The limitations of the traditional budget process have been recognized for a long time. Examples, quoted from the Beyond Budgeting Institute’s white paper, “The Case for Moving Beyond Traditional Budgeting,” include “the validity of the budget is relatively short…very time-consuming…assumptions are quickly outdated…decisions are made too early and at too senior a level.” In response to these limitations, two alternatives have evolved over the last several decades: activity-based budgeting (ABB) and abandoning traditional budgeting altogether.
A variety of books and articles have been published on the subject. We’ll reference two of them in this article. The first book is Management Accounting: A Strategic Focus by Shahid Ansari, Jan Bell, and Thomas Klammer. Part of it has been used in the “Activity-Based Budgeting” module, Version 1.2, Cengage Online Learning. The second is the breakthrough book from the Consortium of Advanced Manufacturing-International (CAM-I), The Closed Loop: Implementing Activity-Based Planning and Budgeting, Stephen C. Hansen and Robert G. Torok, editors, Bookman Publishing and Marketing, 2004.
According to Ansari, et al., “The budget process has three distinct phases:
- Context: The context phase establishes common assumptions about the environment to guide budget preparation” (e.g., inflation rate).
- “Preparation: The preparation phase requires detailed analyses and estimates of work activities, unused and additional capacity needed, resources required for activities, and resource prices” (emphasis added). The steps in Phase 2 include:
- Document all activities.
- Identify the “activity drivers” or factors that cause an increase or decrease in the volume of these activities. The drivers determine the budgeted costs for the next period.
- Estimate the amount of each activity driver needed for next year’s production.
- Identify resources needed to perform activities.
- Estimate the costs for providing the resources.
- Consolidate across all activities.
- Review and approval
- The forecast is used to generate the demands for activities and their associated resources.
- Resource demand is balanced with resource supply to match the demand, creating operational balance.
- Having computed the necessary resources and associated activities required to achieve the forecast, they are converted into dollar amounts with the appropriate cost factors to produce a financial projection.
- A variety of “levers” (i.e., quantity/mix of forecast, resource and activity consumption rates, resource capacity, unit resource costs, unit prices) are then adjusted until a satisfactory financial projection is achieved.
See Figure 1 for the way the traditional budget starts: with the forecast, which is, in turn, passed to the departments.
The activity-based budget starts the very same way: with the forecast, which is then passed to the various departments. In this case, they are production (i.e., cost of goods sold or COGS), sales/marketing and distribution, and, finally, service and support (i.e., selling, general, and administrative or SG&A). See Figure 2.
At this point, the activity-based budget preparation departs significantly from the traditional budget preparation. Phase 2, identify the “activity drivers,” is what makes ABB so different from traditional budgeting. Basically, this step is building an activity-based model of the various departments from past periods that, in turn, generates the dollar amounts in the activity-based budget. Engineering students learn in their freshman year that the volume and mix of demands on work multiplied by unit-level consumption cost rates, calibrated from activity-based costing (ABC), equals the capacity required—the number and types of employees and the spend level for purchases. In a traditional budget, while there may be some kind of analytics that support the budget line items of one or more departments, only dollar amounts are provided. In other words, the critical distinction between an activity-based budget and the traditional budget is that the former is cause-driven and the latter is effect-driven. This is what allows activity-based budget models to be built—something that isn’t possible with effect-driven budgets.
To elaborate, using the production budget shown in Figure 2 as an example and quoting from the “Activity-Based Budgeting” module, Version 1.2, Cengage Online Learning: “The production budget has several important cost components. Manufacturing companies have traditionally grouped these costs into three main categories—direct materials and parts, direct labor and manufacturing support or overhead costs.”
The first and third of these groups, direct labor and manufacturing support, will be used as illustrations of the kind of detail required in an activity-based budget model.
First, direct labor is displayed in Table 1. The drivers are required to develop the budget, where drivers are those variables that, when multiplied appropriately by various constants (i.e., the unit-level consumption rates), provide the desired result. For direct labor dollars, there’s only one driver: production quantity. Everything else in the direct labor model is a constant, as indicated with an asterisk (*). See line items 2, 3, 5, and 9 in Table 1.
Next, let’s look at a model with more than one driver: manufacturing support. Table 2 shows the different drivers involved in computing the manufacturing support budget. In this case, five additional drivers are required in addition to production quantity: number of inspections, number of receipts, number of batches, receipt hours, and hours used. The result across the company is a wide variety of different drivers.
Turning now to The Closed Loop, Hansen and Torok’s book describes an activity-based budget with only one driver: production quantity (i.e., the forecast). Basically, it’s a four-step process:
It was a genuinely new and original idea to create an activity-based income statement using just the forecast as the driver. But the concepts presented never found any commercial acceptance. This was due largely to an admission the editors were candid enough to make in the book: “While the concepts are straightforward, performing the necessary calculations is fairly intricate” though they remained convinced that the concepts were “the most significant development in the field of Planning and Budgeting in the last thirty years.” Also, “We view the activity-based budgeting and planning process as having more to do with planning than budgeting. In the long run, a successful organization will switch from a primary focus on generating budgets to a more fruitful focus on planning”(italics added).
In summary, The Closed Loop couldn’t be implemented because no predictive activity-based modeling software was available to employ the closed loop model (CLM).
But now there’s the advent of the OIS.
Abandoning Traditional Budgeting
Finally, a number of companies have been planning very successfully without a budget for decades. They were motivated by the same current budgeting process limitations and are supported in their efforts by the Beyond Budgeting Institute (https://bbrt.org). Their approach is to provide managers with decision rights to add or remove employees and make purchases without seeking formal approval from their senior supervisors. But then the managers are held accountable for their spending decisions by monitoring the decisions with key performance indicators (KPIs), targets set by the supervisors. Examples of KPIs are the number of sales calls to prospective customers and number of new products or services introduced. The executives set the target numbers. The actual numbers are then used to monitor the progress against the targets toward accomplishing the strategic objectives that in turn align the managers’ actions and decisions with the executive team’s strategy.
TRADITIONAL BUDGETING AND THE OPERATIONAL BUDGET
The traditional income statement is developed after the budget process is completed.
Needless to say, there are a variety of ways to aggregate the budget’s line items to create the income statement. In our opinion, one of the best discussions of this topic is in Randall Bolten’s excellent book, Painting with Numbers. Bolten views the income statement as the “one report every organization needs” and devotes an entire chapter to the subject of creating an income statement that communicates the necessary information clearly and crisply.
As illustrated in Figure 3, however, the OIS isn’t developed from the budget. It starts by identifying all the activities contained within the company’s income statement just as with the CLM model. This is the first column in Figure 3. Each activity cost’s relationship to volume (i.e., cost functions) is then entered into the OIS model. This is the second column—where the horizontal axis is volume and the vertical axis is dollars. These cost functions are used for the COGS and G&A portions of the income statement and serve the purpose of relaxing the assumption of a fixed supply chain in OIS.