FSN: Activity Based Budgeting (ABB) is catching on

Activity Based Budgeting (ABB) is catching on

9th July 2007
Traditional budgeting based purely on costs collected in the general ledger provides little insight into why they were incurred of how they contribute to value creation. The notion of ‘value for money' is completely obscured and organisations struggle to identify opportunities for overhead reduction whilst still meeting strategic objectives. The problem is exacerbated by existing budgeting practices that are notoriously underserved by technology. Unsurprisingly, few budget holders have confidence in the outcome, says Gary Simon, FSN's managing editor.

Activity Based Budgeting (ABB) is emerging as a prominent technique for allowing companies to better understand their cost base, focus on value adding activities and respond to fluctuating market demands with increased forecasting accuracy.

Conceptually very different from existing budgeting techniques, ABB has many embedded advantages, such as, empowering employees to make decisions, defining workloads on individual departments, identifying unused capacity and eliminating waste. But it imposes significant demands on technology, for example, the need to manage disparate data sources and support flawless integration between related applications such as activity based costing, budgeting, forecasting, consolidation, reporting, strategic planning, scorecards and dashboards.

Conventially, companies seek to create shareholder value by growing market share, revenue growth and profit margin. Alternatively, management can ‘sweat the assets' (make them more productive), reduce overheads or manage the cost of capital. But there are challenges on both sides of the accounting equation. For example, the scope to increase prices may be limited by price transparency on the internet and increased competition. Conversely, many industries have cut costs to the ‘bone', leaving little room for manoeuvre if management is to avoid damaging business prospects.

For the majority of services based organisations, such as financial institutions, overhead costs can amount to around two thirds of total costs, yet in many cases, little is understood about the true nature of those costs, for example, those that contribute to value creation and those that are ‘diversionary' or non-value added.

It is not just the budgeting of overheads that presents a challenge. The workforce represents the other major cost to companies but how does one make reductions when everyone appears fully employed? Which employees are engaged in value added activities and which are merely responding to non-value added activities or inefficiencies elsewhere in the organisation? Or what opportunities are there for re-deploying people to activities that are value creating and strategically aligned?

Faced with so many conflicting demands it is not surprising that organisations often respond inappropriately when setting their budget, for example, blanket measures, such as reducing headcount by five percent across the board imposed in a ‘top down' fashion.

So is there a more scientific way of making budgeting decisions that discerns opportunities for value creation from non-value added activities? One answer is to use Activity Based Budgeting (ABB). Traditional budgeting and ABB are conceptually very different. For the majority of organisations, budget setting revolves around the chart of accounts structure which define the level of ‘resources' for the coming year in strict financial terms, for example, salaries, rent, IT infrastructure, marketing and so on. Grounded in double entry bookkeeping a budget expressed in these terms provides little insight into an organisation's ability to deliver on its strategy.

In reality, the success of all organisations whether in the public sector or private sector is measured on their ability to deliver products and services, i.e. ‘outputs' to customers and other stakeholders. So it seems logical to enquire at the commencement of a budget setting process “What am I a being asked to deliver this year?” or given my current capacity “What should I be able to produce?” The trouble is that neither of these questions sit comfortably with the usual budgeting techniques because there is no detailed relationship between outputs and costs.

ABB seeks to plug the gap between outputs and resources by providing a thorough understanding of what activities have to be performed to deliver a certain level of output and in the context of a budget, what activities and resources would be required to satisfy the projected level of customer demand. Armed with this information, managers can make informed decisions about the appropriateness of resourcing levels and the demands placed on them by top down targets. Matching supply and demand in this way could for example, involve budgeting for more resource, transferring resources from another area, changing staff mix or releasing spare capacity to another part of the business – all insights that would be difficult to achieve in a traditional budgeting environment. ABB makes explicit the relationship between revenue targets, volumes of production and the impact on workload.

By linking outputs to activities and resources in a disciplined way the technique also informs the more difficult and intangible areas such as increasing ‘customer satisfaction', or ‘employee loyalty'. The impact of budgeting for a five percent improvement in customer satisfaction ratings becomes more transparent in terms of the activities required to drive success. Whether this involves more follow up calls by salesmen, or site visits by engineers, an ABB approach will reveal whether the resources are available to support the objective or perhaps whether increased customer satisfaction is being achieved at the expense of new sales. An interdisciplinary or cross-functional view of budgeting decisions would be almost impossible to achieve in a normal budgeting environment where cost centres have to accept cross charges between departments with little sense of the value received.

A bi-product of this more rigorous method of analysis is that managers who are not generally accountants, can budget for their businesses in terms that they understand. This empowerment of managers underpins better decision making, more accurate forecasts and ultimately, tighter strategic alignment.

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