Activity-based budgeting is a planning system under which costs are associated with activities, and budgeted expenditures are then compiled based on the expected activity level. This approach is quite different 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 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.
The downside of activity-based budgeting is the increased workload required 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. Consequently, setting up such a system can be difficult. 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.