities that your business does.

On top of that, you have to identify the costs associated with such activities.

That takes time, and sometimes, even money.

Not only that, activity-based budgeting requires a deep understanding of the different activities of your business.

The ones involved in the budgeting process must be able to identify which activities are necessary, and which ones should be prioritized.

Without the required understanding, you may end up with a half-baked budget that may not be able to satisfy the conditions to reach your goals.

Also, implementing and maintaining an activity-based budget plan is another matter.

The people implementing the budget must be able to handle it effectively.

If the employee handling it is not trained or knowledgeable enough, it can botch the whole system.

You’ll have to train certain employees to handle the budget. And that is an additional cost.

The other alternative is to let top management handle the whole budgeting system, but that is even more costly.

Lastly, activity-based budgeting tends to focus on the short-term objectives and goals of the business.

You only plan for the year ahead after all.

This isn’t inherently bad.

However, if you only focus on short-term goals and forget to plan for long-term ones, it can be very fatal for your business.

Tips for activity-based budgeting

  • Do use activity-based costing when you plan to go with activity-based budgeting. It helps in making the whole process easier to understand and follow.
  • Since it’s costly and requires more time and effort, you may want to use activity-based budgeting only when your overhead costs are a significant portion of your total operating costs. If your operating costs are mostly direct costs, it may not be worth the effort to go with activity-based budgeting.
  • Communicate with personnel involved in the budgeting process. This not only includes the ones preparing the budget, but also the ones who may be affected by an activity-based budget. Let your employees be aware of the rules, procedures, and changes that come with an activity-based budget.
  • Have a clear outline of your objectives and goals. This helps in aligning the budget with your goals for the year. With it, you can set clear targets for your budget. This makes the activity-based budgeting process easier to follow

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  1. Harvard Business School "6 BUDGETING TIPS FOR MANAGERS" Page 1. February 1, 2022

  2. Penn State "Integration of activity-based budgeting and activity-based management" White paper. February 1, 2022

  3. Mercer County Community College "Activity-Based Costing" Chapter 4. February 2, 2022