Poor cash flow management is a catalyst for money problems. In fact, cash flow problems are one of the top reasons why small businesses fail. And that’s precisely why managing your cash and expenses accurately is so important.
One way to keep your costs under control (and maximize your profits 📈) is to use a business budgeting method like activity-based budgeting. This method gives you insights into your operating costs and helps you identify which expenses are directly responsible for bringing in money 💰 and which don’t contribute to your bottom line.
So, what exactly is activity-based budgeting? How does it work and how is it different from other methods? Let’s find out. Here's what we'll cover in this article:
What is activity-based budgeting?
Activity-based budgeting is a system that documents, researches and examines cost drivers for a business. A “cost driver” is the direct cause of an expense. For instance, if you have hourly employees, labor cost is determined by the total hours worked. This makes the number of hours that employees work your cost driver.
When executing an activity-based budget, start by analyzing all activities that have costs associated with them (which should be most of them). Then, look for potential ways to reduce those costs. For example, imagine implementing budgeting software that reduces the hours your accounting team spends on categorizing expenses. Not only did you discover a more effective solution, but you also reduced an important cost driver!
Once you finish analyzing all activities, you end up with a budget.
What does activity-based budgeting analyze?
But how do you know which activities to analyze when using the ABB method, and how? 🤔 First, you need to understand the difference between direct and indirect costs.
Direct costs: Direct costs are costs that directly contribute to the production of your products or services. In other words, the product or service could not exist without incurring these costs. Consider the labor costs of engineers building your product, for example. Your product wouldn’t exist without their help, making it a direct cost.
Indirect costs: On the other hand, indirect costs refer to expenses that are not directly related to creating a product or service. Indirect costs are expenses incurred by your business operations as a whole. These may include rent, legal fees, utilities, phone and internet bills, or security costs.
Activity-based budgeting only focuses on indirect costs that don’t directly contribute to your products or services. But how do you know which indirect costs to reduce? To answer this question, you need to use a method known as activity-based costing.
What is activity-based costing (ABC)?
Activity-based costing (ABC) is a process that allows you to allocate overhead costs by assigning indirect expenses to activities more precisely. The objective of the ABC method is to reduce or eliminate overhead costs.
To illustrate this further, suppose you lease a small factory you use as a manufacturing facility. The rent you pay for the factory is an indirect expense. Becoming aware of this cost allows you to eliminate it if you choose to outsource manufacturing instead of renting your own facility. This would help lower your overhead costs.
All businesses want to minimize their costs and maximize profits (after all, you need to make money at the end of the day). The key, though, is to determine when and how to reduce activity costs. Cue how activity-based budgeting works.
How activity-based budgeting works
Activity-based budgeting looks at daily business activities—like running digital ads, packaging 📦and production—and determines areas where you can reduce costs.
The activity-based budgeting process involves three steps:
1. Identify and prioritize your cost drivers
Start by identifying items that result in expenses for your business, known as “cost drivers.” For instance, a manufacturing facility's 🏭 main cost driver is machine hours. Think about it this way: a machine must run longer to manufacture more goods. And as it runs, the costs increase. These costs may include the electricity required to run the machine, the salaries of the people who manage it, and any other supplies needed to maintain it.
Then rank the cost drivers from the most to the least important, allowing you to allocate resources to essential activities first.
An example of an essential activity is the production of goods. After all, you can’t sell what you don’t have.
An example of a secondary activity is a subscription payment for your point of sale system. It’s not necessary, but it adds value by ensuring smooth business operations.
Finally, some activities are neither necessary nor value-adding, and you should remove them. Imagine the cost savings you would see by eliminating the office rent and operating remotely. 🤯
2. Forecast what you’ll spend on each cost driver
Each activity can be measured in units, such as the number of orders or labor hours. You’ll need to forecast how many of these units each activity will need to allocate a budget.
For example, if you have two virtual assistants who spend six hours a day, five days a week, doing data entry for your business, their total labor hours will be 60 hours per week (2x6x5).
3. Calculate the cost per unit of activity
Lastly, calculate 🤓the cost per unit to determine a budget. For instance, if your office uses 30 units of water every month, and the water company charges you $4 per water unit, your budgeted water cost would be $120 (30x4).
The outcome is a budget that identifies the basic needs of every cost driver. You can then use it to determine future costs by reducing or eliminating activities.
Difference between zero-based budgeting and activity-based budgeting
As the name suggests, zero-based budgeting doesn’t use the current budget as a base. You don’t use historical information, and all business costs are justified and approved at the beginning of the fiscal year.
In zero-based budgeting, each company division is assessed for needs and expenses. Let's highlight some of the top differences:
In zero-based budgeting, resource allocation depends on the importance of the needs and costs of every department. On the other hand, resource allocation in activity-based budgeting is done by assessing activities that incur costs and finding ways to reduce overhead costs.
Activity-based budgeting determines potential business profits, while zero-based budgeting doesn't. In activity-based budgeting, costs are linked to business revenue, ensuring that only sales-generating expenses are considered. This helps you accurately forecast profit. Zero-based budgeting only considers the costs necessary for every department instead of the overall business revenue goals.
In activity-based budgeting, costs are eliminated based on alignment with business objectives. On the contrary, zero-based budgeting eliminates costs based on whether the individual departments can justify them.
Activity-based budgeting example
Let’s use a content marketing business as an example. The activities that generate the highest costs are content production and content editing. So, the cost drivers are the number of written articles and the number of edited articles. The business owner sells 200 articles monthly. But he just got five new clients and will deliver 250 articles in the coming month. Assuming he pays $200/article to a freelance writer and $100/article to a freelance editor, what will the budget look like the following month?
Activity | Content Production | Content Editing |
Cost Driver | No. of written articles | No. of edited articles |
No. of Units | 250 | 250 |
Cost per Unit | $200 | $100 |
Total Cost | $50,000 | $25,000 |
We’ve figured out the activities and cost drivers, then predicted the number of units within the cost drivers. Seems easy enough, right?
Cost per unit, in this case, is determined before hiring writers and editors for the job. You set the rate you’re willing to pay for outsourcing written and edited content and then hire the writers and editors. But here’s the magic question: can activity-based budgeting help you reduce production costs without sacrificing output or quality? The answer is yes!
Using the above example, you might realize that you can save 25% of the cost by hiring salaried in-house writers and editors. Say you hire ten writers and five editors at a salary of $3750/month each. How does this change the unit costs?
The new unit cost per written article is the Total Salaries to Writers / Number of Articles = $150 (3750*10/250), while the unit cost per edited article is Total Salaries to Editors / Number of Articles = $75 (3750*5/250).
The budget would now look like this:
Activity | Content Production | Content Editing |
Cost Driver | No. of written articles | No. of edited articles |
No. of Units | 250 | 250 |
Cost per Unit | $150 | $75 |
Total Cost | $37,500 | $18,750 |
In this new model, we wouldn’t need to determine the unit cost again the following months unless we hire new writers and editors.
Pros and cons of activity-based budgeting
Advantages of activity-based budgeting 👍
1. Better cost control
Since all revenue-generating activities are examined during the activity-based budgeting process, you’re able to exercise more control over costs as you look for efficient ways to cut expenses.
2. Competitive advantage
Lower operational costs allow you to sell products at a better price than your competitors, giving you a competitive edge 🏆in the market.
3. Effective resource allocation
All businesses have limited resources. Therefore, the activity-based budgeting method allows you to allocate resources to only those activities that generate revenue, eliminating non-profitable activities.
Disadvantages of Activity-Based Budgeting 👎
1. More costly
Activity-based budgeting works on a macro level by collecting data from multiple departments, making it more costly to implement and maintain than traditional budgeting.
2. Time-consuming
You need to dot your i’s and cross your t’s when analyzing business activities and how they impact profitability, which can be time-consuming. ⏰
3. Complex
The budgeting team needs to understand all the functional areas of the business before determining cost drivers. The process is complex, especially for a company doing it for the first time.
How to stick to your ABB budget once you’ve created it
You have your budget. Now what? Sticking to an ABB budget can be challenging without the right help. That’s where Relay comes in.
Relay allows you to deposit budgeted amounts for multiple expense accounts (like payroll, vendor fees, and delivery costs) to help you stick to your budget. Now that’s proactive budgeting done right.
It has never been easier than now.
Happy budgeting! 😉
