Zero-based budgeting is a process that requires the formulation of a budget from zero. In this method, all the business activities are assessed every time the budget is prepared. This budget is developed without making any reference to the base amounts of past budgets.
This budgeting starts from a “zero base,” and every department within an organization is analyzed for its needs and costs, and after the analysis, the budget is prepared.
Old and new business activities are ranked in accordance with their importance. Available resources are then allocated on the basis of the importance of these activities without taking into consideration past budgets and activities.
In easy terms, under this budgeting approach, the cost component needs a specific explanation as if the activities relating to the budget were carried on for the very first time.
Hence it is the responsibility of the manager to explain the reason for spending money on a particular activity and also explicate, what would be the effects of the proposed activity is not attempted and no money is spent. If the approval is not given for certain expenditures, then the budget allowance would be zero for that specific expenditure.
Activity-based budgeting does not take the historical costs into consideration when forming a budget. Under this budgeting method, activities are thoroughly analyzed to predict costs.
The cost incurred by a business is observed closely in order to determine if efficiencies can be created, and costs can be reduced. This might be in the form of a diminution in activity levels or removal of unneeded activities altogether.
Finally, activity-based budget aims to examine business cost drivers and alter the business to become more productive.
Though the traditional budgeting method also adjusts last year’s costs, based on inflation, other factors, or changes in any business activity, activity-based budgeting is a much more in-depth way of looking at costs.
Difference Between Zero-based Budgeting and Activity-based Budgeting
Following are discussed some fundamental differences between zero-based budgeting and activity-based budgeting;
1. The basis for the preparation of budget
Zero-based budgets are formulated right from the start, without taking into consideration last year’s budget. Management of the organization does not need to look back on previous costs or business activities, they just need to focus on the current situation and upcoming year.
Under this approach, resources are allocated based on the needs and assumed costs of each department. On the contrary, activity-based budgeting also does not consider the previous year’s analysis and budget, but the resources here are allocated majorly based on the efficiencies in business operations.
Zero-based budgeting is based on justification given for each expense related to an activity performed. This does not determine the possible profitability of the business.
Whereas, activity-based budgeting adjusts the business activities with the objectives and goals of the company. This will help to know the potential profitability of the company.
3. Resource allocation
In zero-based budgeting, the activities of the business are ranked on the basis of their vitality. When the expenses incurred are justified, resource allocation is then taken place.
In contrast to this, in the case of activity-based budgeting, after justifying the cost drivers, resources are allocated to each department.
4. Connection to business objectives
In zero-based budgeting, the first step is to revalue all the programs of the company. Once the revaluation is done, resources are then allocated based upon that revaluation. Resources are firstly allocated to the program which will yield more than that one which will yield less.
While on the other side, activity-based budgeting allocates resources after analyzing the relationship that exists between business functions and business objectives. Resources here are allocated to only those business functions whose business objectives are in line with the objectives of the company.
5. Wasteful expenses
Zero-based budgeting reevaluates all the activities of the business each year and allocates money only to those activities which justify the expense to avoid unnecessary spending. Hence, by eliminating unnecessary activities, extra costs can be saved.
In activity-based budgeting, each function of the business is keenly examined keeping in view the prime objectives and goals of the company. It removes those functions that do not go parallel with any other function or with the objectives of the company and in this way it leads to further cost-saving.
|Basis of comparison
|Zero Based Budgeting
|It uses activity-based costing-methodology. Every year each function of the organization needs to justify itself.
|This budgeting method starts from the scratch.
|Resource allocation is based on the justification of cost drivers.
|Allocation of resources is based on the justification of the expenses incurred.
|Wasteful expense which are not in line with the goals and objectives of the company are eliminated.
|Wasteful expenses are eliminated not on the basis of last year’s budget but on the current assessment.
|Connection with business objectives
|Activity-based budgeting has a connection with business objectives in a way that only those functions of the company are allocated with the resources whose objectives are similar to the objectives of the company and other functions with opposed goals and aims are shut down.
|Zero-base budgeting has a connection with business objectives in a way that during the preparation of the budget for the upcoming year, the past year’s budget is ignored completely and a new assessment is done for all the account heads.
|It helps in determining the potential profitability of the company.
|It does not determine the potential profitability of the business.
|It is activity-oriented.
|It is function-oriented.
All in all, in a zero-based budget, every department of the company prepares its budget not based on the past year’s activities and performance but on the basis of what they actually need this time.
This helps the company in optimum utilization of resources and prevents them from wastage. While activity-based budgeting technique is also somewhat identical to zero-based budgeting technique since it also helps in saving costs.
However, here each department of the company needs to show their importance and proof that how their goals and objectives are parallel to those of a company, on the basis of which resources are allocated. Both budgeting methods have their own significance, however, the selection and application depend on the policy of the company.