Posted by Neha De
October 6, 2020 | 7-minute read (1214 words)
Zero-based budgeting has received a lot of attention over the last few years. The concept first made waves in the 1970s before fading in popularity over the following decades. Termed as a growth enabler, zero-based budgeting originated in the consumer goods industry and has since gained momentum across sectors as businesses seek to maximize value and drive sustainable change.
Zero-based budgeting offers a number of benefits that apply to companies in all stages of the corporate cycle, including remarkable spending visibility, persistent cost discipline, reallocation of resources in an agile manner and a culture of continuous improvement.
So what is zero-based budgeting, and why are so many organizations talking about it?
Zero-based budgeting is a bottom-up approach as well as a sustainable cost philosophy to rigorously reset the cost base of a business, by identifying inefficient resources and spending usage that can be freed up and better deployed elsewhere.
Zero-based budgeting exposes inefficient spending, allowing an organization to reinvest in long-term sustainable growth opportunities — such as product development and innovation — by resetting its cost base and ensuring it remains lean in the long run. Zero-based budgeting is also about cultural change that calls for new processes, roles and responsibilities.
How Does a Zero-Based Budget Work?
Starting from a zero base — with no expenses or balances carried over — each period in an organization’s calendar is budgeted entirely with regard to the costs and needs for that period, which can either be for a month, a quarter or a year (whatever works best for a business).
At the start of a new period, the justified expenses and financial requirements are taken as the primary inputs for the business’ budget, irrespective of whether the budget was higher or lower during the previous period. When the next period begins, you begin at zero base and repeat the process.
Zero-Based Vs. Traditional Budgeting
The zero-based budgeting technique operates in stark contrast to the traditional annual budgeting methodology. A traditional annual budget often takes the previous year’s actuals and adds a few percentage points to account for inflation and wage increases. This type of incremental budgeting can lead to inefficiencies and missed opportunities for increased cost savings.
On the other hand, zero-based budgeting requires companies to build their annual budgets from scratch (zero) every year in order to verify that all components of the annual budget are relevant and cost-effective, and that they drive improved savings.
Here’s an example: In traditional budgeting, if an enterprise anticipates a five percent increase in production (say, because it landed a new client), it would simply add five percent to the budget from the previous period. This cost-based budgeting takes for granted that all previous expenses for production and operations are essential, and subsequently moves ahead with maintaining the budget for those functions without further analysis.
However, in zero-based budgeting, every expense has to be justified for every period; therefore, all recurring expenses are reviewed before approval, or are adjusted or discontinued based on necessity. New expenses are analyzed with the same attention as in traditional budgeting, but with the perception that costs should be optimized for value and efficiency.
Is Zero-Based Budgeting Right for You?
What zero-based budgeting essentially boils down to is that it allows you to address what’s happening in your company right now, rather than basing decisions on past, outdated trends. However, it’s not a one-time endeavor and may not work for every business. Therefore, before deciding whether zero-based budgeting is right for your company, be sure to weigh the following advantages and disadvantages.
Let’s look at the pros first:
- Zero-based budgeting is great for cutting costs, because you have total control over how much you cut. While this method lets you be aggressive about cutting costs, how much you cut and where you reallocate funds is entirely up to you.
- Historical trends are definitely useful when creating a budget, but they don’t necessarily offer a detailed look at the total spending. Zero-based budgeting requires that you examine all activities in the budget, ensuring that money is distributed in the most efficient manner — based on current needs, instead of than past trends.
- Starting from zero every time may sound like a lot of work; however, you can build a structured approach to zero-based budgeting by allowing the leaders in your organization to participate in the process and offer expert insights into the activities that make up the budget.
- Zero-based budgeting is a not simply a budgeting method; it is a tool to rid your enterprise of all inefficiencies. By taking a look at each activity along with the decision-makers in every department, it allows you to cut out activities that are counterproductive to the success of your organization.
Now, let’s look at the cons:
- Even though you can implement repeatable processes with zero-based budgeting, it can sometimes be more time-consuming than traditional budgeting.
- While you can get your department heads to cooperate, they might not be able to adequately measure their needs for the entire budgeting period.
- The budgeting process might not include fixed costs included in a contract, such as a building lease.
- Although a particular cost may not seem important to your business’ operations, it might damage the customer’s experience.
- If you run a large company, zero-based budgeting might turn out to be too expensive and require too much commitment from other departments to be functional.
How Can You Deploy a Zero-Based Budget?
The following seven steps can provide a baseline for implementing zero-based budgeting:
- Begin: Create a fresh annual budget from scratch without using last year’s actuals as a baseline.
- Evaluate: Evaluate every area of cost. Remove and minimize unnecessary activities or services.
- Account for: Justify all components of the budget. Identify areas that are relevant and cost-effective, and that drive cost savings.
- Streamline: Figure out which activities should be performed and how. Standardize and automate processes where possible.
- Execute: Roll out absolute planning and execution processes. Communicate uncomplicated plans, processes, roles and responsibilities.
- Examine: If any mistakes have been made, adjust and move forward with the process in the next period, or discontinue those task(s) altogether.
- Start Over: Begin at the first step at the beginning of a new period (annual in this case).
Consider These Tips
- Zero-based budgeting requires you to completely rethink your budgeting process. So before you begin, do your research and speak to experts to get a clear idea about the extent of the change within your organization. Be thorough about what you want to achieve.
- Changing to zero-based budgeting will have implications on business-wide processes and activities. Ensure that the senior leaders in your company understand its benefits, are onboard with the need to change and are willing to drive the change across all departments.
- Take time to ascertain the extent of the change in all areas of your business. Make sure you’ve evaluated the implementation process, the end result and how you will get there. Get help from a third party, if you have to, who can guide you on a best practice approach.
- Get your department heads onboard and ensure that they are involved in order to achieve their goals. Keep them apprised of the reasoning behind the change and ensure that everyone understands the impact.