One of the main behavioural problems in the budgeting process is how to encourage managers to make an honest statement of intent rather than produce a loaded cost budget which will soften the blow of the inevitable percentage cuts. Even at the most senior level how can functional managers be encouraged to adopt a stance that is in the best interest of the business rather than putting their functional perspective first?
ABC seeks to discover the causal factor, known as the cost driver, which determines the demand for each separate overhead activity i.e., what explains the activity to occur. Activity costs, and the instances of cost driver occurrence, are measured and are used to determine overhead absorption rates. The idea behind activity based costing is to develop an activity model (or series of linked cost centre activity models) of resource requirements. This model can then be flexed to affect different volume assumptions. It can also be used as a basis for identifying and producing performance improvement.
In developing the activity based budgeting model it is important to understand and identify:
- What activities are being/need to be carried out?
- How efficiently the activities are being carried out and to what quality and standard.
- What is driving the level of resource required to perform this activity (the activity level volume driver).
- The relationships between the activity level volume driver and its root cause.
- How the root cause may be changed and how this can affect the activity resource required.
In summary, ABC is a five stage process:
- Identify the various activities within an organisation;
- Determine the key cost driver for each activity;
- Create cost pools to collect activity costs having the same cost driver;
- Measure the incidence of each cost driver for each product/service;
- Attribute the cost of each pool (and activity) to products/services based on the cost drivers.
Usually, these inputs or variables are reflected in the individual cost centre activity model (or matrix) over which each individual manager has responsibility. However, the logic of having a budget model with an integrated set of product volumes and unit price assumptions is already established.