Zero-base budgeting

Overview of Zero-Base Budgeting

A zero-base budget requires managers to justify all of their budgeted expenditures. This is opposed to the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. Thus, a manager is theoretically assumed to have an expenditure base line of zero (hence the name of the budgeting method), no matter what the actual budget was in the prior year.

In reality, a manager is assumed to have a minimum amount of funding for basic departmental operations, above which additional funding must be justified. The intent of the process is to continually refocus funding on key business objectives, and terminate or scale back any activities no longer related to those objectives.

The basic process flow under zero-base budgeting is:

  1. Identify business objectives

  2. Create and evaluate alternative methods for accomplishing each objective

  3. Evaluate alternative funding levels, depending on planned performance levels

  4. Set priorities

The concept of paring back expenses in layers can also be used in reverse, where you delineate the specific costs and capital investment that will be incurred if you add an additional service or function. Thus, management can make discrete determinations of the exact combination of incremental cost and service for their business. This process will typically result in at least a minimum service level, which establishes a cost baseline below which it is impossible for a business to go, along with various gradations of service above the minimum.

Advantages of Zero-Base Budgeting

There are a number of advantages to zero-base budgeting, which include:

  • Alternatives analysis. Zero-base budgeting requires that managers identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business.

  • Budget inflation. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot.

  • Communication. The zero-base budget should spark a significant debate among the management team about the corporate mission and how it is to be achieved.

  • Eliminate non-key activities. A zero-base budget review forces managers to decide which activities are most critical to the company. By doing so, they can target non-key activities for elimination or outsourcing.

  • Mission focus. Since the zero-base budgeting concept requires managers to link expenditures to activities, they are forced to define the various missions of their departments – which might otherwise be poorly defined.

  • Redundancy identification. The review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where management wants it to be centered.

  • Required review. Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically.

  • Resource allocation. If the process is conducted with the overall corporate mission and objectives in mind, an organization should end up with strong targeting of funds in those areas where they are most needed.

In short, many of the advantages of zero-base budgeting focus on a strong, introspective look at the mission of a business and exactly how the business is allocating its resources in order to achieve that mission.

Disadvantages of Zero-Base Budgeting

The main downside of zero-base budgeting is the exceptionally high level of effort required to investigate and document department activities; this is a difficult task even once a year, which causes some entities to only use the procedure once every few years, or when there are significant changes within the organization. Another alternative is to require the use of zero-base budgeting on a rolling basis through different parts of a company over several years, so that management can deal with fewer such reviews per year. Other drawbacks are:

  • Bureaucracy. Creating a zero-base budget from the ground up on a continuing basis calls for an enormous amount of analysis, meetings, and reports, all of which requires additional staff to manage the process.

  • Gamesmanship. Some managers may attempt to skew their budget reports to concentrate expenditures under the most vital activities, thereby ensuring that their budgets will not be reduced.

  • Intangible justifications. It can be difficult to determine or justify expenditure levels for areas of a business that do not produce “concrete,” tangible results. For example, what is the correct amount of marketing expense, and how much should be invested in research and development activities?

  • Managerial time. The operational review mandated by zero-base budgeting requires a significant amount of management time.

  • Training. Managers require significant training in the zero-base budgeting process, which further increases the time required each year.

  • Update speed. The extra effort required to create a zero-base budget makes it even less likely that the management team will revise the budget on a continuous basis to make it more relevant to the competitive situation.

Related Courses

Capital Budgeting