What is Zero-Based Budgeting?
Zero Based Budgeting is a type of budgeting process where each expense item under consideration is evaluated from scratch for the new period and starts with zero and is taken only when its needs are fully justified.
It allows organizations to start with zero for each item in their budgeting list. So there was almost no chance of error if the right factors are taken into consideration.
The main benefit of this type of 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 zero-based budgeting concept?
There are a few reasons for which this budgeting works well. They are –
- Systematic analysis is mandatory: Before ensuring which department or unit will get the funding, this 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 practiced 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, things are questioned, approaches are analyzed, 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 this budgeting.
- Profit center: This 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 funding to generate more revenues and profits.
- Very detailed: Details can save a business. This approach also reduces errors and helps 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. This type of 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 a business to achieve something worthwhile.
- It’s situational: It 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.
There are a couple of demerits which we should point out –
- No focus on cost centres: Since cost centres don’t help in generating immediate profits, this budgeting doesn’t encourage funding them. And that is a downside because cost centers are responsible for the 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: It 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.
This has been a guide to what is Zero-Based Budgeting, its concepts with examples. Here we also discuss the advantages and disadvantages of zero-based budgeting. You may have a look at the following articles to learn more about Budgeting –