Zero Based Budgeting
Before discussing the advantages and disadvantages of Zero Based Budgeting, let’s have the idea of what this budgeting approach is all about and how it is different from traditional budgeting.
This budgeting approach is different from traditional budgeting in a way that the later normally forecasts the amounts for the current year based on the previous year’s budget and then make small adjustments into it on the basis of various components which might include updated projections, actual spending, inflation, appreciation, and depreciation of the currency, etc. while zero-based budgeting cleans the board every month and inquires about each line item before making projections of expenditure and other account heads for the next period. Here no item from the previous month’s budget is transferred to the next month automatically.
It can be said that this budgeting method is more forward-looking than back-ward 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 to understand actual need of the expense for the upcoming period irrespective of how much it was spent previously.
Advantages of Zero Based Budgeting`:
This budgeting process has 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 “why” approach. The former asks how much expense is going to be spent this time as compared to previous time while the later one discusses why expense is to be incurred, is there any genuine need for spending. It aims more towards 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 not particularly focusses on observing the changes in expenses between current and previous period and 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 incurrence of this expense. It is therefore required that 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, hence ensures that the resources of the organization are being utilized economically and in efficient manner.
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 every time when the budget is in the process of preparation. Management of the organization makes sure that only those expenses are to be taken into consideration in the formation of budget which are necessary for achieving the objectives and would prove to be beneficial for the organization.
Discontinuance of disused processes
All those processes in the manufacturing units and other departments which have become obsolete and are no more providing benefits to the organization are identified during this budgeting process and are 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 benefit in the same year of incurrence of the expense. This mostly happens in 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 is required to make a list of all the expenses which 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. For this, an organization may make a provision in zero-based budgeting to overcome this.
Skills and managerial conflicts
Preparation of this budget requires knowledge, skills and experience of the management staff. On one side, this budgeting approach provides the benefit that this budgeting process is operational both in horizontal as well as in vertical directions in the organization however, on the other side it may results in management conflicts due to multiple opinions from multiple people. The conflict may also arise since zero-based budgeting requires a considerable amount of time and effort from the managerial and executive staff. Sometimes, this also happens that the skills required to formulate this budget lack in the staff who have been assigned the task of preparation of 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 and in order 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 not merely rely on the last year’s data. Training of staff and holding multiple meetings for the formulation of this budget would definitely increase the expense of the organization.
All in all, target of zero-based budgeting is to identify efficient and alternative methods for the organizations that prefers optimum utilization of resources in order to ensure efficiency and effectiveness which would finally result in wealth and profitability. However, on the other hand, this budgeting approach consumes much time and is more complex than traditional budgeting, but delivers businesses a powerful cost reduction opportunity by reducing needless expense and prioritizing smart decision making and strategic allocation of resources. Moreover, the budget is very flexible in a way that it can be applied to various costs like operating expenses, marketing costs, administrative expenses, cost of goods sold (COGS), etc.