Zero-Based Budgeting- The Future of Budgeting?

What is zero based budgeting (ZBB)?

Among the various budgeting disciplines, zero-based budgeting (ZBB) is one very useful technique that can help an organization reduce expense bloat and lean out its operations. The foundation of zero-based budgeting is built on the premise that each functional area of an organization starts with a “zero-base” and must justify each expense as its various needs and costs are analyzed. As needs and costs are identified they are then layered into the budget.

In this way, the approach disregards previous periods’ budgets and instead is built around the needs of the upcoming period only. This is critical to understand because it varies so much from other types of budgeting processes which often take much less time. It is an extremely detail-oriented process, a rolling process that often takes place over a period of years. The goal of zero-based budgeting is to lower costs. If you think about this logically, it makes sense—rather than making increases or decreases that are estimated and occur in a sort of “blanket” format where there may be excess resources allocated to departments that don’t need the resources allocated to them, or worse, departments that are in serious need of funding are not able to get the resources they need, departments tend to get exactly what they need—no more, no less.

Benefits of Zero-Based Budgeting

Because each cost and need are scrutinized, a zero-based budget is highly detailed. As a result, the zero-based budgeting process may be rolled from period to period and can help to reduce costs by ignoring blanket increases that are often incorporated into traditional budgets. Because it avoids overarching increases it reduces the chance that departments will “burn” cash to not have their budgets reduced in the following periods.

An effective zero-based budget can help to create operational efficiencies to support growth because it is a forward-looking plan that helps to reduce costs associated with outdated operations.  

One major benefit is that managers attempting to implement strategic goals into the budget can directly marry the goals to specific functional areas and then measure identified cost and needs against previous results and expectations. In short – it helps to bring a company’s spending behavior in-line with its strategic goals, keeping managers accountable for their department’s spending. The value of this is hard to overstate. It’s a long-running joke in many organizations and firms that certain departments get far more than they need and are able to spend as they please while others are constantly strapped for cash. This can lead to a feeling in some departments of favoritism, which in turn can lead to resentment in some departments that they aren’t getting the resources they need while other departments can become wasteful and complacent.

Drawbacks of Zero-Based Budgeting

As departmental needs are identified and each cost assessed, the zero-based budget process grows. As stated before, it is an extremely detail-oriented process that can be done over a period of several quarters or even years. It can take much longer than a traditional budget and might consume a great deal of resources to complete. This cost is something to consider as the back office may become far more expensive to operate than the organization or firm can afford.

Another drawback is that the approach tends to bias departments that generate revenue directly. The reason for this is that the cost associated with revenue-generating departments is more justifiable than strict cost-centers. Again, this can cause serious problems within an organization when resentment or fear begin to accumulate. One has to carefully consider both the benefits and drawbacks of such an approach before implementing either type of budgeting. Generally speaking, zero-based budgeting is not the first option that organizations want to choose until lean processes become necessary to cut costs for one reason or another.

Adopting a Zero-Based Budget Over a Traditional Budget

The most obvious reason a finance manager might elect a zero-based budget over a traditional budget is to “reset” a budget. Over time, traditional budgets can become bloated with departments having been granted increases in their spending allowances regardless of their actual behavior. By justifying both old and new expenses a zero-based budget can reveal departments with a bloated budget and help to realign a department’s expenses to a more reasonable level.

Another reason an organization might adopt a zero-based budget is to help identify and justify old, recurring expenses in addition to new expenses. A traditional budget only looks forward, attempting to justify new expenses. By analyzing old expenses, a department might be able to identify areas where cost can be reduced or consolidated.

 Finally, as opposed to a traditional budget, a zero-based budget puts the responsibility of justifying expenses onto the managers of each department. In this way, it can provide a great deal of value by attempting to optimize costs in addition to revenue.

Creating a Zero-Based Budget

There are five key processes to zero-based budgeting:

The first is to create a new budget from scratch, beginning at zero.

Next, evaluate every cost area, eliminating and reducing activities or processes that are no longer needed. In some cases, this may mean consolidating activities with other business units that might perform similar tasks or use similar resources.

After all the costs have been evaluated, it is time to justify each one, accounting for each piece of the budget as you do. Diligently identify each area that is effectively managing cost or that is relevant to the business.

Once the necessary cost and activities have been identified, it is important to determine which activities should continue to be performed. In this phase, care should be taken to identify areas that may be automated or standardized.

Finally, implement the budget by communicating a clearly defined plan of action. Be sure to clearly identify roles and responsibilities.