Zero-based budgeting is a process that allocates funding within an organization to expenses based on current needs and efficiency, not the budget history. In traditional budgeting, businesses will increase or decrease funding based on prior expenses. Zero-based budgeting requires managers to justify all expenses to receive funding.
What is zero-based budgeting?
Zero-based budgeting scraps any previous budgets, focusing on the factors that are driving company success now. It starts with a "zero base," where every program and expense isn't allocated anything. Management determines a budget based on how efficiently it believes a certain expense will drive results for the business.
A business can apply zero-based budgeting to any type of expense -- operating expenses, capital expenditures, or cost of goods sold. The idea is to allocate the budget in a way that ultimately makes the most of what it has to spend in a given period.
How zero-based budgeting works
Zero-based budgeting requires management to identify strategic goals for the upcoming budgeting period and then allocate resources that best achieve those goals.
For example, if a company's primary focus is growing its revenue, it will allocate a lot of money to sales and marketing expenses. It may also need to budget for higher cost of goods sold if its product or service doesn't scale effectively.
On the other hand, if a company wants to improve its operating margin, it will look to find ways to cut operating expenses. It might also look to improve efficiencies in its supply chain, driving down the cost of goods sold.
Managers must justify every dollar in the budget, identifying how it drives the business toward its strategic goal for that period. If a dollar doesn't move the business closer to its goal, it might be cut. That can drive meaningful cost improvements and better results for the business.
Zero-based budgeting vs. traditional budgeting
Traditional budgeting typically takes the previous budget and makes incremental adjustments to each item. It focuses on the best way to allocate the increase (or decrease) in the budget instead of how best to allocate the total budget.
In other words, traditional budgeting is focused on what to remove; zero-based budgeting is focused on what to keep. This can result in significant cost cuts when moving from a traditional budget to a zero-based budget.
Traditional budgeting may focus on existing activities. Zero-based budgeting may push managers to come up with new solutions to problems that are a more effective use of money than current activities. For example, management may outsource or in-source certain activities when they move to a zero-based budget.
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Advantages and disadvantages of zero-based budgeting
Not every business adopts a zero-based budgeting system, and with good reason. There are a lot of pros and cons for zero-based budgeting. Here are some advantages and disadvantages.
Advantages
- Forward-looking. Since zero-based budgeting scraps the previous budget, it's only looking at what will drive future results for the business.
- Increased accountability. Managers are forced to justify expenses, which makes them accountable for driving results within the budget they're allocated for certain departments or projects. They need to produce results this year to receive a similar or greater allocation next year.
- Challenges assumptions. A zero-based budget can drive management to come up with new solutions to problems instead of doing things the same way they've always done them. It can also improve collaboration across teams catalyzed by a common strategic goal.
Disadvantages
- Overly focused on short-term results. Since zero-based budgeting is focused on strategic goals and measurable results within a given budgeting period, it deemphasizes areas that don't support those short-term goals. For example, research and development are essential for the long-term success of many businesses, but the expense is a drag on operational efficiency in the near term.
- Expensive. Zero-based budgeting requires a lot more time and resources than traditional budgeting. Management reviews every line item, asks for proposals from department heads, and builds an entirely new budget from scratch. Management needs to expect the benefits to outweigh the upfront costs before moving to a zero-based budget.
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