What is Zero-Based Budgeting and Is It Right for Your Business?

What is Zero-Based Budgeting and Is It Right for Your Business?

There are a variety of different budgeting techniques that businesses can utilize to allocate capital across departments.

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified and approved for each new period. Developed by Peter Pyhrr in the 1970s, zero-based budgeting starts from a “zero base” at the beginning of every budget period, analyzing needs and costs of every function within an organization and allocating funds accordingly, regardless of how much money has previously been budgeted to any given line item.

Traditional budgeting is the most commonly-used approach. This is the top-down method of targeting, applying a growth rate to prior year budgets, that many organizations employ. Zero-based budgeting is a less common approach that’s getting more attention recently, and it can provide some benefits over traditional budgeting.

The rolling forecast, which is increasing in popularity, is another budgeting approach that can be highly useful to fast-growing or dynamic enterprises. The tactic you utilize will largely depend on your business model, as each budgeting approach has pros and cons that are contingent on the culture, type, and size of the business.

What Is Zero-Based Budgeting?

zero based budgetingTraditional budget approaches allocate money based on the spending trend of previous years, whereas zero-based budgeting starts the budget at zero. Every time a new budget is formulated, the financial team starts from scratch, basing the budget on the most current needs of each department, rather than historic spending habits. This approach was very popular in federal and state governments in the 70’s, who were looking to drastically reduce costs. Given the amount of work required, this approach went out of style but it’s getting revisited by some public sector and private sector organizations in recent years.

What Are the Benefits of Zero-Based Budgeting?

One of the core advantages of zero-based budgeting is the ability to highlight inefficiencies in spending and allow businesses to optimize their capital allocation to produce the best results. When the budget resets to zero each period, it allows the financial team to thoroughly assess the most up-to-date needs of each department, so money is distributed based on current needs, rather than historic, possibly outdated trends.

What Are the Disadvantages of Zero-Based Budgeting?

While zero-based budgeting offers a fresh approach to allocating resources, it isn’t without its faults. Zero-based budgets are often much more time-consuming to create. You have to build a complete business case, then compare and contrast the needs of each department, while methodically distributing every dollar, before the overall budget can be approved.

It’s also challenging because it requires every department to accurately quantify their services. While the needs of the sales department can be easily quantified, given the link between quota-carrying headcount and revenue, other departments often have difficulty pinning their financial needs down. It’s difficult to quantify less tangible activities, such as marketing, human resources or customer service, which inevitably results in poorly distributed funds.

Another issue with Zero-based budgeting is the “ship at sea” challenge.  Some argue that this approach isn’t feasible for an ongoing business that already has existing contracts and commitments in place, that carry fixed costs.  Examples include office lease commitments, owned buildings, leased or owned vehicles, and labor contracts.

Are There Alternatives to Zero-Based and Traditional Budgets?

rolling forecastsWhile both traditional budgets and zero-based budgets have their flaws, they aren’t the only budget approaches that businesses have available to them. Rolling forecasts provide another budgeting alternative that is often ideal for fast-growing or dynamic enterprises. With rolling forecasts, after the initial budget is set, budget assumptions are updated periodically throughout the year (e.g., quarterly or monthly) and a new budget is created that extends 4 – 6 quarters into the future, basically extending the original budget out beyond the end of the fiscal year.

This allows financial teams to reallocate funding as needed, so they can quickly respond to new trends. For dynamic businesses that experience frequent fluctuations among consumers or product lines, rolling forecasts are particularly ideal, as they provide the elasticity needed to rapidly respond to changes in the company. Once they have mastered the rolling forecast technique, some organizations have eliminated the annual budget completely. But that approach is not common.

Select the Right Approach for Your Business

There are a variety of different budget approaches that businesses can utilize, and the tactics chosen will largely depend on the culture, as well as the size and model of your business. For smaller companies, that aren’t growing rapidly, the traditional budgeting approach is often sufficient. For fast-growing, dynamic organizations, rolling forecasts can be leveraged to more accurately allocate future funds, providing the versatility businesses need to respond to changes quickly. And zero-based budgeting can be leveraged in public sector organizations, or private sector companies looking to make sure all departmental costs are completely justified before funds are allocated.

Whichever approach you choose, make sure your budgeting software is flexible enough to handle multiple approaches.  With cloud-based enterprise performance management (EPM) software, your business can support standard or Zero-based budgeting, with the flexibility to augment the budget with rolling forecasts on a quarterly or monthly basis.

To learn more about how your organization can adopt a more dynamic planning approach, read Best Practices in Rolling Forecasts or read our Zero Based Budgeting use case.

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