Career & Finance Fridays

“Most people aren’t broke because of income—they’re broke because of ignorance.” ― Joseph C. Kunz Jr.

What Is Zero-Based Budgeting (ZBB)?

Zero-based budgeting (ZBB) is an intensive budgeting technique that requires justifying all expenses from a 'zero base' for each new period. Unlike traditional budgeting, which generally increases on prior budgets, ZBB involves analyzing and justifying each cost, focusing on strategic objectives and financial efficiency. Though primarily utilized by companies to identify and cut unnecessary expenditures, individuals and families can also adopt ZBB to improve their financial decision-making.

Key Takeaways

• Zero-based budgeting requires every expense to be justified for each period, starting from a "zero base."
• This budgeting method can lower costs by avoiding automatic increases based on prior budgets.
• Zero-based budgeting is time-consuming but offers detailed insights compared to traditional incremental budgeting.
• It tends to favor operations that generate direct revenue, potentially underfunding long-term projects like R&D.
• While mainly used by businesses, zero-based budgeting can also be beneficial for individuals and families.

Mira Norian / Investopedia

Implementing Zero-Based Budgeting in Organizations

Zero-based budgeting helps align top-level goals with specific areas of an organization during the budgeting process. Costs are grouped and compared to past results and current expectations.

Zero-based budgeting can be ongoing for years, with only a few functional areas reviewed at a time due to its detailed nature. It can help reduce costs by preventing blanket budget changes, though it is more time-consuming than traditional budgeting.1

Important

This practice favors areas with direct revenues or production, as their contributions are easier to justify than those in departments like client service and research and development.

While primarily used in business, individuals and families can also adopt zero-based budgeting.

Comparing Zero-Based Budgeting to Traditional Budgeting

Traditional budgeting typically involves incremental increases, like a 2% rise in spending over previous budgets. Zero-based budgeting requires a justification of both old and new expenses.

Traditional budgeting also only analyzes new expenditures. ZBB starts from zero and calls for a justification of old, recurring expenses in addition to new expenditures. Zero-based budgeting aims to put the onus on managers to justify expenses. It drives value for an organization by optimizing costs, not just revenue.

Real-World Example of Zero-Based Budgeting

Imagine a construction equipment company using zero-based budgeting to closely examine its manufacturing expenses. The company sees that the cost of some outsourced parts rises by 5% annually.  

The company can make those parts in-house with its workers. It finds that, after weighing the positives and negatives of in-house manufacturing, it can make the parts cheaper than the outside supplier.

The company can identify a situation in which it can decide to make the part itself or buy the part from an external supplier for its end products instead of blindly increasing the budget by a certain percentage and masking the cost increase.

Traditional budgeting may not allow cost drivers within departments to be identified, but zero-based budgeting is a more granular process that aims to identify and justify expenditures. Zero-based budgeting is also more involved, however, so the costs of the process itself must be weighed against the savings it might identify.

What Is Zero-Based Budgeting?

Zero-based budgeting was created in the late 1960s by former Texas Instruments account manager Peter Pyhrr.2

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

Zero-based budgeting starts from scratch, analyzing each granular need of the company instead of using the incremental budgeting increases found in traditional budgeting. This essentially allows for a strategic, top-down approach to analyze the performance of a given project.

What Are the Advantages of Zero-Based Budgeting?

Zero-based budgeting offers several advantages, including focused operations, lower costs, budget flexibility, and strategic execution. The highest revenue-generating operations come into greater focus when managers think about how each dollar is spent. Zero-based budgeting can reduce costs by preventing resource misallocation seen in incremental budgeting.

What Are the Disadvantages of Zero-Based Budgeting?

Zero-based budgeting has several disadvantages. It's time- and resource-intensive. The time cost may not be worth it since a new budget is created each period. Using a modified budget template instead may prove more beneficial.3

ZBB might favor short-term perspectives by giving more resources to operations with the highest revenues. As a result, areas like research and development or long-term projects may be overlooked.

The Bottom Line

Zero-based budgeting (ZBB) offers a detailed approach to financial planning by requiring justification for all expenses each period. Unlike traditional budgeting, which increments past budgets, ZBB starts from scratch, ensuring that every financial decision aligns with current organizational goals. This method promotes cost efficiency by preventing the automatic growth of budgets and encourages strategic spending. Although time-intensive, its focus on optimizing costs can lead to significant long-term savings and strategic financial management for both companies and individuals.

Money & Finances

Have you ever tried zero-based budgeting, or do you have another budgeting method that works well for you?