Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified for each new period. The process of zero-based budgeting starts from a “zero base,” and every function within an organization is analysed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether each budget is higher or lower than the previous one.
Unlike the conventional approach to budgeting, you don’t have any benchmark budget to compare with in the case of a Zero-based Budget. As the name suggests, here the budget technically starts from zero. This kind of a budget requires you to justify every associated cost before adding it, thereby helping you check unnecessary and unexplained expenditure that could be denting your finances. A new budget will have to be prepared with the start of a season.
More consolidated and planned, the significance of this approach lies in the fact that it enables you to realize and verify the value of every single expense before it is accommodated in the budget. Past trends, sales and expenditure are not expected to continue and hence, not carried forward. Here, no expenses are pre-committed and the budget is built with zero-basis.
Example of Zero-Based Budgeting
Suppose a company making construction equipment implements a zero-based budgeting process calling for closer scrutiny of the expenses in its manufacturing department. The company notices that the cost of certain parts used in its final products and outsourced to another manufacturer is increasing 5% every year. The company has the capability to make those parts in-house and with its own workers. After weighing the positives and negatives of making the parts in-house, the company finds that it can make the parts cheaper than the outside supplier.
Instead of blindly increasing the budget by a certain percentage and masking the cost increase, the company can identify a situation in which it can decide to make the part itself or buy the part from the external supplier for its end products. With traditional budgeting, cost drivers within departments may not be identified, while zero-based budgeting is a more granular process that aims to identify and justify expenditures. Zero-based budgeting is more involved, however, so the costs of the process itself must be weighed against the savings it may identify.
- Accuracy of costs and better cost management
This type of budgeting forces every department to reconsider various items of the cash flow and compute their operation expenses, thereby providing an accurate estimation of costs. Clear understanding of all the expenses across different categories allows better cost management as well.
- Allocation of resources
Since Zero-based budgeting looks at the actual numbers for the upcoming time period and not the past data, you get an accurate estimate regarding the allocation of resources.
- Less redundant expenditure
One of the benefits of putting every cost under the scanner is that it helps you separate the most important ones from the near wasteful expenses. This makes it easy for the organization to identify and root out all unproductive activities while curbing wasteful expenditure.
- Know where the money is going
Since Zero-based budgeting warrants a careful evaluation of every cost category, insiders in the organization know the exact whereabouts of every unit cost – from the total amount expended to the department such costs are allocated to.
As a business owner, you will have to factor in every cost while budgeting and planning your finances for the next season; and Zero-based budgeting can help you do exactly that. Should you want to expand your operations and propel your business to the next level of growth and productivity, Business expansion loan from Reliance Money can help you in your end eavours.
This helps in efficient allocation of resources (department-wise) as it does not look at the historical numbers but looks at the actual numbers.
- Coordination and Communication
It also improves coordination and communication within the department and motivates employees by involving them in decision-making.
Zero-based budgeting is a very time-intensive exercise for a company or a government-funded entities to do every year as against incremental budgeting, which is a far easier method.
- High Manpower Requirement
Making an entire budget from the scratch may require the involvement of a large number of employees. Many departments may not have an adequate time and human resource for the same.
- Lack of Expertise
Explaining every line item and every cost is a difficult task and requires training the managers.
Zero-based budgeting aims at reflecting true expenses to be incurred by a department or a state [in the case of budget making by the government]. Although time-consuming, this is a more appropriate way of budgeting. At the end of the day, it is a company’s call as whether it wants to invest time and manpower in the budgeting exercise to provide more accurate numbers or go for an easier method of incremental budgeting.