Zero Based Budgeting: Definition, Benefits and How to Create
Zero-based budgeting is useful for managers to keep in check how and where the money is going. Although this is a helpful method for tracking and controlling expenses, it has some drawbacks as well as benefits.
Keep reading further to know more about the zero-based budgeting system.
What Is Zero-Based Budgeting?
Zero-based budgeting is a budgeting technique which is used by companies to keep close track of all their expenses. This is done from "zero-base" or scratch. It is reviewed periodically and focuses on expenditures which are absolutely necessary. A new budget is created for every new budgeting period regardless of the scale of the previous budget.
How to Create a Zero-Based Budget?
Accounts/fund managers generally consider these steps while using the zero-based budgeting system:
Step 1: Commencement of a task
This is the base from where one starts their zero-based budgeting, without any influence from the previous period's budget.
Step 2: Identification of departments or areas
An organisation works with the joint effort of multiple departments. All these departments need to submit their reports on upcoming expenses and how much budget is required.
Step 3: Breaking down and segmenting the units
The departments are further segmented into smaller units for the ease of allocation of funds. They have to submit an appeal stating their goals which should align with the company's final objective and requirement of funds.
Step 4: Sorting the units
After submission of all the appeals, they are sorted depending upon urgency and priority. This is done following the cost-analysis method. The idea is to remove any chance of flawed allocation of funds which would later create a scarcity of resources.
Step 5: Distribution of resources
In this step, managers allocate funds as per the sorted list considering the previous step. The most innovative and urgent goals get the foremost priority.
Step 6: Supervising and monitoring
In the final step, the management monitors the units’ operations and analyses the driven results. This is to check if the allocation of resources was carried out justifiably.
What Is the Use of Zero-Based Budgeting?
Zero-based budgeting is like a rest button for a company’s budget. It deletes all the previous data and starts afresh. This method is strategic and cost-effective. It can prove to be beneficial at times when a company needs to get their fund allocation on the right track or if there is over-staffing or over expenditure.
Zero-based budgeting helps a company to identify if there is a flaw in resourcing and rectify the same. It is also a very good option for start-up companies that have limited fund availability.
Example of Zero-Based Budgeting
To understand the concept of zero-based budgeting, you might consider going through the example given below:
Suppose there is a bookstore which has been doing quite well in the market for the last few years. Now the owner has decided to keep up with technology and give his store an online presence.
E-commerce is a fast-growing space and has heavy competition. The previous strategies might not work for his business anymore. A zero-based budget would be the ideal strategy for his business as there will be new aspects to be taken into consideration.
Some of the core areas to which he should pay attention are staffing, marketing, advertising and rent.
Supposedly, he paid rent of Rs.30,000 per month for the 3 outlets; he can save a lot from this now. Also, he can cut down on the staffing cost for the same reason.
But, there would be higher costs involved for marketing and advertising, which can get challenging. Hence, zero-based budgeting will be ideal for such a situation. He can start again from scratch at the beginning of the next budgeting period and allocate the funds to different departments as per their needs.
Zero-Based Budgeting vs Traditional Budgeting
Traditional budgeting is the most widely used budgeting technique. The following table will take you through the differences between traditional and zero-based budgeting:
Calculation involves the previous period's budget.
The calculation does not involve any influence from the previous budget and is done from scratch.
Influenced by numbers of the previous budget.
Considers current financial requirements.
Perspective depends on historical data.
Perspective depends on estimated data.
Orientation is based on accounting.
Orientation is based on units and their goals.
The final decision is mostly influenced by whoever makes the previous budget.
The final decision is in the hands of the upper management.
Caters to all the departments in an organisation collectively.
Focuses on the departments that have the potential to make profits.
What Are the Advantages of Zero-Based Budgeting?
Zero-based budgeting has multiple advantages. Following are some of the ways it can benefit a company:
- Precision: Unlike other budgeting methods, it makes each department take a look at its goals and expenses individually. This leaves less room for flaws and more for rectification. This, in turn, also helps reduce costs and saves resources.
- Orderliness: It helps in the proper allocation of funds and resources of the company and makes sure that they don't go to waste. Sorting and prioritising the units also help in maintaining the orderliness of the objectives.
- Budget inflation: Since zero-based budgeting starts from scratch and focuses and prioritises the goals, it helps in reducing the risk of budget inflation.
- Collaboration: As it includes all the departments but segments them in an orderly manner, it helps each department to communicate with each other and improves collaboration among every unit.
What Are the Disadvantages of Zero-Based Budgeting?
Apart from the lucrative advantages that zero-based budgeting offers, some may find it tedious due to the following disadvantages:
- Time-consuming: This can prove to be a very time-consuming task for companies with huge funds. Starting budgeting from scratch at the beginning of every budgeting period can get complicated.
- Requires skilled human resources: Zero-based budgeting is a complex task which requires skilled and knowledgeable individuals, which may not be available to every company.
Zero-based budgeting focuses on more justifiable and accountable use of resources. Though it can be time-consuming and complex, it is a more appropriate way of budgeting. However, it depends on the company and its circumstances whether to go with zero-based budgeting or the traditional budgeting method.