Activity-based budgeting

A budget plays a vital part in an effective system of planning, control and performance management. It shows expected future income and expenditure, and translates into financial terms what an arts organisation’s future, planned activities are. Traditional budgeting systems look at current cost levels and adjust for inflation and changes in income in order to produce an annual budget.

A likely outcome of using this system is management planning to reduce the activity levels required to generate revenue, which in turn improves financial performance

An alternative and more powerful approach is to adopt activity-based budgeting (ABB), a planning system under which costs are associated with organisational activities (cost drivers), and budgeted expenditures are then compiled based on the expected activity level.

ABB in practice

Here is an example of how ABB works. An arts organisation that aims to provide staff training will need to consider what levels of activity it wishes to achieve and what the cost implications will be. The costs of the training sessions will be £x, made up of three trainers for three training sessions of half a day each, a room for half a day capable of accommodating 15 people per session for the three sessions, plus on-costs of delivering the programme, such as printed materials and refreshments.

In this illustration costs are driven by the number of sessions being run, which in turn ‘drives’ the number of staff members that can be offered training. In addition to the costs identified, there will be the overhead costs of supporting and administering the training, such as the finance function, IT and administration.

Direct and indirect costs

Understanding your cost base is important in planning, decision-making and control. The cost base includes both the direct costs of performing an activity, but also the overhead (or indirect) costs in support of the activity. Direct costs are those costs that can be directly identified with service delivery or project work such as artists’ fees, hire or equipment and training materials.

Indirect costs, commonly called ‘overheads’, but more appropriately viewed as support costs are those costs that cannot be associated directly with the service delivery or project work. Nonetheless, support costs are an integral part of organisational capacity, and are there to help deliver outcomes and support the organisation. Examples of support costs include admin, finance, HR, development/fundraising, marketing and IT. We should aim to allocate a fair and equitable proportion of the support costs to our organisational activities.

Without knowing the level of overhead costs, it is very difficult to effectively budget, monitor performance or make key decisions about future plans or strategy. Arts organisations need to know what their total costs are in order to:

• create accurate budgets and forecasts
• make applications for funding
• effectively monitor costs
• understand the basic funding needs of the organisation
• aid decision-making and the allocation of costs to projects and activities
• make strategic decisions.

Overhead costs such as salary costs can be allocated to activities based on a cost driver such as time spent on each activity. Stakeholder relationship costs can be allocated based on a cost driver such as hours of meeting and contact time. And IT costs can be allocated based on a cost driver such as computer hours and usage.

Advantages and disadvantages

An activity-based budgeting system allows for a high degree of refinement in cost planning, and focuses attention on the types of activities occurring within the organisation. A likely outcome of using this system is management planning to reduce the activity levels required to generate revenue, which in turn improves financial performance. It also means there is greater cost transparency and individuals more strongly associate costs with activities.

Another advantage of the system is the strong link with organisational objectives. Ideally, an organisation can use an ABB system to see how much cost is associated with each of its activities, and then decide whether funds need to be allocated to or away from each of these areas. This could result in a shift in funding to support projects and parts of the business where greater emphasis is desired.

The downside of ABB is the initial time and resources needed to set up systems to track and monitor activities. Also, costs need to be traced back to activities, for which there may be no current system in place. However, an effective accounting and financial management system makes this task easier.

The central idea behind ABB is to develop an activity model of resource requirements. This model can then be adjusted to affect different demand assumptions which may need to be evaluated after the first stage of the budgeting process. It can also be used as a basis for identifying and producing performance improvement. Once the final budget model has been agreed, it then forms the basis for management control through variance analysis with a more complete understanding of the impact of changing volumes on activity resource requirements.

Final considerations

Finally, in developing the ABB model it is important to identify the following:

• What activities are being or 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 resources required to perform this activity (the activity level volume driver).
• The relationships between the activity level driver and its root cause.
• How the root cause may be changed and how this can affect the activity resource required.

Whatever system of budgeting we use, we need to remember that a meaningful budget links directly to our strategic and business plan - otherwise our budgets lack meaning and relevance.

Mahmood Reza is Owner and Manager of Pro Active Resolutions and Knowledge Grab.
www.proactiveresolutions.com

This article, sponsored and contributed by Pro Active Resolutions, is part of a series sharing insights into accountancy issues in the arts.