Zero-based budgeting is a way for a company to cut costs and become much more efficient. In zero-based budgeting (ZBB), every expense must be justified before allocating dollars to it. This article will cover how zero-based budgeting works, how it compares to other types of budgeting, and the best scenarios to take advantage of it.
The way ZBB works is that each department begins with a budget of $0, or a zero base, which can only increase after every function of the company has been analyzed. Once a company’s needs and costs have been analyzed from all levels, only then will budgets increase from zero.
Zero-based budgeting contrasts greatly from other forms of budgeting. Often, each department in a company will receive the same budget each period and will decide how to allocate that budget. With zero-based budgeting, it does not matter how much the allocated dollars differ from period to period.
What Is a Budget?
A budget is determined by how much a company is expected to earn, how much is necessary to spend to reach those earnings, and what your expected profits are after expenses.
Types of Budgets
There are generally four ways that a company will create a budget: incremental-based budgeting, activity-based budgeting, value proposition budgeting, and zero-based budgeting. Of these four, zero-based is the most detail-oriented and time-consuming, but it may also be the most efficient.
Many companies simply take the incremental budgeting approach, as it is the easiest. With this type of system, a percentage of last year’s budget is added or subtracted in the new year. If costs stay relatively steady, incremental-based budgeting may seem to make sense. But there are many underlying problems that can make this system extremely inefficient.
Activity-based budgeting and value proposition budgeting take more details into account when arriving at a number. But only zero-based budgeting strips away all the noise and leaves a company to budget only the essential expenses for each department to operate.
How Does Zero-Based Budgeting Work?
Zero-based budgeting will work effectively for young companies or companies that are looking to reduce expenses. It may also be a rolling process for well-established companies that target a few different departments each year. Zero-based budgeting is also a perfect tool for small businesses that have fewer expenses to consider, making it a more viable option to use consistently than in a larger company with many more moving parts.
With zero-based budgeting, every single expense needs to be justified upfront. The problem with this can be unforeseen costs and unexpected changes that are inevitable throughout the year. To successfully pull off zero-based budgeting, a company needs every last employee to contribute. Each aspect of the business must plan in advance what they will need throughout the budget period. Once those estimations are in place, then they must be approved as necessary expenses.
Here are the general steps to take when undergoing a zero-based budgeting strategy:
- Step 1 – Identify goals for the given period
- Step 2 – Figure out how those goals can be achieved
- Step 3 – Find new ways to fund business practices
- Step 4 – Prioritize which practices should be funded first
By taking these steps, a company can fully understand what is necessary to achieve each goal. Once the highest priority practices are determined, then a company can find new ways to spend or save its excess cash.
Rather than a budget staying steady each period, with small increases or decreases based on the previous budget, your new budget may vary widely from period to period. One budget might be $100,000, while the next is $50,000.
When to Take Advantage of Zero-Based Budgeting
Although zero-based budgeting is an effective way to cut costs and increase efficiency, it is a time-intensive process that likely cannot be a company’s sole way of budgeting. A busy small business owner may not have the time to create new budgets from scratch multiple times per year. On the other hand, a small business with not too many working parts may benefit significantly by taking the time to use zero-based budgeting.
For larger companies, it is not realistic to use zero-based budgeting as the primary way to determine expenses. There are simply too many working parts in a large company to start from scratch with a budget that requires the cooperation of many different employees and approvals. Every few years, though, creating this type of budget can be an effective way to place checks and balances on current budgets and discover ways to save money or use it more efficiently.
The perfect place to start with a zero-based budget is with a startup company that has no previous numbers to work with. Not only will creating this type of budget teach you valuable skills, but it can also ensure that a company gets off on the right foot.
For existing companies, the best reason to try a zero-based budget is when you need to cut costs and are not sure how to do so. Zero-based budgeting forces you to only focus on what is essential and trim away excess costs. It also reveals to a company exactly where each dollar is going and how to prioritize expenses. Due to the labor-intensive nature of this type of budgeting, it’s likely not a sustainable process to continue year over year. But by using a zero-based budget every few years, it can be the perfect way to periodically stay on track with expenses.
What’s Wrong with Traditional Budgeting?
The problem with a traditional budget that is based on the previous year’s numbers is that most managers will be happy to take an increase regardless of how necessary it is. A manager is concerned first and foremost with their own department. If the department looks good, the manager maintains his or her job and likely continues to receive pay increases and bonuses. To make a department look good, some managers may overestimate the budget they need, in order to consistently stay under that budget.
Bottom Line on Zero-Based Budgeting
For companies with large departments and several different managers, zero-based budgeting provides an excellent system of checks and balances to cut costs. And for startups or small businesses without too many working parts, ZBB can be the perfect way to set an initial budget.