Assume you have just started a small business after knowing the ins and outs of the trade. But you also know that your bookkeeping or budgeting skills are not good enough. Still, you can come up with a budget or at least an estimate of what will be needed in terms of capital fairly easily. Without a budget, you run the risk of spending more money than your business is taking in, or conversely, not spending adequate funds to grow the business. While a basic business budget includes projected expenses and income for a specific period, what will you do after that period is over? There are several budgeting types that prioritize different factors when deciding on a financial plan, one of which is zero-based budgeting.
What sets zero based budgeting apart from others is that it sets each item at zero rupees at the start of a new period or financial year before reallocating the budget. In this blog post, we will cover the concept of zero based budgeting in detail.
What Do You Mean by Zero Based Budgeting?
Zero based budgeting or simply ZBB is a budgeting technique that requires all expenses to be justified for a new period or financial year starting from zero instead of making adjustments to the previous budget. It is an effective business planning technique that can help you identify and eliminate unnecessary expenses, exercise better control over spending, and focus more on high-profit initiatives.
For businesses, zero based budgeting means reducing unnecessary costs by carefully looking at where cost-cutting can be done. Here, you need to justify each expense before adding it to the overall budget. Creating a zero based budget will require employees’ involvement. You need to ask them about the kind of expenses the business has to bear and where expense control can be exercised. If specific spending fails to benefit the business, it should be strategically axed from the budget.
The importance of zero based budgeting in India can be realized from the fact that funding is allocated to different line items based on their necessity and efficiency. Just because an item was included in the previous budget does not mean that it has to be included automatically in the next budget as a part of the technique.
Here, the stakeholders involved in your business create the budget, review every expenditure and program at the start of each budget cycle, and justify each line item to receive adequate funding.
History of Zero Based Budgeting:
Peter Hyrr, accounting manager at Texas Instruments, created this budgeting method in the 1970s to incorporate strategic objectives into the budget by tying them with functional areas. Starting from a zero base means no funding allocation at the start of every period.
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Zero Based Budgeting Example
Let’s explain zero based budgeting with an example. Assume you run a small restaurant where you sell different types of packaged products to customers. Last year, you bought these products from a supplier for Rs. 1,20,000 (Rs. 10,000 per month).
You then decided to use the features of zero based budgeting for this year.
While listing the products, you realize you can make the products in your list by yourself at a comparatively lower cost than the supplier’s price. Making your own eatables to be sold via the restaurant will save you Rs. 70,000 per year.
You also realize you can cut back on the advertising cost and benefit more from referrals for repeat business. Instead of spending Rs 3,000 per month, you choose to spend only Rs. 1,000 for advertisements.
You then find out you can get a better rate for packaging and disposable items from a different supplier and save Rs. 5,000 per month.
Had you considered your last year’s budget to create the budget for this year, you might not be able to realize different expenses you can cut back on. Using the features of zero based budgeting means you can ensure that every rupee is accounted for.
Differences between Zero Based Budgeting and Traditional Budgeting
- Under zero based budgeting, various business activities are re-evaluated and hence, started from scratch each time the budget is created. This is different from traditional budgeting in which the last year’s budget is used as a base or reference to prepare the next budget.
- Traditional budgeting emphasizes previous expenditure levels whereas ZBB focuses on creating a new economic proposal each time the budget is created.
- Zero based budgeting in India is decision-oriented whereas traditional budgeting is accounting-oriented and works on the principles of cost accounting.
- Traditional budgeting does not necessarily involve justification of every line item and expense. On the other hand, ZBB requires proper justification of the cost and benefit of each line item.
- In terms of clarity, transparency, and responsiveness, zero-based budgeting is considered a better approach than traditional budgeting.
- Most of the top management in the business decides any amount to be spent for different activities. Contrary to this, the decision to spend a particular amount on a product or activity is left in the hands of the individual managers.
Thinking you should also start including ZBB as your budgeting approach? Let’s explain zero based budgeting advantages first.
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Zero Based Budgeting Advantages and Disadvantages
Here are some of the advantages of ZBB:
Improved efficiency
ZBB can help your business with the efficient allocation of resources, team-wise or department-wise by looking at the actual numbers of expenses and projected revenue.
Better accuracy
Zero based budgeting means computing operational and other costs by checking the need for every line item. This will ultimately give a true picture of costs vs. expected results along with reducing the overall expenses to some extent.
Improved communication between teams
It provides better communication and coordination between departments and teams by involving them in the decision-making process.
Elimination of redundant activities
It helps identify cost-efficient ways of doing things and eliminate various redundant/unproductive activities.
Like every coin that has two sides, ZBB also comes with a few disadvantages.
Disadvantages of Zero Based Budgeting
- This budgeting approach is quite time-intensive for you to do annually as against the traditional incremental budgeting approach.
- Justifying every line item and the cost element involved in the budget can be problematic for intermediate managers.
- Here, the budget is to be prepared from scratch and involves a large number of employees to contribute their thoughts and ideas. But many departments may not have the bandwidth or human resources to get involved in this activity.
Let’s get into the actionable part.
4-Step Process of Zero Based Budgeting
Given below are the four main zero based budgeting steps:
Step 1: Decision unit identification
This involves finding decision units that require justification of different line items of expenditure in the budget proposal.
Step 2: Decision package preparation
Here, decision packages refer to the separate identifiable activities that are connected to fulfill your business objectives. They are self-contained proposals to seek funds and explain the activities involved, their need, benefits, and the amount involved.
Step 3: Decision package ranking
The next step of zero based budgeting is to rank different decision packages based on the cost-benefit analysis.
Step 4: Fund allocation
Based on the above findings, the funds are then allocated under a pyramid ranking system to gain maximum benefits.
FAQs
What is ZBB full form?
ZBB stands for Zero Based Budgeting.
When was zero based budgeting introduced in India?
ZBB was adopted by the Department of Science and Technology in India in 1983 and it was later implemented by the Indian government as a method of determining the expenditure budget in 1986. It was made mandatory for all the Ministries to review their activities/programs and prepare estimates based on the concept of zero based budgeting.
How does zero based budgeting work?
It works on the principle that the projected expenditure for every program or project related to a business must start from zero every year. It does not include the previous year’s estimations and all budget requests are freshly considered for every year with a cost-benefit analysis.
What makes a zero based budget effective in nature?
A zero based budget makes you aware of the amount flowing in and out of the business, thus preventing him from spending what he does not possess.
What is meant by zero based budgeting?
It refers to the budgeting technique in which various expenses need to be justified for a new year or period starting from zero. It is different from traditional budgeting in which the previous year’s budget is taken as reference and adjusted as needed.
What are the benefits of zero based budgeting?
Under this budgeting approach, all the managers need to justify all operating expenses by checking the areas that generate revenue. It also keeps the legacy costs in check that are linked to providing healthcare and other benefits to the employees.
What is the difference between a fixed budget and a zero-based budget?
In a fixed budget approach, you get a specific amount to run different sides of the business. In flexible budgeting, one can shuffle it a little depending on the areas that are most productive. But in a zero-based budget, you get a fixed amount allocated as per forward-looking projections of the costs involved.
What is the process of ZBB?
The process of ZBB involves controlling the costs in a company and preparing every budget from scratch by taking the base to be zero. You can follow the four zero based budgeting steps mentioned above.
