What is Zero based budgeting? – How to implement it!

As we all know, anyone would need to prepare and update their business budget on a regular basis to stay on top of their expenses. When making a conventional budget, we usually start with the previous year’s budget and make changes. But this method of budgeting may not be the most effective, particularly for small businesses. Zero-based budgeting is another option.

Did you know?
As a former accounts manager to Texas Instruments in Dallas, Texas, Peter Pyhrr had pioneered zero-based budgeting in the 1960s.

What is zero-based budgeting?

Zero-based budgeting (ZBB) is a modern technique designed to revitalize the process of budgeting. A company should not only make decisions about potential new programmes, but it should also from time to time check the appropriateness of current programmes. Zero based budgeting is one such technique of making such an appraisal.

As the name suggests, it explores and evaluates a programme, function, or responsibility from scratch. It requires each cost element to be specifically justified, although the activities to which the budget relates are not being undertaken for the first time.

Zero-based budgeting is an activity-based budgeting mechanism in which a budget is created for each activity and justification in the form of cost-benefits for the activity is needed to be given. The management evaluates and prioritizes activities based on factors such as availability of funds, regulatory requirements, and alignment with organizational goals, among others. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one.

The Chartered Institute of Management Accountants (CIMA) defines zero-based budgeting as “a method of budgeting whereby all activities are re-evaluated each time a budget is set. Discrete levels of each activity are valued and a combination is chosen to match funds available.”

Zero based budgeting may be better termed as “De nova budgeting” or budgeting from the beginning with absolutely no reference to any base, past budgets, or actual events. This budgeting is based on the idea that every rupee of expenditure spent needs a valid justification.

It is a revolutionary approach to planning future activities, and it is sharply contradictory to traditional budgeting. Traditional budgeting includes expenditures of previous years that are automatically incorporated in new budget proposals (with a cutback or increase). Only incremental expenses are subjected to debate.

However, zero based budgeting assumes that a responsibility-centre has had no previous expenditure. It starts from scratch or zero and not on the basis of trends or historical levels of expenditure. It is based on the premise that the budget for the next period is zero as long as demand for a function, process, project, or activity is not justified for each rupee spent. The assumptions are that without such a justification, no expenditure would be approved. As a result, the burden of proof transfers to each manager to justify why the money should be spent in the first place and to clarify what would happen if the planned activity were not carried out and no money was spent.

Difference between Traditional budgeting and Zero-based budgeting

In traditional incremental budgeting, departmental managers justify only variances from previous years, assuming that the “baseline” is automatically approved. On the other hand, in zero-based budgeting, every line item of the budget (and not just adjustments) must be approved. During the process, no reference is made to the past level of expenditure. Zero based budgeting necessitates the budget proposal to be re-evaluated thoroughly, starting from the zero-base. This process is independent of the fact that whether the total budget or specific line items are increasing or declining.

Traditional budgeting	Zero-based budgeting
Accounting oriented approach	Decision-making approach
Stresses on previous levels of expenditure to form a basis	Requires all programmes, old and new, to compete for scarce resources
First reference is made to past level of spending and then demand for inflation and new programmes	Focuses attention only on decision packages, which enjoy priority to others
Scope for deliberate increases and cuts in budget proposals	Carefully devised result-oriented package avoids unnecessary enhancements
Responsibility on the top management	Responsibility is shifted from top management to the manager of the decision unit

Features

Some of the important features of zero based budgeting are:

• The focus of budgeting efforts is not merely on “how much” a unit will spend but also on “why” it needs to spend.
• The cost of each activity needs to be justified and without justification, the budget allowance is zero.
• Choices are made based on what each unit can offer for a specified cost.
• The objects of individual units are linked to corporate targets.
• By avoiding blanket increases or decreases to a previous period’s budget, zero-based budgeting may help reduce costs.

Steps

ZBB involves a number of stages, which are:

1. Identification of decision packages (or functions, activities) and their description in detail

A decision package refers to a tangible activity or group of activities for which a single manager holds the responsibility for successful performance. Thus, it could be a programme or a project, or a segment of the company for which separate budgets are to be prepared.

Each package should give details of costs, returns, purpose, expected results, the alternatives available, and a statement of the consequences if a particular activity is reduced or not performed at all.

2. Evaluation of decision packages

For each decision package, the next step is to evaluate and allot ranking to an activity against other activities competing for the same scarce resources.

These are evaluated against factors like synchronization with organizational objectives, availability of funds, regulatory requirements, etc.

3. Selection of decision packages according to priority

Further, it is decided whether to accept or reject or amend the activity. Because of this prioritization feature, ZBB is also known as Priority-based Budgeting.

4. Allocation of resources after approval of the budget committee and the top management

Based on the alternative selected and approved through the ranking process, the allocation of available resources of the organization is made to the selected decision units. Budgets are prepared like it is done for the first time without making reference to previous budgets.

An example of how ZBB works

In ZBB, all expenses should be justified in order to qualify for being placed in the budget. For example, if an entity expects to incur INR 2,50,000 on salaries and wages, and thinks that the entire sum of INR 2,50,000 is essential to operate the business smoothly, then it would be included in the budget provided each allowance of salary/wages for every employee is reviewed and justified. If each expense is justifiable, only then it would be included in the budget. Otherwise, not.

Also, it might be possible that the entity’s management determines that instead of paying some wages, it can save costs by substituting existing machinery with less costly & improved technology (worth Rs. 60,000). This would lower the need for manpower and, hence, cut down on wages by Rs. 85,000. In that case, it would make adjustments to the budget accordingly and Rs. 2,25,000 would be set aside instead of Rs. 2,50,000. (INR 2,50,000 – cost savings + cost of new technology)

But, if traditional budgeting were to be used, the entity would have escalated the figures of salaries and wages from the previous period at a standard incremental rate of 20% or so. So, if the previous year’s figure was Rs. 2,20,000, then the company would budget for Rs. 2,64,000. This would be done regardless of whether the expense is justified or not and whether the prospect of improved technology could reap some benefits or not.

As a result, by avoiding vague percentage increases in traditional budgeting, there is absolutely a better chance of achieving cost reductions with ZBB. In addition, ZBB allows the company to analyze every expense/aspect of the business one by one. By challenging assumptions and reviewing expenses, it enhances performance and operational efficiency.

Let’s take another example. Assume that a government scheme distributes crores of rupees to MPs every year. Only a small portion of that is expended, and the rest is allowed to roll over or carry forward. In zero based budgeting, this money would not be allocated to anyone who did not spend; instead, it would be allocated where it is most needed or most efficiently used. Now, when hundreds of crores would have to be justified across departments, much larger gains will be realized.

Advantages

Zero-based budgeting is better than conventional budgeting because of the following reasons:

• It allows the management to assign resources to different activities after a rigorous cost-benefit analysis. Allocation of resources is made according to needs and the benefits derived. Hence, the chances of arbitrary cuts and enhancement are avoided.
• It offers a systematic approach for evaluating different activities or decision units and ranks them in order of preference for the allocation of scarce resources.
• It enables the management to identify inefficient operations and eliminate wasteful expenditure.
• It also makes it easier for the management to relate functional budgets to corporate goals.
• Lowered costs may arise as ZBB may prevent the misallocation of resources that can occur over time when a budget grows incrementally.
• It develops a demanding and questioning mind-set rather than embracing the current practice.
• It ensures that the different functions undertaken by a company are critical to the achievement of its goals and are being performed in the best possible way.
• It facilitates the introduction of a system of Management by Objectives (MBO). Thus, not only does it overcome the limitations of traditional budgeting, but it can also be used for a variety of other purposes.

Disadvantages

Zero-based budgeting can pose a number of challenges. Firstly, it is a time-consuming process that takes much longer than traditional budgeting as a new budget is developed each period. (Source)

Secondly, ZBB requires large manpower. Making an entire budget from the scratch will necessitate the participation of a large number of employees. Many departments will be unable to do so due to the lack of time and human resources.

Furthermore, explaining every line item of the budget and every cost is a complex task and would, therefore, require expertise and training on the part of managers.

Areas where zero based budgeting is applicable

ZBB is suitable for both corporate and non-corporate organizations. In the case of non-corporate organizations like Government departments, local bodies, not-for-profit companies, these entities need to justify the benefits of expenditures on the execution of their social programmes such as mid-day meals, installation of street lights, provision of drinking water, etc.

In the case of corporate entities, ZBB is ideally suited for discretionary costs such as research and development expenses, training programmes, advertisements, etc.

The costs that are essential rather than discretionary (say, heating and lighting charges in a school or hospital) will anyhow have to be paid, irrespective of the budget amount allocated to them. Therefore, it could be argued that it is pointless to carry out ZBB in relation to these. Traditional or incremental budgeting would be more suitable for these.

Zero based budgeting in India

In 1983, the Department of Science and Technology in India adopted the ZBB. The Indian government adopted ZBB as a method for assessing the Expenditure Budget in 1986. All ministries were mandated by the government to review their activities and programs and prepare budget estimates based on the ZBB definition. In the seventh Five-Year Plan, the ZBB system was promoted. However, not much progress could take place later.

Conclusion

Zero-based budgeting, unlike traditional budgeting, starts at zero and justifies each individual expense for a reporting period.

Zero-based budgeting identifies alternative and productive ways of utilizing limited resources in order to achieve specific goals. It is a flexible management strategy that provides a compelling basis for reallocating resources by focusing on thorough review and justification of the funding and performance levels of existing programmes, functions, or activities.

Also read: What is Target costing? – An overview and application