Zero Based Budgeting ( ZBB ) - Overview & Advantages

What is Zero-Based Budgeting?

As the name says “Zero-based budgeting” is an approach to plan and prepare the budget from the scratch. Zero-based budgeting starts from zero, rather than a traditional budget that is based on previous budgets. With this budgeting approach, you need to justify each and every expense before adding it to the actual budget. The primary objective of zero-based budgeting is the reduction of unnecessary costs by looking at where costs can be cut.

To create a zero-base budget involvement of the employees is required. You can ask your employees what kind of expenses the business will have to bear and figure out where you can control such expenses. If a particular expense fails to benefit the business, the same should be axed from the budget.

How Zero-Based Budgeting Helps Your Financial Goals

By rigorously reviewing every cost, zero-based budgeting provides clear insights into the core financial elements every business needs to address:

• Expense Determination: It helps you accurately figure out how much you will spend by forcing a detailed review of every cost.
• Revenue from the Project: With a clear understanding of expenses, you can better project how much you will earn to cover those costs and beyond.
• Profit Prediction: By carefully managing expenses and understanding revenue, you get a more precise prediction of the target profit you will achieve after all costs are accounted for.

Differences between Traditional Budgeting and Zero Base Budgeting

How Zero-Based Budgeting (ZBB) Works

Zero-based budgeting starts from a clean slate. Every function, activity, or expense of the company must prove its value before approval. Here's how the process unfolds:

1. Identify Decision Units
   
   The organisation will be divided into individual units, such as departments, projects, and functions, where spending occurs. Each unit will be treated as a separate cost.
    
2.  Create Decision Packages
   
   These units will then develop a proposal justifying the need for their expenses. This proposal will include objectives, costs, expected outcomes, and the consequences of not receiving funding.
    
3.  Evaluate and Rank
   
   The management reviews these proposals and ranks them based on priority, relevance, and return on investment.
    
4.  Allocate Resources: 
   
   Funds are then allocated based on rankings. The most critical or high-impact activities receive funding. This ensures spending is intentional and aligned with business goals.

Advantages of Zero-Based Budgeting

• Efficiency: Zero-based Budgeting helps a business in the allocation of resources efficiently (department-wise) as it does not look at the previous budget numbers, instead looks at the actual numbers
   
• Accuracy: Against the traditional budgeting method that involves mere some arbitrary changes to the earlier budget, this budgeting approach makes all departments relook every item of the cash flow and compute their operation costs. This methodology helps in cost reduction to a certain extent as it gives a true picture of costs against the desired performance.
   
• Budget inflation: As mentioned above every expense is to be justified. Zero-based budget compensates for the weakness of incremental budgeting of budget inflation.
   
• Coordination and Communication: Zero-based budgeting provides better coordination and communication within the department and motivation to employees by involving them in decision-making.
   
• Reduction in redundant activities: This approach leads to identifying optimum opportunities and more cost-efficient ways of doing things by eliminating all the redundant or unproductive activities

Although this concept is a lucrative method of budgeting, it is also important to know the disadvantages as listed below:

Limitations of Zero-Based Budgeting

• Time-consuming: ZBB is an extensive process that requires detailed planning, repeated justifications, and thorough documentation, taking more time to prepare than traditional methods.
   
• High Manpower Requirement: ZBB requires involvement from multiple levels of management, which can weaken the bandwidth and resources in large organisations.
   
• Risk of Short-Term Thinking: Since ZBB prioritises clear cost-benefit outcomes, it can underfund long-term projects that don't give immediate returns. 
   
• Skill Gap: Not all managers are trained in analytical budgeting. Justifying every line item demands financial knowledge, which may not exist uniformly across departments.
   
• Manager Bias: There’s potential for internal politics or manipulation, where managers present certain expenses as “essential” to secure funds, even if they’re not mission-critical.
   
• Change Fatigue: Implementing ZBB year after year can be overwhelming. Therefore, organisations will adopt different types of ZBB models, applying them selectively across different departments.

Conclusion

Zero-based budgeting targets at presenting true expenses to be incurred by a department. Although this budgeting method is time-consuming, this is a more appropriate way of budgeting. This includes an all-inclusive analysis of the budget proposal and if the managers make irrelevant variations so as to achieve what they want, they are probably exposed.