Zero Based Budgeting
http://www. businessdictionary. com/definition/zero-based-budgeting-ZBB. html zero based budgeting (ZBB) Definition Method for preparing cash flow budgets and operating plans which every year must start from scratch with no pre-authorized funds. Unlike the traditional (incremental)budgeting in which past sales and expenditure trends are assumed to continue, ZBB requires each activity to be justified on the basis of cost-benefit analysis, assumes that no present commitment exists, and that there is no balanceto be carried forward.
By forcing the activities to be ranked according to priority, ZBB provides a systematic basis forresource allocation. http://www. investopedia. com/terms/z/zbb. asp#axzz1bUWFIuzm Zero-Based Budgeting – ZBB What Does Zero-Based Budgeting – ZBB Mean? A method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a “zero base” and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one.
ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization, where costs can be first grouped, then measured against previous results and current expectations. Investopedia explains Zero-Based Budgeting – ZBB Because of its detail-oriented nature, zero-based budgeting may be a rolling process done over several years, with only a few functional areas reviewed at a time by managers or group leadership. Zero-based budgeting can lower costs by avoiding blanket increases or decreases to a prior period’s budget.
It is, however, a time-consuming process that takes much longer than traditional, cost-based budgeting. The practice also favors areas that achieve direct revenues or production; their contributions are more easily justified than in departments such as client service and research and development. http://www. accountingformanagement. com/zero_based_budgeting. htm Definition Explanation and Concept of Zero Based Budgeting (ZBB) Method: Zero based budgeting (ZBB) is an alternative approach that is sometimes used particularly in government and not for profit sectors of the economy.
Under zero based budgeting managers are required to justify all budgeted expenditures, not just changes in the budget from the previous year. The base line is zero rather than last year’s budget. In traditional approach of budgeting, the managers start with last year’s budget and add to it (or subtract from it) according to anticipated needs. This is an incremental approach to budgeting in which the previous year’s budget is taken for granted as a baseline. This approach is called incremental budgeting. Zero based budgeting approach requires considerable documentation.
In addition to all of the schedules in the usual master budget, the manager must prepare a series of decisionpackages in which all of the activities of the department are ranked according to their relative importance and the cost of each activity is identified. Higher level managers can then reviewthe decision packages and cut back in those areas that appear to be less critical or whose costs do not appear to be justified. Zero based budgeting is a good idea. The only issue is the frequency with which a ZBB reviewis carried out. Under zero based budgeting (ZBB) ,the review is performed every year.
Critics of such type of budgeting charge that properly executed zero based budgeting is too time consuming and too costly to justify on an annual basis. In addition, it is argued that annual reviews soon become mathematical and that the whole purpose of zero based budgeting is then lost. Whether or not a company should use annual reviews is a matter of judgment. In some situations, annual zero based reviews may be justified; in other situations they may not because of the time and cost involved. However, most managers would at least agree that on occasion zero based reviews can be very helpful.
Advantages and Disadvantages of Zero Based Budgeting: Advantages | benefits of zero based budgeting process: 1. Efficient allocation of resources, as it is based on needs and benefits. 2. Drives managers to find cost effective ways to improve operations. 3. Detects inflated budgets. 4. Municipal planning departments are exempt from this budgeting practice. 5. Useful for service departments where the output is difficult to identify. 6. Increases staff motivation by providing greater initiative and responsibility in decision-making. 7. Increases communication and coordination within the organization. . Identifies and eliminates wasteful and obsolete operations. 9. Identifies opportunities for outsourcing. 10. Forces cost centers to identify their mission and their relationship to overall goals. Disadvantages | Limitations of zero based budgeting method. 1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive. 2. Forced to justify every detail related to expenditure. The research and development (R&D) department is threatened whereas the production department benefits. 3. Necessary to train managers.
Zero based budgeting (ZBB) must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process. 4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details. 5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results. http://www. duncanwil. co. uk/zero. html Zero Base Budgeting Introduction
I originally prepared this page for another client but felt that this was a better place for it! From my researches over the years, I think you will find that this is the best summary article on the subject of zero base budgeting that you are likely to see. Zero base budgeting hasn’t exactly set the budgeting world on fire but it does have a lot to recommend it. Read this page and make up your own mind, though! The Name Zero Base Budgeting! The name zero base budgeting derives from the idea that such budgets are developed from a zero base: that is, at the beginning of the budget development process, all budget headings have a value of ZERO.
This is in sharp contrast to the incremental budgeting system in which in general a new budget tends to start with a balance at least equal to last year’s total balance, or an estimate of it. Definition of Zero Base Budgeting (ZBB) A method of budgeting whereby all activities are reevaluated each time a budget is set. Discrete levels of each activity are valued and a combination chosen to match funds available. CIMA Terminology This is not a very comprehensive definition; after all, it is not very descriptive as we’ll see; and it does not mention the attainment of corporate objectives. Still, it’s a beginning. Objectives and Benefits of ZBB
What zero base budgeting tries to achieve is an optimal allocation of resources that incremental and other budgeting systems probably cannot achieve. ZBB starts by asking managers to identify and justify their area(s) of work in terms of decision packages (qv). The way that ZBB forces managers to justify their work is by saying to them that unless and until they put forward a budget that more senior management can support, at least to a large extent, the budget will not be approved and funded. If ZBB is applied as literally as it is designed, then unjustified work simply stops, no matter who the boss is and no matter what work they are doing.
An effective zero base budgeting system benefits organisations in several ways. It will ? Focus the budget process on a comprehensive analysis of objectives and needs ? Combine planning and budgeting into a single process ? Cause managers to evaluate in detail the cost effectiveness of their operations ? Expand management participation in planning and budgeting at all levels of the organisation (adapted from President Carter’s memorandum referred to below) Example of ZBB and Decision Packages
In order to explain ZBB, it’s best if we work through an example. We’ll keep the argument simple so that the concepts are clear. Duncan plc consists of three departments A, B and C; and each department is in the process of preparing its budgets for the coming financial year. In addition to its mainstream work, each department is trying to secure funding for 2 new projects. However, only a total of two of these projects can be funded in addition to basic departmental funding, due to financing constraints.
A decision package is a plan or budget for each project or departmental plan. The decision aspect relates to each budget being decided on as being accepted or rejected; and it’s called a package because, essentially, that’s what it is: a whole package of initiatives, ideas and proposals. Table 1 illustrates decision packages for Department A. It is also possible that the work of each department can be sub contracted by the organisation if it feels that an outside contractor can provide a better service than the internal departments.
In practice, we see this kind of idea in the sub contracting of school meals, sub contracting refuse collection by Local Government … and the Xerox Corporation allowing its divisions to buy in payroll services and expertise from accounting organisations other than its own accounting department. For the sake of brevity, we won’t pursue outsourcing here. Budget Preparation and Decision Packages The following table shows the work that each department must now undertake as it seeks to win funding for its mainstream work and its additional work: we’ll just illustrate Department A, though, since all departments will be similar in this example.
Budget to prepare| Comment| Decision Package A1| | Department A budget, including| | Mission, aims, objectives …| This is a crucial aspect of the budget since the department has to submit THREE budgets. One budget at 100% of normal output and a budget at, say, 120% of normal output and another at, say, 80% of normal output. Roughly the equivalent of normal case, best case, worst case scenarios. | Levels of output| | Materials| | Labour| | Overheads| | Capital budgets …| | | | Decision Package A2| | Department A new project budget| |
Mission, aims, objectives …| Since the department is requesting brand new funding here, it will have to provide a decision package for this. We are assuming here that this project is not just part of the overall department but it’s essentially something new. For example, a new product that needs new machinery, people and facilities; or an extension of the product range needing new technology and skills. Again, the decision package will call for 100%, 120% and 80% level plans. | Levels of output| | Materials| | Labour| | Overheads| | Capital budgets| | | Decision Package A3| | | Department A new project budget| | |
Mission, aims, objectives …| The same approach applies here as to Decision Package A2| | Levels of output| | | Materials| | | Labour| | | Overheads| | | Capital budgets| | | Notes to the table 1: 1. the concept of normal is crucial here: it is the level of output that the organisation can expect to achieve under normal conditions. That is, allowing for all meal breaks, planned maintenance, machine changeovers and so on. 2. senior management has to see the impact on every department of a decision that might cut their budget request by up to 20% of normal, or might grant an additional 20% of finance over and above normal.
That is, it’s assessing its margins of safety, flexibility and so on. 3. each of these budgets is called a decision package. The Department A overall budget is Decision package number 1, called A1 in the table. The requests for funding for new projects are separate decision packages, called Decision Packages A2 and A3 in the table. So, the organisation is split into areas that can be put in or taken out in a modular kind of way. Consequently, if the department can be operated as before OR replaced by a sub contractor or abandoned altogether then a decision package approach is appropriate.
If the department is part of a more complex structure and cannot simply be got rid of or replaced by a sub contractor, then this department will be part of a larger decision package. 4. ZBB is a perfect example of the implementation of Flexible Budgeting. Example budgets Another simplified example will help to illustrate how ZBB budgets are put together. Department A’s basic departmental budget, Decision Package A1 is at the level of 100% of output; and there are two decision packages in this department are: package A1 at the 80% and 120% levels respectively.
Firstly, the total, outline, budget is shown in figure 1. Figure 1Decision Package A1 Secondly, figure 2 shows the formulae based version of this model, for interested spreadsheet fans! For reference, the title Department A: Decision Package A1 is in cell B2. Figure 2 Decision Package A1: Spreadsheet Formulae Version We can see here why we mentioned flexible budgeting: such packages are nothing more or less than flexible budgets. Now that management has these alternative decision packages, it can see the output and financial impact of them.
At the 80% of normal output level, we can see that total costs are ? 36,450, of which fixed costs are ? 11,250. Such information can then be set against previous years’ plans, current assessment of the market, developments in other parts of the business … to see whether this is the level of output that is required. Indeed, who set 100% of output at 1,000 units and how did they arrive at this figure? In fact, a great deal of analysis can be carried out at this first stage, bringing in the idea of the inter relationships of budgets and how that has an impact on the ZBB process.
In this respect, we would look at the 80% of output level and then assess the impact of it on the overall production budget or plan; and the impact of the new decision packages on this decision package … and so on. Selection of projects With incremental budgeting, it is usually the case that only one version of one budget will be provided, albeit it may have to be revised once or twice before it is finally accepted. The ZBB approach calls for three versions of every decision package and we now need to resolve the issue of how to decide on which version of which package to implement?
ZBB proceeds from the budget preparation stage by way of a voting system. Each level of management has a say in which package is accepted: it then recommends to the next highest level of management the packages it then has to vote on and implement. At the top of the organisation, the Board of Directors ratifies the decisions of the lower levels of the organisation. The following chart illustrates the voting regime for our simplified example: starting from the bottom and working upwards. Figure 3 Department A: Decision Package Voting Outcomes Note: figure has been cropped so we can only see Department A’s decision package progression.
We can imagine the rest for Departments B and C. Imagine that the final overall budget package for this organisation consists of the decision packages shown in table 2: A1| 1| A3| 1. 2| B1| 1. 2| C1| 1| C2| 1| Table 2 Final Decision Packages: All Departments Huge amount of work involved Even though we are dealing with a relatively simple example, the key single reason why ZBB has not been widely implemented is that it generates a huge amount of work. Just consider a medium sized business along the lines that we have suggested, with three departments … even they have to start by preparing 27 budgets, not just three.
Then the various levels of management have to wade through all of them and decide on the combination of decision packages they finally recommend. More than this, as the CIMA definition said, ZBB makes us go through this process every time we prepare our budgets. For this reason, some organisations implement ZBB on a partial basis. That is, for example, only Department A uses ZBB this year, only Department B uses it next year and only Department C uses it the year after that, then it’s back to Department A. In the meantime, the other departments use, for example, incremental budgeting.
ZBB in the USA Whilst not inventing the regime, among the best known exponents of ZBB was President Jimmy Carter of the United States of America. Carter had been the Governor of the State of Georgia which had successfully used ZBB. Shortly after he took office as President, Carter sent a memorandum to the Heads of Executive Departments and Agencies within the Federal US Government in which he said: During the [Presidential election] campaign, I pledged that immediately after the inauguration I would issue an order establishing zero base budgeting throughout the Federal Government.
This pledge was made because of the success of the zero base budget system adopted by the State of Georgia under my direction as Governor. A zero base budgeting system permits a detailed analysis and justification of budget requests by an evaluation of the importance of each operation performed. … I ask each of you to develop a zero base system within your agency in accordance with instructions to be issued by the Office of Management and Budget. The Fiscal Year 1979 budget will be prepared using this system.
By working together under a zero base budgeting system, we can reduce costs and make the Federal Government more efficient and effective. Criticisms of ZBB Whilst ZBB has many stated advantages, there are several journal papers and books around which categorically deny that ZBB is in any way effective. The following is an extract from a chapter in a book aimed almost solely at destroying ZBB as a useful alternative budgeting system. … there has been a substantial reallocation of financial resources within state government during Governor Carter’s administration – especially during his first year of office.
All the evidence suggests that ZBB played a negligible role … there had been no apparent shifting of financial resources as a result of employing the ZBB system. This story is repeated across Texas, New Jersey and Delaware. Hammond ; Knott (1980) p61 The rest of the chapter, negatively, concentrates on quotations and evidence (much of it anecdotal) that proves that ZBB never works. It should be pointed out, however, that the book was written after only one year of ZBB being in operation in the Federal Government. Florida Power and Light and ZBB
On a more optimistic note, comes a report from a US Electricity Utility where ZBB is reported as having been a success. Early benefits of having installed the system are reported to be 1. it can be used to control indirect labour and expenses 2. it can be used effectively to require supervisors to set priorities on proposed new work 3. it can be used as an effective communications tool to identify what was being done now that would not be done in the future and gain concurrence up the line that it was all right to stop it 4. y applying resource constraints in forcing setting of priorities, we could squeeze out the low payoff work rather than keep it forever, and thereby protect our ability to limit growth in staff areas Dady (1979) p3 Dady also gives guidance to those who feel they would like to install a system of ZBB. ? an orthodox sophisticated budgeting system must already be in place ? MBO [Management By Objectives] must run alongside ZBB ? top management must be prepared to say “No” to pet projects, even of other senior managers, which do not measure up.
Conclusions ZBB has a lot to offer it in terms of the way it forces management at all levels in an organisation to become involved in the budgeting process. ZBB begins by saying what you have in the future depends on your ability to persuade the rest of your management team that you deserve it: justify nothing and you’ll get nothing! However, no one can claim that ZBB has been widely adopted by managements of profit making companies or non profit making organisations.
There is evidence, though, from those who have implemented it that it can make a big positive difference to their resource allocation and management, despite the negative view of Hammond and Knott. Moreover, ZBB is heavily resource intensive in terms of the effort required to set up and run the annual budgeting process: as we show in these notes, even small organisations need to allocate major amounts of resources just to the budget preparation process, let alone budgetary control and the rest of the corporate planning process.
Splitting budget elements into decision packages allows management to look at their business from a micro point of view; and from the point of view of a detailed analysis of cost behaviour, production and productivity and so on. In the end, ZBB has a lot to commend it; but there are few management teams brave enough to commit the resources year after year to keeping the system going: hence, the suggestion that a partial implementation of ZBB can be the optimum optimorum solution to an organisation’s resource allocation problems. http://humanresources. about. om/od/glossaryz/g/zero_base. htm Zero-base budgeting does not use the previous year’s budget or expenses in setting a new budget, since the company’s circumstances and finances may have changed. When building a budget from a zero base, every expense must be justified. This differs from only having to explain the amounts requested in excess of the funding received during the prior year or quarter. Zero-base budgeting helps you control spending and expenses because you build your budget from zero rather than building your budget on top of what was spent during the prior period funded. ttp://www. investorwords. com/5375/zero_base_budgeting. html Budgeting method for a corporation or government in which all expenditures must be justified each year, not just amounts in excess of the previous year. http://financial-dictionary. thefreedictionary. com/Zero+Based+Budgeting Zero Based Budgeting A system of budgeting where each department or division of a company must justify allexpenditures and allocations rather than simply increases over the previous fiscal year.
That is, the budget is made with every department starting at zero dollars to spend, and each department must demonstrate need for what it wants to receive. Zero-based budgeting is advantageous because it is more detail-oriented than other forms of budgeting; among other things, it makes it easier to detect and eliminate over-inflated budgets. On the other hand, zero-based budgeting is more difficult and time consuming to put together and often has a bias toward departments that directly produce revenue instead of departments like R&D.
