If you’re looking for a budgeting system to implement in your small business, activity-based budgeting is worthy of consideration—especially if you’re looking to cut costs in your operation. Not only does having a clear budget help you keep your operation running, it also allows you to identify supply chain problems in need of resolution. Perhaps most important of all, a budget helps you determine whether or not you’re on target to meet your goals—and if not, where you’re coming up short.

In this article, we’ll explain exactly what activity-based budgeting is, how the method works, and why you may want to consider using it for your business.

What is activity-based budgeting

Much like traditional budgeting, activity-based budgeting is a process by which you identify, analyze, and research your business’s key expenses and activities, then use that information to produce the budget. Where it differs from more traditional budgeting, however, is that instead of relying on prior-year values to set a forward-looking budget, an activity-based approach identifies cost drivers and accounts for them accordingly.

For example, instead of simply increasing your marketing department’s budget by 3% next year, activity-based budgeting breaks down the expenses associated with marketing for the year ahead and accounts for their anticipated costs in the upcoming year.

If you’re a business owner who feels overwhelmed by your expenses, or struggles each month to understand where your money went, this approach could be useful. Since you’re essentially trimming all the fat until only the most essential line items in your budget remain, you’re sure to save money with activity-based budgeting.

This approach to budgeting is rigorous and intense—if you’ve been working with a more lenient, traditional budget, you may find this approach difficult to adjust to at first. But if you need a whole new method to budgeting to start growing your accounts, the initial struggle could be worth it.

How activity-based budgeting works

Here’s how you would go about establishing and maintaining an activity-based budget for your own business:

  • Identify your cost drivers: Identify each and every cause of costs relevant to your business. These could include things like labor costs, the price of renting your facilities, manufacturing costs, materials, and products returned by customers. Be sure to include not only the revenue-generating activities but also those necessary to fulfill orders and keep your business running.
  • Determine the number of units necessary for each cost driver: This could include the number of staff working on administrative tasks, vehicles needed to make deliveries, and staff members working on producing physical materials.
  • Calculate the cost per unit for each cost driver: For each cost driver, determine the cost per unit. The formula used to determine this involves taking the total number of units for a given cost driver and dividing that number by the total cost for that cost driver.
  • Push activity costs to the appropriate budget: Once you quantify cost drivers, attribute them to the business’s core cost centers. This will begin to paint a picture of the business’s overall budget. This will give you your general framework for your activity-based budget.

Once you have your activity-based budget, compare it with your expenses from the last six months. Are there other areas where you’ve spent significant money? How will removing them from your budget shift your operation or the quality of the product?

Looking at your expenses from the standpoint of what is truly essential will allow you to determine where you’ve been unnecessarily spending. Over time, you may also realize that things you left off your list originally were actually essential to your operation. Feel free to adjust and reevaluate what is included in your budget as you move through the year to ensure it’s aligning well with your business needs.

Activity-based budgeting in practice

To give you a sense of what this approach to budgeting actually looks like in day-to-day situations, let’s take a look at a real-life example of the system in action.

Let’s say that your business wants to create a forward-looking budget for its widget department. At the beginning of the year, you’ll ask your vice president of widget development to put together a budget of the anticipated costs to run this business line. Then, as expenses are incurred for the widget department, they’re pushed to that cost center and reviewed against projected costs.

Over time, the budget becomes clearer based on where projected costs are realized, exceeded, or not incurred at all. As a result, the business gets a better understanding of how much it’s actually spending on the widget department.

In this method, because the cost of each activity is consistently updated, you don’t need to consider things like inflation when projecting your upcoming year’s budget—the cost per unit has already been corrected to reflect that.

Advantages and disadvantages of activity-based budgeting

The advantage of approaching budgeting in this way is that you as a small business owner have more control over the process of budgeting overall. Since planning for your expenses and projecting your revenue each period is broken down into individual units and activities, you’re more clearly seeing your business’s bottom line. Consider which costs are necessary in order to reach your goals, and which ones need to be eliminated or substituted for a more cost-effective alternative.

One of the major downsides is that this budgeting method requires careful analysis of both your business model and your finances to establish and maintain it. While this is often seen as a negative, for business owners who are struggling to overcome their financial challenges, adopting a budgeting system that forces you to look closely at your operation on a regular basis can be just what you need to turn things around.

Final thoughts

There is no perfect budgeting model for every business. In order to find yours, consider carefully what your objectives are and what is realistic for your business to take on and maintain. While the activity-based budgeting system can be more intensive than other models, it’s a great way to tap into your business, determine what’s working and what isn’t, and trim the fat until you get your operation on the path toward growth.

Although it’s not always a model most small business owners are interested in maintaining over the long term, the rigorous analysis baked into activity-based budgeting can help you quickly achieve your short-term financial goals.