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Advantages and Objectives of Zero Based Budgeting

Updated on October 1, 2012

Application and Strength of Zero Based Budgets

In order to avoid situations in which ineffective elements of a business continue to exist simply because they were on the prior budget, some companies use zero-based budgets,which, as the name implies, start with zero dollars allocated. While the traditional budget focuses on changes to the past budget, the zero-based budget focuses on constant cost justification of each and every item in a budget. Managers must conduct in-depth reviews of each area under their control to provide such justification.

The strength of the zero-based budget is that it forces review of all elements of a business. Zero-based budgets can create efficient, lean organizations and are therefore popular with government and nonprofit organizations. A zero-based budget is a way of taking a new look at an old problem.

Steps in preparing Zero Based Budget

The first step in developing a zero-based budget is to have each department manager rank all of its activities from most to least important and assign a cost toeach activity. Upper management reviews these lists, called decision packages, and cuts items that lack justification or are less critical. Upper management asks questions such as “Should the activity be performed and if is not, what will happen” or “Are there substitute methods of providing this function such as outsourcing or customer self- service”

Managers may also use benchmark figures and cost-benefit analysis to help decide what o cut. Only those items approved appear in the budget. The cost of the accepted Items may be arrived at through discussion and negotiation with the department managers. Once the budget figures are determined, the zero-based budget becomes the basis for a master budget.

The main advantage of ZBB

Theoretically, zero-based budgets have the advantage of focusing on every line item instead of just the exceptions. They should motivate managers to identify and remove items that arc more costly than the benefits provided. These budgets are especially useful when new management is hired. Zero-based budgets have a major drawback in that they encourage managers to exhaust all of their resources during a budget period for fear that they will be allocated less during the next budget cycle. if a manager has incorporated budget slack into the budget, a zero-based budget can encourage a significant amount of waste and unnecessary purchasing.

The only dis advantage is it is time consuming process

One issue with zero-based budgeting is the time-consuming and expensive annual review process and as a result, the review may often be less thorough than it is intended to be. In addition, by not using prior budgets, the firm may be ignoring lessons learned from prior years. If used every year, a zero-based budget may actually become little more than an incremental budget with a little extra processing. Managers simply remember their old justifications and figures and use them the following year.

The time and expense of a zero-based budget is often mitigated by performing zero- based budgets only on a periodic basis, such as once every five years, and applying a different budget method in the other years. Or, the firm might rotate the use of zero- based budgeting for a different division each year.

How ZBB take edge on Incremental Budget

An incremental budget is a general type of budget that starts with the preceding year’s budget and uses projected changes in sales and the operating environment Co adjust individual items in the budget upward or downward. It is the opposite of a zero-based budget. The main drawback to using this type of budget (and the reason that some companies use zero-based budgets) is that the budgets tend to only increase in size over the years. A sense of entitlement may also arise with the use of an incremental budget.

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