Activity-based budgeting definition

What is Activity-Based Budgeting?

Activity-based budgeting is a planning system under which costs are associated with activities, and expenditures are then budgeted based on the expected activity level. This approach differs from the more traditional budgeting system, where existing cost levels are adjusted for inflation and major revenue changes in order to derive the annual budget.

An organization may find that this type of budgeting can be more easily rolled out on a pilot basis, perhaps by using it for a single department or profit center, and monitoring its impact on the budgeting process. Given the cost of operating this system, it is more likely to be applied within a larger, more profitable organization.

When to Use Activity-Based Budgeting

Activity-based budgeting makes the most sense in organizations where understanding the true drivers of cost is critical for effective planning and decision-making. Here are the key circumstances where this type of budgeting is especially valuable:

  • Complex operations. In companies with diverse product lines, service offerings, or customer segments, costs are often spread unevenly across activities. ABB helps allocate costs based on actual usage of resources by each product or service, giving a more accurate picture of profitability and supporting better pricing and resource allocation decisions. For example, a manufacturing company that produces multiple product types with different production processes can use ABB to understand how much each product consumes in setup time, quality control, and packaging.

  • Need for cost transparency and efficiency. Organizations aiming to reduce waste or improve efficiency can benefit from ABB. It highlights where resources are being consumed and why—enabling management to assess the necessity of certain activities and find opportunities for cost-saving. For example, an IT department might discover through ABB that a large portion of its budget goes to maintaining outdated systems used by only a few departments, prompting a reevaluation.

  • Project-based or service-based industries. In consulting, healthcare, legal, or construction sectors where services vary by client or project, ABB allows for budgeting based on the volume and complexity of work expected, rather than static department-wide assumptions.

  • Dynamic business environments. Organizations undergoing growth, restructuring, or new product launches benefit from ABB’s flexibility. Since it’s activity-driven, the budget can adjust more accurately to reflect realistic operational demands rather than relying on past data.

Advantages of Activity-Based Budgeting

An activity-based budgeting system allows for a high degree of refinement in cost planning, and focuses attention on the volume and types of activities occurring within a business. A likely outcome of using this system is management planning to reduce the activity levels required to generate revenue, which in turn improves profits. It also means that managers are forced to have a detailed knowledge of company processes if they want to enhance the cost structure of a business.

Another advantage of the system is the strong link between it and the goals of the parent company. Ideally, management can use the system to see how much cost is associated with each part of a business, and then decides whether funds need to be allocated to or away from each area. This could result in a shift in funding to support parts of the business on which management wants to place a greater emphasis, such as on the development of new products or a product rollout in a new geographic region.

Related AccountingTools Courses

Budgeting

Capital Budgeting

Disadvantages of Activity-Based Budgeting

There are several disadvantages associated with an activity-based budgeting system, which are as follows:

  • More work. There is an increased workload to track activities, for which there may be no traditional tracking systems. Also, costs need to be traced back to activities, for which there may also be no systems in place.

  • Higher cost. If new data tracking systems have to be installed, then this adds a layer of cost to the business.

  • Implementation requirements. Setting up new data tracking systems can be difficult, and may require the use of specialists who are skilled in setting up and operating new systems.