Activity-based budgeting focuses on identifying costs of activities and their relationships within a business to create realistic budgets. It differs from cost-based budgeting, which only considers actual expenses. Proponents believe it creates more accurate financial forecasts and eliminates unnecessary activities. Critics argue it doesn’t account for external factors.
Activity-based budgeting is an approach to the budgeting process that focuses on identifying the costs of activities that take place in each area of a business or organization, and determining how those activities relate to each other. Data about those activities and how they relate to each other is used to set goals that move the organization forward. By understanding the relationship between all activities in 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 is based on assessing actual expenses that are connected to a previous budget period, and simply adjusting those amounts based on the current rate of inflation, or to account for changes in the amount of income 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 allocates funds to each activity based on how much it will cost to successfully complete those activities.
Proponents of this style of budgeting consider this approach more realistic, as it involves looking inward at activities and costs rather than basing the budget on external influences. From this perspective, it is understood that this strategy creates financial forecasts that are more accurate and, therefore, encourages the organization to make the most efficient use of its resources. As an added benefit, analysis of each activity and its contribution to the ongoing success of the organization means that any activities that do not appear to be related to other activities within the organization structure may in fact be unnecessary and can be eliminated without adverse effect. . effect on 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 outdated equipment. According to this line of thought, the internal approach of the activity-based method only represents part of the data needed to develop a viable budget. Only when this internal analysis is combined with consideration of external factors that could exert some degree of influence during the next budget period, can the organization hope to write a budget that is truly practical and can meet the needs of the organization throughout the year. course. Next period.
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