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Zero-based budgeting (ZBB) is a budgeting technique that allocates funding based on efficiency and necessity rather than budget history. Management starts from scratch and develops a budget that only includes operations and expenses essential to running the business; there are no expenses that are automatically added to the budget.
All expenses must be justified in order to qualify to be placedinthe budget. For example, if a company expects to incur $100,000 in salaries and wages expenses, and believes that the full $100,000 is necessary to operate the business smoothly, then it will be included in the budget – however, each individual allotment of salary/wages has to be examined and justified in order to be included.
If instead of paying some salaries, the company’s management determines that it can substitute technology at a lower cost, then adjustments to the budget are made accordingly.
All businesses use budgets to keep track of spending and improve ways to minimize costs and maximize profit. Budget planning for the current/next year is usually based on budgets from previous years. In fact, traditional budgeting begins with the previous year’s budget and usually implements incremental percentage increases or decreases to meet new goals. These percentages usually range anywhere from 1% to 10%.
Sometimes, budgets can get out of control, or in some years, may show significantly higher or lower costs, depending on the overall market outlook and other external factors. In such scenarios, it does not make sense to look at last year’s budget because significant changes in the company’s situation have taken place. The entire budget needs to be redone from scratch – hence, a zero-based budget.
In a zero-based budget, the company analyzes every expense/aspect of the business one by one. This is referred to as starting from a “zero base.” While zero-based budgeting examines all expenses, traditional budgeting only examines proposed new expenses.
Advantages of Zero-based Budgeting
The final output is well justified and is aligned with the company’s overall business strategy or business plan.
Encourages more collaboration throughout the company
Improves performance and operating efficiency by challenging assumptions and examining expenditures
By avoiding traditional budgeting percentage increases, there is a significantly better chance of making cost reductions.
Disadvantages of Zero-based Budgeting
Implementing a zero-based budget requires qualified personnel and specialized training, which can be time-consuming and costly.
May harm the company’s overall culture or brand image
May be cost-prohibitive (because of time, research, and analysis required) for companies with minimal available funding
It is substantially more complex and tedious to start from a zero base. Traditional budgeting is much simpler, faster, and easier to implement.
To sum up, although zero-based budgeting is an option that can create numerous benefits, there are also some potential drawbacks.
Implementing zero-based budgeting is not solely an accounting decision and must be considered in conjunction with the company’s overall business strategy and goals. While a zero-based budget may help companies better reduce costs, they may completely change the value of the company and its culture.
For example, if companies rely heavily on maintaining a positive, vibrant, and accessible environment for their employees but all the expenses to maintain this environment were eliminated due to the zero-based budget process, the company’s overall culture may change. This change may lead to higher turnover rates and negative changes in brand perception.
According to a study by Accenture, only about 50% of companies can sustain cost savings for more than one to two years, and in such cases, traditional budgeting becomes ineffective.
Zero-based budgeting must be a collaborative, unanimous decision within the company after careful consideration of its relative advantages and disadvantages.
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
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