What Is Zero-Based Budgeting? Definition and Examples | Glossary (2024)

Zero based budgeting is a budgeting approach that takes a fresh perspective on your finances. Instead of relying on previous budgets, you start from scratch and build your budget from the ground up. It means you don’t carry over any assumptions or allocations from the past.

Here’s how it works: you analyze your income and expenses meticulously, ensuring that every dollar has a purpose. The goal is to prioritize and allocate resources based on your current needs and goals. By doing so, you clearly understand where your money is going. You have the choice of how you want to use it.

For example, let’s say you’re using zero based budgeting for your monthly expenses. You begin by listing all your sources of income, then allocate funds to different categories such as rent, groceries, utilities, and entertainment. This method encourages intentional spending and helps you maximize your money.

In a nutshell, zero based budgeting gives you the power to manage your money and make wise decisions about how to spend it. Let’s jump in and start learning about zero based budgeting, shall we?

What Is Zero-based Budgeting?

Zero based budgeting is a method of financial planning that involves starting the budgeting process from scratch with a zero base.

Unlike traditional budgeting approaches that rely on incremental changes to previous budgets, zero based budgeting requires a thorough evaluation of all expenses, irrespective of past allocations. Its primary goal is to eliminate inefficiencies, enhance cost management, and optimize organizational resource allocation.

The process of zero based budgeting typically involves the following steps:

• Identifying decision units: Decision units are organizational units or activities that can incur costs and make decisions. These can be departments, projects, programs, or other relevant units.
• Analyzing activities and costs: Each decision unit gets examined to identify its activities, outputs, and associated costs. It involves understanding each activity’s purpose, objectives, and resource requirements.
• Evaluating alternatives: Different alternatives or methods of accomplishing the activities get considered, and the associated costs and benefits get evaluated. It encourages the exploration of more efficient and cost-effective approaches.
• Allocating resources: The analysis and evaluation determine the allocation of resources to the decision units based on their priority and value to the organization. Approving expenses for each decision unit builds the budget until fully allocating the available resources.

This approach can help businesses to:

• Understand their expenses better. By scrutinizing every expense, businesses can identify areas where they can save money.
• Be more proactive in budgeting. Zero-based budgeting forces businesses to think about their goals and priorities before they start budgeting. This can help them to allocate their resources more effectively.
• Be more accountable and transparent. Because every expense must get justified, zero-based budgeting can help to create a culture of responsible spending.

History of Zero-based Budgeting

Peter Pyhrr first developed zero based budgeting (ZBB) in the 1970s. Pyhrr was a manager at Texas Instruments, and he was frustrated with the traditional budgeting method, which often led to inflated budgets. ZBB is a budgeting approach that starts from scratch each year. Every expense must be justified, and there is no assumption that the previous year’s budget will get used as a starting point.

The first large-scale implementation of ZBB was by the state government of Georgia in the mid-1970s. Governor Jimmy Carter and his budget director, Bert Lance, implemented ZBB to address financial challenges and control government spending. This implementation was successful, and it helped to popularize ZBB.

Over time, It has evolved, and many various organizations have adopted it. The initial focus of ZBB was on cost reduction and eliminating unnecessary expenses. However, modern approaches to ZBB also emphasize strategic alignment and prioritization of resources. It has become more dynamic and flexible, incorporating performance-based metrics and considering value creation rather than solely focusing on cost-cutting.

Types of Zero-based Budgeting

• Traditional zero-based budgeting: This approach involves starting the budgeting process from scratch, requiring justification for all expenses regardless of whether you had included them in the previous budget. Each activity or expense gets evaluated independently, and budgets are built based on their merits.
• Modified zero-based budgeting: In this variation, certain items or activities that do not significantly change from period to period may get exempted from the zero based evaluation. This allows for a more streamlined budgeting process while still ensuring critical expenses are justified.
• Continuous zero-based budgeting: Instead of conducting a periodic zero based budgeting exercise, this approach involves continuously reviewing and evaluating expenses continuously. It encourages a proactive mindset to identify cost-saving opportunities and allocate resources efficiently throughout the year.

How to implement Zero-based Budgeting

Here are the steps on how to implement zero-based budgeting

1. Identify all activities and expenses. This includes both recurring and one-time expenses. Recurring expenses are those that occur on a regular basis, such as salaries, rent, and utilities. One-time expenses occur less frequently, such as travel expenses, equipment purchases, and marketing campaigns.

2. Determine the cost of each activity. This includes direct costs, indirect costs, and any relevant overhead expenses. Direct costs are those that can directly get attributed to a particular activity. Indirect costs are those that get shared by multiple activities. Overhead expenses incurred for the general operation of the organization, such as rent, utilities, and insurance.

3. Justify each activity. Evaluate the necessity and importance of each activity. Assess its contribution to organizational goals and determine if it aligns with strategic objectives. Justify the costs based on the value and benefits derived from each activity.

4. Approve or disapprove each activity. Based on the justification and evaluation, approve or disapprove each activity or expense. Prioritize resources towards activities that align with strategic goals and add significant value. Ensure that the approved budget reflects the organization’s priorities and objectives.

Advantages and Disadvantages of Zero-based Budgeting

Advantages of Zero based Budgeting:

• Cost Control: Zero based budgeting (ZBB) forces organizations to justify all expenses, even if they were in the budget the previous year. This can help to identify unnecessary expenses, reduce waste, and improve decision-making.
• Resource Optimization: Zero-based budgeting (ZBB) is a budgeting method that starts from a zero base, requiring managers to justify all expenses, not just new ones. This process helps organizations optimize their resource allocation by ensuring that resources are aligned with organizational goals and priorities.
• Enhanced Efficiency: Zero based budgeting promotes a thorough examination of activities and processes, allowing for the identification of inefficiencies and opportunities for process improvement.
• Strategic Alignment: Zero based budgeting ensures that every activity and expenditure is aligned with the strategic objectives of the organization, fostering a more focused and goal-oriented approach.
• Budget Transparency: Zero-based budgeting (ZBB) provides greater transparency in budgeting by requiring justification for all expenditures. This makes it easier to track and understand the allocation of resources. In traditional budgeting, managers only need to justify changes to existing expenses. This can lead to a lack of transparency, as it is not always clear why certain expenses are incurring. ZBB, on the other hand, requires managers to justify all expenses, including new ones. This makes it easier to see how you are using the resources.

Disadvantages of Zero based Budgeting:

• Time-consuming: Zero-based budgeting (ZBB) can be a time-consuming process. This is because ZBB requires managers to justify and evaluate every activity and expense, even those that have been in place for years. This can be a significant undertaking, especially for large organizations with complex budgets.
• Resource Intensive: Implementing zero based budgeting may require additional resources, such as personnel and technology, to support the detailed analysis and evaluation of expenses.
• Resistance to Change: Adopting zero based budgeting may face resistance from employees accustomed to traditional budgeting methods, as it involves a significant shift in mindset and requires additional effort to justify existing activities.
• Potential Bias: Zero based budgeting (ZBB) is a budgeting method that requires managers to justify all expenses, not just new ones. This process can get influenced by personal bias or subjective judgments, potentially impacting the fairness and objectivity of resource allocation decisions.
• Short-term Focus: Zero based budgeting may lead to a short-term focus on cost reduction, potentially neglecting long-term investments and strategic initiatives.

Real-World Examples of Zero-based Budgeting

1. Procter & Gamble (P&G): P&G implemented zero based budgeting in 2012 to drive cost savings and improve resource allocation. The company aimed to review and justify all expenses, resulting in significant cost reductions and increased efficiency.
2. Kraft Heinz: In 2015, Kraft Heinz implemented zero based budgeting (ZBB) after the merger of Kraft Foods and H.J. Heinz Company. ZBB is a budgeting method that requires managers to justify all expenses, not just new ones. This process helps organizations identify cost savings and eliminate inefficiencies.
3. Coca-Cola: Coca-Cola adopted zero based budgeting in 2014 to enhance its cost management practices. The company aimed to eliminate waste, reduce complexity, and redirect resources to high-priority areas. ZBB enabled Coca-Cola to optimize its spending and achieve cost savings.
4. Kellogg’s: Kellogg’s implemented zero based budgeting in 2013 to improve profitability and reallocate resources to growth initiatives. The company focused on evaluating the return on investment for each activity, resulting in cost reductions and improved efficiency.
5. State of Tennessee: The state government of Tennessee implemented zero based budgeting in the late 1970s under the leadership of Governor Lamar Alexander. The implementation of ZBB helped Tennessee control spending, eliminate inefficiencies, and improve accountability in budgeting.