All businesses prepare budgets; they provide the management useful tools for planning, forecasting, controls, and performance evaluations. The traditional approach towards budgeting is to analyze the past year’s budgets, make adjustments, and prepare the next year’s budgets. The revolutions of new business trends demand robust and flexible approaches. Stakeholders are demanding for extra scrutiny for management decisions. The Zero-Based Budgeting or ZBB is one budgeting method where all activities need to be justified before financial resources are allocated for these activities. So what is Zero-Based Budgeting (ZBB) approach?
The zero-based budgeting approach says “all budgets start with a zero base, with each cost element (activity) need to be justified prior to the budget allocation”.
The zero-based budgeting has a three step approach
The Zero-Based Budging (ZBB) has three main steps approach as follow:
1. Prepare The Decision Packages:
The first step for the managers is to identify the activities that require resources in the upcoming budget. Those identified activities must state the costs associated with, the revenue generation, and any other benefits or losses that may help in the decision making process. The decision package must include:
- The purpose of the activities
- The expenses and revenues associated with the activities
- Alternative options (if available) or to state, why the process is inevitable.
As a starting point, the decision package should include only the necessary resource demands, or it should start as a base approach. Additionally, a cost-benefit analysis to help the decision making should be added. Although the ZBB approach does not require any links to past budget allocations, the past budgets can be used as a starting point for the referencing purpose only.
2. Evaluation Ranking the Decision Packages:
The strategic management or the decision centers will evaluate each activity and rank them accordingly. The ranking helps management make decisions on a priority basis. In this step, the management may decide to discard the avoidable costs or ask for the reassessment. In this step, the management may identify mutually exclusive activities. The evaluation process also serves the purpose of establishing the cost measures, i.e. performance measure parameters for the activities.
3. Resource Allocation:
In the third step, resources are allocated for each cost activity approved. The resources may be provided on the ranking and priority basis.
The ZBB approach has numerous advantages.
Advantages of Zero-Based Budgeting:
- In contrast to the traditional budgeting approach, The ZBB makes evaluation and re-assessment of the activities. This helps to improve efficiency and discard any waste activities. This makes the spending more useful and the inefficiencies are removed.
- As it requires careful identification and preparing the decision packages from the management staff, it increases the collaboration amongst the staff.
- Traditionally the budgets require an incremental approach with no sense of accountability; the ZBB encourages more sense of responsibility as each cost activity needs justification.
- As the management prepares the decision packages, they conduct valuable research. It also helps adapt to the changes in market trends.
- The ZBB approach overall improves the efficient allocation of resources at all levels in a company.
Disadvantages of Zero-Based Budgeting:
- The decision making can become difficult under this approach for the cost activities mutually exclusive.
- The ZBB approach requires specific skills to prepare the decision packages and evaluation process which may not be available for all businesses.
- The ZBB approach requires considerable time and effort, in large organizations; this can be a cumbersome job to perform.
- This approach may not allow the management to change the budget allocation during the actual work stages, as the planning and allocation take place at the beginning of the budget periods.
The Zero-Based Budgeting is different in approach in contrast to the traditional budgeting in many ways. As the process starts with “zero base” the decision making is not based on the historic data only. The ZBB approach towards the cost activity analysis, evaluation, and prioritization help create a sense of responsibility. It focuses on overall process improvements as the budget allocation is linked closely to the cost-benefit analysis. However, it doesn’t make any sense to follow this lengthy approach for base activities in an organization which may be part of a routine workday. The management may feel demotivated if the hard worked plans end up in the waste bin. The focus of the management may also deviate from actual performance to analyzing the processes.