Activity based budgeting is a budgeting method in which budgets are prepared using Activity Based Costing after considering the overhead costs. In simple words, activity based budgeting is management accounting tool which does not consider the past year’s budget to arrive at current year’s budget. Instead, the activities that incur the cost are deeply analyzed and researched. Based on the outcome of the study, the resources are allocated to an activity.
Need of Activity Based Budgeting
Activity based budgeting is carried out to bring efficiency in the activities of an organization. Budgets are prepared after justifying the cost drivers. Thus, activity based budgeting is activity oriented and not function oriented.
Let us now have a look at the benefits of activity-based budgeting method.
Advantages of Activity Based Budgeting
- Evaluation: Activity based budgeting method evaluates each and every cost driver. It takes into consideration all the steps involved in an activity. The irrelevant activities are eliminated and only the necessary activities form a part of the business.
- Competitive Edge: Activity based budgeting system eliminates all sorts of unnecessary activities, which helps the business to save its costs. The saved cost results in the production of goods and services at lower cost than that of competitors. It also helps the organization to gain a competitive edge in the market.
- Business as a Unit: This budgeting technique helps in viewing the business as a single unit and not in the form of departments. The managers or the top management prepare the budget for the business unit as a whole and not keeping in mind any single department as done in the case of other methods of budgeting.
- Elimination of Bottlenecks: Budgets under activity based budgeting are prepared after deep research and analysis. This study removes all the unnecessary activities of the business. By doing so, the business eliminates all sorts of bottlenecks associated with an activity and business functions are carried out more smoothly.
- Improves Relationship: Activity based budgeting system helps in improving the relationship between the organization and its customers. The main aim of this budgeting method is to eliminate unnecessary activities and serve the customers with the best quality at best price. This enforces (indirectly) the employees of the company to serve the customers in the best way possible and ensure customer satisfaction. In turn, the relationship between the organization and the customers improves.
Let us have a look at disadvantages of activity based budgeting.
Disadvantages of Activity Based Budgeting
Activity based budgeting offers many advantages. However, like every process, this too has its disadvantages as listed below:
- Requires Understanding: Activity based budgeting requires a deep understanding of various functional areas of the business. If the manager preparing the budget is incapable of understanding and evaluating the areas of business, it would lead to inaccurate budget preparation.
- Complex: Activity based budgeting system is complex in nature. It requires research and analysis of various factors. This budgeting method comprises of estimation of demand and based on that, it does the estimation of resources to be employed in various activities.
- Resource Consumption: The process of budgeting in this method consumes a lot of resources of an organization. It needs to employ top officials for conducting numerous analyses. It is a very time-consuming task too. If these resources are employed in other operational activities, they can give better returns.
- Cost Involved: Implementation of activity based budgeting requires trained employees. An employee, who is not trained enough, cannot handle the budgeting exercise effectively. So business needs to incur extra costs to train its employees. Moreover, the process requires the involvement of top management, so proves to be costly too.
- Short Term: Activity based budgeting focuses on short-term goals of the business. It does not take into account the long-term scenario of the business. Focusing more on short-term goals rather than long-term goals can prove to be very fatal for the organization.