What Is Zero-Based Budgeting?
Zero-based budgeting is an accounting practice that forces managers to think about how every dollar is spent in every budgeting period. It can have both benefits and drawbacks.
Pete Pyhrr developed the idea of zero-based budgeting in the late 1960s to early 1970s while he was an account manager at Texas Instruments. Many Fortune 500 and private equity companies have since adopted this budgeting technique.
Key Takeaways
- Zero-based budgeting differs from traditional budgeting in that the companies using it create a budget for each new period.
- Potential drawbacks of this method are that it can reward short-term thinking and be resource-intensive.
- Zero-based budgeting can be manipulated by savvy managers.
- The benefits can include lower costs by keeping old and new expenses in check.
Understanding Zero-Based Budgeting
A study from Accenture Strategy on zero-based thinking was published in 2018. It found that this budgeting method grew exponentially among the world's 85 largest companies at a rate of 57% each year from 2013 through 2017. The companies included Kraft Heinz Co., Mondelez International Inc., and Unilever PLC.
Companies start with the previous period's budget as a template in traditional budgeting. They then build upon it. Each new budget usually increases incrementally compared to the previous period's budget. Companies only have to justify new expenses.
Zero-based budgeting deviates from traditional budgeting in that the budget for each new period is created starting from a "zero base." Companies must justify each expense before adding it to the new budget, even old and recurring expenses.
Benefits of Zero-Based Budgeting
The major advantages of zero-based budgeting are flexible budgets, focused operations, lower costs, and more disciplined execution.
Managers Must Justify All Operating Expenses
Zero-based budgeting ensures that managers must think about how every dollar is spent and they must do so every budgeting period. This forces them to justify all operating expenses and to consider which areas of the company are generating revenue.
It Keeps Legacy Expenses in Check
Legacy costs might not be examined for years in traditional budgeting until there's some sort of economic shock that forces the company to take extreme actions. Expenses tend to grow over time with each department protecting its budget from cuts.
This can lead to significant misallocation of resources over time. Zero-based budgeting can prevent this from happening if it's done correctly.
Managers must justify all expenses with zero-based budgeting. It generally doesn't matter if the new budget is higher or lower than the one preceding it.
Drawbacks of Zero-Based Budgeting
The drawbacks of zero-based budgeting include the possibilities of resource intensiveness, being manipulated by savvy managers, and bias toward short-term planning.
It Can Reward Short-Term Thinking
One of the major drawbacks of zero-based budgeting is that it can reward short-term thinking by shifting resources toward areas of companies that will generate revenue over the next calendar year or budgeting period. Some areas of companies that aretypically viewed as long-term investments that aren't directly tied to revenue may be left with smaller budgets than they need as a result.
These long-term investments can include research and development or worker training. This could potentially hurt a company because these areas are often key to remaining competitive over the long term but they won't be generating revenue in the near term.
It's Resource Intensive
Zero-based budgeting takes a lot more time and effort to closely review and justify every budget element rather than simply modify an existing budget and review only new elements. Some critics argue that the benefits of zero-based budgeting don't justify its time cost due to this factor.
It Can Be Manipulated by Savvy Managers
The process of zero-based budgeting can be gamed by savvy managers to get more resources into their departments. This can lead to a change in culture. There can be a decreased spirit of cooperation in the company because workers feel expendable.
What Are Operating Expenses?
Operating expenses are costs that a company incurs just to keep up and running. They don't include financing or investing. They produce revenue. They're either fixed such as rent or mortgage payments or they're variable, such as salaries paid to workers. Salaries can be tweaked if necessary. Mortgage payments are more carved in stone.
What Are Legacy Costs?
Legacy costs are expenditures that are associated with providing retirement and health benefits to a company's workers. They're a common expense for government employers but they're common among corporate employers as well.
Can a Zero-Based Budget Be Applied to Personal Finances?
It can and the math is really simple. Add your monthly expenses to the amount of money you'd like to save each month. Subtract the total from your monthly income. You have a zero-based budget if the result is zero or very close to it. You'll want to make adjustments if your budget is less than zero. You're in pretty good shape if it's more. Decide where you want to put that extra money.
The Bottom Line
Zero-based budgeting effectively creates a new, start-over budget for each accounting period. Each budget begins at zero as the name suggests. A focus like this can keep costs and expenses under a microscope and it can give managers more control. Opponents argue that this type of budgeting doesn't keep an adequate eye on future needs.
Business owners might want to do a trial run on paper first, at least for a little while, before jumping in with both feet and committing to the process of zero-based budgeting.
FAQs
Potential drawbacks of this method are that it can reward short-term thinking and be resource-intensive. Zero-based budgeting can be manipulated by savvy managers. The benefits can include lower costs by keeping old and new expenses in check.
What are some benefits and disadvantages of zero-based budgeting? ›
Zero-based budgeting encourages an intentional financial planning stance. Requiring you to review and reconsider every expense regularly instills a habit of mindful spending, paving the way for long-term financial success. On the other hand, zero-based budgeting can be time-consuming.
What are the benefits of zero-based budgeting for an individual? ›
Zero-based budgeting means budgeting by justifying and approving all expenses for each accounting period, rather than basing it on your past spending. By starting from a 'zero base' at the beginning of each budget, you can create a really effective process for analysing and deciding where to allocate your funds.
How a company could benefit from applying zero-based budgets? ›
Zero-based budgeting offers several advantages, including focused operations, lower costs, budget flexibility, and strategic execution. The highest revenue-generating operations come into greater focus when managers think about how each dollar is spent.
What are the advantages of creating a zero-based budget what disadvantages did you encounter with this style of budgeting? ›
It reduces wastage and propels organized financial discipline. It forces you to evaluate each expense carefully. The disadvantages of zero-based budgeting include the fact that it's time-consuming and you need to make decisions on every single spend. It might also prompt unnecessary spending to match the set budget.
What is an example of zero-based budgeting? ›
For example, let's say you're using zero based budgeting for your monthly expenses. You begin by listing all your sources of income, then allocate funds to different categories such as rent, groceries, utilities, and entertainment. This method encourages intentional spending and helps you maximize your money.
What does zero-based budgeting overcome the weakness of? ›
Budget inflation: Since every line item is to be justified, zero-based budget overcomes the weakness of incre- mental budgeting of budget inflation.
Why is zero-based budget the best? ›
Key takeaways
Zero-based budgeting is a way to plan how you use each dollar you earn. This budgeting style may give you greater insight into your finances and provides you the flexibility to customize your budget each month. Zero-based budgets require advance planning, particularly for those with inconsistent incomes.
When would you use a zero-based budget? ›
If you want a tool that will help you put every dollar of your income to its highest and best use, a zero-based budget could work for you. A zero-based budget is one in which every dollar is allocated for a specific purpose, whether it's rent, retirement savings or recreation.
What is the major appeal of zero-based budgeting? ›
The foremost theoretical advantage of ZBB is that it offers a rational and comprehensive means to cut the budget. ZBB can be used to make different cuts to different services based on the perceived value to the organization (rational) and all spending is put under scrutiny (comprehensive).
Overall, a zero-based budget promotes deeper analysis and more strategic decision making. Alignment with strategic goals: When every line item must tie back to three to five strategic goals of an organization, the clarity on what to prioritize can be significant.
What is a zero-based budget for dummies? ›
Zero-based budgeting is when your income minus your expenses equals zero. Perfect name, right? So, if you make $5,000 a month, everything you give, save or spend should add up to $5,000. Every dollar that comes in has a purpose, a job, a goal.
What is the major feature of zero-based budgeting? ›
The biggest difference between zero-based budgeting and the traditional budgeting method is that the budget for each new planning period is created from zero. This enables analytical re-planning.
What are the drawbacks of zero-based budgeting? ›
The drawbacks of zero-based budgeting include the possibilities of resource intensiveness, being manipulated by savvy managers, and bias toward short-term planning.
What companies use zero-based budgeting? ›
Among the businesses using zero-based budgeting in 2023 and beyond include, but aren't limited to:
- Auto manufacturer General Motors Co.
- Industrial firm Honeywell International Inc.
- Cosmetics business Coty Inc.
- Chocolate maker Hershey Co.
- Alcoholic-beverage company Diageo PLC.
Which of the following is an advantage of zero-based budgeting? Zero-based budgeting forces managers to justify each dollar in the budget to ensure that some expenses are lower in a current year compared to what they were in previous years.
What are the advantages and disadvantages of budgeting systems? ›
Advantages & Disadvantages of Budgeting
- Advantages of Budgeting. Improved Planning and Control. Better Resource Allocation. Enhanced Communication and Coordination. Increased Motivation.
- Disadvantages of Budgeting. Inflexibility. Time-Consuming. Potential for Conflict. ...
- Table comparing advantages & disadvantages of budgeting.
Activity-Based Budgeting – Disadvantages
The biggest disadvantage of implementing ABB is that it is more costly and time-consuming to implement than other budgeting methods. As all costs associated with a business activity are tracked, all technical details must be recorded as they occur.
What are the advantages and disadvantages of a bottom up budget? ›
Bottom up budgeting advantages and disadvantages
A sense of ownership may be achieved, along with increased job satisfaction. The disadvantages include a tendency for department heads to over-budget, to ensure they have enough money for the year.
