What is Zero-Based Budgeting

What is Zero-Based Budgeting?

Zero-based budgeting assigns all your income toward expenses to fulfill every business need. This budgeting system aims to convert every dollar you earn into a valuable asset. Whether you want to buy a new asset or pay debt obligations, zero-based budgeting utilizes all your income into productive expenditures and keeps the gain at breakeven

If there is still income left in the account, zero-based budgeting shifts it into another category or keeps it in emergency funds for the future. This budgeting system is standard for new startups working on expanding their businesses. Such businesses use their income to develop themselves for a minimum of three years.

On an individual level, this budgeting strategy distributes your income into different categories for the future, such as emergency funds, holiday funds, college education, etc. It is important to note that zero-based budgeting is a technologically driven budgeting strategy and needs regular assessment after implementation.

Most companies hire an external advisor that excels in developing budgeting strategies. The external advisor guides the senior management on the departmental budgets and their justifications.

How is Zero-Based Budgeting Different from Traditional Budgeting?

Every company uses a budgeting method to manage its expenses. Although most businesses use traditional budgeting, some rely on zero-based budgeting for initial-stage business growth.

Traditional Budgeting

In the traditional budgeting system, companies use the past year’s budget as the groundwork for the new budget. It matches the cost with revenue generated to develop a new budget with capital invested in appropriate expenditures. It is a conventional accounting process developed under the supervision of top management. The justification for allocating the budget to different departments is minimum. It depends on accounting principles and traditional formulas to form a budget.

Zero-Based Budgeting

On the other hand, in zero-based budgeting, the costs are developed from scratch. Moreover, companies assign every budget according to income level. Therefore, there is no income left for the stakeholders once the zero-based budget applies to a company. 

Furthermore, this strategy originates through decision-making and future forecasting. First, every department develops its budgeting according to the capital allocated. Then, all the departments clarify and reason their budget for every penny before submitting it to the higher authorities.  

Advantages and Disadvantages of Zero-Based Budgeting:

Every budgeting strategy has its pros and cons. These can vary from organization to organization, depending on the nature of their business.

Advantages 

  • Zero-based budgeting justifies every cost in the budget. This analysis helps the company in changing budgets regularly, mainly every month. 
  • The expenses of a business grow over time. Therefore, companies develop emergency funds for future crises. Companies can utilize these funds as legacy costs. Zero-based budgeting helps create these funds to control the economic situation.  
  • Another advantage of a zero-based budgeting strategy is that it prioritizes using capital for the expansion of business rather than taking it as profit. As a result, this strategy concludes debt payments quicker and uses the money to invest in assets for the company. 
  • It is the most transparent budgeting method as it justifies the entire business capital invested. 

Disadvantages

  • The complete shift of resources can affect the company in the long run. Therefore, zero-based budgeting can benefit the company with short-term goals only. However, there are better strategies for companies that hold investments for extended periods, such as three to five years.
  • It takes time to justify every single dollar. All the departments need to work on their justifications for this method. It can be a very time-consuming and costly method of budgeting.
  • One major drawback of this budgeting method is managers’ use of technical knowledge to benefit themselves. These managers manipulate the budgets and cash in more resources than required. Unfortunately, this execution is practiced by many dishonest managers, although it is a financial fraud.
  • For some departments, justification can be very tough. For instance, the procurement department has many overheads and fixed costs. These costs can’t be justified beforehand and need regular assistance.

Developing a Zero-Based Budget for Business

There are four steps to developing a zero-based budgeting plan.

Planning

We begin the process by creating a budget from scratch. Therefore, there is no need for past budgets. The entire zero-budget development process uses financial and data analysts to create a budget with reasonable assumptions.

Estimation

In the second step, we design the basic layout of the budget. Then, list all the activities we would use in your business process. For example, a company can undertake advice from different departmental heads on their estimated budget. In addition, analysts track the total budget and the percentage of that budget utilized by various departments.

Justification

The budget justification is an explanatory narrative on all the parts of a budget for a project put forward. In the third step, we justify every activity and the budget allocated to that project. Then, find all the areas where you can save your costs. 

The analysts collaborate with different departments in this step to reason their budget estimation. This association initiates collaboration between the analyst and the department head, ensures trust, and minimizes fraud risk. 

Implementation

The last step involves the implementation of the created strategy. Finally, companies initiate the new budget with regular moderation and analysis after all the significant measures.   

One must be clear about implementing zero-based budgeting as it nullifies the old budget. Therefore, a company should analyze its goal and what result it wants to achieve before going for a zero-based budget.

Example of Zero-Based Budgeting

Let us check the instance with the 50/30/20 principle of capital budgeting. In the 50/30/20 principle, companies allocate 50% of their income to necessary costs, 30% to investments for future preparations, and 20% to savings, emergency funds, and debt payments. 

For example, a new fintech startup wants to create value from the profit gained. Their yearly income is $25000, and they wish to utilize it through zero-based budgeting. According to the principle, the tech company will spend 50% of $15000 on necessary costs such as office rent, web application costs, and stockbroker commissions. The other 30%, or $9000, will go into emergency funds or investments such as buying new computers. At last, the remaining 20% or $6000 will fulfill the company’s debt obligations or interest payments, if any.  

Final Thoughts

Zero-based budgeting is a quick method to reevaluate your budget for any project. This method is vital for rapidly growing companies to adjust their costs. Although it is time-consuming, it justifies every dollar invested in the company. This method also creates a transparent financial image of the company. Managers can use this budgeting strategy to examine regular costs from point zero. The design will also develop a fund for future crises.

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