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Advantages and Objectives of Activity Based Budgeting

Updated on April 8, 2015

Introduction to Activity Based Budget and its difference from traditional budgeting

An activity-based budget focuses on activities instead of departments or products. Each activity is matched with the most appropriate cost driver, which is any volume-based (e.g., labor hours or square feet) or activity-based (e.g., number of parts to assemble for a machine) unit of measurement of the cost of a job or activity needed to sustain operations. Costs are divided into cost pools such as unit, batch, product, and facility. Cost pools include homogeneous costs that all vary in the same proportion to the rise and fall of production. Fixed costs are in one pool, and different levels of variable costs are in their own pools. The accuracy of these groupings should be evaluated each time a master budget is prepared.

Whereas traditional budgeting focuses on input resources and expresses budgeting units in terms of functional areas, ABB focuses on value-added activities and expresses budgeting units in terms of activity costs. Traditional budgeting places emphasis on increasing management performance; ABB places emphasis on teamwork, synchronized activity, and customer satisfaction. ABB proponents believe that traditional costing obscures the relationships between costs and outputs by oversimplifying the measurements into such categories as labor hours, machine hours, or output units for an entire process or department. Instead of using only volume drivers as a measurement tool, ABB uses activity-based cost drivers, such as number of setups, to make a clear connection between resource consumption and output. ABB will also use volume-based drivers if they are the most appropriate measurement unit for a particular activity, lithe relationships arc made clear, managers can see how resource demands arc affected by changes in products offered, product designs, manufacturing techniques, customer base, and market share. Each planned activity will have its cost implications highlighted. Because of this, companies using ABB will be able to continuously improve their budgeting. Conversely, traditional budgets focus on past (historical) budgets and often continue funding items that would be cut if their cost-effectiveness were better known.

ABB serve as the foundation of Master Budgeting

ABB can be used as the foundation of a master budgeting process. The resulting sub- budgets would be based on different ways of measuring the costs, so the resulting proportions of costs would be weighted differently. For instance, some portion of the indirect materials or labor that would be part of overhead could be tracked more carefully and included in direct materials and direct labor amounts.

For example: Figure below displays an overhead budget created for a Manufacturing Company using an activity-based approach. It shows overhead cost by activities, such as production setup, fabrication, assembly, quality control inspections, and engineering changes.

More Precision in Determining and Tracking Costs

A key advantage of ABB is greater precision in determining costs, especially when multiple departments or products need to be tracked. This advantage comes at a cost, and a potential drawback to ABB can occur if the cost of designing and maintaining the ABB system exceeds the cost savings from better planning. Therefore, ABB is most appropriate in businesses that have complexity in their number of products, number of departments, or other factors such as setups. This is because the more complex a situation becomes, the less useful is the broad brush of traditional costing. The management of small private limited company can also take advantages by using this technique.


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