Zero-based budgeting is an approach that is used by the management of the company to prepare a budget by taking base as zero.
Unlike other techniques that are used for the formulation of the budget, this technique does not use the previous year as a base year. It is a process that is used for controlling the unnecessary costs of the organization.
The process of 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.
Key elements of Zero-based Budgeting
- Identification of the goals and objectives of the organization and development of an operating plan and budget for the upcoming year.
- Identification of alternate and efficient ways of achieving the current activity.
- Evaluation of budget reductions and expansions in a systematic manner to allow for re-allocation of the resources, as per the priorities of the organization.
- Diagnosing the unnecessary activities that the budgeting process often upholds.
5 Steps in zero-based budgeting
Five-step approach is used for formulating a zero-based budget.
- Identifying the decision units
- Making decision packages
- Ranking decision packages
- Allocating available resources
- Assessing and controlling
The steps are discussed in detail as under;
Step 1 Identifying the decision units
The zero-based budgeting process initiates by identifying the decision unit. A decision unit can be a single activity or a bunch of activities that can be distinguished independently.
An activity that is isolated and not overlaps with other activities is termed independent. Each cost center in an organization can be a decision unit.
So, every decision unit needs to be separated from each other. The entire organization is divided into many decision units, and each cost center like the marketing department, production department, human resource department, research, and development department, etc. can work as a decision unit.
The manager of each decision unit is required to give justification for the proposed expenses and required budget allotment for his decision unit and such justification given by the manager should not be based on the prior period’s budget or based on his decision unit’s expenditure in any of the preceding year.
This step plays a crucial role in justifying each item of expenditure in the budget. Since zero-based budgeting involves the preparation of the budget from the start, therefore the justification for the required budget should be convincing.
Step 2 Making decision packages
In this step, the decision units that were separated in the first step are further broken down into more small-scale decision packages. However, such decision packages must be parallel with the aims and objectives of the organization.
Every decision package behaves like a completely different proposal that is attractive for the allocation of funds. Under each decision package functions, activities, operations of the proposal, need for the proposal, economic and intangible benefits associated with the implementation of the proposal are determined.
Determination of loss of opportunity is also ascertained if funds are not apportioned to the proposal. An appropriate decision package must contain the following information:
- The task for which the decision package has been made.
- Analyzing the need for the task.
- Analysis of the technical and operational practicality of the task.
- Objectives and goals of broader decision unit of which it is a part.
- Objectives and goals of the decision package.
- Analyzing the alternative course of action.
Step 3 Ranking decision packages
The third step involves raking the decision packages in the zero-based budgeting process. In this step, ranking in order of their importance and priority is done for all the decision packages within a decision unit and among various decision units.
The main idea behind prioritizing the decision packages is the efficient allocation of scarce resources of the organization. Cost-benefit analysis is mainly used for ranking the decision packages. All alternate options must be evaluated in order to select the best cost-effective option while doing a cost-effective analysis.
However, top senior management reserves all the rights to refuse or approve a decision package. Those decision packages which assist the organization to achieve its predetermined objectives and aims are approved.
While ranking the decision packages, management also ensures that the costing in each decision package is accurate, naturalistic, and free from error.
Step 4 Allocating available resources
Under this step of zero-based budgeting, funds are allocated to decision packages that were ranked in the previous step. This step can be said to be an elongation of the previous step.
Hence, the highest-ranked decision package gets better funding. Due to this step, optimum utilization of scarce resources is ensured.
Step 5 Assessing and controlling
This is the last step in the formation of zero-based budgeting under which decision packages are closely monitored and evaluated for their performance and output.
Assessing the performance of the decision packages helps the management to understand whether the allocation of resources is done in an accurate manner or any change is needed in the decisions taken previously.
Zero-based budgeting can be better understood by this example, Let’s suppose a company makes construction equipment and wants to implement this budgeting approach.
It calls for a close examination of the expenses of the manufacturing department. The company notices that the manufacturing of certain parts that are used in the final product is outsourced to another manufacturer and its cost is also increased by 7% per annum.
It is observed that the company has the capability to manufacture those parts in-house as well using its own workers at a cheaper rate instead of outsourcing.
Hence instead of increasing the budget next year by a certain percentage without scrutinizing, this approach assists the company to identify the tasks of which it has the ability to make it by itself like in this example upon examination it came to surface that certain parts company can produce hence no need of outsourcing is required and as a result, the cost can be minimized and saved.
Zero-based budgeting is a controlling cost technique however the significant thing here is to note that the steps involved in the process of implementation of zero-based budgeting are followed in a proper and advisable manner.
A detailed description of how the allocated funds would be used by each cost center and how this would benefit the organization is determined under this budgeting technique.
This approach provides the most systematic method of allocation of the company’s funds but it consumes time as well.