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.
Incremental budgeting is a budgeting method that is based on the concept that a new budget can be prepared by doing only some marginal changes to the current year’s budget.
In other words, with incremental budgeting, the amounts of the current budget are used as a base to which incremental assumptions are either added or subtracted from these amounts in order to arrive at the new budgeted figures.
Simply, this budgeting process is based on minor changes from the preceding period’s budgeted results or actual results. An important thing to note here is that no standard formula is there to determine the applicable marginal changes in the budgeting process.
The said changes are determined using certain assumptions based on last year’s budgeting and expenses amounts.
This type of budgeting approach is usually adopted by those companies whose management is not intended to spend a great amount of time and who do not have enough resources to formulate the budget or who do not think of any need to conduct a re-evaluation of business.
7 Difference Between Zero-Based Budgeting and Incremental Budgeting
Following are discussed some fundamental differences between incremental and zero-based budgeting;
- Definition: Zero-based budgeting is a process of budgeting, whereby, every time the budget is created, revenues and costs are considered and thus started from the start. It estimates all the results and avoids the current performances. While on the other hand, incremental budgeting allows increasing the revenues and costs in the upcoming budget by considering the current year’s performance.
- Application: The zero-based budgeting method is much complex and time-consuming because here resources have to be allocated from the start every time a new budget is formulating, and before doing this, targets are also needed to be revised. The incremental budgeting technique is very simple and easy to understand by the management of the company so it is the most common method used for budgeting. Furthermore, without incurring much cost for the formulation, it also provides reasonable targets.
- Prime Focus: The activities that are most significant for an organization are the prime focus of zero-based budgeting since this type of budgeting method needs resources and time. This budgeting method is used at the strategic level to set the budget for the upcoming year according to its goals and objectives. On the contrary incremental budgeting focuses mainly on day-to-day activities and those activities for which not much expertise is required. Such budgeting methods can be enforced at operational and management levels where variables and aims do not change very instantly. For instance, purchases and sales, etc.
- Learning and Innovation: Zero-based budgeting encourages learning and innovation in an organization. The main reason behind this is that the task firstly needs to be evaluated from its base. This will not only make the systems and procedures more effective but would also enhance the knowledge and information of the management about the organization’s processes. Furthermore, this budgeting method will also compel the management to modify their understanding of the business and to bridge any competence gap by attending professional development programs and training. While in incremental budgeting technique, no effort is needed to produce the budget, management only applies minimum efforts to formulate this budget, due to which they become very conservative.
- Resource allocation: Resources are important for every organization. Human and financial resources are involved when developing a zero-based budget. The preparation of a zero-based budget requires the knowledge and expertise of the management who must have the ability to analyze and critically assess what is important for the organization and how the budget should be prepared to achieve the set targets and objectives. In contrary to this, not that much knowledge, expertise, and skills of the management are required for the preparation of incremental budget since the formulation of this budget is not a complex method and only a few adjustments are required to make in the previous budget in order to make an incremental budget for the year. Current management with basic knowledge is even able to prepare this budget. In this way, both human and financial resources can be saved.
- Cost analysis: Zero-based budgeting reduces the chances of risks and errors in an activity as much as possible. This is because the zero-based budgeting technique assesses every activity from the base and removes them from the budget who are not adding any value. This would result in increased effectiveness of operations, systems, and procedures. While on the other hand, incremental budgeting does not attempt to bring new changes to the general processes involved in a task, instead it simply adds or subtracts the values in relation to the last year’s results, therefore in this budgeting technique, this could not be ascertained that which expenses are necessary for achieving the objectives of the organization and which are not, this may cause failure to recognize unneeded expenses which subsequently results in loss of organization’s valuable resources and time. This is the main drawback of using the incremental budgeting method while formulating a budget. Both the budgeting techniques have their own importance however which method is to be adopted during the development of the budget is purely up to management’s discretion.