Achieving efficient growth is the name of the game for SaaS companies in today’s cash-strapped environment.
With the precipitous fall in the ARR growth of early-stage companies from 200%+ YOY growth in 2021 to just 111% in H1 2023, startups need to be more vigilant than ever about how they're investing their resources to ensure the growth they need and their investors expect.
This starts with a company's budget, and more specifically, its budgeting process. SaaS businesses must move away from a traditional budgeting approach to more strategic budgeting methods, which are more flexible and can be tailored to meet the unique needs of the business.
In this blog, you’ll learn what activity based budgeting (ABB) is and why it is particularly relevant in the SaaS industry, especially now as the “growth at all costs” mindset has given way to one of more efficient, but solid growth.
What is activity based budgeting?
An ABB system starts with a thorough evaluation of all the different activities in the business and their cost drivers. This allows businesses to figure out the minimum resources necessary for every activity so they can allocate the budget necessary to achieve the goal or objective they're intended to support.
Once you know the activities and their associated costs, you can determine how many “units” of each activity you need to achieve a specific goal or objective and thus the total costs that you’ll need to budget for.
In the context of SaaS, a "unit" could be winning a specific number of new logos, reducing churn by some percentage, or developing a new product or pricing strategy.
ABB enables businesses to prioritize activities within the context of their relative costs and the company’s goals while at the same time, finding efficiencies that can help reduce overall costs in the business.
In addition, ABB allows a detailed analysis of profit potential in reference to different activities and products because it requires drilling down to minute details of what each activity in your business costs.
How to do activity based budgeting in 5 steps
In this section, we'll show you the five steps required for ABB. Note that in order to successfully implement this method of budgeting, you'll need to have your accounting system set up for activity-based cost accounting.
In simple terms, activity-based cost accounting assigns costs to all the different activities in the business and assigns those cost to products or services based on how much of each activity is required to produce or deliver those products and services.
In contrast, traditional cost accounting allocates costs based on the quantity of resources required to produce a product or deliver a service.
While activity-based costing is commonly associated with more traditional sectors like manufacturing, it is equally applicable to SaaS businesses to support activity-based budgeting.
Step 1. Identify all the activities in your business and their cost drivers
Activity based budgeting looks at all your business activities and then focuses on identifying cost drivers for each activity to determine where savings can be achieved.
In SaaS, most activities fall into one of four main activity groups:
- Delivering your product or service to customers (e.g. cloud hosting costs and payroll for customer support and customer success teams.
- Research and development (R&D), which includes any activities related to developing, maintaining, and upgrading your product or service (e.g. payroll for your engineering team, product designers, and product managers, as well as any software needed).
- Sales and marketing (S&M), which incudes any activities associated with making your products and services attractive to your target market (e.g. payroll for your S&M and product marketing teams, advertising, content marketing, and events).
- General and Administrative (G&A) activities, which includes all the overhead and indirect costs associated with running your business (e.g. Payroll for company leadership and administrative staff, software and tools to support business operations.
At this step, it’s useful to further categorize each activity into main or secondary activities; doing so will make it easier to identify unnecessary costs.
- Main activities are essential activities and they can’t be eliminated because they are directly related to their purpose. ABB examines these activities to find efficiencies but does not consider eliminating them. They are not discretionary in nature.
- Secondary activities are discretionary as they may generate value for the business, but aren’t essential. These are the primary focus of ABB when looking for ways you can reduce costs while at the same time, become more efficient.
In the steps that follow, we'll walk you through two examples to help illustrate how ABB plays out in the SaaS context. One example will create an ABB budget for a main activity (maintaining your product or service), and the other will create one for a secondary activity (event sponsorship).
Step 2. Determine the cost per unit for each cost driver
This step requires that you first define what constitutes a “unit” for each cost driver and then figure out the cost for each unit.
For a SaaS company, this can be difficult because the activities associated with SaaS are not as amenable to parsing out into units as those associated with producing and selling a physical product. Thus, using ABB requires a thorough understanding and some decisions upfront about how to translate specific activities in your SaaS business into units for the purposes of determining their associated costs.
This is why you should only consider ABB in conjunction with an activity-based accounting system. If you're already using activity-based cost accounting, you probably already know what constitutes a “unit” for each activity in your business. If not, implementing ABB is still possible, but it will require a lot of additional work on the front end.
One of the few disadvantages of ABB is that it's more expensive to implement in terms of staff resources in the first year than other strategic budgeting systems.
Example 1: Maintaining your product or service (a main activity)
Let’s say the activity you’re looking at is the cost of maintaining your product or service (e.g. bug fixes, testing, performance monitoring, and updates). This activity involves the following cost drivers from the R&D activity group:
- Payroll costs for all the developers working on the team responsible for maintaining the product and the product manager
- The costs of software & tools used to maintain the product and its architecture and monitor its performance
Note that this activity might also include some portion of the company’s overhead and indirect costs depending on how you choose to allocate those in your accounting system.
In your accounting system, your unit of cost for payroll is full-time equivalents (FTEs), and your unit for software costs is defined as a unit of time, a monthly cost.
Once you define your units for each cost driver, determining the actual cost per unit is pretty straightforward. As an example, say your software costs are $6K per month, which is the cost for each unit.
To get the unit cost for the payroll cost driver, we determine the total payroll cost for the team that maintains the product. The team is made up of 6 FTEs whose annual salaries, including benefits, total $720K. One just has to divide this number by 6 to get the per-unit cost of $120K.
Example 2: Event Sponsorship (a secondary activity)
Now, let’s say you’re looking at sales and marketing activities in your business to determine the budget allocations. In the SaaS context, many of the activities in this group and their associated costs are considered secondary, those that generate value for the business but are not absolutely necessary to keep the lights on.
In this example, we’ll focus specifically on trade show sponsorship, which we identified in Step 1 as an expected activity for S&M.
Now, in this step, we’re determining the unit cost for each driver. This will be based on historical data from our previous year's budget.
Depending on the strategic goals and objectives of the company, sponsoring events may or may not be a priority.
Remember that ABB aims to identify and eliminate unnecessary costs. Given this, every cost must be justified.
In our example, we've decided that event sponsorship is a priority, because each event will generate leads with the potential to result in some number of sales.
What our ABB needs to determine, is what our activity level should be (i.e. how many sponsorships and which ones should we consider as we're creating a budget).
Step 3. Determine how many “units” of each cost driver are required for each activity
Example 1: Maintaining your product or service
We already know the how many units of each cost driver required. Since maintenance is a required and ongoing activity, for each annual budget cycle, we’ll need the entire team (6 FTEs) plus 12 monthly “units” of software.
Example 2: Event Sponsorship
In the previous year, we sponsored four events and found the ROI acceptable for three of them. So, we plan to sponsor the three shows that provide a good ROI again in the coming year.
Based on last year's budget, we spent an average of $22K per event. To determine the budget for event sponsorship this year, we could simply base our allocation on the average cost of $22K per event multiplied by the three events we want to sponsor in the coming year, which would total $66K.
However, this approach misses the whole point of ABB, which is to find opportunities to reduce costs, ideally without compromising results. Most of these opportunities are going to be found in cost drivers that are variable in nature.
In the case of event sponsorships, since travel is a significant cost, we might ask ourselves whether we can get away with sending three employees instead of four and still provide demos to everyone who visits our booth. Or we might re-evaluate what we’re getting with each tier. Would dropping to a lower sponsorship tier impact our ROI?
Once these and other decisions are made regarding how many units you need for each driver, you can then calculate the cost for each unit of activity (the cost per event sponsorship).
Step 4. Calculate the cost per unit of activity
Example 1: Maintaining your product or service
Now that we know our unit cost for each cost driver associated with maintaining our system and we know how many units doing so will require, calculating the cost for each unit of activity – annual maintenance of our product – is simple:
We’re developing an annual budget, so we want to calculate the maintenance costs as an annual unit of activity. To do this, we multiply the monthly software costs by 12 to get $72K and add that to the $720K for the 6 FTEs.
Example 2: Event Sponsorship
For event sponsorships, the unit of activity is a single event. To calculate the cost we incur for each unit of activity, we have to determine the total cost for each driver based on the decisions we made in Step 3.
Because ABB is focused on costs, by closely examining those cost drivers that are variable and discretionary in nature, we’re able to identify unnecessary activities that we can eliminate to reduce costs, ideally, with minimal impact.
Step 5. Forecast the number of units of each activity needed for the next budget period
To get the budget allocation for each activity, you multiply the units forecasted for each activity by the unit cost calculated in Step 4.
Example 1: Maintaining your product or service
Obviously, we’re going to continue to maintain our product, so this cost would be considered a main activity. We could look for efficiencies there, perhaps less expensive software tools, but for the most part, the costs associated with this activity are not going to change. So, for this particular activity, the next step – forecasting how much of an activity you’ll need to budget for – isn’t really necessary because it is a required and ongoing activity.
Example 2: Event Sponsorship
By diving deeply into all the factors that drive costs related to event sponsorships, we can identify relevant activities (those events that offer the greatest ROI and potentially higher profits).
With this approach to budgeting, we're able to identify three events to sponsor in the coming year instead of four based on their relative ROI.
Further, by sending one less person to each event and cutting our printing costs by half, we were able to reduce the cost of each event from $22K to $19.5K. For three events, the total budget allocation for event sponsorships for the coming year is $58.5K.
Make your activity based budget a rolling budget
A rolling budget is one where you can make tweaks as and when necessary based on both market conditions or other internal factors. This kind of budget, though data-intensive, gives you the much-needed flexibility to adapt faster and stay agile in an increasingly unstable environment.
If you are convinced that ABB is the way forward, it is best to make it a rolling budget as it can help you achieve your strategic goals better. Data-driven insights will help you make informed decisions about real-time budget adjustments.
Implementing your budget as a rolling budget does require you to implement a system to track budget vs. actual performance, conduct regular reviews, and revise based on conditions, which can seem pretty daunting if you're budget is created using spreadsheets.
However, with an FP&A tool like Drivetrain, it is possible to implement rolling budgets without any hassles as it aggregates all your data and makes it available in real time. this means you can updated your budget based on the most current data anytime.
Best practices for activity based budgeting
- Track your activities, both main and secondary, at regular intervals. Gather the required data at a drilled-down time scale (monthly) + one year’s worth of data so you can come up with an accurate forecast.
- Build a deep and reliable repository of data for your planned activities. ABB’s success is heavily dependent on data and the ability to track it to achieve the set goals.
- Designate people as owners of specific activities so that they track them religiously and can stick to the allocated budget.
Fuel innovation with a more strategic approach to budgeting
All said and done, ABB is dependent on the assumptions about unit costs and the number of units required for a given activity, which can lead to inaccuracies in budgeting. However, this can be overcome to a certain extent by setting realistic assumptions backed by deep research of both market benchmarks and internal benchmarks.
For SaaS companies that are focused on innovation, ABB is the best bet as it helps one cost cut at the right places to find the necessary resources for innovation initiatives. With the right technology platform, companies can reap the benefits that ABB offers.