An organization’s budget is its playbook for the next year. Unlike traditional budgeting, which assumes an incremental increase in the previous year’s budget, zero-based budgeting starts from scratch. Each expense must be reviewed at the start of the budgeting period. The advantages and disadvantages of zero-based budgeting weigh tighter expense controls and better goal alignment with a greater lift in time and resources.
As more finance chiefs shift to this approach in the face of inflation and other economic factors, it’s a good time to consider whether or not the zero-based approach is right for your organization.
Traditional Budgeting: A Budgeting Method of the Past
Most companies want the budget planning process to take as little time and resources as possible. Traditional incremental budgeting takes the current year’s budget and adds a multiplier to it. A two to five percent increase is allotted most years, although company growth and economic conditions may warrant a greater impact on costs.
Disadvantages of Incremental Budgeting
Of the many budgeting methods available, this type of budgeting inherently assigns importance to historical expenses with its built-in assumptions and logic. This comes with several major disadvantages:
- Ignored economies of scale: When businesses set a goal, such as an increase in sales, they assume an increase in expenses by a proportional amount, which can lead to waste.
- Unnecessary inflation: If you’re not reviewing each expense during the process, you may include expenses in next year’s budget that aren’t necessary, such as one-time purchases, like computers.
- Missed opportunities to reduce spending: A busy shipping department that sees a budget similar to last year’s is unlikely to carve out time to evaluate other carriers that could provide a significant price advantage. So, an intention to reduce spending is unlikely.
What is Zero-Based Budgeting?
Using a zero-based budget is an ideal way to shake up a stale environment. This approach is a longer process than the incremental method, but it is an effective way to scrutinize expenditures and identify outgrown needs.
A zero-based budget starts with the strategic goals of the organization. Improving customer experience, withdrawing from an international market or pursuing digital transformation would each provide key information to management as they create their new budget. This allows management to take every revenue and expense item and tie them back to strategic goals and key KPIs.
Is Zero-Based Budgeting Right for My Industry?
This budgeting method is ideal for companies in mature industries where growth has stagnated and it’s necessary to pursue cost efficiencies, such as the healthcare industry. On the other end of the spectrum, zero-based budgeting can be useful at a startup. Many earlier stage companies are in constant testing and validation mode, so their expenses, revenues and short-term goals are more flexible and fluid.
Despite its advantages, many smaller organizations and entities like the government are less likely to use zero-based budgeting in order to save time.
By examining the advantages and disadvantages of zero-based budgeting, you can determine if it’s the right method for your business.
The Advantages of Zero-Based Budgeting
Zero-based budgeting shouldn’t be dismissed due to its upfront time and resource needs. Overall, a zero-based budget promotes deeper analysis and more strategic decision making.
- Alignment with strategic goals: When every line item must tie back to three to five strategic goals of an organization, the clarity on what to prioritize can be significant.
- Better cost control: Unsupported expenditures from prior years are called into question. Single-year expenses are not accidentally carried over into next year’s budget. Users can better grasp economies of scale, and ongoing spending must be justified based on its added value to the company.
- Greater accountability: Managers who contribute revenue and expense projections during the budgeting process are held accountable for their performance. Planning is followed up with frequent monitoring throughout the year.
- Enhanced communication: Collaboration is a necessity as the finance function and operations work together to build a detailed budget that’s supported at all levels.
- Focus on drivers: Forcing managers to justify expenditures and analyze projects based on key drivers and past learnings can improve the most important areas of your service or product and, in turn, improve the customer experience.
Key Challenges of the Zero-Based Approach
Incorporating zero-based budgeting into your budgeting cycle requires a shift in mindset for the managers who propose and are accountable for their budgets.
- Required buy-in: A new budgeting approach requires openness to change, which means you may need buy-in from potentially unwilling stakeholders.
- Potential layoffs: During the budgeting cycle, areas of redundancy can lead to layoffs or warrant reassignments and skills training.
- Time crunch: The time needed to prepare zero-based budgets may increase stress on an already-loaded team.
- Skill gaps: Accounting and finance department experience may be limited and require additional ramp up time during its first year in use. A fractional expert can assist you during the transition year.
- Short-term focus: Management may stay exclusively focused on short-term goals and stop short of fully funding long-term projects and objectives. Clear direction is needed to keep long-term initiatives funded and staffed if their value remains intact.
Additional Considerations for Implementing Your New Budget
In addition to the advantages and disadvantages of zero-based budgets, there are certain considerations to take when switching from your current method to your new method. These can apply to any budget, but they are especially true as your process becomes more complex.
Do You Need a Zero-Based Budget Template?
Should your business use zero-based budget templates, macro-laden spreadsheets or specialized budgeting software? Whichever method you choose, using the same format and tools provides an edge when consolidating departmental budgets together at the corporate level.
Be sure to discourage leaders from trying to fill in every line item. It is expected that your budget and chart of accounts has the capacity for many items that are only needed intermittently—such as for expenses incurred during a triennial audit.
Explore Your Compensation Strategy
As with any other significant change, management incentives should be reviewed to ensure they support completing the budget process. Accountability for meeting the budget goals should be compensated in an appropriate manner.
Enhance Your Budget
Adopting zero-based budgeting enables businesses to make better decisions. Businesses of all sizes can experience the advantages of zero-based budgeting and benefit from its transparency, accountability and value to decision making.
Does your business need flexible talent to ease your transition into a new budgeting method? Paro’s elite community of remote finance experts can help you build a more accurate and forward-facing budget. Get the expertise and guided insights you need to achieve your plan.