Along with the development of globalization, companies must maintain an efficient system to maintain a competitive advantage. The wide application of new technology provides a foundation for the emergence of Activity-Based Budgeting (ABB).
Nowadays, more and more companies are starting to use ABB in the budgeting process. When referring to ABB, companies benefit during their budgeting period. This shows that ABB itself has many outstanding characteristics. In this article, we will compare ABB with traditional budget methods, to provide a general study about the characteristics and benefits of ABB.
What is Activity-Based Budgeting (ABB)?
Definition of ABB
Brimson (1991) describes ABB as a managing process that is based on activity levels to achieve permanent improvement in cost and operation. ABB presents a budget in terms of a company’s cost of products and services (NDMA, 2006).
Background of ABB
ABB evolved from Activity-Based Costing (ABC) and is the “application of ABC and ABCM principles in a budgetary control setting” (Williamson, 1996). ABB is based on product planning to generate and sell unfinished products. It is activities that incur costs, and products that create demands for activities. ABB allows us to obtain the activity needed for quantities of products and sales. We need to know the “historical data by following ABC” (learningnet), and with this information, we can estimate the resources and costs for each activity.
How does ABB work?
Based on products, quantity, and a combination of both, ABB calculates the cost of activities according to planned products. A comparison of the current resource supply and the planned products and quantity determines the resource cost budget according to the cost of activity.
Benefits of ABB
Comparison between Traditional Budgeting Method and ABB
Budgeting provides managerial individuals with the necessary information for decision-making and cost apportionment for each aspect of production. Therefore, budgeting should offer an advanced material and provide a view of financial projections.
Compared to the traditional budgeting method, ABB has many differences during the budgeting period:
Tools for budgeting balance
With the traditional budgeting method, companies usually refer to data from the previous year and the financial statement of the activity plan to “give a new annual budget by increasing or decreasing the cost according to predictions or other requirements” (Dong Ying, 2006). Companies can only achieve budget balance by adjusting the quantity of product/service supply or resource capability.
In contrast, with ABB, companies can achieve operating budget balance before the financial budget by adjusting “the quantity of budgeted annual product/service supply, current resource capability, resource driver rate, activity driver rate” (Pan Fei, 2006), etc.
Allocation of indirect costs
The traditional budgeting method typically allocates production costs by labor hour. Since production costs are diverse and caused by changing factors rather than just quantity, it is not reasonable for companies to only consider cost drivers related to quantity.
ABB identifies the cost driver by first accounting for the reasonable basic activity used for apportioning indirect costs. Thus, the key differences of ABB are (a) to reduce the scope of indirect cost allocation, and (b) to increase the allocation standards.
Product pricing
With the traditional budgeting method, the costs of high-giving up products are overestimated, and the profits are undervalued. On the contrary, the costs of low-giving up products are underestimated, and the profits are overvalued.
However, with ABB, management can reduce the price of high-giving up products to increase market share and gain more profits while increasing the price of the special and less profitable products. If customers accept it, the company can earn high profits, and if they do not accept it, the company can reduce the production and allocate the spare labor to other products.
Resource consumption reaction
Under the traditional budgeting method, cost is a gross concept. Cost budgeting is only a simple division of direct material, direct labor, factory overhead, and period expenses, but it cannot reflect every resource consumption point.
Under ABB, the reflection of each activity’s resource consumption point and quantity is clear. With this, the resource allocation and activity consumption are transparent to achieve the optimization of resource allocation.
Organizational structure
The traditional budgeting method is located in a vertical organizational structure, while ABB focuses on a flat organizational structure, breaking down the barriers between departments within the company. It is beneficial for optimizing the value chain.
Financial analysis
The traditional budgeting method analyzes financial indicators based on organizational structure, while ABB can assign financial indicators to each activity based on their characteristics, making each individual responsible for the index. In this way, scarce resources can be allocated more efficiently.
Stationarity
Intense competition requires companies to consider the cost variable. However, the traditional budgeting method separates the cost into variable and fixed and emphasizes the variable cost, while it considers the fixed cost immutable.
ABB believes that, in the long run, most costs are variable, and it “seeks to understand the forces that cause overhead costs to change over time” (Colin Drury, 1998).
Benefits of ABB
Although there are also problems with ABB, such as high work-out costs, complex plans, and the inability to carry out tasks separately by a single section of a company, ABB’s benefits outweigh the problems. The information about costs is more scientific and relevant by following ABB, and ABB makes green goods, sale, and pricing decision-making more sensible and realistic. The table below gives us a brief but clear insight into the benefits of ABB (Bailey 1991).
Benefits % of sample Probably leading to:
- Greater accuracy in product costing 100 Improved pricing, make-or-buy decisions
- Greater involvement of production managers 90 Improved cost awareness, sense of ownership, interaction
- Improved management information 70 Greater awareness of departmental managers, better product design, improved strategy, management control, and quality management
Improved profitability
Decrease in costs Greater profitability, improved investment, enhanced performance, business opportunities. Under ABB, the balance of operating cycle budget and financial cycle budget can be achieved separately. When companies work out a budget, they can achieve operating cycle in advance and then move on to the financial budget based on the result rather than calculate the imbalanced operating cycle budgeting result.
More importantly, ABB focuses on working out a budget directly according to the activity and resource, and it has more nonfinancial cost drivers such as the amount of testing and debug time. This is favourable for clearly analyzing the inefficient or imbalanced operating causes when analyzing fluctuations. It is beneficial for optimizing resource allocation, reducing costs and pricing decisions, and providing essential information for optimizing the value chain.
ABB, based on “activity”, is now developing in many aspects of company management. ABB removes the problems of the lack of strategic relevance by connecting strategy and budget, and then gives budget control more functions in strategy management. The strategic management which based on ABB is an activity chain and value chain management in the operating process. It holds the direction of the market demand, process of producing, and after-sale service so that companies know how to behave in the market hazardous environment.
Companies gain more profits by allocating resources, exercising coordinated functions among departments, and producing links, and then achieving the scale advantage goal of “1+1 > 2”.
For labor and management levels, the budgeting data provided by ABB shows them a clear view of the number of activities they must complete every month during the budget year, so they understand and accept the budget better and carry it out more efficiently. This helps staff increase enthusiasm and passion for working.
Conclusion
The basic principle of ABB is to determine the cost according to activity or workflow. It is different from traditional budgeting methods that are based on cost factors. The resource demand comes from planning activity or workload to ensure that it meets the frequent changes of customer demands, departmental goals and strategies, changes in workflow and services, and efficiency increases, among others.
Based on activity, workflow, and value chain, ABB focuses on achieving complete achievements in order to enhance the capability of dealing with affairs between departments. ABB increases the connection between budgeting and strategic planning, and the organizing process is beneficial for reducing costs and inefficient activities.
The use of ABB makes it possible for companies to reflect the strategic direction clearly. Under ABB, there is a budgeting figure for each activity, so when the budget is executed, everyone knows how much they should do during the budgeting period. At the same time, ABB makes the company’s strategy embodied and understood in daily operations.
Bibliography:
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