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 they consider the right factors.
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 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 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 make much profit for the last few years (since cost centers need more time to generate profits), it will get less funding for the next year.
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For eg:
Source: Zero Based Budgeting (wallstreetmojo.com)
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 budgetingTraditional BudgetingTraditional budgeting is one of the ways for preparing a company's budget for a specific time period in which the previous year's budget is used as the base for preparing the current year's budget.read more.
- 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 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 bases 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 were 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.
Advantages
- Profit center: This budgeting prioritizes profits over expenses. That’s why the preference is given to departments or units which generate direct or indirect profits. As a result, businesses can get funding to create 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 a business aims 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 wealthMaximizing The WealthWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.read more of a business.
Disadvantages
There are a couple of demerits which we should point out –
- No focus on cost centers: Since cost centers don’t help in generating immediate profits, this budgeting doesn’t encourage funding them. And that is a downside because cost centersCost CentersCost center refers to the company's departments that don't contribute directly to the corporate revenue; however, the firm has to incur expenses for keeping such units operative. It comprises research and development, accounting and human resource departments.read more 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 complicated job for managers. However, this method pays off.
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