It’s important to devote enough time to optimize your company’s financial health for which budgeting is mandatory. Various traditional budgeting techniques are simple and easy to use or set up. However, today’s advanced world needs some more smart strategies to win the competition. One such popular accounting practice is zero-based budgeting (ZBB).
Zero-based budgeting is a kind of accounting practice where the budget is prepared from scratch and for every budgeting period. Every item of the cash flow statement needs proper justification and re-evaluation in this technique. Just like anything else, zero based budgeting advantages and disadvantages are also there which we will discuss through this guide.
The idea of this budgeting methodology was introduced by Pete Pyhrr in the late 1960s to early 1970s. Recently, both Fortune 500 and private equity companies are using this. No historical expenses or sales are carried forward in this technique, so the budget is fully built with zero prior bases.
Let’s now go through the steps and a zero-based budgeting example before directly moving into the zero based budgeting advantages and disadvantages.
Table of Contents
- 1 Zero Based Budgeting Examples
- 2 What are The Four Characteristics of Zero based Budgeting ?
- 3 What is The Purpose of Zero Based Budgeting?
- 4 Zero Based Budgeting Advantages And Disadvantages
- 5 Zero-Based Budgeting Process
- 6 Incremental Budgeting Pros and Cons
- 7 Criticism of Zero Based Budgeting
- 8 Final Words
Zero Based Budgeting Examples
The major steps included in zero-based budgeting involves –
- Task identification,
- Searching ways and various procedures to complete the task,
- Finding out the solutions and also various alternatives for fund sourcing,
- Setting the priorities and budgeted numbers.
To understand this better, we have highlighted a zero-based budgeting example below.
Suppose, there is a company XYZ that has a manufacturing department whose expenses were $1 million the previous year. They now need to calculate the budget for this year. The various ways include –
Solution1: The Company’s board of directors planned a meeting and decided to either increase or decrease the total expenses for optimizing their profits. Thus, the solution came from the management’s decision and XYZ’s manufacturing department received either $0.9 million or $1.1 million.
Solution2: XYZ’s senior management can also decide to maintain the same amount of expenses as the last year. In this case, the manufacturing department will get the same as the previous year, which is $1 million.
The above two solutions are based on traditional budgeting strategies and not based on actual expenses. This may impact the overall productivity of the company because of inflation and price hikes. Let’s now move on to the third solution.
Solution3: The management now utilizes the zero-based budgeting strategy, thereby eliminating last year’s expenses of $1 million in calculating the new budget. With the help of this zero-based budgeting strategy, they calculate the expenses of all departments with proper justification. That figured out the real balance needed by the manufacturing department this year, which may end up to $1.06 million.
What are The Four Characteristics of Zero based Budgeting ?
The four major characteristics of zero-based budgeting are –
- The decisions are based on the offerings of each unit at a given cost.
- The objectives of each unit are in alignment with the corporate objectives.
- If required, immediate adjustments can be done to the budget.
- There is the participation of all organizational levels in the decision-making process.
What is The Purpose of Zero Based Budgeting?
Zero Based Budgeting Strategy has multifold benefits and thereby, most companies are following it. As per a study from Accenture published in 2018, from 2013-2017, there was an exponential growth of this budgeting method among the 85 largest companies at a 57% rate every year.
The traditional budgeting processes used a template of the previous year’s budget and then build the new budget for the current period. This resulted in an increased budget every year and the new expenses require justification only.
On the other side, zero-based budgeting requires every dollar spent to be justified without any extension from the previous budgeting period. Even old and recurring expenses need to be justified in this approach.
This opens up the purpose of zero-based budgeting because it helped in focused operations and more disciplined execution strategies. It enhances the efficiency and effectiveness of every minor expense of the cash flow statement. Moreover, the systematic review and reporting of all activities helped businesses to grow properly.
Let’s now go through the top 10 advantages and disadvantages of zero-based budgeting.
Zero Based Budgeting Advantages And Disadvantages
There are plenty of advantages and disadvantages of a zero-based budgeting strategy. However, we have pointed out the top 10 best that you need to be aware of.
After going through all the below points you can find various zero-based budgeting pros and cons.
Benefits of Zero Based Budgeting
- Accurate calculation: As mentioned earlier, the traditional budgeting strategies take the previous year’s amount into the calculation. However, the zero-based budgeting technique doesn’t involve last year’s expenses. Every department needs to re-evaluate every item and then perform the calculation of costs incurred with justifications. So, this process is a much more accurate form of budget calculation.
- Efficient method: The zero-based budgeting is focused on actual expenditures and not on the differential structure. Hence, that enables efficient resource allocation for every department of a company.
- Inflated budget: There are justifications involved for every single dollar spent by each unit of a company. So, the weakness of incremental budgeting which is budget inflation can be easily overcome by this strategy.
- Redundant activities: Along with efficient resource allocation, zero-based budgeting follows a systematic approach. This helps to identify newer opportunities and other cost-effective solutions. Therefore, less productive or redundant activities can be reduced to a certain extent by implementing zero-based budgeting.
- Increased coordination: As per the fourth characteristic of zero-based budgeting strategy, all organizational levels are valued in the decision-making process. Thus, the coordination and communication will increase within each department and also makes the employees more motivated.
- Outsourcing opportunities: We already mentioned that zero-based budgeting opens up scope for various cost-effective solutions. So, if you find that you can save some money by not compromising on quality and productivity, then that opens up the new scope for outsourcing for better results.
What Are The Disadvantages of Zero-Based Budgeting
- Time expensive approach: Unlike incremental budgeting or other approaches, zero-based budgeting requires more time to be prepared. It’s simple to understand the reason; because everything needs to be prepared from scratch.
- Higher employment cost: For preparing a budget out of zero-based budgeting techniques, your finance department will require more employees. Every line item needs to be analyzed and justified without considering the previous budgeting period expenditures. So, that requires more people to get involved.
- Unpredictable income: Yes, having a variable income each month can stand as a problem here. For instance, if you are running a freelancing business, the amount of money to allocate can feature as a disadvantage there.
- Lack of skill: Zero-based budgeting is not an easy strategy to implement, it requires enough financial skill. So, adequate training of financial managers is necessary before adopting this new budgeting strategy.
Hope you must have got a fair idea about zero based budgeting benefits and drawbacks from the above listed points.
Zero-Based Budgeting Process
A zero-based budgeting process is a key way to create efficient and effective budgets. By using a zero-based budgeting system, you can ensure that your money is put towards what is most important to you, instead of wasting it on things that are not essential or necessary.
This will help you stay on track with your goals, and allow you to make informed and responsible decisions about where your resources should be focused.
Zero-based budgeting is a process that helps you stay within your budget and remain mindful of your needs. Beginning with a level 0 budget will help you focus on what’s most important and allow you to easily adapt necessary expenses to meet your goals.
One of the benefits of using a zero-based budgeting process is that you can track your spending and see how much money you’re able to save without having any negative consequences.
You could also use this system to create budgets for specific goals (e.g. getting in shape, car repairs, etc.) With a little creativity, you can come up with budgets that work for your individual situation and lifestyle.
Incremental Budgeting Pros and Cons
Incremental budgeting has several benefits, but it can also lead to problems in the long run. This method is more conservative than traditional budgeting methods, which reduce flexibility for companies. It limits a company’s ability to respond to changes and isn’t suitable for companies that are constantly growing and making rapid changes.
In addition, this method uses the budget set for the current fiscal year as a baseline for the next fiscal year. Because the organization is assuming that it will operate with the same budget, incremental budgeting is more suitable for organizations that don’t perform a thorough annual analysis to set a fixed budget.
Another negative side of incremental budgeting is that it discourages innovation. It encourages managers to spend the same amount of money year after year, and this can lead to overspending. It can also lead managers to manipulate budgets by overestimating revenue growth and underestimating expenditure. This is a problem because the variance between expenditure and revenue is a potential source of profit for managers. Incremental budgeting does not encourage innovation, which is vital in today’s business environment.
One of the biggest benefits of incremental budgeting is that it is quick to implement. Unlike traditional budgeting, this method does not require detailed analysis and can be implemented in a matter of minutes. In addition, incremental budgeting is best suited for programs that are expected to continue to be funded in multiple years. This way, there’s less risk of budget conflicts and the budget is more likely to run smoothly.
Criticism of Zero Based Budgeting
One criticism of zero based budgeting (ZBB) is that it can be easily manipulated by managers to over-promise and under-deliver. The reason why this happens is that managers base the budget on benefits that will be promised in the future but do not have to deliver them. The best way to ensure that people keep to their commitments is to create clear accountability by measuring results against original targets.
One of the best ways to improve the profitability of your business is to create a budget that starts with a zero balance. This budgeting process enables you to make changes to your spending over time. For example, you can replace banner ads with social media and reduce stationery costs by $12 a year by using electronic records. You can also save money on labor costs by combining redundant functions.
Using zero based budgeting can also lead to better accuracy in your budgets. This method forces departments to evaluate their operations and cash flow in order to determine which projects are most effective. The method also helps you find opportunities for cost reduction and eliminates duplicative activities. It also promotes greater transparency and improves communication among management teams.
People who use zero based budgeting find it easier to monitor their expenses. This method is especially beneficial for those who are new to managing money. It can help new budgeters who want to save for a vacation or pay for their children’s sports. Additionally, it can help those who need to set up an emergency fund.
Although zero based budgeting has its benefits, it also comes with some disadvantages. If you’re new to money management, zero based budgeting might be an ideal option for you. It will allow you to adjust your monthly expenses and set up an emergency fund, which is essential if you need funds for something unexpected. It also allows you to save for a vacation or for your kids’ sports teams.
In order to make the most of zero-based budgeting, you must monitor expenses closely. Creating the budget from scratch and justifying every element requires a significant time investment on your part. You’ll also need input from senior leadership and employees, which can take up valuable time. Another disadvantage of zero-based budgeting is that it rewards short-term thinking.
One disadvantage of zero-based budgeting is that it’s difficult to measure the benefits of each expense. However, this can be overcome with thorough analysis and the services of management consultants. Additionally, because zero-based budgeting is based on the cost and benefit analysis of a single period, the benefits of an expense may not be realized until several years after the expense is incurred. It’s important to consider these limitations before making a final decision.
Although zero-based budgeting can help you manage your finances, it can be difficult for people who have unpredictable income and variable expenses. If your income fluctuates wildly, you may want to avoid zero-based budgeting altogether. Instead, you can create an alternative budget that takes variable expenses into account.
One alternative to zero-based budgeting is to use a strategic plan to set goals and set spending based on those goals. It allows you to identify unnecessary expenses and align your spending with your business goals. A strategic plan can help you make decisions that will improve your growth and decrease your costs.
Another alternative to zero-based budgeting is to use a traditional budget. In a traditional budget, expenses must be less than or equal to income. A zero-based budget, on the other hand, requires that expenses match income. Moreover, it generally requires more detailed categories than a traditional budget. However, it may also include combining categories to make things simpler.
We hope that you have gained enough information regarding the zero-based budgeting methodology. Its main focus is on the actual expenses committed by a department or a state. It’s time-consuming and has other drawbacks too, but this is a perfect form of budgeting.
Lastly, it’s entirely a company’s decision whether it wants to invest time and manpower for adopting this newer budgeting process or it wants to stick to the easier traditional methods.
Thanks, take care!