Zero-Based Budgeting

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Zero-Based Budgeting Definition

Zero-based budgeting starts from zero and does not consider historical data. The income is categorized into fixed costs, variable costs, and savings in such a manner that the balance results in a zero.

Each expenseExpenseAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more item is evaluated from scratch and is taken only when its impact is justified—based on current requirements and activities. Since there is no reference point if managers want to invest more in marketing, for example, they can. They are starting from a zero, after all.

Key Takeaways

  • Zero-based budgeting (ZBB) can be used for monthly, quarterly, semi-annual, and annual budgets. Managers start from a nil balance and do not take the previous year’s budget into account.
  • Individuals, families, and companies can formulate zero based budgets.
  • ZBB aims at cost-effectiveness. Every budget item becomes the direct result of profit generation. For example, if the human resources department doesn’t make much profit for the last few years, it will get less funding for the next year.

Zero Based Budgeting

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How Zero-Based Budgeting Works?

Zero-based budgeting (ZBB) identifies irrelevant costsIrrelevant CostsIrrelevant costs are those that are not useful or are not considered when a company makes a business decision. However, this does not imply that such costs will be irrelevant for an extended period and may become relevant if the business environment or priorities change.read more incurred by a business. The ZBB method is applied along with other costing techniques—process costingProcess CostingProcess costing is a method of costing wherein the products go through two or more processes and the costs are assigned/charged to individual operations averaged over the number of units produced during that time. It is used commonly in manufacturing units like paper, steel, soaps, medicines, vegetable oils, paints, rubber, and chemicals.read more, unit costing, etc.

In the 1960s, Peter Pyhrr was hired by Dallas-based; Texas Instruments where he proposed zero-based budgeting. In 1970, he presented the concept at Harvard Business Review, and In 1977, he published Zero Based Budgeting.

The steps of Zero-based budgeting process are as follows:

  1. Begin budgeting with zero balance.
  2. Decide the objective of budgeting.
  3. Analyze business activitiesBusiness ActivitiesBusiness activities refer to the activities performed by businesses to make a profit and ensure business continuity. read more.
  4. Study the budget components to determine the relevance of expenses, cost reduction, and the scope for saving.
  5. Prioritize the activities that need cost reduction.
  6. Finalize a budget plan.
  7. Prepare a report and convey roles, responsibilities, and activities to relevant parties.

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Features

The prominent characteristics of zero-based budgeting that differentiates it from the other budgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time.read more methods are mentioned below:

  • Every zero based budget starts afresh, i.e., with a zero balance.
  • All the departments of a business entity together take the budgeting decisions.
  • It focuses on cost reduction.
  • Such a budget can be modified or adjusted with time.

Zero-Based Budgeting Example

RP Corp. is a bag manufacturing company. RP Corp’s monthly Trading and P&L A/c is as follows:

Zero Based Budgeting Example 1

To improve the budget, the manager strategized the following:        

  • The company doesn’t require two people to work on a machine—salary costs can be reduced by $300.
  • An unoccupied factory space can be sub-let to a zip manufacturing partner—saving $400.
  • Social media advertising can replace banner ads to save another $40.
  • Many records can be maintained electronically to reduce the stationery expenses by $12.

Now, using the given information, prepare a zero-based budget of RP Corp. for December 2021.

Solution:

Zero Based Budgeting Example 1-1

You can make use of the following, excel template:

The zero-based budget template

Zero-Based Budgeting Advantages

It has the following advantages:

Disadvantages

The following disadvantages of ZBB cannot be overlooked:

  • Profits Overemphasized: Every budgeting item becomes the direct result of whether it generates profits or not. For example, if the human resources department doesn’t make much profit for a few years, it will get less funding in the ZBB method.
  • Consumes Time and Manpower: ZBB requires a lot of effort—managers and employees from different departments are involved. It is, therefore, very labor-intensive. In addition, the collection and interpretation of data take a lot of time.
  • Requires Expertise: The budgeting method demands a lot of mathematical, accounting, and analytical knowledge.
  • Centralizes Cost: Since it focuses on the cost factor and its reduction, essential objectives like product quality and customer service get compromised.
  • Doesn’t Consider Sudden Expenses: This method fails to estimate immediate or emergency expenses.
  • Confusion: When too many departments and individuals are involved, the inputs are often contradictory.

Frequently Asked Questions (FAQs)

How to do zero-based budgeting?

First, the budget planner needs to identify the purpose of budgeting. Consequently, a new budget is created from zero. Next, managers analyze fixed costs and variable costs for relevance, effectiveness, and the scope for saving. Finally, a budget report is sent to relevant parties.

Why is the zero-based budget the most effective type of budget?

ZBB is more realistic than other approaches. It ensures real-time income allocation to various business expenses and savings. Most other methods use outdated historical information. Therefore, ZBB is the most efficient form of budget preparation.

How does zero-based budgeting differ from traditional budgeting?

Zero-based budgeting is the creation of a budget from scratch, without considering the previous year’s budget. Traditional budgets, on the other hand, rely on historical data and perform incremental budgeting.

This article has been a guide to zero-based budgeting & its meaning. We discuss its features, process, examples, steps, advantages & disadvantages. You may have a look at the following articles to learn more about budgeting –

Reader Interactions

Comments

  1. Gideon says

    Thank you sir.

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