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What is Zero-based Budgeting: Advantages & Disadvantages

Zero-Based Budgeting means starting from zero every time you plan a budget and it could be a way to keep a closer eye on your businesses finances.

Why do companies go through the budgeting process?

The budgeting process is one of the most important planning tools of any finance professional. It helps you lower costs by asking stakeholders to justify expenses, improve your cost management by comparing the new budget to previous budgets, and allows you to evaluate the current expectations of income and plan around that.

It's not an easy process and the more detail that you can pack into your budget, the clearer the financial picture you will be able to paint. For example, extra expense categories will allow you to really pinpoint your planned spending and drive cost savings in your business. This is why it's often recommended to get a certified financial planner to help with your budgeting.

There are several different ways to create a budget and, although they are all basically variations on the same concept, it can be tough choosing the right budgeting method for you. Think about what your biggest worries or priorities are as a company? What are your cost drivers? Are you more concerned about cutting costs, increasing savings, or increasing monthly income? Asking yourself these sorts of questions will help you choose which method to choose for budgeting for the new period.

What is a Zero-Based Budget and how does it work?

Zero-based budgeting (ZBB) is a technique for financial planning that starts from zero every time you plan a budget rather than from the closing figure of the previous period, as with traditional budgeting. This technique has been used in many companies and government organizations to create more transparency in their finances because the zero-based budgeting process for every function of a business starts from zero dollars at the beginning of a new period.

This means that every expense for anything must be justified. If a department wants to spend a certain percentage of their budget on an expense they must break down what they're using it for, why, and what the return is going to be for the company. Every dollar is accounted for.

This budgeting method is usually chosen by organizations that are looking to cut costs and expenses. Maybe the previous results of their budgeting or cost-cutting haven't proved to be an effective approach for them. Zero-based budgeting (ZBB) gives them a structured approach to cutting expenditures.

Let's say that the new financial year is starting for a software sales business. Each of the different specific functional areas (sales, development, HR, ops), through a review process, must ask for the money that they need for the next year. They must be able to account for the money that they're investing in the services and resources that they need. But how does is this idea different from how most companies budget?

How Does Zero-Based Budgeting Differ From Traditional Budgeting?

Most budgets start from the previous period's budget and go from there. Maybe they need to adjust for inflation, maybe there are some known increased expenses, or maybe they cut costs in the previous year; you factor in what you know and adjust from the previous year. Then from there, it's a top-down approach. You have $X to spend, how do we split that between all of the different services and resources that we need for the year.

Zero-based budgeting starts from the zero base and builds from there. Once you have accounted for every expense and cost that you might have over the period, you'll have the final budget figure that needs to be worked to across the period.

What’s are the Advantages of Zero-Based Budgeting?

  • A zero-based budget is more accurate than a traditional budget as it is re-evaluated every period.
  • A zero-based budget isn't based on the assumption that just because something was used in the previous period, it will be used again, and that it returned the desired results. Zero-based budgeting means that everything is examined and things that aren't useful are cut from the budget.
  • If you’re new to managing money, this can be a great way to make sure money doesn’t run away from you or even find some pots of money that can easily be saved

What are the Disadvantages of Zero-Based Budgeting?

  • Zero-based budgeting can be more time-consuming in the short term until the process is practiced and you've got the hang of it.
  • If you manage staff or have multiple departments who have to manage this then this increased time consumption is passed onto them and may impact their productivity.
  • An error at the beginning of the year could lead to knock-on effects or deficits later on as, because any money in the budget is associated with an expense, the budget could be derailed.

How to implement Zero-Based Budgeting in your business

Step 1 - Start at zero

This one shouldn't come as a surprise. Don't come into the process with pre-conceptions or "essentials". This is zero-based budgeting, not "a little bit based budgeting".

Step 2 - Evaluate your expenses

Evaluate every cost that the business has. Get rid of anything that isn't necessary or isn't bringing in the value that it should.

Step 3 - Justify the costs

Take a look at what's left and justify these costs. Are they bringing in the return that they should be? Are there cheaper/better alternatives out there? Are these costs getting bloated?

Step 4 - Put the plan into action

Communicate what has been decided and roll out the processes to the appropriate stakeholders. Stick to the budget!

Step 5 - Do it again next period

The key to this process is that it is iterative. As soon as you choose not to do it, you're then not zero-based budgeting, because you're using the last period's budget. Always start from zero!

Zero-Based Budgeting FAQs?

Who introduced zero-based budgeting?

Zero-based budgeting was introduced in the 1960's by Peter A. Pyhrr. He published an article in the Havard Business Review in 1970 and the concept took off from there!

Which known companies use zero-based budgeting?

Walgreens Boots Alliance, Philip Morris International, and Unilever are among the 1000's of companies worldwide that use zero-based budgeting.

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