Zero-based budgeting (ZBB) is a budgeting system in which all expenses for each new period must be justified. The method of zero-based budgeting begins with a "zero basis," and each function within an organization's needs and costs are examined. Regardless of whether each budget is bigger or smaller than the previous one, the budgets are then formed around what is required for the following quarter.

Explanation

How Does zero base budgeting It Work?

In business, ZBB ties top-level strategic goals to specific functional areas of the corporation, where expenses can be first aggregated and then measured against prior results and present expectations.

Because of its detail-oriented character, zero-based budgeting may be a multi-year process, with managers or group leaders reviewing a few functional areas at a time. By avoiding sweeping additions or decreases to a previous period's budget, zero-based budgeting can help cut costs. However, it is a time-consuming process that takes significantly longer than typical cost-based budgeting. The method also favors departments that generate direct money or produce goods, as their contributions are easier to justify than those in client service.

Budgeting with a Zero Base is an example of zero-based budgeting.

Consider the case of a construction equipment company that implements a zero-based budgeting process that necessitates a closer examination of manufacturing department costs. Every year, the cost of some parts utilized in the company's final products that are outsourced to another manufacturer rises by 5%. Those parts can be made in-house by the company's employees. After considering the benefits and drawbacks of in-house production, the corporation discovers that it can produce the parts for less money than the outside provider.

Rather than just increasing the budget by a specific percentage to hide the cost rise, the company can identify a situation in which it can select whether to manufacture the part itself or purchase it from an external source for its end goods.

What Are the Benefits of a Zero-Based Budgeting Approach?

Zero-based budgeting has a number of advantages as an accounting technique, including focused operations, lower costs, budget flexibility, and strategic execution. When executives consider how each dollar is spent, the top revenue-generating operations become more apparent. Meanwhile, cheaper expenses may result from zero-based budgeting, which avoids resource misallocation that might occur over time as a budget develops incrementally.

What Are the Drawbacks of a Zero-Based Budgeting Approach?

There are several drawbacks to zero-based budgeting. It is, first and foremost, timely and resource-intensive. Because each month requires a new budget, the time investment may not be worthwhile. Using a customized budget template, on the other hand, may be more effective. Second, it may reward the company's short-term thinking by providing greater resources to the operations that generate the most money. As a result, areas like research and development, as well as those with a long-term view, may be disregarded.

Traditional Budgeting vs. Zero-Based Budgeting

Traditional budgeting requires incremental increases above previous budgets, such as a 2% rise in expenditure, rather than an explanation of both old and new expenses, as zero-based budgeting requires.

Traditional budgeting only considers new spending, whereas ZBB starts from the beginning and requires justification of old, recurrent expenses as well as new expenditures. Zero-based budgeting tries to place the onus on managers to justify expenses and to maximize an organization's value by reducing costs rather than increasing revenue.