What Is Zero-Based Budgeting?

What Is Zero-Based Budgeting?
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Zero-based budgeting is a method of budgeting typically used in the governmental sector as well as in public/private businesses. Unlike the top-down concept of traditional budgeting, a theoretical zero-based budget is built on the assumption that the expenditure base line is $0, and each budgeted expenditure will have to be justified in order for that base line amount to increase. In reality, companies will have a minimum baseline budget, and any additional increases in that amount must then be justified in order to be approved and added to the budget.

Zero-based budgeting is advantageous in many ways. Its used to effectively allocate an organizations resources, as a zero-based budget focuses on the vital goals and initiatives, ultimately eliminating the spending of money in unnecessary and/or obsolete aspects of business. Along these lines, the various departments of an organization are then guided in identifying what their separate mission/goals are in order to prevent any redundant activities carried out in two or more departments. Additionally, it encourages managers (as well as other individuals involved in the establishment of a zero-based budget) to consider various methods of accomplishing the same goal (e.g. Outsourcing) in order to find better, more cost-effective ways. A zero-based budget also prevents any artificial inflation in the budget; as such changes will be easy to spot. As a zero-based budget requires extensive reviews and considerations, it helps the heads of organizations understand where cash outflows occur. This information aids in future budget constructions as well as in comparisons against performance expectations.

To establish a zero-based budget, a company/organization will have to re-state the vision(s) of the business and consider what initiatives and resources will be needed in order to maximize success in the market. The company will then have to identify the steps needed to achieve its goals and brainstorm over various alternative methods that can be used to accomplish each goal. Justification of activities and where the money is going into being necessary in order to generate an accurate zero-based budget. It must be noted that cash outflow includes both major and minor expenses it is easy for large organizations to forget or choose to forgo including expenditures such as providing employees with a free bottle of water per day, but the cost of that bottle per person will add up to a considerable amount over time.

The degree of cost reduction is entirely dependent on the organizations goal (which can be constantly altered over time). For example, if the total reduction target of Organization A is to have a 10% reduction in overall expenditures, the visible changes in cost reduction will not be as evident as compared to that of another company that has a 25% total reduction target. Zero-based budgeting can be tailored to apply to any type of cost, and if there are variable costs involved, adjustments will have to be made to the budget monthly (or a time period decided on by the company) in order to reflect the correct, required budget.

A simple example of a zero-based budget is as follows:

Company A spent $10 million in the year 2014. Under a traditional budget, the company heads may choose to cut back on their expenditures by 5% in the next year, effectively eliminating $500,000 from any expenditure category of their choice. Under a zero-based budget, however, the company will start with $0 in funding, and after thoroughly going through the various categories of expenditures, may end up with a budget that can be either lower or higher than the $10 million spent in the previous year. Regardless, the amount established by the zero-based budget is reflective of the companys actual needs in the coming year. If the budget is undesirable, changes can be made to each justified expense, and alternative methods can be implemented in an effort to further reduce the amount spent.

Summary

Despite a zero-based budgeting being more time-consuming and requiring more effort to implement as compared to traditional budgeting, it can lead to a considerable amount of sustainable savings. Companies, organizations, and governments that operate under a zero-based budget will see a strengthening in their cost management abilities, as a zero-based budget provides them with accountability at all levels of expenditure. Moreover, working under a zero-based budget will see a substantial if not a complete removal of unproductive costs, thus allowing the amount saved from these areas to be redirected into more productive areas that will help support future growth.

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