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Zero-Based Budgeting

A budget starting from scratch

What is Zero-Based Budgeting (ZBB)?

Zero-based budgeting (ZBB) is a budgeting technique that allocates funding based on efficiency and necessity rather than on 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 placed in the budget. For example, if a company expects to incur $100,000 in salaries and wages expenses, and believes that the full $100,000 is absolutely 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 – and at a lower cost – then adjustments to the budget are made accordingly.

To learn more, check out our budgeting and forecasting course now!

 

Zero-Based Budgeting vs Traditional Budgeting

All businesses use budgets to keep track of expenses 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 these scenarios, it does not make sense to simply 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.

 

zero-based budgeting

 

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 being able to make 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
  • Might 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.

 

Final Thoughts

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 its employees but all the expenses to maintain this environment were eliminated due to the zero-based budget process, then the overall culture of the company 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 all its relative advantages and disadvantages.

To learn more, check out our budgeting and forecasting course now!

 

 

Related Articles

Thank you for reading CFI’s guide to zero-based budgeting. To further advance your knowledge of financial analysis, take a look at one or more of the following free resources.

  • Budget Head
  • Budget Holder
  • Projecting Balance Sheet Line Items
  • What is Financial Modeling?

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