Updated July 19, 2023
Introduction of Zero-Based Budgeting
Zero-based budgeting (ZBB) is a way of budgeting in which the budget is prepared in alignment with the organization’s strategies and goals. In ZBB, the exercise starts from zero bases (i.e.) all the elements of budgeting must be justified for every budgeting period.
It is made from scratch. In Zero-based budgeting, a proper analysis must be conducted to determine the budget value for each year, such as expenses, costs, revenue, etc., for each element. Unlike traditional budgeting, where the current budget is drawn from the previous period (i.e., an increase or decrease of the last budget), this budget actively differs in its approach. (E.g.) In the current budget, a 2% increase is considered in Administrative expenses from the previous budget.
ZBB is a time-consuming process that involves a more extensive procedure than traditional cost-based budgeting. It drives the budget right from identifying the cost drivers, understanding and analyzing the previous year’s expenses, framing the value for recurring costs, the justification for the new expenses, etc. This budgeting method makes cost optimization possible as it starts from a zero base instead of allocating an increase and decrease from the previous budgets.
In ZBB, the funds are allocated to expenses according to the necessities and requirements which drive business efficiency and performance. It prioritizes the justified costs rather than following the prior period budgeting trends. It is more of a strategic budget as it allocates the fund after a complete analysis and reasoning of expenses. The managerial personnel actively require detailed documentation and explanation for the approval of the budget. ZBB brings discipline to the organization system regarding spending and management, leading to improved tracking and performance.
Steps in Zero-Based Budgeting
The following are the steps in zero-based budgeting are:
- Start from scratch (ZERO BASE).
- Identification of business targets and requirements in terms of budgeting.
- We are forming the route map, methods to accomplish the target, and proper justification for all budget components.
- We are assessing the identified methods and looking for alternative ways to achieve the business targets. Standardize the process and set up goals.
- Finalize the budget numbers, actively roll out the budget plan, and ensure effective plan communication to the respective functions.
Examples of Zero Based Budgeting
Zen Corp is the manufacturer of various car models. A significant part of the car making is procured externally, and the price of the same is increasing year on year. Considering the zero-based budgeting model, the company looks out for other alternatives for that significant part, like whether the company can afford to manufacture that major part on its own, does it have all the facilities, and also does the cost-benefit analysis; thus, in turn, starts the estimation from scratch and finally conclude.
X Space Inc. is a book-selling company growing in e-commerce that previously had traditional book sales outlets. In the current year, it has completely migrated to the e-commerce business. Now the company plans to do ZBB as there is a complete shift in operations. So, they look into some necessary expenses: rent, advertisement, staff, etc.
- Rent expense in the prior period is $1,000 per month per outlet. They had ten outlets in the city, which comes to $10,000/ month. Now with the present set up, they hardly require two offices for which they used two outlets. So, there is a cost saving of $8,000 per month.
- Conversely, the e-commerce business is challenging with many emerging players. So, they decided to spend a lot on advertising to attract customers. In the previous period, they had spent only $10,000 on an advertisement that year, but now they have increased it to $50,000.
As mentioned above, ZBB looks into every element of budgeting and starts from scratch to find the right amount for a reasonable expense without the influence of prior period budgets.
ZBB is an accurate budgeting method as the budget is made from zero bases with proper analysis. Each element of cost in budgeting is considered after collecting the correct data.
- Instead of relying on drawings from the previous period, it is actively made based on the present needs and requirements. It is an efficient budgeting method, and proper targets can also be set.
- It involves analyzing the previous period’s expenditure and considering the current requirements, so it helps reduce unwanted expenses. It leads to cost optimization and looks for possible savings.
- This budgeting requires collective efforts from all the teams and departments in the organization, so it helps better coordination and transparency in the system.
- In ZBB, all budget elements must be accepted, unlike the old incremental budgeting style.
- The company actively justifies costs and allocates funds according to the set targets. Activities and functions of performance do all allocations.
- The orientation of cost allocation and expenses concerning the organization’s goals, vision, and mission.
- ZBB is a time-consuming process. It takes a lot of time and effort from staff.
- To prepare ZBB, additional staff may be required, which increases the organization’s cost. It may not be comfortable for small-sized firms with limited funding.
- The purpose of ZBB can be defeated if the results are uncertain.
- It is tough to justify all the expenses for considering the same in budgeting. Sometimes, despite being unable to explain certain expenses, they still play an essential role in the business prospects. (E.g.) Advertisement expenses.
- To prepare ZBB, the company must actively provide proper training to staff and managerial personnel as it requires them to understand the activities performed and the associated cost structure. It again comes with some cost and time.
Zero-based budgeting actively aims to arrive at the reasonable expenses required to be incurred by the organization based on its needs and requirements. ZBB can bring cost optimization, bringing significance to the budgeting exercise. It helps set the correct targets, improving business performance and operating efficiency. Though ZBB is a time-consuming exercise, it is the most fitting and appropriate way of budget preparation. It also brings accountability and a sense of ownership to the system across all functional teams.
In ZBB, all budget amounts need to be justified, and it needs to be approved. ZBB aims to look for opportunities, improve budgeting efficiency, and reduce unnecessary expenses and costs. It is the concept of proper spending for suitable activities. It, in turn, leads to better utilization of the organization’s funds for critical actions which could bring desired results to the organization. It is a forward-looking way of budgeting.
This is a guide to Zero Based Budgeting. We also discuss the introduction and steps in zero-based budgeting and its advantages and disadvantages. You may also have a look at the following articles to learn more –