What is zero-based budgeting (ZBB)?
in-house manufacturing, the company finds it can
Zero-based budgeting (ZBB) is a budgeting technique
in which all expenses must be justified for a new
period or year starting from zero, versus starting with
the previous budget and adjusting it as needed.
ZBB is a highly effective business-planning tool to
help a company identify and eliminate unnecessary
costs, keep control of your spending, and focus on
high-profit initiatives.
Budgeting, including ZBB, is the tactical
implementation of a company’s strategic plan. To
deliver the financial and operational goals in the
strategic plan, an organization needs to translate its
long-range plan into a detailed set of expected
revenues and expenses that can be measured to track
performance. These can be refined and adjusted along
the way to keep the company on track with its goals to
achieve the desired business outcomes.
Above all, budgets enforce ownership and
accountability so that financial decisions are made
sensibly. They help companies project profits, spot
potential problems, and identify new opportunities so
that finance leaders can make the necessary
adjustments.
Zero-Base Budgeting (BOOK)
Zero-base budgeting is a budgeting process that
requires managers to prepare budgets from a zero
base. A typical and traditional budgeting process is
an incremental process that starts with the current
budget. The process assumes that most, if not all,
current activities and functions will continue into
the budget period. the primary focus in a typical
budgeting process is on changes to the current
operating budget.
A zero-base budgeting process on the other hand
allows no activities or functions to be included in
the budget unless managers can justify their needs.
Zero-base budgeting requires managers or
budgeting teams to perform in-depth reviews and
analyses of all budget items. Such a budgeting
process encourages managers to be aware of
activities or functions that have outlived their
usefulness or have been a waste of resources. A
tight, efficient budget often results from zero-base
budgeting.
Example of Zero-Based Budgeting
Suppose a construction equipment company
implements a zero-based budgeting process calling for
closer scrutiny of manufacturing department expenses.
The company notices that the cost of certain parts used
in its final products and outsourced to another
manufacturer increases by 5% every year. The
company can make those parts in-house using its
workers. After weighing the positives and negatives of
make the parts more cheaply than the outside supplier.
Instead of blindly increasing the budget by a certain
percentage and masking the cost increase, the
company can identify a situation in which it can decide
to make the part itself or buy the part from the external
supplier for its end products.
Traditional budgeting may not allow cost drivers
within departments to be identified. Zero-based
budgeting is a more granular process that aims to
identify and justify expenditures. However, zero-based
budgeting is also more involved, so the costs of the
process itself must be weighed against the savings it
may identify.
Example of Zero-Based Budgeting
Let’s say you run a hair salon and sell shampoo and
conditioner to customers. Last year, you purchased
these products from another company for $30,000.
You decide to use zero-based budgeting for the
upcoming year. As you’re listing expenses, you realize
you can make your own hair products for cheaper than
the supplier’s price. Making your own products will
save you $22,000.
When creating your zero-based budget, you would
only mark $8,000 ($30,000 – $22,000) as the expense
budget for the beauty products.
You also realize that you can cut back on
advertisements. Instead of spending $10,000 in this
example of zero-based budgeting, you only need to
spend $3,000. You would mark $3,000 for
advertisements.
And, you find out you can get a better rate from a
different office supplier, saving you $500. Instead of
$1,500, your supplies will now only cost you $1,000.
If you had based your upcoming budget on a previous
year’s budget, you might not have realized the
different expenses you could cut back on. But with
zero-based budgeting, you make sure that every dollar
is accounted for.
Zero-based budgeting vs. traditional budgeting
The typical budgeting process is translating a long-
range strategy into annual operating plans that are
pushed down to finance, lines of business, and
operations. This communicates the financial targets
across the organization in every line of business. The
targets can be financial and operationally aligned.
Some examples of this are revenue and expense
budgets, R&D costs, marketing expenses, project costs
and revenues, and capital expenditures.
The budgeting process requires analyzing and
comparing actual versus expected financial
performance to determine how to allocate expenditures
for the organization to achieve the budget targets set.
With traditional budgeting, the process of projecting
your business’ revenue and expenses for the upcoming
year is typically based on your previous budget which
is used to help predict, analyze, and track revenues,
expenses, profits, and cash flows. Traditional
budgeting calls for incremental increases over previous
budgets, such as a 2% increase in spending, as opposed
to a justification of both old and new expenses, as
called for with zero-based budgeting. Traditional
budgeting only analyzes new expenditures, while ZBB
starts from zero and calls for a justification of old,
recurring expenses in addition to new expenditures.
Zero-based budgeting was developed in the 1970s
by Pete Pyhrr, a former accounting manager with
Texas Instruments. The original goal of ZBB was to
help organizations reduce costs and promote fiscal
responsibility.
With zero-based budgeting, the budget is started from
scratch or a “zero base” each year. Using this
approach, every line of business within an organization
is analyzed for its needs and costs while ignoring
historic spending. The key difference is justification:
Zero-based budgets need to review every expenditure
at the beginning of the budget cycle, and lines of
business have to justify the need and impact of each
line item before funding can be approved.
Each budget line item is reviewed without the
influence of the last period’s actuals as a baseline.
Each item is carefully evaluated to determine if any
programs, services, or activities will be increased,
maintained, reduced, or removed. Managers need to
account for all elements of the budget and identify
cost-effective, relevant, and cost-saving areas.
ZBB can be applied to any type of cost: capital
expenditures, operating expenses, research and
development (R&D) expenses, or even cost of goods
sold (COGS).
Zero-based budgeting vs. traditional budgeting
Unlike traditional budgeting, zero-based budgeting
does not look at budgets made in prior years.
Traditional budgeting looks at prior-year budgets and
adjusts based on the information in those budgets. For
example, if you hire one new employee, you would
increase your budget since you would add new wages
to your payroll expenses.
Zero-based budgeting is more time-consuming than
the traditional approach because you need to start from
scratch and strategize where your expenses can be cut.
You need to know where every dollar is going to
implement zero-based budgeting.
Both zero-based and traditional budgeting are
important in creating departmental budgets. If you
have managers of different departments, you might
allocate funds to them for the year. With traditional
budgeting, managers are encouraged to spend their
allowance so they don’t lose it. Zero-based budgeting
is a little more frugal, and you might not see
unnecessary spending, since every expense is
accounted for.
Advantages of zero-based budgeting
ZBB has many advantages over traditional budgeting.
It has a bad reputation for being a complete cost
cutting exercise, but ZBB an help you align spend to
more revenue generating opportunities. ZBB offers a
number of advantages, including lower costs, budget
flexibility, and strategic execution. When every
expense is carefully scrutinized, the highest revenue-
generating activities are prioritized. Expenses are often
reduced because ZBB helps to prevent the
misallocation of resources that happens when a budget
grows incrementally over time.
How can zero-based budgeting help small
businesses?
Zero-based budgeting is a great way to improve and
manage your small business budget. It can help you:
Create your first budget: Zero-based budgeting is
necessary if you are a startup. Startups do not have
previous budgets to look at, so you would need to start
from scratch. This gives you the chance to really plan
your budget and shop around for the most inexpensive
vendor.
Save money: Zero-based budgeting can help you save
money and improve your profits for the year. By
analyzing where unnecessary business expenses are
coming from, you can eliminate them. Instead of
doling out cash for the same things that have no
benefit to your business, you can strategize how to
effectively spend money.
Know where money is going: If you give managers a
budget, you want to know where the money is going.
Managers must write a description of how much
money they need and what they will use it for.
What Are the Disadvantages of Zero-Based
Budgeting?
Zero-based budgeting has a number of disadvantages.
First, it is timely and resource-intensive. Because a
new budget is developed each period, the time cost
involved may not be worthwhile. Instead, using a
modified budget template may prove more beneficial.
Second, it may reward short-term perspectives in the
company by allocating more resources to operations
with the highest revenues. In turn, areas such as
research and development, or those that have a long-
term horizon, may get overlooked.
Zero-based budgeting challenges
While ZBB can be an effective budgeting strategy, it
can also be quite challenging to implement. Since
budgets are created from scratch, it’s much more time-
consuming than traditional budgeting. The unintended
consequence of ZBB is that it can promote short-term
cost savings over long-term benefits. In an effort to
minimize costs, some key expenses, such as research
and development or long-term strategic projects, may
get overlooked.
Best practices for zero-based budgeting
Adopt a strategic approach
ZBB is more than just slashing costs. It’s a necessary
step for freeing the resources and funds needed for
growth initiatives. Working with the line of business
leaders, you can identify overspending and reallocate
those resources toward more strategic use.
Select the right planning platform
To reap the benefits of zero-based budgeting, modern
planning and budgeting software is essential. Cloud-
based planning solutions that use AI and machine
learning can help managers make data-driven
decisions to recommend the best path forward. A
planning and budgeting solution should not only be a
blank canvas for modeling: it should also contain
planning intelligence and purpose-built capabilities for
predictive planning, driver-based budgeting, robust
“what-if” scenario modeling, sandboxing, top-down
and bottom-up budgeting, and approvals and
workflows as best practices that are readily available.
Embrace connected planning
Siloed, line of business planning might have sufficed
before, but today the focus is about connected and
continuous planning across the enterprise. Disruption
has become a constant, and plans are now made to be
changed, refined, and adjusted continuously.
Successful CFOs are partnering with sales, marketing,
HR, and operations to make faster decisions using
connected, accurate, and timely information. In this
new world, connected enterprise planning is not just a
best practice—it is a necessity.
Business benefits of ZBB
Zero-based budgeting can drive significant savings and
efficiency, but it is much more than simply building a
budget from zero. ZBB is all about building and
promoting a culture of cost management and
accountability. With profitability and cost
management, narrative reporting, and scenario
modeling, ZBB allows your company to consider the
highest priorities as opposed to what has been done
historically. With the cost savings that are discovered,
business leaders can then focus on making the changes
necessary to keep up with customer needs, emerging
competitors, and economic shifts.
Above all, ZBB allows businesses to identify cost
savings, reallocate those savings to more strategic use,
and fuel sustainable growth.
Activity-Based Budgeting (BOOK)
Activity-based budgeting (ABB) is a budgeting
process based on activities and cost drivers of
operations. ABB starts with the budgeted output and
segregates costs required for the budgeted output into
homogenous activity cost pools such as unit, batch,
product-sustaining activity cost pools based on
similarity of their resource and activity consumption
cost drivers.
Activity-based budgeting can be a simple extension of
a firm's activity-based costing systems that has
grouped its costs into activity cost pools. The firm
needs to review the appropriates of its activity cost
pools and accuracy of its activity costs for the budget
period, however, before employing them in budgeting.
Either internal or external relevant operating factors
may have changed and rendered the data from the
current activity-based costing inaccurate or irrelevant,
especially when a firm has experienced inexplicable
variances.
What is Activity-Based Budgeting (ABB)?
Activity-based budgeting (ABB) is a system that
records, researches, and analyzes activities that lead to
costs for a company. Every activity in an organization
that incurs a cost is scrutinized for potential ways to
create efficiencies. Budgets are then developed based
on these results.
Activity-based budgeting (ABB) is more rigorous than
traditional budgeting processes, which tend to merely
adjust previous budgets to account for inflation or
business development.
Activity-Based Budgeting (ABB) Vs. Traditional
Budgeting Processes
Activity-based budgeting (ABB) is an alternative
budgeting practice. Traditional methods are more
simplistic, adjusting prior period budgets to account
for inflation or revenue growth. Rather than using past
budgets to calculate how much a firm will spend in the
current year, activity-based budgeting (ABB) digs
deeper.
Activity-based budgeting (ABB) is not necessary for
all companies. For example, established firms that
experience minimal change typically find that applying
a flat rate to data from the previous year to reflect
business growth and inflation is sufficient.
In contrast, newer companies without access to
historical budgeting information cannot consider this
an option. Activity-based budgeting (ABB) is also
likely to be implemented by firms undergoing material
changes, such as those with new subsidiaries,
significant customers, business locations, or products.
In these types of cases, historical information may no
longer be a useful basis for future budgeting.
Example of Activity-Based Budgeting
Company A anticipates receiving 50,000 sales orders
in the upcoming year, with each single order costing
$2 to process. Therefore, the activity-based budget
(ABB) for the expenses relating to processing sales
orders for the upcoming year is $100,000 ($50,000 *
$2).
This figure may be compared to a traditional approach
to budgeting. If last year’s budget called for $80,000 of
sales order processing expenses and sales were
expected to grow 10%, only $88,000 ($80,000 +
($80,000 * 10%)) is budgeted.
Example of Activity-Based Budgeting
To demonstrate how ABB can be implemented, it is
useful to compare it to a traditional budgeting method.
Suppose Company ABC expects to sell 1,000 units of
its product over the next month, and the product costs
$5 to produce. Under activity-based budgeting, the
company will estimate the cost of goods sold to be
$5,000.
Also, assume Company ABC reported a cost of goods
sold at $4,000 last month, with the rate of increase
averaging 10% each month in the past. Under the
traditional budgeting method, the company will
estimate the cost of goods sold in the upcoming month
to be $4,400 [$4,000 + ($4,000 x 10%)].
Advantages and Disadvantages of Activity-Based
Budgeting
Activity-based budgeting (ABB) systems allow for
more control over the budgeting process. Revenue and
expense planning occurs at a precise level that
provides useful details regarding projections. ABB
allows for management to have increased control over
the budgeting process and to align the budget with
overall company goals.
Unfortunately, these benefits come at a cost. Activity-
based budgeting (ABB) is more expensive to
implement and maintain than traditional budgeting
techniques and more time consuming as well.
Moreover, ABB systems need additional assumptions
and insight from management, which can, on occasion,
result in potential budgeting inaccuracies.