Zero based budgeting is a cost benefit approach where by it’s assumed that the cost allowance for an item is zero and will remain so until the manager responsible justifies the existence of the cost item and the benefit the expenditure brings.
Traditionally budgets are prepared by taking current years estimates as the base and then adjusting for the impact of inflation, proposed increase in the level of activity, expected increase in the resources. This means that budgets for each year are always a percentage of previous year’s budget.
Zero based budgeting on the other hand requires each manager to justify his entire budget request in detail from scratch hence (zero base). Zero-base refers to a nil budget as the starting point. It starts with the premise that the budget for the next period is zero so long as the demand for an activity is not justified. The assumption is that without such a justification no spending will be allowed. Each manager is responsible to justify why the money should be spent at all and to explain in detail as to what would happen if the proposed activity is not carried out and no money is spent thus each manager is required to make a cost benefit analysis of each of the activities under his control. Zero based budgeting is best applied to service and support expenditure including administration, marketing, personnel, research and development, finance and accounting etc. Implementing zero based budgeting The overall process of implementing zero based budgeting can be subdivided into 3 stages:
a) Definition of decision packages – a decision package refers to an activity or a group of activities for which a single manager has the responsibility for successful performance. The decision package is specified by the managers concerned and must show details of anticipated cost and benefits expected.
- Mutually exclusive decision package- are alternative activities required to carry out the same job
- Incremental decision packages- are complementary activities.
b) Packages are evaluated and ranked – when the decision packages have been prepared, the management will rank all the packages on the basis of their benefit to the organization. This ranking provides a basis for allocation of resources between activities. c) Resources are allocated- the packages are accepted in the ranked priority sequence and then resources are allocated.
Advantages of zero based budgeting
- It results into a more efficient allocation of resources to activities.
- It focuses on the relationship between the input of recourses and output of benefits.
- It develops a questioning attitude and makes it easier to identify inefficient obsolete or less cost effective operations
- The zero based budgeting process leads to greater staff and management knowledge of operations of the organization and can increase motivation.
- It provides a budgeting and planning tool for management which responds to changes in the business environment; obsolete items of expenditure and activities are identified and ceased.
- It adds a psychological impetus to employees to avoid wasteful expenditure.
Disadvantages of zero-based budgeting
- There is considerable management skill required in both drawing up the decision packages and for the ranking process. Such skills may be lacking in the organization.
- It may encourage the wrong impression that all the decisions have to be made in the budget. Circumstances may change and new opportunities and threats can arise at anytime and organizations must be flexible enough to deal rapidly with these circumstances when they occur.
- Zero based budgeting may be unacceptable to staff who may prefer the status quo and who may see the detailed examination of alternatives, cost and benefits as a threat and not a challenge.
- There are problems in the ranking due to subjectivity.
- It emphasizes short term benefits to the detriment of the long term ones.