Companies use different budgeting techniques to allocate capital and set forecasts for the future. Two of the most common techniques are zero-based budgeting and traditional budgeting, which exist on polar opposite sides of the spectrum.
Traditional budgeting
Simple by design, traditional budgeting processes are quick to implement, because it's all about tweaking prior-year budgets. If a company spent $10 million on labor in one year, it might try to spend only $10.5 million the next year, to account for a 3% increase in compensation and a 2% increase in workers, for example.
The advantage of a traditional budgeting system is that it's fairly easy to implement, because budgets are quickly approved based on the variance from the prior year's spending. Managers can spend more time running the business than planning on how to run the business.
The traditional budgeting process has a few shortfalls, however. Because the various business units of a company know that next year's budget will be based in part on current year spending, managers often adopt a "use it or lose it" approach to managing their department budgets. Fearing that thrift will result in a smaller budget next year, the traditional budgeting process encourages managers to spend every dollar they can before year end, even if it is spent on frivolous expenses or bad investments.
Likewise, the traditional budgeting approach often leaves the decision-making to the people who have little insight into a company's varied business units. Top management makes the decisions in a traditional budgeting system, whereas the managers of the individual business units probably have a much better vision of where the company should allocate its capital in the year ahead.
Finally, traditional budgeting encourages managers to consolidate several different projects into one larger group. A poorly performing project may be combined with an outperforming unit. Together, the two projects may appear to be very valuable to the business, when in reality one project is carrying the weight of another.
Zero-based budgeting
The biggest difference between zero-based budgeting and traditional-based budgeting is that capital isn't allocated to business units based on previous spending. Instead, zero-based budgets start at zero, with all business units inside a company competing for each dollar when the new budget is made.
The advantages are numerous. A zero-based budget, upon implementation, often reveals serious inefficiencies that are created by years of traditional budgeting. In addition, it also encourages managers to think about ways to minimize spending within their departments, rather than maximize their spending so that they can receive a larger budget the next year.
Projects are also carefully considered independently of one another, allowing a company to think about opportunities project by project rather than department by department.
Finally, managers of each department must request top managers for approval for their budgets. These managers are closer to the day-to-day events in their units and probably have a better view of where a company's limited resources can be invested in the next year.
The major downside with a zero-based budget is that it's more time consuming. Projects must be compared and contrasted, and finally approved, before being added to the annual budget. This can lead to an unhealthy situation where more time is spent arguing the case for each project rather than actually implementing a project.
In addition, another downside is that zero based budgeting favors business units that have readily measurable benefits to the company. A sales team has the job of attracting new customers and growing sales. Support teams have the job of retaining dissatisfied customers. It's much easier for a sales team to quantify an increase in sales than it is for a support team to quantify how many customers it retained, for example.
According to management consulting firm McKinsey & Company, zero-based budgeting is becoming increasingly popular among publicly traded companies, noting that more companies are referring to the process in their earnings reports and conference calls. The consultancy firm wrote that 45 years after the concept was first invented, zero based budgeting "seems likely to stick: the new incarnation is more likely to become a widespread norm than to fade into the ether."
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