When you create a zero based budget for your business, you start from ground zero and analyze how much money you’ll need to run your business according to your overall company plan. In other words, you start planning your budget without regards to last year’s budget. Of course, in real life, you usually look at historical budgets to see estimate things such as labor, materials and other costs. A zero based budget is built from the ground up. Each department estimates the number of employees, amount of materials, and any other costs that their department will incur, and then comes up with a cost structure for such a plan. The expense portion is then matched to the sales and revenue forecast to make sure that they are achievable and both attainable.
For example, let’s say you run a product line for your company and you need to create a budget for the next year. You will start by looking at a sales forecast and seeing how many products you plan to sell. You’ll have to account for new products that are launching, as well as products that are on the decline. Next, you’ll have to figure out the staffing requirements and set an appropriate budget. You’ll need to consider current employees, as well as any raises and new hires. Then, you’ll have to predict the cost of the raw materials for your products. You can look at current trends to see what you think the material prices for the year will be. Of course there are lots of other costs that you’ll need to take into account, but hopefully you get the general idea of how you approach a zero based budget. Now to the advantages.
Advantages of Zero Based Budgeting
As with any method, the system is only as good as the people that use it. With that said, there are quite a few advantages to this method. The biggest method is that it doesn’t presume anything. Instead of starting with last year’s budget and adjusting it, this type of budgeting makes you start from zero and make a new case each year for how much money you’ll need to operate your business.
Another advantage is that it works well for businesses that are changing rapidly, whether through acquisition or organic growth. The more a company changes, the more the future finances change, and the better a method like this works.
Yet another advantage is that this type of budget minimizes waste. Businesses are encouraged to make a budget that meets their department needs, but they don’t have to feel like they have to spend the money in the budget or lose it, like they do in other systems. In fact, this technique encourages managers to discuss and review expenditures each year, and can actually cut down on wasteful spending.
Since I already found another good website that lists much more detailed advantages, I’ll stop here. Let’s check out what others on the web are saying about this topic.
What Others Are Saying
This is the part of each post where we look around the web to see what others have to say. In this case, we found a very detailed list of pros and cons. In fact, according to the Accounting Tools website, the advantages of zero based budgeting are as follows:
- Alternatives analysis. Zero-base budgeting requires that managers identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business.
- Budget inflation. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot.
- Communication. The zero-base budget should spark a significant debate among the management team about the corporate mission, and how it is to be achieved.
- Eliminate non–key activities. A zero-base budget review forces managers to decide which activities are most critical to the company. By doing so, they can target non-key activities for elimination or outsourcing.
- Mission focus. Since the zero-base budgeting concept requires managers to link expenditures to activities, they are forced to define the various missions of their departments – which might otherwise be poorly defined.
- Redundancy identification. The review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where managements wants it to be centered.
- Required review. Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically.
- Resource allocation. If the process is conducted with the overall corporate mission and objectives in mind, an organization should end up with strong targeting of funds in those areas where they are most needed.
You can find the entire article at http://www.accountingtools.com/zero-based-budgeting.
As you can see, the benefits of this type of budgeting are numerous. According to the research we’ve done on this versus the other methods, it appears, at least on paper, that this is the best budget method to use.
Do you have any thoughts to share?