Activity-Based Budgeting: How to Use It for Your Company

Activity-Based Budgeting (ABB) is a system that has been growing in popularity in recent years. It is based on the idea that all activities in an organization that incur a cost should be scrutinized for potential ways to create efficiencies. This can lead to significant savings for businesses. In this blog post, we will discuss how ABB works and how you can use it for your company!

Why It Matters

Forecasts are all about the future. That said, we usually start the forecasting process by looking at the past. That isn’t the case with Activity-Based Budgeting. With ABB you use the current cost of completing an activity (the rate) along with the number of times the activity will be repeated (volume). This helps drive efficiencies by not rolling over wasteful spending. Instead, you are starting with a clean slate and only building in costs that are truly essential to your operation.

Once complete, the activity-based budget can be used like any other forecast. It can become part of your business planning and cost management process. This reliable forecast can also be used for scenario planning and stress testing your business with different operational and product decisions.

Breaking It Down

When you work on any forecast, you need to step back and break the forecast down into pieces. What are the drivers behind the forecast?

For Activity-Based Budgeting, there are three steps to follow as we dig into the drivers.

Step 1: Identify The Drivers Of Various Activities

The first step is to identify the drivers of various activities. These drivers can be things like machine-hours, labor hours, or material costs.

Step 2: Forecast The Activity Cycles (Volume)

The second step is to forecast the activity cycles. This is where you will estimate how often an activity will be repeated. For instance, you are producing widgets, and you have to produce 100 widgets. In that case, you would likely run the widget machine 100 times. That said, you may only box the widgets 25 times if there are 4 widgets per case. Your activity cycles would be 100 runs of the widget machine and 25 boxes.

Step 3: Calculate The Cost Per Unit (Rate)

The third and final step is to assign activity costs. This is where you will determine the cost of completing an activity. These costs can be fixed or variable. In our widget example, the cost of running the machine may be $0.50 per hour. The variable cost of the widget would be the material costs which could be $0.20 per widget.

Now that we have reviewed the drivers, let’s look at how to bring the forecast together.

The Forecasting Process

Step 1: Determine What You Need to Forecast

With activity-based budgeting, we already dug into the drivers and know the components of our rate and volume.

Step 2: Collect Inputs and Assumptions

For each of the drivers, you will need to collect the inputs and assumptions behind them. For example, business changes may be driven by promotions that you could get from the sales or marketing team.

If you are a new business, you may need to estimate things like production demand based on competitors. If you are an existing business, you might want to consider locked-in sales contracts or historical volumes. Yes, I did say that ABB doesn’t use historical data. That is focused on the rate side more so than the volume side.

Step 3: Layout the Forecast Model

Once you have determined what to forecast and collected the inputs, it is time to start building a model. Forecasting models can be as simple or as complex as you want them to be. For example, if we’re forecasting production rates for one factory with many years of historical data, the spreadsheet for your model would be really simple.

On the other hand, if you are forecasting production for 1,000 factories across a country, you will need a complex model with more details.

Step 4: Run and Adjust the Forecast

Once your model is set up, you simply need to run it and adjust the inputs as needed. You will want to do this on a regular basis, especially if your business is growing or changing. Forecasting is not a one-time event; it should be done regularly to ensure that your numbers are accurate.

Step 5: Review and Summarize

You should look at your forecast results to ensure they make sense and summarize them in a way that works for your business. For example, if you are forecasting customers on a monthly basis, you may want to do quarterly and annual views. If you are forecasting by store, you may want to view it by region. You may even want to look at trend views to ensure there aren’t any outliers.

Tips and Tricks

Make Sure ABB Benefits Your Business

While activity-based budgeting is a great way to manage your costs, the actual process is time-consuming and complex. You need to make sure that it will benefit your business before you invest the time and resources into it.

Some businesses may not be appropriate for ABB. For example, if you have a very simple business with few products and low volume, ABB may not be worth the effort.

Finding Data And Assumptions

Forecasts are only as good as the data and assumptions you put into them. So where can you find solid data? If you have an existing business, the first place to look is your financial system. Historical data is one of the best inputs to a forecast. You can also work with your operations teams to understand what it will take to deliver a certain level of performance.

For a new business without historical info, you will have to dig a bit deeper. Economic data and market research are your best bets. This can include digging into resources like the Consumer Product Index (CPI) for inflation or studying your competitors.

Step Back And Do A Gut Check

As you get into the weeds of your forecast, it is important to step back and ask yourself, “Does this make sense?” Think about how the forecast looks year-over-year and sequentially. Do you have the capacity and workforce to even deliver the forecast? Do the trends seem reasonable or are there unusual outliers in the forecast?

It is critical to sanity-check your work and ensures you put out a great product

Build For the Future

When working on a forecast, do yourself a huge favor and build it for the future. Well, obviously a forecast is for the future, but I mean the model itself. If you are running a forecast today, you are likely to run the forecast again. Make sure the model is dynamic enough to pull in new actuals and roll forward for future time periods. Avoid hardcoding, and try to link everything up to data tables. Make it clear which periods and cells are actuals and which are forecast.

This may take some extra time to set up, but it will really pay off down the road.

Let’s Recap

Activity-based budgeting (ABB) is a system that records, researches, and analyzes activities that lead to costs for a company. Every activity in an organization that incurs a cost is scrutinized for potential ways to create efficiencies. Budgets are then developed based on these results.

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