What is Zero-based Budgeting? – Definition
In the Zero-based budgeting approach, all organizational activities are initially set to zero. Zero-based Budgeting is the newest approach to Budgetary Planning and Control. It was successfully developed and implemented in the seventies by Peter A. Phyrr. The approach became further popular when President Jimmy Carter, in 1979, required its use for the federal government.
The premise behind the zero-based budgeting (ZBB) approach is twofold. First, it attempts to break away from the past: the activities mandated, their budget allocations and their expected increments. It suggests that service departments should justify their annual budget allocations from the ground upwards. Any previous allocations in the past are not considered and the focus becomes one of emphasizing future objectives and goals.
Secondly, while many organizations may have no great difficulty in correlating expenses such as salaries, telephone calls, maintenance of photocopying machines, etc., with a specific activity, there is no fundamental questioning of the activity itself. ZBB goes as far as to prompt the question: ‘Do we need the
activity or service in the first place?’
The Zero-Based Budgeting approach — although received with mixed results in many firms — has one powerful advantage in addressing these drawbacks: it implies a constant review of activities and priorities by those directly involved. The costs involved can then be assessed in a structured fashion and ranked in order of importance with other equally pressing needs for resources.
The traditional method takes the current level of operations as the starting point for developing the future year’s budget. In the traditional approach, it is assumed that all previous activities are essential for achieving the on-going objectives. However, the important limitations of the traditional approach are:
a) Budgets tend to get larger and larger over the years as inefficiencies of earlier years are carried forward.
b) New projects receive a raw deal, being more susceptible to be dropped out in case of budget cuts.
c) Alternative ways of achieving the same objectives are not identified. Things are taken for granted.
d) Key problems and decision areas are not highlighted.
Thus, the traditional approach of using the existing budget as the starting point for developing the next budget needs reappraisal.
The second approach to budgeting is the Zero-Based budgeting approach. This approach is defined by Peter A. Phyrr “An operating, planning and budgeting process which requires each manager to justify his entire budget request in detail from scratch (hence Zero-based) and shift the burden of proof to each manager to justify why he should spend any money at all“.
The Zero-based Budgeting technique starts from scratch each year and puts much less emphasis on what was budgeted in the past. The approach involves the evaluation and review of all activities and programs on the basis of a cost-benefit analysis.
Key elements of Zero-based Budgeting
- Identification of the objectives and developing an operating plan and budget for the coming year.
- Identifying alternative and efficient ways of achieving the current activity.
- Evaluate budget reductions and expansions in a systematic manner to allow for a re-allocation of the resources, as per the priorities of the organization.
- Diagnosing the unnecessary activities that budgeting often perpetuates.
Procedure of Zero-based budgeting
The basic steps involved in Zero-based budgeting are:-
1. Identification of decision units. The decision units are somewhat like cost-centers.
2. Analysis of each decision package in a decision unit. Once the decision units have been identified, managers try and analyze the decision packages in each decision unit. Each decision unit has several decision packages. For each decision package, managers evaluate the incremental benefits that they get from the incremental cost. The decision packages also try and find out alternative ways of accomplishing the same activity.
3. Ranking the decision packages so as to allocate the resources in the best possible manner. The ranking also helps the top management to determine the benefits of each decision package to the organization which will be evaluated by systematic analysis and ranked in order of importance.
Ranking establishes priorities amongst the functions as described in the decision package. Generally, the manager at the level of the divisional manager ranks the package. This allows them to trade the expenditure on cost planning, maintenance, sales, and administration. Top management prepares a consolidated ranking to identify the best allocation of resources.
Management can now decide a cut off level on any or all rankings. It may decide to fund only the first fifteen packages out of a total of twenty-five. This might mean funding for some new high priority programs at the cost of other ongoing low priority ones.
4. Preparation of Budgets. The final step is the preparation of budgets on the basis of decision packages and the availability of funds.
Advantages of Zero-Based Budgeting
(1). It ensures that all activities and programs and their alternatives have been evaluated by the manager. This helps to allocate resources according to the priority of the programs as only the best program is considered.
(2). Zero-based budgeting starts from scratch each year and hence it can eliminate the unnecessary activities/expenses that traditional budgeting often results in. This improves resource allocation and profitability of the organization.
(3). The Zero-Based approach requires integrated linkages to long-range plans and strategies. By constant reiteration of the process, both plan and budget are brought into consonance. Also, the plan is more responsive to market needs and more sensitive to profits.
(4). Zero-Base budgeting techniques facilitate rational analysis and decision making. Decision packages are ranked in order of importance.
Drawbacks to Zero-Based Budgeting
Will it continue?
Like everything that is novel, the results at the beginning can be impressive but short-lived: the new ethos of appraisal, the breakdown of departmental barriers, the cutting out of unnecessary costs and the boosting of revenues are of little use if the momentum does not continue. Pressure from other parts of the organization particularly from the users of central services — should be encouraged if it questions whether, at their current size, such activities really do add value.
Such probing can lead to a healthy keenness to subcontract out as many services: as possible. One UK banking group, after years of uneven quality from the central IT service to users and frustration on the part of IT experts because users were unable to articulate, their requirements, adopted a new approach: some of the computer functions were devolved into the main business areas of the bank and competition was introduced into other IT services.
Are existing budget procedures so bad?
Before managers are blamed for not arriving at the best cost/benefit relationship for their services, the informal practices used in appraising performance should be investigated. Do they do similar things in a less structured fashion but arrive at the same results?
It can be time-consuming
The amount of time and labor required can be substantial because of the scope and depth of questioning involved. This makes ZBB unsuitable for annual implementation as it can distract focus from the key issues during the budget process rather than on them. Consideration should be given to scheduling the ZBB review process not annually but periodically so that all responsibility centers are covered at least once every four to five years. Alternatively, specific line item budgets such as those for MIS, advertising, travel, document reproduction or photocopy maintenance could be examined one after another year as a global expenditure activity, even if they are allocated across several responsibility centers.
Will Zero-Based Budgeting make managers less flexible in innovating and varying activities?
Over time there is a risk that Managers may feel threatened by the thought of minimal increments to their budgets as this implies cuts which are damaging to the growth of their departments. Encouraging managers to think along the lines of examining new alternatives can also have the same effect: ‘Shouldn’t I have thought of this before?’ Exposing the weaknesses in a project and even questioning the underlying logic could discredit managers and turn them against the Zero-Based Budgeting process completely. Care is needed not to allow the ZBB method to become a number-crunching exercise performed only to please the boss. Rather it should be a more fundamental analysis aimed at, for example, enhancing the proper functioning of routine tasks.
Do we have the expertise to appraise and rank those packages?
The traditional and somewhat narrow focus of management training in many countries has created single-discipline managers capable of being good accountants, lawyers or salespeople, but ones who have no knowledge of other functions. In such circumstances, it is difficult to ask unit heads to contemplate an in-depth analysis of those other functions which impact on their activities and ultimately their costs.
What about the costs of conducting such an exercise?
The most frequent complaint heard from critics of the Zero-Based Budgeting method is the cost of introducing the concept and getting it working. The most significant cost to organizations will be the initial time and staff effort spent in setting up the system. The design of the system itself and the preparation of a systems manual will take time. Training existing senior staff on ZBB methodology within each department will also generate costs. However, experience gained by American corporations in the implementation of ZBB indicates that there is a steep learning curve that flattens out over the second and subsequent years.
The multi-functional team approach
One way of addressing these frequent drawbacks is to spread the time factor and responsibility evenly by seconding a small number of executives from their line and staff duties to look afresh at the key operations of the company. Rather than working in isolation within their own departments as a ‘think tank’, they should be encouraged to get out into the business, to question and evaluate services in individual offices, stores, warehouses, and factories.
Their mandate should be to investigate not only whether each job, task, method of operation, etc, could be done better, but also whether it need to be done at all. In this manner, a multi-functional team within a leading European retail group discovered a mountain of unnecessary paperwork creating a chain of costly activity throughout the organization. They had simply asked the question: ‘Is it really needed?’