Differences Between Traditional Budgeting and Zero Based Budgeting
Companies budget the costs/expenses to make sense of what may happen in the future. Setting a budget ensures that the businesses are allocating their capital right and are allowing the costs to be minimal.
One of the most common budgeting methods is traditional budgeting. As per traditional budgeting, a company sets forth its forecast of expenses on the basis of previous year’s expenditure.
On the other hand, zero-based budgeting which happens to be a popular budgeting method assumes nothing; rather they base their assumptions on budgeting as zero.
The most important difference between traditional budgeting and zero based budgeting is that in traditional budgeting the costs aren’t minimal since the previous year’s expenditure is taken into consideration; however, in zero based budgeting, the costs can really be minimal as the starting point is considered to be zero.
Traditional Budgeting vs Zero Based Budgeting Infographics
There are many differences between traditional budgeting vs zero based budgeting. They’re as follows –
What is Traditional Budgeting?
In simple terms, traditional budgeting is a method of budgeting which depends on the exact preceding year’s spending to do the budgeting of the current year.
The only benefit of going for this sort of budgeting is simplicity. If a company follows traditional budgeting, they don’t need to rethink over every item on the list. Rather they can simply look at the spending of previous year and then add/deduct inflation rate, market situation, consumer demand etc.
Most people and companies prefer traditional budgeting because they can sit with whatever data they have with them and then they can create a budget quite quickly.
Common method of budgeting
Traditional budgeting is very common since traditional budgeting saves time and if you can be incremental in your approach, you can quickly figure out how much you may need to spend as a company/individual.
If you go back and think how you budget your expenses you will see that the general tendency is to look backward and see how you have spent your money.
Most people look back and take the previous year as a base for setting a budget for their spending/income.
While making the budget, they consider few factors which they think may affect their spending or income.
These factors can be controllable or sometimes uncontrollable.
Advantages of Traditional Budgeting
The advantages of traditional budgeting are as follows –
- Offers a solid framework: Since traditional budgeting is based on a reference point (the data points of the previous year), it becomes easy to manage the financial activities of the organization. Alternatively, this reference point allows the company to base their budget on a solid framework which is easy to execute and easy to control.
- Encourages decentralization: Since everyone can look at the preceding year’s spending and can decide upon the budget for next year, the idea becomes decentralized. And the top management doesn’t need to think about how to budget for the next year. And as a result, they can concentrate on other high value tasks.
- Traditional budgeting becomes part and parcel of organizational culture: Since traditional budgeting is the most simplistic method of budgeting, soon it becomes part of the organizational culture. And perpetually the method goes on and on and on. If the new method is introduced (for example “zero-based budgeting”) then it would be a risky endeavour for the business.
But traditional budgeting also has many disadvantages for which companies tend to move toward zero-based budgeting more than anything.
Let’s look at the disadvantages of traditional budgeting.
Disadvantages of traditional budgeting
Here are the major drawbacks of traditional budgeting –
- Chances of human errors are higher: Since traditional budgeting is all about looking at a lot of spreadsheets, it’s natural to err and make mistakes. As a result, sometimes the mistakes become too costly for businesses.
- Time-consuming: In traditional budgeting, managers depend on a lot of spreadsheets. As a result, it takes a lot of time to sort things out, to compare the previous year’s spending with the expected expenditure by adding the inflation and other factors.
- Doesn’t encourage expected behaviours: If a company wants to promote innovative and loyal behaviours, the companies should put in more budget into those departments where the employees regularly innovate and think of organizational goals first. But as per traditional budgeting, the expected behaviours can’t be encouraged as it depends on the spending of the previous year.
- No alignment between spending and strategy: Every year’s strategy is different since every year every organization wants to reach higher. With the similar spending scenario, it would be impossible for an organization to a strategist for a year to year profits and development.
- Inaccurate predictions: Since the traditional budgeting takes preceding year’s data points as base points, the budget predictions for next year can’t reach accuracy. How can one year be just like the previous year? It’s always wise to revisit the factors, look at the strategic plans of the future, and then go ahead and budget the spending of the next year. Without proper thinking and the right approach, ensuring accuracy is almost impossible.
Finally, does traditional budgeting work?
The short answer is – not ideally.
But yes, if you are a small firm and you don’t have many overheads to include into your budget, then you may choose traditional budgeting.
Though, zero-based budgeting can be way more superior to traditional budgeting since you can think about the next year with a blank slate.
So given the choice between traditional budgeting and zero-based budgeting, any firm irrespective of the size or revenue should go for zero-based budgeting without a tinge of doubt. The only exception is the firm which has issues with centralized process and adapting to change.
What is Zero-based budgeting?
Zero-based budgeting allows organizations to start with zero for each item in their budgeting list. So there has almost no chance of error if the right factors are taken into consideration.
The main benefit of zero-based budgeting is that you don’t need to depend on any reference point to think over the budget of a particular item. For example, if you see that if you invest more money into your marketing department this year, you can because you are starting the budget from zero.
The main pitfall of this sort of budgeting is that every budgeting item becomes the direct result of whether it generates profits or not. For example, if the human resources department doesn’t generate much profit for the last few years (since cost centres need more time to generate profits), it will get less funding for the next year.
Why is zero-based budgeting one of the best approaches?
There are few reasons for which zero-based budgeting works well. They are –
- Systematic analysis is mandatory: Before ensuring which department or unit will get the funding, zero-based budgeting encourages careful analysis of why the funding is required. If the manager can’t give enough reasons to approve funding, there will be no funding available for that particular unit which comes down to the next reason for choosing zero-based budgeting over traditional budgeting.
- Ensures cost-effectiveness: One of the most important reasons for which zero-based budgeting is practised is because it saves a lot of cost upfront. Let’s say that you as a manager sees that one of the departments (let’s say accounting) isn’t doing well. The employees in the accounting department are performing poorly and their work isn’t adding value to the profit generation of the company. In this scenario, you can do two things – first, you can put the employees of accounting into other job roles which will help them appreciate their own talent and abilities plus you can outsource the whole accounting department from next year. Since you’re starting from zero, there will be almost no downside until you sit again next year to re-evaluate your decision.
- It is based on decisions over routine: In traditional budgeting, most of the activities are routine. But in zero-based budgeting, decision triumphs over routine. In zero-based budgeting, things are questioned, approaches are analysed, and things are redone. As a result, there’s no room for habituation or wastage of time, money, effort. And the management also feels more in control because decision matters more than routine in zero-based budgeting.
Advantages of zero-based budgeting
Let’s look at why zero-based budgeting is being used by most of the companies –
- Profit centre: Zero-based budgeting prioritizes profits over expenses. That’s why the departments or units which generate direct or indirect profits are given preference. As a result, businesses are able to get the funding to generate more revenues and profits.
- Very detailed: Details can save a business. This approach also reduces errors and help a business look deeply into its processes. As a result, inefficiencies are taken care of and business becomes very effective.
- It’s strategic: Since the aim of a business is to grow, get more clients, and serve more customers; it helps to become strategic. Zero-based budgeting allows the business to be strategic in their approach and only expend the amount they need to grow. As a result, spending would have a direction and would become a means for business to achieve something worthwhile.
- It’s situational: Zero-based budgeting doesn’t encourage the practitioner to follow any rules/regulations. It is done with an end in mind and for achieving a purpose, i.e. maximizing the wealth of a business.
Disadvantages of zero-based budgeting
There are couple of demerits which we should point out –
- No focus on cost centres: Since cost centres don’t help in generating immediate profits, zero-based budgeting doesn’t encourage funding them. And that is a downside because cost centres are responsible for long-term health and profits of a company. If they aren’t nurtured well, the whole company will get affected at the end of the day.
- Too complex: Zero-based budgeting needs detailed attention and analysis. That’s why it’s become a complex job for managers. However, at the end of the day, this method pays off.
Traditional Budgeting vs Zero Based Budgeting – Key differences
Let’s look at the most important differences between traditional budgeting vs zero-based budgeting –
- Traditional budgeting needs a reference point; zero-based budgeting on the other hand always starts from zero.
- Traditional budgeting takes the preceding year’s expenses as base data points; zero-based budgeting takes the strategic approach to assign budgets to each unit/department.
- Traditional budgeting is simplistic since it is done regularly with a similar approach; zero-based budgeting is quite complex since it encourages re-evaluation every time it is used.
- Traditional budgeting is basically based on historic information, that’s it revolves around accounting. Zero-based budgeting is based on estimated information and that’s why it revolves around decision making.
- Traditional budgeting encourages similar costing of the previous year. Zero-based budgeting encourages cost effectiveness.
Traditional Budgeting vs Zero Based Budgeting (Comparison Table)
|Basis for Comparison – traditional budgeting vs zero based budgeting||Traditional budgeting||Zero-based budgeting|
|1. Meaning||It’s computed by keeping the previous year’s budget as base.||It’s computed by keeping the starting point as zero.|
|2. Preparation||Quite simple.||Very complex.|
|3. Emphasis||Expenditure of previous year.||Each item is considered as per the new economic appraisal.|
|4. Approach||Based on historical information.||Based on estimated information.|
|5. Cost effective?||Doesn’t encourage cost-effectiveness.||The purpose is ensuring cost effectiveness.|
|6. Prefers||All departments.||Only profit centres.|
|7. Effectiveness||Effectiveness depends on the individuals who did the previous year’s budgeting.||Effectiveness depends on the current top management of the company.|
|8. Linked to||Assumptions of the previous year.||Estimation of which department can bring more profits.|
|9. Clarity||Almost none.||High.|
|10. Orientation||Orientation revolves around accounting.||Orientation sits around project/decision unit.|
Conclusion – Traditional budgeting vs Zero based budgeting
Traditional budgeting is truly out-dated. And other than becoming a simplistic process it doesn’t serve the company, a business or even an individual.
Not only traditional budgeting is simplistic, it’s also very time consuming because it involves a lot of spread-sheets. And chances of errors are also more in using this method.
On the other hand, zero-based budgeting ensures cost effectiveness and detailed-orientation which help a business generate more profits and an individual save and invest more money.
Without a tinge of doubt, zero-based budgeting is a far superior approach than traditional budgeting.