Zero Base Budgeting: Features and How to Do It
The zero - based budgeting is a method or budget process in which all expenses must be justified for each new period. The zero-based budgeting process starts from a “zero base”, analyzing each function within an organization to determine its needs and costs.
Budgets are then created, allocating funds based on efficiency and what is needed for the next period without using the budget from the previous year, regardless of whether each budget is higher or lower than the previous one.
Zero-based budgeting enables high-level strategic objectives to be implemented in the budgeting process by linking them to specific functional areas of the organization, where costs can first be grouped and then measured against previous results and current expectations.
Zero-based budgeting can help reduce costs by avoiding overall budget increases or decreases from a prior period. However, it is a slow process that takes much more time than traditional cost-based budgeting.
In the past, companies only looked at a few specific things and assumed that everything was already in place and that they didn't need to double-check. However, the zero-based budget must approve everything that is going to be budgeted.
Since this type of budget requires approval in order to budget, it means that budgets are started from a zero base, with a new decision every year on everything that is done.
Essentially, management must start from scratch and look at every operation and activity to determine whether the company's money is worth spending. Management must also set entirely new spending targets.
It is expensive, complex and time consuming, since the budget is rebuilt annually. A traditional budget is simpler and faster, as it only requires justifying incremental changes.
Zero-based budgeting requires a justification of recurring and old expenses, in addition to new expenses. It aims to give managers accountability to justify their expenses. It also aims to generate value to an organization, by optimizing costs and not just income.
How to do it?
Sometimes company budgets and expenses are so out of control that the entire cost structure of the company needs to be reviewed. In this case, it makes no sense to look at the budget for the previous year.
The entire budget must be completely redone again. This kind of drastic change is known as zero-based budgeting. Unlike the traditional budget, no item is automatically included in the next budget.
No activity is assumed to be untouchable. All expenses are analyzed and must be justified to stay in budget.
In the zero-based budget, the task force reviews each plan and each expense at the beginning of each budget cycle. You must justify each budget line in order to receive funds.
The work team can apply a zero-based budget to any type of cost: capital expenses, operating expenses, sales, general and administrative costs, marketing costs, variable costs or the cost of the merchandise sold.
Steps to follow
The steps to follow in the zero-based budgeting process refer to the detailed analysis of each activity for all areas of the company:
- Identification of an activity.
- Find different ways and means to carry out the activity.
- Evaluate these solutions and also evaluate different alternative sources of funds.
- Establish budgeted numbers and priorities.
Advantages and disadvantages
When successful, zero-based budgeting produces radical savings and frees companies from closed methodologies and departments. When it is not successful, the costs to an organization can be considerable.
This type of budget helps companies examine all departments to ensure they receive the correct amount of money. The resulting budget is well justified and aligned with the business strategy.
It helps to consider the real needs by focusing strictly on current numbers, rather than taking into account previous budgets. Improve operational efficiency through rigorous assumption analysis.
Reduction of wasteful spending
You can eliminate redundant expenses by reexamining potentially unnecessary expenses. It helps in reducing costs, avoiding automatic increases in the budget.
Coordination and communication
It enables better communication within departments by involving employees in decision making and budget prioritization. Catalyzes broader collaboration across the organization.
Creating a zero-based budget within a company can take enormous amounts of time, effort, and analysis that will require additional staff.
This could make the process counterproductive to cut costs. It can be cost prohibitive for organizations with limited funds.
By using a zero-based budget, managers could try to skew the numbers to turn expenses into vital activities. Thus, they can create a "need" for themselves.
This would cause companies to continue wasting money on things they don't really need.
This type of budget requires departments to justify their budget, which can be difficult on many levels. Departments such as advertising and marketing have to account for expenses that they may or may not use next year due to market fluctuations.
This could cost profit in the future because a certain amount of money cannot be justified. It is risky when the potential savings are uncertain.
Zero-based budgeting requires a cost of additional time and training for managers.
This means finding additional time each year to budget, to make adjustments, and to receive proper training to understand how to zero-base budgeting.
Slower response time
Due to the amount of time and training required to do zero-based budgeting, managers are less likely to review in response to a changing market.
This means that it will take longer for a company to transfer money to the departments that need it most at any given time. Zero-based budgeting could leave a gap in a company because this instrument might not react to sudden department needs.