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What Is Activity Based Budgeting?

Activity based budgeting calculates the amount that specific activities will cost in relation to one another.
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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 18 April 2014
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Activity based budgeting is an approach to the budgeting process that focuses on identifying the costs of activities that take place in every area of a business or organization, and determining how those activities relate to one another. The data regarding those activities and how they relate to one another is used to establish goals that allow the organization to move forward. By understanding the relationship between all the activities of the organization, it is often possible to create realistic budgets for each department that are more equitable and in the best interests of the company in the long run.

The concept of activity based budgeting is different from the process known as cost-based budgeting. Often, the cost-based approach relies on assessing the actual expenditures connecting with a previous budgetary period, and simply adjusting those amounts based on the current rate of inflation, or to account for changes in the amount of revenue generated. By contrast, activity based budgeting is more concerned with what is being done within the organization, how those actions or activities work together, and then allocating funds to each activity based on how much it will cost to successfully complete those activities.

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Proponents of this style of budgeting see this approach as more realistic, since it involves looking inward at activities and costs rather than basing the budget on outward influences. From this perspective, this strategy is understood to create financial forecasts that are more accurate, and thus prompt the organization to make the most efficient use of its resources. As a bonus, the analysis of each activity and its contribution to the ongoing success of the organization means that any activities that do not appear to relate to other activities within the organization structure may in fact be unnecessary, and can be eliminated without having an adverse effect on the overall operation.

Those who favor a cost-based approach over the use of 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 outmoded equipment. According to this line of thinking, the inward focus of the activity based method only accounts for part of the data needed to develop a workable budget. Only when this inward analysis is coupled with consideration of outside factors that could exert some degree of influence during the upcoming budgetary period can the organization hope to draft a budget that is truly practical and likely to meet the needs of the organization over the course of the upcoming period.

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Discuss this Article

MrsPramm
Post 2

@KoiwiGal - The problem is that examining all the activities that a company does from a budgetary standpoint takes a lot of time and money (depending on how big the company is) so it's not something that you really want to have to do too often. I agree that it's important to reevaluate every now and then, but you don't need to have an ongoing evaluation happening all the time if there are no planned or major changes.

Budget forecasting is tricky and you need to balance the ability of the accountants to micromanage the accounts with advantages to doing that.

KoiwiGal
Post 1

It sounds like the best way to deal with the budget is to try and use a combination of the two approaches, taking the best from both of them. While the cost based budgeting is probably better for ongoing budgets it sounds like it probably doesn't take into account the fact that activities change as well, so you can't just say we'll draft a budget based around activities and then never examine them again and only work with the real costs.

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