Zero-based budgeting is an accounting practice that forces managers to think about how every dollar is spent in every budgeting period. It can have both benefits and drawbacks.
Zero-Based Budgeting: An Overview
Pete Pyhrr developed the idea of zero-based budgeting in the late 1960s to early 1970s while he was an account manager at Texas Instruments. In recent years, both Fortune 500 and private equity companies have adopted this budgeting technique.
A study from Accenture Strategy on zero-based thinking published in 2018 found that from 2013 through 2017, this budgeting method grew exponentially among the world's 85 largest companies at a rate of 57% each year. Those companies include Kraft Heinz Co., Mondelez International Inc., and Unilever PLC.
In traditional budgeting, companies start with the previous period's budget as a template and then build upon it. Usually, each new budget increases incrementally compared to the previous period's budget, and companies only need to justify new expenses.
Zero-based budgeting deviates from traditional budgeting in that the budget for each new period is created starting from a "zero base." They must justify each expense before adding it to the new budget—even old and recurring expenses.
The major advantages are flexible budgets, focused operations, lower costs, and more disciplined execution. The disadvantages include the possibilities of resource intensiveness, being manipulated by savvy managers, and bias toward short-term planning.
Benefits of Zero-Based Budgeting
The benefits of this budgeting method include:
Managers Must Justify All Operating Expenses
Zero-based budgeting ensures that managers think about how every dollar is spent, every budgeting period. This process also forces them to justify all operating expenses and consider which areas of the company are generating revenue.
Keeps Legacy Expenses in Check
In traditional budgeting, legacy costs may not be examined for years until there is some sort of economic shock that forces the company to take extreme actions. Expenses have a tendency to grow over time, with each department protecting its budget from cuts. This approach can be myopic and, over time, it can lead to significant misallocation of resources. If done correctly, zero-based budgeting can prevent this from happening.
While managers must justify all expenses with zero-based budgeting, generally, it doesn't matter if the new budget is higher or lower than the one before it.
Drawbacks of Zero-Based Budgeting
There are also several drawbacks to zero-based budgeting:
Can Reward Short-Term Thinking
One of the major shortcomings of zero-based budgeting is that it can reward short-term thinking by shifting resources toward areas of companies that will generate revenue over the next calendar year or budgeting period. As a result, some areas of companies that are typically viewed as long-term investments that aren't directly tied to revenue, such as research and development or worker training, may be left with smaller budgets than they actually need. This could possibly hurt a company because, although these areas won't be generating revenue in the near term, they're often the keys to remaining competitive over the long term.
Zero-based budgeting is also resource-intensive. It takes a lot more time and effort to closely review and justify every budget element rather than modify an existing budget and review only new elements. Because of this, some critics argue that the benefits of zero-based budgeting do not justify its time cost.
Manipulation by Savvy Managers
In addition, the process can be gamed by savvy managers to get more resources into their departments. If this happens, it can lead to a change in culture where there is a decreased spirit of cooperation in the company, as workers feel expendable.
- Zero-based budgeting differs from traditional budgeting in that the companies that use it create a budget for each new period.
- The benefits of this method include that it can lower costs by keeping old and new expenses in check.
- Potential disadvantages are that it can reward short-term thinking, be resource-intensive, and could be manipulated by savvy managers.