8 MIN READ

Zero-Based Budgeting

Reviewing Finances From the Bottom Up

Start afresh with your budget every year.

Imagine that you're planning a household budget. You probably begin by compiling a list of all your expenses and estimating how much you spend on each one. You prioritize the necessities, such as monthly mortgage payments, groceries, fuel, and utilities, but you also want to plan for other costs, like dining out, gifts and holidays.

You can use the same principle when you prepare a budget for your team, department or organization, and this is called "zero-based budgeting." It is the process of compiling all your expenditure from scratch, rather than looking at what you can cut from or add to your previous year's budget.

In this article, we'll look at what exactly zero-based budgeting is. We'll identify its advantages and disadvantages, and we'll explore the role that managers play in implementing it.

What Is Zero-Based Budgeting?

Peter A. Pyhrr developed what he then termed zero-base budgeting (now more commonly known as zero-based budgeting) in the 1960s, and implemented it at Texas Instruments. In 1970, he wrote a Harvard Business Review article about it, and it quickly gained a following.

After Pyhrr published his 1977 book, Zero-Base Budgeting, President Jimmy Carter invited him to the White House to establish zero-based budgeting throughout the U.S. federal government. However, the tool was subsequently criticized for being impractical and time-consuming, and it fell into obscurity.

Despite this setback, increasing numbers of organizations have started using it over the last few years, and it has experienced a renewed popularity.

In zero-based budgeting, you review every dollar you want to include in your new budget from the bottom up. This encourages a workplace culture of cost management.

In traditional budgeting, you only need to account for increases or decreases in spending, compared with your previous year's budget. In zero-based budgeting, the process starts from zero every year and you must consider and justify each expense. In this way, you examine all expenditure, rather than just additional costs.

Why Is Zero-Based Budgeting Important?

Zero-based budgeting has recently experienced a renewed interest because it provides a clear way to focus on your priorities and business goals cost effectively. Organizations and their departments have to question and rationalize all their expenditure, which reduces unnecessary costs.

Zero-based budgeting isn't based on past activities, and it doesn't make assumptions such as, "We've always spent $XXX on XXX, so we'll continue to do so."

Advantages of Using Zero-Based Budgeting

There are many advantages to using zero-based budgeting with your team or department. These include:

Analyzing spending. Zero-based budgeting requires you to identify your team's or department's activities, and to look for more cost-effective ways of doing them. This could include delegating tasks to freelancers or switching to offshore suppliers. It also means that you have to analyze the effects of these different spending approaches.
Avoiding budget inflation. Zero-based budgeting makes it difficult for managers to inflate their budgets artificially, because they must explain and justify their activities and expenses.
Increasing communication. Zero-based budgeting encourages open discussion, because everyone must explain their expenses in relation to the organization's goals.
Eliminating waste. As part of this process, you have to review your activities, and decide which are necessary and which you could drop.
Focusing on goals. Zero-based budgeting encourages you to determine your departmental goals and priorities, while evaluating your expenses.
Identifying duplication. The review process helps to identify activities that multiple people or departments may be working on. By dealing with such duplication, you can eliminate additional expenses.
Allocating resources effectively. Once you complete the zero-based budgeting review process, you can allocate funds to the areas that need them most.

Disadvantages of Using Zero-Based Budgeting

Despite its benefits, zero-based budgeting also has several disadvantages. These include:

Requiring extra effort and dedication. Zero-based budgeting takes a lot of energy and attention, since it's based on evaluating and reviewing every expense in an organization. It can also be very time consuming, particularly for managers who must add this task to their existing duties. As a result, some managers may be reluctant to use it, or only use it once every few years or when there are major changes in the company.
Increasing competition. Managers might feel driven to skew their budgets to ensure that they receive their "fair share" of the organization's resources.
Hard to justify. Some expenses are not as easy to define as others. Areas of a business that don't produce immediately tangible results, such as research and development, can be harder to justify.
Training needed. Organizations need to train managers in the zero-based budgeting process, which takes additional time and effort.

Note:

If you're interested in implementing zero-based budgeting, consider how you can make it more manageable. This could include looking at your budget on a regular cycle, or one team at a time. Alternatively, you could review it at specific times, during periods of change, every few years, or a combination of these.

The Role of Managers in Zero-Based Budgeting

As a manager, you have to be fully engaged with zero-based budgeting, and this needs to be part of your organization's culture. For example, adopting zero-based budgeting means that everyone must make room for cost management in their workday, and this may affect your productivity.

However, this process gives individuals with no previous financial experience the opportunity to gain skills in this area, develop robust business cases, and ultimately progress their careers.

You may also need to think differently. Rather than accepting past expenditure, you must question all of your expenses and activities, and make a thorough case for what you need. For example, you might ask questions such as, "Is this activity really necessary?" "What would happen if we stopped doing this?" or, "How else can we carry out this task?"

Create a "Decision Package"

Once you've decided on the essential activities that you want to include in your budget, you should create a "decision package." This helps you identify different ways to perform tasks and find alternatives. The package should include the following:

The activity's cost.
Its purpose.
Alternative ways to achieve this purpose.
Performance measurements.
The consequence of not performing the activity, or of performing it differently.

Your organization's finance director will then rank all the packages from each department, in order of their benefit to the company and their alignment to corporate goals. This allows the company to decide how much to spend and where to spend it. It will then allocate resources based on priority order.

Key Points

Peter A. Pyhrr brought zero-based budgeting to public attention in the 1970s. It differs from traditional budgeting because it works from the bottom up.

Instead of cutting or increasing expenses from the previous year's budget, you start from zero and build a new budget based on evaluating and reviewing each expense's necessity to the department and the organization.

There are significant drawbacks to this system, particularly the time, effort and personnel required to carry out the task. However, if organizations have a clear and solid plan in place, zero-based budgeting can benefit them.

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