Zero Based Budgeting (ZBB)
a form of budgeting where all the expenses for each new period must be justified and approved.
How Zero-Based Budgeting (ZBB) Works
In Zero-Based Budgeting (ZBB), the budget is prepared from scratch with a zero-base. It involves the re-evaluation of every line item of the cash flow statement and approving all the expenditure that is to be acquired by the department. The definition of zero-based budgeting goes as a method of budgeting whereby all the expenses for the new period are estimated. You create it on the ground of actual expenses that are to be incurred and not on a distinctive basis, which involves just altering the expenses incurred, taking into account any shifts in operational activity.
Here, every activity needs to be justified, explaining the revenue that every cost will develop for the company. Zero-based budgeting begins from a "zero base," where every function within an organization is evaluated for its needs and costs. You set up a budget around what the impending period requires, and it is done irrespective of if the budget is higher or lower than the last. ZBB allows the implementation of top-level strategic objectives into the budgeting process by tying them to particular functional areas.
Costs can be grouped first and then evaluated against previous outcomes and current prospects. Due to its detail-oriented nature, zero-based budgeting may be a rolling procedure done over many years, with a few functional areas evaluated at a time by managers or group leaders. Zero-based budgeting can help reduce costs by averting blanket increases or decreases to a prior period's budget. It is, nevertheless, a time-consuming method that takes much longer than traditional, cost-based budgeting.
Example of Zero-Based Budgeting
Assume a company making construction equipment executes a zero-based budgeting process calling for closer study of manufacturing department expenses. The company discovers that the cost of parts used in its final products and deployed to another manufacturer grows by 10% annually. The company can make those parts in-house by utilizing its own resources. After analyzing the positives and negatives of in-house production, the company realizes it can make the parts faster than the outside supplier.
Instead of a blind budget increment by a substantial percentage and masking the cost increase, the company can spot a situation in which it can decide to produce the part itself or purchase the part from the external supplier for its final products. Zero-based budgeting is a more crude process that aims to spot and justify expenditures. However, zero-based budgeting is also a more involved process; therefore, you must weigh the value of the process itself against the savings it may point out.
Zero-Based Budgeting vs Traditional Budgeting
Traditional budgeting demands incremental increases over past budgets. It is like a 2% increase in spending, opposite to a justification of both past and new expenses, seen with zero-based budgeting. Traditional budgeting evaluates only new expenditures, while ZBB begins from scratch and calls for a justification of old, reiterating expenses and new expenditures. Zero-based budgeting aims to place the duty on managers to justify expenses and enhance value for an organization by improving costs and not just revenue.
Significance of Zero-Based Budgeting
As an accounting system, zero-based budgeting has various benefits. When managers think about how every dollar is spent, the highest revenue-developing operations come into greater focus. However, reduced costs resulting in zero-based budgeting may prevent the misallocation of resources periodically when a budget grows.