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Unlike traditional budgets that aim to control costs, activity-based budgeting focuses on redesigning products and improving processes rather than simply controlling costs. Traditional cost-based budgets start with input costs and work outward whereas activity-based budgeting starts by listing the activities that created the results and then identifying the cost of such activities.
Preparing an activity-based budget entails:
- Recording the activities that incur costs in the functional areas of an organization.
- Defining and analyzing the relationship among such activities.
- Linking such activities to strategic goals.
- Preparing a budget with the costs of activities needed to fulfill organizational objectives and strategies.
Activity-based budgeting allows aligning activities with objectives through better coordination and synchronization, reduces and streamlines costs, and helps in the continuous improvement of business practices.
Image Credit: flickr.com/Mike Tigas
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The many advantages of activity-based budgeting notwithstanding, this technique remains a comprehensive and time-consuming exercise. The process requires identification of activities, estimation of activity output demands, and estimation of the costs of resources needed to provide the demanded activity output. The budgeting of physical inputs and costs as a function of a planned activity requires the use of an activity-cost hierarchy and making estimates on the consumption by such activities.
Activity-based costing bases itself on defining or analyzing the relationship among costs and activities, which might not always be possible. Even otherwise, the contextual information that plays an important role in shaping the results may not always be available or considered.
Success of activity-based budgeting depends on a thorough and in-depth understanding of the business processes and an accurate activity analysis. Not all managers remain competent to perform such tasks, and the resultant distortions make the activity an exercise in futility.
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Among the major disadvantages of activity-based budgeting is its consumption of organizational resources. Spending too much resource on an analytical function such as activity-based budgeting becomes counterproductive.
The complexity of the activity-based budgeting exercise means that it takes away considerable organizational resources in the form of managerial time and money. Such resources, if deployed in a core operational activity, would contribute to a much better bottom line.
The broad scope of activity-based budgeting invariably necessitates an activity-based budgeting software, as well as training all managers to use the software and learning how to make correct activity analyses, adding to the resource demands.
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A major limitation of activity-based budgeting is that it is not a control budget and as such does not replace the department or line-item budget. Activity-based budgeting only provides supplemental information, and it acts as a panacea rather than a tool. It therefore does not eliminate or substitute any process but adds to the administrative functions of an organization.
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Finally, another major activity-based budgeting disadvantage includes its tendency to focus on the immediate and short term and ignore the long term. Activity-based budgeting uses historic data for forecast analysis, which may not always be practical. Focusing on activities that create immediate results might work well in the short term, but might cause long-term damage to an organization.
While activity-based budgeting helps the organization if implemented with the correct data, preparing an activity-based budget with distorted data runs the risk of arbitrary budget cuts and creates a dysfunctional organization.