Zero Based Budgeting as an Alternative to Traditional Budgeting
Budgeting is a wise idea to preserve dollars and make money work more effectively. There are alternatives to traditional budgeting planning and decision making however. With zero based budgeting, it reverses the budgeting process by providing an assumed baseline in order to meet budget guidelines. This zero level means that each change needs to be preapproved rather than looking at the budget line.
The History of Zero Based Budgets
The terminology was originally introduced in 1970 by Peter A. Phyrr in the Harvard Business Review. However, zero based budgeting gained popularity in the 1970s when Jimmy Carter announced the idea of zero-based budgeting to the federal government. While it failed in the government at large due to the high requirements for development and implementation, it was largely considered a success in Congress in 1977. After this it became used more commonly for business and personal budgeting as well.
Why Zero Based Budgets are Used
Zero based budgeting allows resources to be used based on needs rather than the traditional model of history. This in turn helps employees and managers to become more efficient and search for ways to improve their operating procedures instead of relying on funding based on previous performance. This also helps to improve corporate communication and employee motivation by providing incentive based financing. In addition, it can aid in finding areas of the business that are expensive and indicate more cost effective ways of dealing with the problem.
Reasons Zero Based Budgets are Limited
It can cost more money to implement zero based budgeting though. This is due to the time consumption that can be created by justifying each item. In departments that do not provide a specific product, it can also be difficult to define a specific cost analysis. Because this type of budgeting is less common than traditional budgeting, employees will also need to be trained on how to keep track of expenditures and in a larger organization this may become an impossible task.
How to Create a Zero Based Budget
To create zero based budgeting, it is important to list the income and then allocate the income to expenses. This should include any fluid expenses. The income should be equal to any expenses including any savings. Each month as the spending data changes, the budgeting should be adjusted. By forcing monetary business expenditures to be ranked by priority, this helps to determine how budgeting resources should be properly allocated.
While it may take a lot of time, effort and money to create a zero based budget, it is possible to use this systematic approach to develop a better method of organizing financial needs. When combined with other budgeting techniques, it can even help to justify new budgets and help with fiscal responsibility. It has been found that businesses and governmental agencies that adopt this practice generally report an improved financial savings, an improvement in the services that are offered or both.
The Pros and Cons of Zero Based Budgeting for a Cost Effective Business
Zero based budgeting was a very popular way for companies to manage their funds during the 1970s. However, it has fallen out of favor with many organizations due to the high level of documentation, effort and time expended in properly tracking expenses. It can still be a smart way to determine which departments should be funded though. There are several pros and cons of zero based budgeting that need to be examined before considering using this program.
The Advantages and Benefits of Zero Based Budgeting
The pros and cons of zero based budgeting should first look at the advantages. This type of budgeting plan allows for an efficient allocation of resources based on need. It can help determine where the budget is inflated and drive employees to find more cost effective ways to improve their operations. This can be particularly useful for service based industries where the output is difficult to define. In addition, it increases opportunities for outsourcing and allows staff to have a greater stake in the decision making process.
The Disadvantages and Limitations of Zero Based Budgeting
There are also several disadvantages when looking at the pros and cons of zero based budgeting. For example, it is difficult to define the units used to determine need. This can be a time consuming and exhaustive process. Each department is also forced to justify every expenditure that they make. Staff must also be trained to properly be implemented, and they are relied upon to provide accurate results. If there is any exaggeration, the results may be skewed.
Why Zero Based Budgeting Works
With zero based budgeting, the assumption is that each year a new budget needs to be built from scratch without looking at last year’s figures or history. Managers are required to prepare their budget based on the cost of running their operations at the lowest possible level. They must then weight the benefits and costs of each decision and how it would affect the budget. Each of these decisions is known as a “decision package.” This allows senior company representatives to determine which departments have the greatest need for any funding.
Why Zero Based Budgeting does not Work
However, this creates practical difficulties for many companies. Traditional incremental budgeting is simple and easily understood by most managers. Meanwhile, zero based budgeting requires training and time consuming paperwork. It is also felt that zero based budgeting may be susceptible to political pressures or influences. Because of this it is not often used anymore outside of public industry or in personal finance.
The benefit of zero based budgeting is that it provides companies a way to allocate scarce resources by focusing on the underlying costs of the company rather than yearly cost increases. This system also does not use inflation or other indicators to determine what future costs will be based on estimates. Because it can be a very effective way to budget funds, it has frequently been used by governmental organization, health organizations and educational organizations to help trim budgets.
A Zero Based Budgeting Example to Define How it is Used in Finance
Zero based budgeting is used to help justify expenses throughout each budget cycles. This prevents programs that are ineffective from continually getting funded without justification for their expenses. It also helps prevent waste, fraud and abuse within the system. This is because the budget starts at zero and each charge is accounted for. This can be particularly useful for charitable organizations and governmental departments where money can easily flow to certain activities with little or no oversight.
The U.S. Department of Agriculture
The U.S. Department of Agriculture was the first organization to begin using a zero based budget. This zero based budget example was originally implemented in the 1960s. However, they found many limitations with this plan and the process was abandoned after only being used for a year. The problems that they discovered included an increased workload and additional paperwork that took away from other regular programs. In addition, they found that the plan did not improve their efficiency or effectiveness.
Texas Instruments
Peter A. Phyrr, the person who brought zero based budgets to the public eye first introduced the zero based budgeting example to Texas Instruments in the 1970s. During this time there was a significant reduction in some of the operations. Meanwhile other areas that needed to grow were able to receive the funding they needed. This was during a period of recession and the company was able to successfully cut the employee level from 22,000 down to 14,000. Since that time companies like Xerox, Westinghouse and Allied Van Lines have implemented this budgeting system.
Non-Profit Companies
A common zero based budgeting example is often found in non-profit companies. This encourages the programs to be fiscally sound each fiscal year compared to alternative programs. This can help to measure organizational objectives and make them quantitatively measurable. By eliminating the programs that are not effective, non-profit companies can allocate their fund raising efforts to best meet the goals of the organization in the most cost efficient manner.
Nokia
In 2010, Nokia was asked to cut spending from their IT department while continuing to meet demand for new business. In order to accomplish this, they began a zero based budgeting program. This helped them analyze the benefits of the management framework and determine which demands and supplies should be prioritized. Once this was accomplished, they were able to decide which IT processes were critical to the success of the company and should be continued.
While this approach requires considerable documentation it is an effective way for businesses to make critical cost cutting decisions based on the activities of each department. Some companies use this plan only in certain departments while others use a whole system approach to monitor business expenses. However, for it to work, a review should be performed annually. A zero based budget is most often used in the government and non-profit sectors of the economy, although other private companies use it as well.
