Advantages and disadvantages of zero-based budgeting

Zero-based budgeting has the power to revolutionize cost management in your organization. It's more than just crunching numbers - it's about fostering an environment of responsibility and operational efficiency.

What is zero-based budgeting?

Zero-based budgeting is an approach to corporate budgeting that requires you to begin each fiscal year with a zero-base. A zero-base requires each department to detail their needs down to the line item, regardless of the amount requested in the previous year’s budget.

Zero-based budgeting advantages

There are several benefits to zero-based budgeting, which make it an appealing option for companies looking to understand how their funds and resources are allocated at a granular level.

1. Enhanced agility

One advantage of zero-based budgeting (ZBB) is that it boosts the flexibility of your finance team. Budget administrators must begin from scratch and defend their resource needs during each budgeting cycle, which is invaluable during periods of economic uncertainty.

2. Optimized data

Companies that take a zero-based approach to their budget treat data as a valuable corporate asset, avoiding the confusion caused by disjointed spreadsheets and poor data governance. Each value assigned to the budget must have an accompanying need, ensuring that no extraneous expenses are added.

3. Quicker reforecasting

Zero-based budgeting requires validated and orderly data, which is another advantage. This same data set can expedite your forecasting processes, significantly reducing the time required to reforecast your earnings and revenue.

Zero-based budgeting disadvantages

Now, let’s look at some of the disadvantages of zero-based budgeting, and how you can overcome them.

1. Limited visibility

While zero-based budgeting (ZBB) excels in many areas, it falls short in projecting long-term outcomes when compared to conventional methods. This is because ZBB's focus is on readjusting the budget, rather than forecasting the future. To address this, it’s important to allocate time to not only reviewing your budget, but also prioritizing long-term strategic initiatives.

2. Labor-intensive

For organizations accustomed to an incremental approach to budgeting, ZBB can seem demanding. Each department must substantiate their expenses and plans without leaning on assumptions from previous years. Despite being a great way to curb overspending, ZBB necessitates collaboration across various departments within the organization.

3. Measurement difficulty

When a department's productivity isn't easily quantifiable, deciding where to allocate funds and justifying these expenses to senior management can pose a challenge.

Benefits of zero-based budgeting

The advantages of zero-based budgeting – enhanced agility, optimized data, and faster reforecasting – can result in significant benefits for your finance team and broader organization, including:

Goal-oriented operations

When you’re forced to consider how each dollar of your budget is spent, you must also evaluate your goals for the year, and the resources you need to achieve them. As a result, the strategic objectives of your organization are more clearly defined, giving you clarity on what’s truly important.

Improved accountability

Zero-based budgeting is a collaborative process that requires each department to submit their resource needs for the year. Since each team is involved in the process, it is easier to hold them accountable for their decisions and performance. Zero-based budgeting also requires frequent check-ins throughout the year, which is an opportune time to come together as a team to identify priorities and make changes.

Optimized cost management

Perhaps the biggest benefit of zero-based budgeting is cost management. When you take an incremental approach to budgeting, in which you increase your total budget amount by a certain percentage each year, you run the risk of carrying over extraneous expenses that don’t align with your strategic objectives. Zero-based budgeting forces teams to justify every cost, so it’s easier to identify areas where you can reduce spending.

Challenges of zero-based budgeting

Let's dive into the challenges you may face when implementing zero-based budgeting, from stakeholder buy-in to a potential shift in focus and the introduction of uncertainty and stress.

Stakeholder buy-in

If you usually take an incremental approach to budgeting, it can be difficult to get stakeholder buy-in for a new method. If your teams are used to receiving a set amount of funds each year, it can be a shock to be asked to justify every line item. Before beginning zero-based budgeting, it’s important to explain the advantages of zero-based budgeting to your organization and get buy-in from all your stakeholders, so everyone is ready to participate in the process.

Short-term focus

Zero-based budgeting takes a granular approach to allocating funds, which is effective for cost management, but can shift your focus to the short-term. When you allocate funds to each line-item, you run the risk of deprioritizing long-term projects, especially those that don’t have a tangible output. Before beginning the process, you must establish a clear direction for your long-term initiatives so that they remain funded and staffed.

Uncertainty and stress

Zero-based budgeting has the potential to introduce uncertainty and stress into your organization. When departments need to advocate for their own budgets, it can feel like they’re competing for funding with other teams, and they may worry that their projects and programs will be eliminated. This is why it’s so important to get stakeholder buy-in before undertaking ZBB, so that everyone understands the organization’s short- and long-term priorities.

Best practices of zero-based budgeting

Let’s explore the most effective strategies for implementing zero-based budgeting in your organization, including evaluation methods, collaborative budgeting, and the use of FP&A software.

Evaluate resource requests against one framework

When using zero-based budgeting, it's best to measure all resource requests against one standard framework. This means comparing every cost in the same way, which makes it easier to decide what's necessary. It also helps ensure that all departments’ budgets are evaluated in the same way, and that the needs of teams with measurable outcomes are not prioritized over other important functions (e.g., marketing, human resources, etc.).

Make it a collaborative effort

For zero-based budgeting to work best, you should make it a team effort. Everyone involved should have a say in their budget needs. This way, everyone understands the decisions and feels part of the process. It's all about working together for the best outcome.

Use FP&A software

ZBB requires you to have full visibility into all your cost centers, including their activities, productivity, and revenue. FP&A software is the ideal solution for this method, as it aggregates data from across your organization, which can be a time-consuming and labor-intensive process in spreadsheets.

It’s worth noting that FP&A software can also be referred to as Financial Performance Management (FPM), Corporate Performance Management (CPM), or Enterprise Performance Management (EPM) software.

How do you do zero-based budgeting?

There are 5 key steps to zero-based budgeting:

1. Define objectives – Outline what you’re hoping to achieve during this budget period, and what resources you need to make this possible.
2. Identify cost drivers – Determine which variables impact your revenues and costs and investigate how they change over time.
3. Classify expenses – Allocate each line item into one of four categories: essential, strategic, supportive, or discretionary.
   1. Essential expenses are nec essary to run your business (e.g., rent, payroll, etc.).
   2. Strategic funds directly support strategic objectives.
   3. Supportive funds indirectly support strategic objectives.
   4. Discretionary funds are usually reserved for travel or entertainment, which are optional.
4. Allocate resources – Assign funds to each expense category and justify the benefits, costs, risks, and alternatives for each line item.
5. Monitor your budget – Compare your actual results against your plan, and report on the results to your stakeholders.

Alternatives to zero-based budgeting

Zero-based budgeting isn’t the only approach out there – there are several budgeting alternatives that may be better suited to your goals and objectives.

ZBB vs. activity-based budgeting

Activity-based budgeting is a top-down approach that requires you to calculate the funds needed to support your desired output or goal. This contrasts with zero-based budgeting, which focuses on detailed accounting for each department’s needs. While activity-based budgeting emphasizes strategic alignment and growth, zero-based budgeting ensures precision and guards against unexpected shifts in costs.

ZBB vs. incremental budgeting

Incremental budgeting is the process whereby you calculate the current year’s budget by adding or subtracting a percentage from the plan. In contrast, zero-based budgeting doesn’t rely at all on the previous year’s budget and requires you to start the process from scratch.

ZBB vs. continuous budgeting

Continuous budgeting involves adding a new month to the end of the budget for every month that elapses. This allows you to evaluate where you stand each month and make changes as you go along. ZBB gives you a detailed plan for the year at the start, where continuous budgeting gives you the opportunity to refine your budget each month.

ZBB vs. value-proposition budgeting

Value proposition budgeting ensures that every cost listed in the budget adds value, by asking questions like: Why is this amount used? Who does it create value for – customers, staff, or stakeholders? Does its value outweigh its cost? If not, is it justified?

Like zero-based budgeting, value proposition budgeting is a good way to eliminate unnecessary expenditures and increase your return on investment.

Conclusion: Zero-based budgeting advantages and disadvantages

In conclusion, zero-based budgeting is a detailed approach to budgeting that requires scrutiny of every cost. While it has its advantages, like better cost control and increased efficiency, it presents challenges like uncertainty and getting stakeholder buy-in. However, with best practices like collaboration and evaluating requests against one framework, these obstacles can be navigated. Remember, there are alternatives to consider if zero-based budgeting doesn't fit your organization. Ultimately, the choice depends on your unique financial needs and goals.