Zero-Based Budgeting
Zero-Based Budgeting versus Incremental Budgeting
Typically, budgets are developed by beginning with the current period’s actual or the current period’s budgeted figures and adjusting them for any changes anticipated in the coming period. This process assumes that the budget period will be related to the current period. The focus is on things that are expected to change during the coming year. This approach to budgeting is called an incremental approach.
Zero-based budgeting is different. Under zero-based budgeting, the budget is prepared without any reference to, or use of, the current period’s budget or the likely operating results for the current period. Every planned activity must be justified with a cost-benefit analysis.
Benefits of Zero-Based Budgeting
- In zero-based budgeting, all the activities a department plans are identified and then justified. Only revenues and costs from activities that are justified are included in the budget. Because the budget is built up from zero, each manager must justify all the expenses in his or her department. The zerobased budgeting approach is preferable to the incremental approach because it enables the company to identify expenses that are not value-adding or that should be reduced due to some development in production methods or something similar.
- Having to justify every activity forces a prioritizing of activities because the activities are ranked according to their cost-benefit analyses to determine which ones are justified. This ranking provides a systematic basis for resource allocation.
- Because a manager needs to examine every single expenditure and activity within the department, he or she is more likely to develop better or less costly methods of accomplishing the same objectives, or both. This development of alternative methods is the chief benefit of zero-based budgeting.
Limitations of Zero-Based Budgeting
- The major limitation of zero-based budgeting is that it can require a nearly impossible amount of work
to review all of a company’s activities every year.
As an alternative to reviewing all of the company’s activities every year, a company could schedule zerobased budgeting on a rotating basis, with only a few different departments or divisions being subject to an in-depth review of their activities each year.
With incremental budgeting, the actual results from the current period are assumed to be acceptable for future periods (with some adjustments for changed circumstances). That assumption is not made with zero-based budgeting