Zero-Based Budgeting: Definition

In the zero-based budgeting (ZBB) approach, all organizational activities are initially set to zero. ZBB is the newest approach to budgetary planning and control.

The approach was successfully developed and implemented in the 1970s by Peter A. Phyrr. It was further popularized in 1979 when President Jimmy Carter of the United States required its use for the federal government.

Zero-Based Budgeting: Explanation

The premise that underpins zero-based budgeting (ZBB) is twofold.

First, ZBB attempts to break away from the past in terms of the activities mandated, their budget allocations, and their expected increments. It suggests that service departments should justify their annual budget allocations from the ground upward.

Any previous allocations in the past are not considered, and the focus becomes one of emphasizing future objectives and goals.

Secondly, while many organizations may not find it difficult to correlate specific activities with expenses like salaries, telephone calls, and machine maintenance, there is no fundamental questioning of the activity itself.

ZBB goes as far as to prompt the question: Do we need the activity or service in the first place?

While ZBB has received mixed results in many firms, it has one powerful advantage in addressing these drawbacks: namely, it implies a constant review of activities and priorities by those directly involved.

In turn, the costs involved can be assessed in a structured fashion. They can also be ranked in order of importance with other equally pressing needs for resources.

The traditional budgeting method, in contrast to ZBB, takes the current level of operations as the starting point for developing the future year’s budget.

In the traditional approach, it is assumed that all previous activities are essential for achieving the ongoing objectives.

However, important limitations of the traditional approach include:

  • Budgets tend to get larger and larger over the years as inefficiencies of earlier years are carried forward
  • New projects receive a raw deal, being more susceptible to being dropped if budget cuts are necessary
  • Alternative ways of achieving the same objectives are not identified, meaning that things are taken for granted
  • Key problems and decision areas are not highlighted

With these limitations in mind, the traditional approach of using the existing budget as the starting point for developing the next budget needs reappraisal.

The second approach to budgeting is ZBB. Peter A. Phyrr, the creator of the approach, defined ZBB as follows:

An operating, planning, and budgeting process that requires each manager to justify their entire budget request in detail from scratch (hence zero-based) and shift the burden of proof to each manager to justify why they should spend any money at all.

ZBB starts from scratch each year and places less emphasis on what was budgeted in the past. The approach involves evaluating and reviewing all activities and programs based on a cost-benefit analysis.

Key Elements of Zero-Based Budgeting

  1. Identifying objectives and developing an operating plan and budget for the coming year.
  2. Identifying alternative and efficient ways to achieve the current activity.
  3. Evaluating budget reductions and expansions systematically to allow for a re-allocation of resources as per the organization’s priorities.
  4. Diagnosing unnecessary activities that budgeting may perpetuate.

Zero-Based Budgeting Procedure

The basic steps involved in ZBB are:

1. Identification of decision units: The decision units are somewhat like cost-centers.

2.  Analysis of each decision package in a decision unit: Once the decision units have been identified, managers attempt to analyze the decision packages in each decision unit.

Each decision unit has several decision packages. For each decision package, managers evaluate the incremental benefits that they get from the incremental cost. The decision packages also try and find out alternative ways of accomplishing the same activity.

3. Ranking the decision packages: This is done so as to allocate the resources in the best possible manner.

The ranking also helps the top management to determine the benefits of each decision package to the organization which will be evaluated by systematic analysis and ranked in order of importance.

Ranking establishes priorities amongst the functions as described in the decision package. Generally, the manager at the level of the divisional manager ranks the package.

This allows them to trade the expenditure on cost planning, maintenance, sales, and administration. Top management prepares a consolidated ranking to identify the best allocation of resources.

Management can now decide a cut-off level on any or all rankings. For example, it may decide to fund only the first 15 packages out of a total of 25. This might mean funding for some new high-priority programs at the cost of other ongoing low-priority ones.

4. Preparation of budgets: The final step is to prepare the budgets using the decision packages and based on the availability of funds.

Advantages of Zero-Based Budgeting

1. The ZBB approach ensures that all activities and programs and their alternatives are evaluated by the manager. This helps to allocate resources based on the priorities of various programs, given that only the best program is considered.

2. ZBB starts from scratch each year, meaning it can eliminate the unnecessary activities/expenses that traditional budgeting often results in. This improves resource allocation and profitability.

3. ZBB requires integrated linkages to long-range plans and strategies. Through constant reiteration of the process, the plan and budget are brought into consonance. Also, the plan is more responsive to market needs and more sensitive to profits.

4. ZBB techniques facilitate rational analysis and decision-making. Decision packages are ranked in order of importance.

Drawbacks to Zero-Based Budgeting

Will It Continue?

Similar to everything novel, the results at the beginning can be impressive but short-lived.

The new ethos of appraisal, the breakdown of departmental barriers, the cutting out of unnecessary costs, and the boosting of revenues are of little use if the momentum does not continue.

Pressure from other parts of the organization, particularly from the users of central services, should be encouraged if it questions whether—at their current size—such activities really do add value.

Such probing can lead to a healthy keenness to subcontract out as many services as possible.

For example, one UK banking group, after years of uneven quality from the central IT service, adopted a new approach: some of the computer functions were devolved into the bank’s main business areas and competition was introduced into other IT services.

Are Existing Budget Procedures So Bad?

Before managers are blamed for not arriving at the best cost/benefit relationship for their services, it is worth taking a moment to examine the informal practices used for performance appraisal.

For example, do they do similar things in a less structured fashion but arrive at the same results?

Zero-Based Budgeting Can Be Time-Consuming

The amount of time and labor required may be substantial due to the scope and depth of questioning involved in ZBB.

This makes the approach unsuitable for annual implementation because it can distract focus from the key issues during the budget process.

Consideration should be given to scheduling the ZBB review process not annually but periodically, ensuring all responsibility centers are covered at least once every four to five years.

Alternatively, specific line item budgets such as those for MIS, advertising, travel, or photocopy maintenance could be examined one after another as a global expenditure activity, even if allocated across several responsibility centers.

Will Zero-Based Budgeting Make Managers Less Innovative?

Over time, there is a risk that managers may feel threatened by the thought of minimal increments to their budgets; this is because it may imply cuts, which is damaging to departmental growth.

Encouraging managers to think along the lines of examining new alternatives can also have the same effect: Shouldn’t I have thought of this before?

Exposing the weaknesses in a project and even questioning the underlying logic could discredit managers and turn them against the ZBB process completely.

Care is needed not to allow the ZBB method to become a number-crunching exercise performed only to please the boss. Instead, it should be a more fundamental analysis aimed at, for example, enhancing the proper functioning of routine tasks.

Is There the Expertise to Appraise and Rank those Packages?

The traditional and somewhat narrow focus of management training in many countries has created single-discipline managers who are capable of being good accountants, lawyers, or salespeople, but ones who have no knowledge of other functions.

In such circumstances, it is difficult to ask unit heads to contemplate an in-depth analysis of those other functions that impact their activities and ultimately their costs.

What about the Costs of Conducting These Exercises?

The most frequent complaint heard from critics of ZBB is the cost of introducing the concept and getting it working. The most significant cost to organizations is usually the initial time and staff effort spent in setting up the system.

The design of the system itself and the preparation of a systems manual will also take a considerable amount of time. Training existing senior staff on ZBB methodology within each department will generate further costs.

Nevertheless, experience gained by American corporations in the implementation of ZBB indicates that there is a steep learning curve that flattens out over the second and subsequent years.

The Multi-Functional Team Approach

One way of addressing these frequent drawbacks is to spread the time factor and responsibility evenly by seconding a small number of executives from their line and staff duties to look afresh at the company’s key operations.

Rather than working in isolation within their own departments as a “think tank,” executives should be encouraged to get out into the business, question, and evaluate services in individual offices, stores, warehouses, and factories.

The executive’s mandate should be to investigate not only whether each job, task, method of operation, etc., could be done better, but also to determine whether it needs to be done at all.

For example, one famous multi-functional team in a leading European retail group discovered a mountain of unnecessary paperwork that created a chain of costly activity throughout the organization. They had simply asked the question: Is it really needed?

Frequently Asked Questions

What is Zero-based Budgeting?

Zero-based Budgeting (ZBB) is a management process that requires managers to justify all expenses in budget categories. This is the case regardless of whether or not expenditures had been made in previous years. It forces managers to review their budgets and propose new solutions, rather than continuing on with past practices--hence the term "zero-based."

What are the key elements of Zero-based Budgeting?

ZBB has five key elements. The first is a defined budget period, usually one year. The next element is an external review process that involves someone who is not part of the manager's organization. The third element is a detailed cost-accounting system. The fourth element is a "preponderance of proof" standard, which means that managers have to justify their expenditures as reasonable and necessary. Lastly, zbb is a continuous process that managers must follow each year.

What are the benefits of ZBB?

The main benefit is that it forces managers to search for lower-cost ways to do their jobs. Rather than performing a yearly, end-of-the-year exercise aimed at justifying past spending, managers instead focus on the future and on more efficient ways of doing business.

What are the challenges of implementing ZBB?

The biggest challenge is that it can be difficult to convince managers who have used traditional budgetary practices for years to put in the extra time and effort needed to justify all their expenses, rather than simply continuing on with past spending habits and assumptions about future budgets.

What are the options for companies who want to implement ZBB?

Companies have several options when introducing zbb. They can bring in an external consultant or coach, use outside consultants to design the system and train employees, or hire new staff whose sole function is to lead zbb initiatives. They can also adopt a phased approach; however, this can result in an inconsistent approach since managers are not sure how to prepare, so they often wait until the second year.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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