Zero-based budgeting (ZBB) was first introduced in a 1970 article by Peter A. Pyhrr in the Harvard Business Review but it soon faded into obscurity. This approach has had a renaissance in recent years as many Fortune 500 companies have adopted this technique. ZBB is a method of budgeting in which all expenses must be justified for each new period. The process 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 each budget is higher or lower than the previous one.
ZBB is a budgeting process to rigorously review every dollar in the annual budget, manage monthly financial performance, and build a culture of cost management. On a very granular level, you go through a company’s spending and determine what resources various business units require. That means looking at individual cost categories across all business units. Rather than compare this year’s spending to last year’s, ZBB looks instead for the most efficient return on spending, from the bottom up. It seems more effective to talk about every dollar spent in terms of efficiency, and ask if it is really necessary, rather than to compare it to last year.
Zero-Based Budgeting vs. Traditional Budgeting
Traditional budgeting calls for incremental increases over previous budgets, such as a 2% increase in spending, whereas zero-base budgeting requires a justification of both old and new expenses. What makes ZBB unique is not the budgeting methodology; it is the mind-set shift that upends managers’ default assumptions. The process puts the burden of proof on the manager who is asking for resources: he or she must demonstrate, on a continual basis, that the resources are in fact still required to achieve business objectives—as much in year three as they were in year one—and that those resources are being managed responsibly.
Benefits and Drawbacks
Zero-based budgeting requires managers to justify how every dollar is spent, every operating period. Expenses have a tendency to grow over time, which could lead to misallocation of resources. Zero-based budgeting requires managers to rethink all expenses, and thus keeps legacy expenses in check.
One of the major drawbacks of ZBB is that it can reward short-term thinking. ZBB can shift resources towards areas that generate revenue or cut costs in the near term, while ignoring long-term investments or historical trends. Certain areas of the company which are typically considered long-term investments and aren’t directly tied to revenue, like research and development, or employee training and development, may end up with smaller budgets.
ZBB is also resource-intensive. It takes a lot more time and effort to closely review and justify every budget item. In certain companies, the benefits of zero-based budgeting may not justify the administrative costs.
Key Takeaways
Zero-based budgeting is much more than building a budget from zero. It is a process that allows the organization to build a sustainable culture of cost management. ZBB is not a slash-and-burn exercise that cuts costs without regard for the expense.
Whether the organization’s primary focus is on growth, profit, or talent retention, cost management remains crucial to its success. With deep visibility into costs, the company can eliminate unproductive costs and redirect those resources to more productive areas.