Though this term normally only applies to company strategy, there are lessons that can be taken for investors.
Zero-based budgeting is a process whereby you analyze every expense from scratch instead of simply increasing or decreasing the budget from the previous year. All of the different aspects of an organization will be individually looked at in terms of their needs and costs. The budget will then be built around these requirements for the period ahead, without considering the previous budget.
Reasons for using zero-based budgeting
This form of budgeting allows a company to implement important strategic goals into the planning process. The goals can be linked with particular functional aspects of the company. Costs can be grouped in each of these aspects and then compared with past results and current expectations.
As there is a lot of detail involved with zero-based budgeting, it may take a few years to complete the entire process across the business. A company may decide to focus on an individual department each year. An advantage of using this approach is that you can often decrease costs as you are not going to be blindly increasing budgets from period to period. You will be able to optimize costs across the entire business.
The main downside is that it takes a lot longer to complete this process than using the normal cost-based approach. It will also be a more favorable approach to areas of a business than can be easily quantified in terms of production or revenue. This is opposed to more intangible aspects of the business, such as research and development or client service.
Differences from traditional budgeting
With traditional budgeting, you will be incrementally increasing budgets compared to previous budgets. For example, you may increase marketing spend by 2%. Therefore, you will not be justifying the old or new expenses as is done with zero-based budgeting.
You will only be analyzing new expenditure with the traditional approach, as opposed to starting from zero and looking at all expenses – old or new. This process will often highlight areas where there can be significant savings. With the zero-based approach, managers will have to justify every expense that they are responsible for, rather than always trying to get the biggest budget possible for their department.
Process of creating a zero-based budget
There are many different steps involved in creating a zero-based budget. You will forecast the revenue or necessary funding levels for the upcoming period and determine the specific strategic goals. Once you have the goal or goals in mind, you can then start to work backward to figure out what resources are necessary in order to achieve them.
Calculate the costs of the resources and make sure that this expenditure will achieve your prioritized goals. Evaluate all current expenses to make sure they are within the spending levels that are necessary to achieve your goals and to ensure that they are necessary costs. You can then implement this budget and start over again when it comes time for the next budgeting period.
A zero-based budgeting example
If a company is looking to focus more on building a strong e-commerce presence in the next budgeting period and not focus as much on its brick-and-mortar business, a zero-based budget may be developed.
All current costs will be looked at from scratch in order to see if they are necessary for the strategic goal of building the online presence. This could mean significantly decreasing the amount of expenditure on traditional advertising, such as ads in local newspapers or sponsoring local events. Instead, the savings can then be used to boost online advertising spend and/or hire a social media expert.
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