Activity Based Budgeting Concept, Rational, issues, Limitations

27/02/2021 0 By indiafreenotes

Activity based budgeting is a budgeting method in which budgets are prepared using Activity Based Costing after considering the overhead costs. Activity-based budgeting (ABB) is a budgeting method where activities are thoroughly analyzed to predict costs. ABB does not take historical costs into account when creating a budget. In simple words, activity-based budgeting is management accounting tool which does not consider the past year’s budget to arrive at current year’s budget. Instead, the activities that incur the cost are deeply analyzed and researched. Based on the outcome of the study, the resources are allocated to an activity. Activity-based budgeting (ABB) is more rigorous than traditional budgeting processes, which tend to merely adjust previous budgets to account for inflation or business development.


Components and Process of Activity Based Budgeting are given below:

  • It starts with identifying activities which revolve around resource consumption and these activities are mainly classified as main activities and secondary activities which denotes to the degree of involvement and importance of an activity to the organization as per their priority, therefore, main activities are activities which are directly related with the objectives and are essential.
  • Secondary activities are those activities that create added value to the customer and change its preference in the organization’s favor which may involve a significant number of resources.
  • After defining the activities, the next task is to identify how to distribute the costs or resources accordingly among the activities which are done with the help of inducers which are factors defining the level of consumption in different activities.
  • Mainly three such inducers influence such decisions which are time which depicts the duration for the processes, number of resources required by each activity and lastly the number of times an activity is repeated after getting all these facts the appropriate costs can be calculated.


Improves Relationship

Activity based budgeting system helps in improving the relationship between the organization and its customers. The main aim of this budgeting method is to eliminate unnecessary activities and serve the customers with the best quality at best price. This enforces (indirectly) the employees of the company to serve the customers in the best way possible and ensure customer satisfaction. In turn, the relationship between the organization and the customers improves.


Activity based budgeting method evaluates each and every cost driver. It takes into consideration all the steps involved in an activity. The irrelevant activities are eliminated and only the necessary activities form a part of the business.

Elimination of Bottlenecks

Budgets under activity-based budgeting are prepared after deep research and analysis. This study removes all the unnecessary activities of the business. By doing so, the business eliminates all sorts of bottlenecks associated with an activity and business functions are carried out more smoothly.

Business as a Unit

This budgeting technique helps in viewing the business as a single unit and not in the form of departments. The managers or the top management prepare the budget for the business unit as a whole and not keeping in mind any single department as done in the case of other methods of budgeting.

Competitive Edge:

Activity based budgeting system eliminates all sorts of unnecessary activities, which helps the business to save its costs. The saved cost results in the production of goods and services at lower cost than that of competitors. It also helps the organization to gain a competitive edge in the market.

Issues, Limitations

  • It is based on forecasting with the use of historical data and future expectations which may sometimes prove to be unreliable if the situations or scenarios planned do not come out to be what was expected to lead to problems that can hamper the entity and its resources.
  • It requires a well-groomed talented team of individuals who are experts in finding gaps and are equally competent in reporting and use of the necessary software as it is a complex process on which the direction of the company is dependent.
  • Activity-Based Budgeting is a lengthy and comprehensive process that requires a considerable amount of time and resources on an entity and spending too much on analyzing may prove to be counterproductive.
  • Activity-Based Budgeting provides only supplemental information.
  • While preparing an Activity Based Budget it is possible that the axis of focus may shift to immediate and short term results and the bigger picture may be ignored causing damage in the long term.


The activity-based budgeting (ABB) process is broken down into three steps.

  • Identify relevant activities. These cost drivers are the items responsible for incurring revenue or expenses for the company.
  • Determine the number of units related to each activity. This number is the baseline for calculations.
  • Delineate the cost per unit of activity and multiply that result by the activity level.