What is Zero-Base Budgeting?

A zero-base budget requires managers to justify all of their budgeted expenditures. This is opposed to the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. Thus, a manager is theoretically assumed to have an expenditure base line of zero (hence the name of the budgeting method), no matter what the actual budget was in the prior year.

In reality, a manager is assumed to have a minimum amount of funding for basic departmental operations, above which additional funding must be justified. The intent of the process is to continually refocus funding on key business objectives, and terminate or scale back any activities no longer related to those objectives.

How Does the Zero-Base Budgeting Process Work?

The main steps in the zero-base budgeting process are as follows:

Define objectives and scope. The organization begins by clearly defining the purpose and scope of the budgeting process. This includes identifying departments, units, or programs to be reviewed and aligning budgeting goals with strategic priorities.
Identify decision units. Each department or activity is broken down into "decision units," which are the smallest segments of operations that consume resources. These units are analyzed individually to understand their functions and costs.
Develop decision packages. For each decision unit, decision packages are created outlining different levels of service or activity, including associated costs, benefits, and potential outcomes. This allows managers to present various funding scenarios and justify each expense from a zero base.
Evaluate and rank decision packages. All decision packages are evaluated and ranked based on their importance, efficiency, and alignment with organizational goals. This step helps prioritize spending by identifying which activities provide the most value.
Allocate resources based on rankings. Resources are allocated starting from zero, based on the ranking of decision packages rather than historical spending. Only those packages that meet strategic or operational criteria receive funding.
Monitor and adjust. After implementation, the budget is continuously monitored to compare actual performance with projections. Adjustments may be made as needed to ensure optimal use of resources and alignment with goals.

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Advantages of Zero-Base Budgeting

There are a number of advantages to zero-base budgeting, which include the following issues:

Allocate resources. If the process is conducted with the overall corporate mission and objectives in mind, an organization should end up with strong targeting of funds in those areas where they are most needed.
Analysis of alternatives. Zero-base budgeting requires that managers identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business.
Reduced budget inflation. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot.
Enhanced communication. The zero-base budget should spark a significant debate among the management team about the corporate mission and how it is to be achieved.
Elimination of non-key activities. A zero-base budget review forces managers to decide which activities are most critical to the company. By doing so, they can target non-key activities for elimination or outsourcing.
Focus on the mission. Since the zero-base budgeting concept requires managers to link expenditures to activities, they are forced to define the various missions of their departments – which might otherwise be poorly defined.
Identify redundancies. The review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where management wants it to be centered.
Require a comprehensive review. Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically.

In short, many of the advantages of zero-base budgeting focus on a strong, introspective look at the mission of a business and exactly how the business is allocating its resources in order to achieve that mission.

Disadvantages of Zero-Base Budgeting

The main downside of zero-base budgeting is the exceptionally high level of effort required to investigate and document department activities; this is a difficult task even once a year, which causes some entities to only use the procedure once every few years, or when there are significant changes within the organization. Another alternative is to require the use of zero-base budgeting on a rolling basis through different parts of a company over several years, so that management can deal with fewer such reviews per year. Other drawbacks are noted below:

Increased bureaucracy. Creating a zero-base budget from the ground up on a continuing basis calls for an enormous amount of analysis, meetings, and reports, all of which requires additional staff to manage the process.
Increased gamesmanship. Some managers may attempt to skew their budget reports to concentrate expenditures under the most vital activities, thereby ensuring that their budgets will not be reduced.
Intangible justifications. It can be difficult to determine or justify expenditure levels for areas of a business that do not produce “concrete,” tangible results. For example, what is the correct amount of marketing expense, and how much should be invested in research and development activities?
Increased management time. The operational review mandated by zero-base budgeting requires a significant amount of management time.
Increased training time. Managers require significant training in the zero-base budgeting process, which further increases the time required each year.
Fewer budget updates. The extra effort required to create a zero-base budget makes it even less likely that the management team will revise the budget on a continuous basis to make it more relevant to the competitive situation.