While some budgets are drawn with broad strokes, zero-based budgeting whittles the process down to its finer details. Keep reading to learn the meaning of zero-based budgeting, and when it’s best applied.
The meaning of zero-based budgeting
Zero-based budgeting is a method used by businesses to apply greater scrutiny to every expense. At the beginning of every financial period, the budget starts from a ‘zero base,’ which means that no expenses or balances from the previous period are carried over.
A zero-based budget requires that all expenses be justified for the period in question. Justified expenses and financial requirements are input into the budget, disregarding whether the budget was higher or lower before this start date. When the business moves on to the next accounting period, the budget returns to its zero base.
Zero based vs traditional budgeting
With traditional budgeting, only new expenditures are analysed. By contrast, zero-based budgeting starts fresh each period with its ‘zero base’ and is more detail-oriented as a result. This ensures that even recurring expenses are given proper scrutiny and justification. For businesses on a tighter budget, this can help cut unnecessary costs. There’s also a greater focus on value with zero-based budgeting. Managers are required to justify each expense with an analysis of how it will add value to the organisation.
For example, imagine a company manufacturing electronics equipment. It normally purchases a certain part from an outside vendor, but this vendor raises its prices by 3% each year. Under a traditional budget, the electronics company might simply choose to raise its budget with a blanket 3% to cover this cost. However, a zero-based budget requires the company to look at the issue more closely. It may find that the blanket increase can’t be justified because the part can be manufactured in-house or purchased at better value from another vendor.
As you can see from the example above, cost-based budgeting assumes that the previous expenses were justified and necessary. A zero-based budget must justify the expense anew each period, leading to new solutions that could provide better value.
How to create a zero-based budget
Although it might seem far more complicated than a traditional cost-based budget, the process is straightforward.
At the start of a new accounting period, identify your business goal. Whether this is cutting costs or increasing revenue, it should be measurable.
Brainstorm actions to achieve this goal, reviewing each in terms of efficiency and resources.
Document the costs needed to implement the actions you’ve selected. Evaluate all of the other expenses necessary to operate your business for the upcoming period, adding in the new essential costs for your goal.
Implement your new tasks and follow the budget.
At the conclusion of the budgeting period, examine all measurements (revenue, cash flow, sales figures, etc.) to determine if the goal has been met. You can then evaluate the process before returning to the zero base to start the process anew in the next period.
Zero-based budgeting pros and cons
A zero-based budget can be a useful tool in business, but it’s not ideal in every situation. Here’s a little more information and the pros and cons of zero-based budgeting.
Advantages of zero-based budgeting
Businesses can test a new strategy over a fixed time period.
Business owners can fine-tune implementation plans.
Zero-based budgets identify areas of inefficiency or wasted money.
The process can reduce costs for daily operations, allocating resources only when necessary.
Disadvantages of zero-based budgeting
Business departments that don’t produce measurable revenue can be overlooked, as it’s more difficult for these to justify their expenses.
Zero-based budgeting is more time-consuming than cost-based budgeting.
It can cost more money to implement, potentially cancelling out the money saved.
Overall, there are pros and cons to the process, but a zero-based budget can potentially increase sustainability and accountability in business.
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