How to Categorize Expenses

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Activity-based budgeting (ABB)

There is an inverse relationship between ABC and ABB. ABB starts with the planned product mix to determine the cost of products. Based on the planned product/volume mix, ABB derives the cost of activities. From the cost of activities, ABB can determine budgeted figures for cost of resources. ABC starts with the cost of resources. ABC then calculates the cost of activities. Based on the cost of activities, ABC derives the cost of the products. (Adapted from Kaplan and Cooper, Cost & Effect)

Organizations that use ABC to allocate overhead and other costs to individual departments may also adopt activity-based budgeting (ABB). Activity-based budgeting starts with forecasting the planned sales volume for each product. Historical data from the activity-based costing system is then used to estimate the required activities to produce that volume, the resources required to support those activities, and the cost of those resources.

The primary advantage of activity-based budgets is that costs can be more accurately associated with activities, making the planning process more precise and corrections more effective. Companies using this approach report benefits including:

  • Establishing more realistic budgets
  • Improved accuracy in identifying resource needs
  • Better linking of costs to outputs
  • More precise allocation of costs to staff responsibilities

The disadvantage of this approach is that it can be costly and complex to establish, so that it may not be worth the trouble for a small company with few products or services. It also has to be adopted by and embedded into the whole organization; one division alone can't decide to develop its own ABC or ABB system. But when the circumstances are right, activity-based approaches to understanding the economic dynamics of an organization provide long-term planning benefits.

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