Zero-based budget is a way to budget all expenses that must be justified for each new period. Zero-based budgeting starts as a zero base, and every step by an individual is evaluated for its needs and costs. Further, a budget is built around the needs of the upcoming period, regardless of whether it is higher or lower than the prior one.
A zero-based budget gives you top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization. Costs are first grouped and then later measured against previous and current expectations.
Zero-based budgeting has been followed over several years, with some functional areas that managers or their group leaders review. It allows you to lower costs by keeping away from blanket fluctuations to a prior period's budget. It is a time-consuming process that takes much longer time than traditional, cost-based budgeting. Still, the practice favors areas that give straight revenues or production, as their contributions are more easily justifiable than in departments such as client service and research and development.
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Zero-Based Budget Advantages
- Accuracy: Zero-based budgeting makes each department re-look every cash flow item and calculates their operation costs. This eventually helps in cost reduction as it gives a clear picture of the expenses against the desired performance.
- Efficiency: This helps inefficient allocation of resources as it does not look at the historical numbers but looks at the actual numbers
- Redundancy reduction leads to identifying opportunities and more cost-effective ways of doing things by removing unrequired activities.
- Budget inflation: A zero-based budget takes over the faults of incremental budgeting.
- Coordination and Communication: ZBB improves coordination and communication within the department and boosts employees' morale by efficient and proper decision-making skills.
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Although zero-based budgeting has its merits ideally, it is essential to know the disadvantages too:
Zero-Based Budget Disadvantages
- Time-Consuming: Zero-based budgeting is a time-intensive exercise for any company or government-funded entities to do every year against incremental budgeting, a more straightforward method.
- Manpower Requirement: Making an entire budget from scratch may require the involvement of a large number of employees. Many departments may not have adequate time and human resources at the same.
- Lack of Expertise: Explaining every item and cost is complex and requires training the managers.
Example of Zero Based Budgeting
Let us take an instance of a manufacturing department of a company XYZ that spent $10 million last year. The concern is to budget the expenditure for the current year. There are many ways of doing so:
- The company's BODs decide to increase/decrease the department's expenditure by ten percent. So the manufacturing department of ABC Ltd gets $11 or $9 million based on what the management decides.
- The company's higher management may decide to give the department the same amount as the previous year without more hiring and increasing the production. This way, the department will end up getting $10 million.
- Last way, this is against the traditional method; management may use a zero-based budgeting rule in which $10 Million of the previous year's is not used for calculation. The ZBB application involves calculating all the expenses of the department and justifying each of these. Thus reflecting the actual requirement of the manufacturing department of the company for $10.6 Million.
Zero-based budgeting aims at reflecting actual expenses to be incurred by a department or a state. It is time-consuming but a much appropriate way of budgeting. It is a company's call about whether it wants to invest time and workforce in the budgeting exercise to give out more accurate numbers or go for a more straightforward incremental budgeting method.
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