Zero-based budgeting is defined as a method where every expense has a meaning and is approved for every budget. It starts from a zero base at the onset of the budget period, analyses the cost and need and allocates funds accordingly regardless of the previous budget.
In this process, all the expenses must be justified so that they can remain in the budget. The zero-based budgeting is an approach that helps to control the costs.
What is Zero-Based Budgeting?
The zero-based budgeting is a popular concept adopted by organisations where the next budget cycle starts from a zero base. The planning and budgeting process is based on the assumption that there are no balances that will be carried forward or any expenses that have been committed at an earlier date.
The system assigns all the money to expenses, debt payments and savings so that the income less expenditure will equal to zero at the end of a month. This method forces the management to know about the expenditure and cash flows of every department. It also involves re-evaluating the cash flow statement and justifying the expenses that are incurred by the departments in an organisation.
The zero-based budgeting does not mean that you have a zero balance in your account. It is merely a process where the income and expenses will be equal to zero. For example, if Rahul earns 10000 dollars every month, then his costs, including investments and savings, must be equal to zero at the end of the month. This way, he will have a fair idea about every dollar he is spending.
Process of zero-based budgeting
The process of zero-based budgeting includes
1. Identifying the decision units
A decision unit can be single or numerous activities, and the first step in the process of zero-based budgeting is identifying these units. Remember an organisation is divided into may decision units and every cost centre like the HR department, marketing department etc. acts as a separate decision unit.
It helps to justify all expenditure in the budget because the manager will have to give the reason for the said expense in the budget allocation of his department.
2. Making decision packages
The decision units that have been identified at the onset are now divided into smaller decision packages. These must be in line with the goals and objectives of the company. All the decision packages are standalone proposals for allocation of funds.
It defines operations, activities and functions of the proposal, the intangible and economic benefits of executing the proposal, the need for the said proposal and loss of opportunities if necessary funds are not allocated to the proposal.
3. Formal decision packages
The formal decision package has details like the reason and the task for which the decision package is made, goals and objectives of the decision package, analysing the need for the task and its operational viability as well as assessing the alternative course of action
4. Ranking the decision packages
It is essential to rank all the decision packages in decision units based on priority and importance. All the alternative options will have to be evaluated to select the best cost-effective option.
This will help in the efficient allocation of scarce resources. It is the prerogative of the top management to reject or approve a decision package after ensuring that the costing in all the packages is realistic and accurate.
Only the ones that will help the company to achieve its predetermined objectives are given the green light.
5. Allocating resources
The decision packages that have been ranked in the previous step are now allocated funds and resources based on the ranking. It ensures maximum utilisation of scarce resources
6. Controlling and monitoring
In a zero-based budgeting process, it becomes essential to monitor and evaluate the performance and output of all the decision packages. This helps the management to know whether the allocation of resources was accurate or not.
Decision packages of zero-based budgeting
The decision packages of zero-based budgeting include
1. The base package in zero-based budgeting
This decision package of zero-based budgeting emphasises the minimum funds needed to keep a decision unit operational. It gives the manager a fair idea about the least amount in the budget that his department will need for effective working.
2. Current service package in zero-based budgeting
This decision package of zero-based budgeting helps to identify the funds needed to keep the decision units at their current level of output or production
3. Enhanced package in zero-based budgeting
This decision package of zero-based budgeting emphasises the amount of fund needed to improve the decision units.
The features of zero-based budgeting include
- The zero-based budgeting is driven managerially, and it is the manager of a decision unit who has to justify the budget allotment for his unit at first without referring to the previous spending
- Activities have to be identified as decision packages and then ranked based on priority
- The onus is on how much each unit will incur and why
- Decision packages must be evaluated through systematic analysis
- The zero-based budgeting should rationalise budget costs
- It takes the budget of the previous year and adjusts it for inflation
- It is useful for relocating resources within departments of an organisation
- Helps to move the firm away from incremental budgeting
- It is useful when the firm has good performances measures in place
- Inputs and outputs are transparent
- Helps to centralise budget decision-making
- Questions all activities and determines whether they should be continued, reduced, increased or eliminated
- Assumes that all the activities are worthy of raised funds to cover increased costs
- Puts onus on capital outlays for plant and property
- It reviews existing as well as newly proposed activities in a critical manner
- The onus is on activities and not functional departments
The advantages of zero-based budgeting are as follows-
- The zero-based budgeting ensures a carefully planned process. It keeps you aware of the money which flows in and out. This will prevent unnecessary spending.
- The zero-based budgeting encourages active participation by management executives at all levels in a budgeting process.
- The zero-based budgeting has proved useful to service or non-profit organisations
- The zero-based budgeting links corporate goals with departmental objectives
- The zero-based budgeting assist in better allocation of resources because funds are used on a priority basis
- The zero-based budgeting helps to save costs in inefficient operations
- The zero-based budgeting promotes operational efficiency
- The zero-based budgeting does not forward any inefficiency to the next year
- The zero-based budgeting assist the finance manager in giving a clear picture of the extent of the available finances and the consequences of raising them
- The zero-based budgeting acts as a tool to overcome the weakness that exists in conventional budgeting
- The zero-based budgeting forces every department to relook each item of the cash flow and compute the operation costs. It leads to cost reduction by giving a clear picture of the expenses against desired performances
- The zero-based budgeting helps to identify opportunities by removing redundant activities
- The zero-based budgeting improves and strengthens communication and coordination within a department. It involves employees in the decision-making process and motivates them to do better. It increases the participation of both employees and managers.
- The zero-based budgeting is considered appropriate for staff and support areas for instance non-manufacturing heads in a company because the inputs are not related directly to the final outputs of a firm
- The zero-based budgeting is considered useful for governments and service departments
- The zero-based budgeting identifies inefficient units and wastage. It leads to minimising costs and better productivity
- The zero-based budgeting urges the managers to avoid unnecessary expenses
- The zero-based budgeting provides the necessary flexibility in the budget
Disadvantages of zero-based budgeting
The disadvantages of zero-based budgeting are as follows-
- The zero-based budgeting is considered a time-consuming and lengthy process as it needs continuous and consistent monitoring.
- It demands a high understanding of organisational skills as well as better managerial skills
- There is a lot of paperwork in zero-based budgeting because of a large number of decision packages
- In a large scale company, there will be numerous decision packages, and this means extra costs
- Making zero-based budgeting from scratch requires the involvement of a large number of employees
- It becomes difficult to explain about all the line items and every cost
- Ranking of packages in zero-based budgeting is subjective and increases the chance of conflicts
- Managers may resist the use of zero-based budgeting because it is different from the traditional budgeting system
- In some cases, the activities might have qualitative benefits instead of quantitative advantages
- The zero-based budgeting puts its onus on short-term benefits
- It becomes necessary to update costs and benefits regularly to make them relevant. New packages must be developed as soon as a new activity emerges
- The success of zero-based budgeting is entirely dependent on the support provided by top management
- The zero-based budgeting is considered a complicated method that needs detailed analysis and constant attention.
Steps to start a zero-based budgeting
Make sure you are planning a realistically viable zero-based budgeting by taking the following steps-
1. Know your income
The first step in starting zero-based budgeting is knowing about your income. Identify all the sources and total the amount of your paycheck, other sources of income and benefits to find out how much money you have.
It will include all the cash that you bring in, for instance, residual income side business etc. Write it down and add it all in your budget
2. Track your expenses
It is important to backtrack a few months and understand what your costs are. Start with transportation, shelter, utilities and food and include every small detail for the instance phone bill, rent, cable etc. Human needs change from day to day and month to month; hence it becomes essential to make a new budget every month and add and subtract funds as per your requirements.
There are always unexpected things that come up, and you need to spend funds on it. Think about the irregular expenses that prop up at the drop of a hat and plan for them. Write down your seasonal expenses as well so that you can be prepared for it from day 1.
This will create a viable framework that will prove helpful in creating zero-based budgeting. Past experiences will identify the areas where you need to cut back and the places where you want to allocate more funds.
3. Categorise your expenses
Identify your expenditure as well as priorities. Include wants, emergency fund, debt, needs and saving goals.
4. Subtract expenses from income
The whole purpose of zero-based budgeting is to bring the balance to zero. It will take some time to get in the rhythm hence do not worry if the balance on the income and expenditure account does not match in the initial period.
Keep working diligently until you reach your goal. If you are spending more, then trim your budget by cutting on unnecessary expenses.
5. Keep a track
To make the zero-based budgeting a success, it is necessary to keep track of all the expenditure throughout the month. This will keep you aware of every dollar that is going out and prove helpful in reaching your goals.
Zero-based budgeting is a structured process that makes sure that the income and expenses match every month. It becomes easy to keep a tab of every dollar or rupee that is coming into an organisation.
The best thing about this managerial tool is that it assists the management to look at all the incurred expenses in every budgeting cycle to ensure that these are necessary for the organisation.