What is activity-based budgeting?

Activity-based budgeting is an approach to the budgeting process that focuses on identifying the costs of activities that occur in each area of ​​a business or organization and determining how these activities relate to one another. Data about these activities and how they relate to each other is used to set goals that drive the organization forward. By understanding the relationship between all of the organization's activities, it is often possible to create realistic budgets for each department that are fairer and that serve the company's best long-term interests.

The concept of activity-based budgeting is different from the process known as cost-based budgeting. Often, the cost-based approach is based on evaluating actual expenses that connect to a previous budget period and simply adjusting those amounts based on the current rate of inflation or to account for changes in the amount of revenue generated. On the other hand, activity-based budgeting is more concerned with what is being done within the organization, how these actions or activities work together, and then allocates funds to each activity based on how much it will cost to successfully complete those activities. .

Proponents of activity-based budgeting see this approach as more realistic, as it involves looking inside activities and costs, rather than basing the budget on external influences. From this perspective, it is understood that this strategy creates more accurate financial forecasts and, therefore, encourages the organization to make the most efficient use of its resources. As a bonus, analyzing each activity and its contribution to the organization's continued success means that any activity that does not appear to be related to other activities within the organization's structure may actually be unnecessary and can be eliminated without adverse effect. effect on the overall operation.

Those who advocate a cost-based approach to using activity-based budgeting note that this approach does not necessarily allow for the possibility of events such as an increase in the cost of raw materials or the need to replace outdated equipment. According to this line of thinking, the internal focus of the activity-based method represents only part of the data needed to develop a workable budget. Only when this internal analysis is combined with consideration of external factors that may exert some degree of influence during the next budget period can the organization hope to write a budget that is truly practical and can meet the organization's needs throughout the budget. period. process. next period.