This article explains Zero Based Budgeting in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is Zero Based Budgeting?
Zero based budgeting is a reverse approach of traditional planning and decision making with respect to budgeting.
In traditional budgeting, managers begin by reviewing the budget of the previous year and make corrections (in revenue and expenditures) based on performance expectations.
The budget of the previous year is consequently considered to be the baseline (starting point). In zero based budgeting all managers are required to justify all budgeted expenses, not just the changes in the budget of the previous year. The baseline in zero based budgeting is not last year’s budget but “zero”.
This financial management approach requires much documentation and justification.
In addition to the total budget, the manager responsible must identify all expected expenditures and rank all of the activities according to their relevant importance and costs.
The persons ultimately responsible (high-level managers) can make decisions about investments and budget cuts that can be justified at all times based on their supporting information and no immediate pre-financing as is the case in the traditional manner of budgeting.
This type of budgeting usually occurs in the government and non-profit sectors. The philosophy behind zero based budgeting is good.
However, it should be noted that zero based budgeting requires frequent reviews. In zero based budgeting reviews are carried every year on account of the fact that it is a time-consuming and costly process.
Interim reviews can be carried out but that is the organization’s choice with respect to time and priority.
Zero based budgeting advantages
Zero based budgeting has the following advantages:
- Efficient allocation of resources, as it is based on needs and benefits.
- This approach drives managers to find cost-effective ways to improve activities.
- This approach detects inflated budgets.
- It is useful for service departments because criteria are not always easy to identify.
- It increases staff motivation because it gives them more initiative and responsibility in the decision-making process.
- This approach increases the communication and coordination within the organization about certain decisions.
- This approach identifies and eliminates wastage and out-of-date operations.
- This approach identifies opportunities for outsourcing.
- This approach forces cost centres to link their mission to the related organizational objectives.
There are also disadvantages to the application of zero based budgeting:
Sometimes the necessary expenditures are hard to define for managers as a result of which it becomes too time-consuming and exhaustive a process to arrive at a solid foundation with respect to the decision-making about the investment.
This approach forces staff (especially managers) to justify every detail related to the expenditures.
For instance, because the R&D department cannot completely underpin their intended innovation, this could have advantages for the budgeting of another department because they are able to justify their expenditures in great detail.
In order to apply this approach appropriately, it is necessary to train managers well. For zero based budgeting to be successfully implemented, managers at all levels of the organization must understand how zero based budgeting works in the organization as they are ultimately responsible for the management, decision-making and the communication of entire process.
Awareness for details
As the volume of the required data and forms is very large in zero based budgeting, no one is capable of knowing every detail of its content and decisions.
There is a risk to compressing information and details because this might remove critically important data. This is a large risk.
Honesty and consistency of the managers must be reliable and uniform. Any manager that exaggerates affects the results negatively.
It’s Your Turn
What do you think? Is the zero based budgeting method applicable in today’s modern companies? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for a good zero based budgeting set up?
Share your experience and knowledge in the comments box below.
- GFOA. (2011). Zero-Base Budgeting Modern Experiences and Current Perspectives. Government Finance Officers Association (GFOA) Research and Consulting Center. Chicago.
- Kong, D. (2005). Performance-based budgeting: the US experience. Public Organization Review, 5(2), 91-107.
- Pyhrr, P. A. (1973). Zero-Base Budgeting: A Practical Management Tool for Evaluating Expenses. Wiley.
- Schick, A. (1978). The road from Zero Based Budgeting. Public Administration Review, 38(2), 177-180.
- Wholey, J. S. (1978). Zero base Budgeting and Programme Evaluation. Rowman and Littlefield.
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