What is zero-based budgeting?
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Zero-based budgeting (ZBB) is a strategy employed when expenses need to be itemized by department and strict budgets must be enforced. It can be used by individuals but is largely used by businesses. In this article, we’ll go through some of the challenges and complications that may arise when trying to implement a zero-based budgeting system. We’ll also outline some of the prime benefits of implementing this budgeting system and some guidelines to consider whether or not it’s right for your business.
What is zero-based budgeting?
Zero-based budgeting is a strategic finance technique where each budget is built from scratch at the beginning of the period. Starting at $0, all expenses and costs for the upcoming period are added and the sum of that total is the budget for the period. This is typically done by department leads to provide the accounting team with more granular numbers.
Companies use zero-based budgeting when outflows need to be carefully monitored. That could be in cases where funding is limited, and costs are weighed carefully, or simply to get spending under control. The technique is not as popular as it once was because pricing and cost structures tend to vary in-period, but it's still highly effective.
How zero-based budgeting works
Zero-based budgeting is primarily a technique to help you better manage business cash flow. According to a global cost management survey conducted by Deloitte, 43% of global companies surveyed reported hitting their cost targets when using ZBB. Businesses that failed to meet their target costs attributed it to over-aggressive pursuit of cost targets and rising inflation.
Success with zero-based budgeting is achieved by carefully monitoring costs throughout the period and strategically managing this cashflow. The system is designed for department heads and executives to give them real-time insights into their spending without the burden of past period estimates and future projections. In short, it’s budgeting that works in the present tense.
Let’s use a marketing department as an example. By budgeting specific amounts for social media spend, advertising design, and search engine marketing, the department is limited in how much they can allocate to their marketing campaigns. This keeps overall costs down and facilitates better financial planning and analysis, which can be used for the next period’s budget.
A simpler analogy for this is that your department is given a certain amount of cash to spend and no credit to go over budget. At least that’s how it works under perfect conditions. Unfortunately, costs are sometimes higher than projected and market conditions can change. Those are two of the factors that can cause challenges with a zero-based budget.
How zero-based budgeting compares to traditional budgeting
Traditional budgets are constructed by reviewing the total amount spent in the previous period and setting the new budget as a percentage increase or decrease from that number. The flaw in this method is that spending is not analyzed and restructured to eliminate waste. Several established companies have traditional budgets that are overinflated. Some of the areas where that waste occurs include:
- Spending money on excess inventory
- Using outdated office equipment
- Double spend on SaaS subscriptions, or lack of SaaS management
- Unnecessary outsourcing
- Energy inefficiencies
- Office supplies
Zero-based budgeting is more of a real-time expense tracking system. Since the numbers are only compiled for the present period, there’s no chance of carrying over wasteful costs and expenses that are no longer relevant. Those can be detected and eliminated if any of them appear during the period you’re operating a zero-based budget.
The key to making all this work is careful monitoring by department heads and accounts payable coordinators. One-time expenses can be checked off as they happen. Categorized expenses that are tracked monthly can be monitored with periodic milestones. Both actions require an accounting system that does real-time expense tracking.
For a company to be effective with zero-based budgeting, everyone must be on board. Supervisors and teams need to work cross-collaboratively while being fully responsible for their individual department budgets. Without this level of cooperation, zero-based budgeting can quickly fall apart.
If you’re transitioning from traditional budgeting to zero-based budgeting, it’s a good time to evaluate expenses where you automate bill payments. Companies that have been around for a while typically have automated expenses that may no longer be valid. Look for software subscriptions, marketing fees, and utility bills for defunct locations.
Pros and cons of zero-based budgeting
With that said, zero-based budgeting may not be appropriate for all businesses. Implementing it requires a cooperative effort between accounting teams and administrators, so communication and transparency are critical for success. Here are some advantages to consider when deciding whether use of ZBB is right for you:
- Focused operations: Implementing zero-based budgeting allows your department heads to focus on only their costs and expenses, eliminating the need to worry about the company’s overall bottom line.
- Lower costs: You can cut down on cash outflows by limiting costs to only those included in the zero-based budget. This reflects well on your quarterly balance sheet.
- Budget flexibility: Zero-based budgets are not tied to previous period budgets, so there’s more flexibility in developing them.
- Strategic execution: Constructing individual zero-based budgets for each department gives you the freedom to be more strategic with business decision-making.
Though a zero-based budget may be simpler for department heads to understand, it’s more complicated for companies to develop, especially if you’re coming out of a period where you used a traditional budget process. Some other disadvantages to consider are:
- Resource intensive: Zero-based budgets need to be created from scratch each period. This makes them extremely resource intensive, requiring a heavy lift up front.
- Short term perspectives: For that period, zero-based budgeting gives you good short-term perspective on spending. However, it does not account for the next or last periods.
- Long-term horizons are overlooked: Since perspective is short-term, long-term horizons for departments like R&D are often overlooked.
Many companies switch to zero-based budgeting for a short period while they’re trying to get costs under control, then transition back to a more traditional budget method. Unlike your accounting system, you’re not “locked in” to do this for the life of the company.
Should my business implement zero-based budgeting?
This is a question of circumstances and needs. If your company has the internal discipline and resources to implement a zero-based budget, you can and should consider it. Once that requirement has been met, ask whether it’s the right choice for you. This is the needs portion. Do you need to get costs under control? Do you need better insights into your spending?
Keep in mind that this does not have to be a permanent change. Zero-based budgeting can be set up as a short-term project to streamline your spending. It’s also a good fit for new department heads who need to be vetted before giving them a more traditional budget and the power to modify spending when needed.
Outline your objectives before devoting the resources to implement zero-based budgeting. You’ll be committing to at least several periods where budgets need to be constructed from zero. That takes personnel and time. Does your company have the bandwidth to pull that off? This is an important question you need to answer before you begin.
Best practices for implementing zero-based budgeting
The success or failure of zero-based budgeting is entirely dependent upon the structure and communications abilities of your company. Objectives must be clearly outlined and timeframe for the project should be decided on before you begin. To ensure your success, we recommend the following best practices for implementing your new zero-based budget system:
Install automated expense tracking software
Determining success or failure with zero-based budgeting is dependent upon the tools you use to track results. Expense automation and tracking software will show you exactly what your costs are.
Define roles and responsibilities
Organize a series of meetings with key personnel who will be involved in managing the new budget. Define roles and responsibilities and make sure everyone is on the same page. Make sure lines of communication are open and that employees are empowered to make the right decisions.
Set goals and milestones
What is your objective in implementing zero-based budgeting? It’s important for you to know and communicate that with others at your company. Set goals for the end of the period and milestones to track during it.
Schedule frequent reviews
No system is perfect on its first iteration. Schedule frequent reviews to track your progress and discuss modifications when necessary. The system will remain the same, but some of the numbers are likely to change.
Don’t give up too soon
Deciding after one iteration that zero-based budgeting doesn’t work is a mistake. Give it enough time to fully evaluate results. Internal resistance and early-stage mistakes are common. Get past those before passing or failing ZBB.
Get full transparency into expenses with Ramp
One of the common stumbling blocks with zero-based budgeting is allowing employees to submit manual expense reports. With Ramp, expenses can be automated and controlled. Limits can be set on spending and certain expenses can be allowed or disallowed. Your company will need a system like this to be effective with zero-based budgeting.
Another advantage to using Ramp is the hundreds of integrations we have with other software systems, including budgeting software and accounting platforms. Our transparency into expenses makes it simpler to create financial reports each quarter, giving you another metric to measure the success of your zero-based budgeting implementation. Visit Ramp.com today to learn more.
ZBB is a budgeting approach that uses a clean slate every period a budget is created. That is, the previous period’s budget is not taken into consideration. Traditional budgeting, in contrast, is a financial planning process where budgets and expenditures from the previous period carry over into the next.
One main advantage of ZBB is its focus on expenses, not the bottom line of the business. This creates a much more focused budget and enables companies to reduce costs. Zero-based budgets are also independent from previous budgets, which provides companies with more financial flexibility.
Zero-based budgeting can be used by individuals for personal finance, but is largely used by businesses for its budget planning advantages.