Zero-based budgeting is an approach used by the company’s management to prepare a budget by taking the 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 used to control the organization’s unnecessary costs.
The budgeting process starts from a “zero base,” and every department within an organization is analyzed for its needs and costs after the analysis, the budget is prepared.
Old and new business activities are ranked by their importance. Available resources are then allocated based on the importance of these activities without considering past budgets and activities.
Key elements of Zero-based Budgeting
- Identify the organization’s goals and objectives and develop 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 systematically to allow for re-allocation of the resources, as per the organization’s priorities.
- Diagnosing the unnecessary activities that the budgeting process often upholds.
5 Steps in zero-based budgeting
The 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 isolated activity that does not overlap 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, production, human resource, research, and development departments can work as a decision unit.
The manager of each decision unit must justify the proposed expenses and required budget allotment for his decision unit.
Such justification given by the manager should not be based on the prior period’s budget or his decision unit’s expenditure in any of the preceding years.
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, the justification for the required budget should be convincing.
Step 2 Making decision packages
In this step, the decision units 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 function, activities, operations of the proposal, need for the proposal, and economic and intangible benefits associated with the proposal implementation 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 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 to select the best cost-effective option while conducting a cost-effective analysis.
However, top senior management reserves all the rights to refuse or approve a decision package. Those decision packages assisting the organization in achieving its 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 forming 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 understand whether the allocation of resources is done accurately or if any change is needed in the decisions taken previously.
This example can better understand zero-based budgeting; 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 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 can manufacture those parts in-house and use 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 in identifying the tasks which it can make by itself in this example upon examination it came to the surface that certain parts of the 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 implementing zero-based budgeting are followed in a proper and advisable manner.
A detailed description of how each cost center would use the allocated funds and how this would benefit the organization is determined under this budgeting technique.
This approach provides the most systematic method of allocating the company’s funds but also consumes time.