Zero-based budgeting (ZBB) is a budgeting technique in which all expenses must be justified for a new period or year starting from zero, versus starting with the previous budget and adjusting it as needed.
ZBB is a highly effective business-planning tool to help a company identify and eliminate unnecessary costs, keep control of your spending, and focus on high-profit initiatives.
Budgeting, including ZBB, is the tactical implementation of a company’s strategic plan. To deliver the financial and operational goals in the strategic plan, an organization needs to translate its long-range plan into a detailed set of expected revenues and expenses that can be measured to track performance. These can be refined and adjusted along the way to keep the company on track with its goals to achieve the desired business outcomes.
Above all, budgets enforce ownership and accountability so that financial decisions are made sensibly. They help companies project profits, spot potential problems, and identify new opportunities so that finance leaders can make the necessary adjustments.
The typical budgeting process is translating a long-range strategy into annual operating plans that are pushed down to finance, lines of business, and operations. This communicates the financial targets across the organization in every line of business. The targets can be financial and operationally aligned. Some examples of this are revenue and expense budgets, R&D costs, marketing expenses, project costs and revenues, and capital expenditures.
The budgeting process requires analyzing and comparing actual versus expected financial performance to determine how to allocate expenditures for the organization to achieve the budget targets set.
With traditional budgeting, the process of projecting your business’ revenue and expenses for the upcoming year is typically based on your previous budget which is used to help predict, analyze, and track revenues, expenses, profits, and cash flows. Traditional budgeting calls for incremental increases over previous budgets, such as a 2% increase in spending, as opposed to a justification of both old and new expenses, as called for with zero-based budgeting. Traditional budgeting only analyzes new expenditures, while ZBB starts from zero and calls for a justification of old, recurring expenses in addition to new expenditures.
Zero-based budgeting was developed in the 1970s by Pete Pyhrr, a former accounting manager with Texas Instruments. The original goal of ZBB was to help organizations reduce costs and promote fiscal responsibility.
With zero-based budgeting, the budget is started from scratch or a “zero base” each year. Using this approach, every line of business within an organization is analyzed for its needs and costs while ignoring historic spending. The key difference is justification: Zero-based budgets need to review every expenditure at the beginning of the budget cycle, and lines of business have to justify the need and impact of each line item before funding can be approved.
Each budget line item is reviewed without the influence of the last period’s actuals as a baseline. Each item is carefully evaluated to determine if any programs, services, or activities will be increased, maintained, reduced, or removed. Managers need to account for all elements of the budget and identify cost-effective, relevant, and cost-saving areas.
ZBB can be applied to any type of cost: capital expenditures, operating expenses, research and development (R&D) expenses, or even cost of goods sold (COGS).