Zero Based Budgeting

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Zero-Based Budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. No reference is made to the previous level of expenditure. By contrast, in zero-based budgeting ^[1], every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases. ZBB requires the budget request justified in complete detail by each division manager starting from the Zero-base. The Zero-base is indifferent to whether the total budget is increasing or decreasing.

The term "Zero-Based Budgeting" is sometimes used in personal finance to describe the practice of budgeting every dollar of income that you receive, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. It would be more technically correct to refer to this practice as "Active Balanced Budgeting"

"With zero-based processing one can forget about last year, pretend that the program is brand-new, and see if one can provide a detail of expenses for what one would need to fully accomplish the program. This technique will help one to develop a complete picture of what the program actually needs to cost and not just what it has been costing." (Batarla, Rob. Playbook: Add Value to Your Budgeting Process. Parks & Recreation, 00312215, Sep 2005, Vol. 40, Issue 9)

1 Advantages of Zero-Based Budgeting
2 Disadvantages of Zero-Based Budgeting
3 Incremental Budgeting
4 References

[edit] Advantages of Zero-Based Budgeting

Efficient allocation of resources, as it is based on needs and benefits
Drives managers to find out cost effective ways to improve operations
Detects inflated budgets
Useful for service departments where the output is difficult to identify
Increases staff motivation by providing greater initiative and responsibility in decision-making
Increases communication and coordination within the organization
Identifies and eliminates wastage and obsolete operations.
Identifies opportunities for outsourcing.
Forces cost centers to identify their mission and their relationship to overall goals.

[edit] Disadvantages of Zero-Based Budgeting

Difficult to define decision units and decision packages, as it is very time-consuming and exhaustive.
Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.
Necessary to train managers. ZBB should be clearly understood by managers at various levels otherwise they cannot be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.
In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.
Honesty of the managers must be reliable and uniform. Any manager that is prone to exaggeration might skew the results.

[edit] Incremental Budgeting

Incremental Budgeting uses a budget prepared using a previous period’s budget or actual performance as a base, with incremental amounts added for the new budget period. The allocation of resources is based upon allocations from the previous period. This approach is not recommended as it fails to take into account changing circumstances. Moreover, it encourages “spending up to the budget” to ensure a reasonable allocation in the next period. It leads to a “spend it or lose it” mentality.

Advantages of incremental budgeting

The budget is stable and change is gradual.
Managers can operate their departments on a consistent basis.
The system is relatively simple to operate and easy to understand.
Conflicts are avoided when departments appear to be treated similarly.
Co-ordination between budgets is easier to achieve.
The impact of change can be seen quickly.

Disadvantages of incremental budgeting

Incremental budgeting assumes activities and methods of working will continue in the same way.
No incentive for developing new ideas.
No incentive to reduce costs.
Encourages spending up to the budget so that the budget is maintained next year.
The budget may become out-of-date and no longer relate to the level of activity or type of work being carried out.
The priority for resources may have changed since the budgets were originally set.
There may be budgetary slack built into the budget, which is never reviewed. Managers might have overestimated their requirements in the past in order to obtain a budget which is easier to work within, and which will allow them to achieve favourable results.