Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Zero-Based Budgeting

What it is:

Zero-based budgeting is a budgeting method that involves starting with $0 and adding only enough money in the budget to cover expected costs.

How it works (Example):

There are many ways to create company budgets. Let's take the marketing department of Company XYZ as an example. Last year, the department spent $1 million. What's the right way to set a budget for next year?

You might simply give the department $1 million again, but this might not reflect the changes in the marketing programs next year, the need to hire more marketing people due to additional sales, or other factors.

Another way might be to give all departments a 10% increase or decrease based on what the board of directors would like earnings per share to be next year. This would give the department $1.1 million  or $900,000, depending on which way the board goes.

A third way would be zero-based budgeting, whereby the department starts with no budgeted funds and must justify every person and expense that should be included in the budget for the coming year. This might result in a budget of, say, $1,024,314, which is higher than last year but reflective of the actual needs next year.

Why it Matters:

Employees and managers often view budgeting as a game to beat rather than a cooperative planning exercise that incorporates goals and expectations. Many of us have heard of "slush funds" and "use it or lose it" philosophies in which departments try to hoard money for undetermined uses just to avoid being penalized later. Zero-based budgeting theoretically conquers this behavior by requiring department heads to understand every cash outflow and the costs of their operations. It also allows executives to get a genuine measure of what things will cost in the coming year and compare that to their performance expectations accordingly.

Some critics argue that justifying costs unduly penalizes functions that don't generate revenue. It is also more analytical and time-consuming than budgeting methods that simply make blanket changes to last year's budget, thus requiring managers to be more educated about the financial aspects of their department operations.