Zero Based Budgeting
Before discussing the advantages and disadvantages of Zero Based Budgeting, let’s have an idea of what this budgeting approach is all about and how it differs from traditional budgeting.
Zero Based budgeting approach is different from traditional budgeting in a way that the latter normally forecasts the amounts for the current year based on the previous year’s budget and then makes small adjustments to it based on various components which might include updated projections, actual spending, inflation, appreciation, and depreciation of the currency, etc.
In contrast, zero-based budgeting cleans the board monthly and inquires about each line item before making expenditure projections and other account heads for the next period.
Here, no item from the previous month’s budget is automatically transferred to the next month.
It can be said that this budgeting method is more forward-looking than backward and does not base on historical data from the previous month, quarter, or year.
Here each expense is analyzed critically before allocation in the budget. Therefore, the development of this budget requires understanding the actual need of the expense for the upcoming period irrespective of how much it was spent previously.
Major Advantages of Zero-Based Budgeting:
This budgeting process has a few advantages over other approaches which are discussed as follows;
Much emphasis on decision making
Traditional budgeting aims at “how much” while zero-based budgeting aims at the “why” approach.
The former asks how much expense is going to be spent this time as compared to the previous time while the latter discusses why the expense is to be incurred, there is any genuine need for spending.
It aims more toward the achievement of an organization’s goals and objectives, that is why it ignores what happened in the past.
Orientation towards cost-benefit analysis
Cost-benefit analysis is the main aim of this budget. This budget does not particularly focus on observing the changes in expenses between the current and previous periods, performing variance analysis, and investigating why expenses increased or decreased in these periods.
Instead, it considers why the particular expense is needed and what benefit the organization would obtain from the incurrence of this expense.
Therefore, accurate information must be considered while forming this budget.
Efficient allocation of resources
Every organization wants a high profitability ratio and maximization of shareholder’s wealth every year which is also the aim of this budget.
This budgeting approach does keen analysis before spending, ensuring that the organization’s resources are being utilized economically and efficiently.
Improvement for the next period
Every year this assumption is taken that the new budget would be prepared without depending on the values of last year’s budget.
Expenses of each department are analyzed whenever the budget is in the preparation process.
Management of the organization ensures that only those expenses are to be considered in forming the budget necessary for achieving the objectives and would be beneficial for the organization.
Discontinuance of disused processes
All those processes in the manufacturing units and other departments that have become obsolete and are no longer providing benefits to the organization are identified during this budgeting process and discontinued.
Discontinuation would result in better costing, pricing, and profitability.
Disadvantages of Zero-Based Budgeting
Following are some disadvantages of this budgeting process;
Only eligible for the long-term goals
This budgeting approach is based on cost and benefit analysis of a particular period. Sometimes, the company may not get benefits in the same year of incurrence of the expense. This mostly happens in the short run.
There are some of the expenses which have to be incurred for the achievement of the long-term goals of the organization.
To overcome this, the top management must make a list of all the expenses that would result in long-term benefits and should not be considered while preparing the budget.
There come times when an organization cannot stick to the budget and circumstances may arise which lead the management to incur the expense on the unforeseen opportunity or to palliate the possible threat.
An organization may make a provision in zero-based budgeting to overcome this.
Skills and managerial conflicts
Preparing this budget requires the management staff’s knowledge, skills, and experience. On one side, this budgeting approach provides the benefit that this budgeting process is operational both in horizontal and vertical directions in the organization however, on the other side it may result in management conflicts due to multiple opinions from multiple people.
The conflict may also arise since zero-based budgeting requires considerable time and effort from the managerial and executive staff.
Sometimes, this also happens that the skills required to formulate this budget are lacking in the staff assigned the task of preparing this budget.
Complex and expensive
Zero-based budgeting can be expensive as well as time-consuming and difficult, to implement and is not like traditional budgeting approaches.
Here additional staff training is also required regarding software usage to obtain understandability of the workflows used in this approach which is surely different from traditional budgets because here, each budget is prepared from the scratch and does not merely rely on the last year’s data.
Training staff and holding multiple meetings to formulate this budget would increase the organization’s expenses.
All in all, the target of zero-based budgeting is to identify efficient and alternative methods for organizations that prefer optimum utilization of resources to ensure efficiency and effectiveness, resulting in wealth and profitability.
However, on the other hand, this budgeting approach consumes much time and is more complex than traditional budgeting.
Still, it delivers businesses a powerful cost reduction opportunity by reducing needless expenses and prioritizing smart decision-making and strategic allocation of resources.
Moreover, the budget is very flexible in that it can be applied to various costs like operating expenses, marketing, administrative expenses, cost of goods sold (COGS), etc.