Finance is the life blood of business. To ensure that this critical resource is allocated appropriately, it is important to prepare budgets. If this is done appropriately, then various departments of the business will be allocated the resources they require and there will be efficient use of funds.
In the normal course of business, a historical budget is prepared, that is, a budget that is prepared based on the past historical data. This is reviewed on an annual basis and corrections and alterations are made based on certain presumptions and assumptions. Anticipated costs and expenditure is factored in and the growth of the business for the forthcoming year is kept in mind.
Zero based budgeting takes a different approach to budgeting from the traditional method. In the traditional method of budgeting the previous year’s figure is taken as the baseline which is then built upon for the next year. Zero based budgeting takes zero as the baseline and therefore it is a kind or reverse approach to budgeting. Here historical figures and performances are discarded and a budget is made from scratch. All managers are required to justify each item of expenditure and not just the change from the previous year. Managers are expected to identify each item of expenditure that may be required and rank all these items based on their importance and cost. This kind of budgeting requires much more extensive documentation than traditional budgets. Based on the overall business, the top management decides on the budget.
Zero based budgeting is a costlier exercise and needs reviews more frequently, at least once a year. It is mostly adopted by the non-profit sector. There are many advantages in zero based budgeting. It ensures efficient use of resources as it is based on requirements. It can prune down inflated budgets and detect inefficiencies. It increases motivations within the organisation and inspires them to be innovative and take responsibility. It also identifies areas that can be outsourced. Each item of expenditure finds its place in the overall organisational aims of the enterprise. There is synchronisation between the organisations mission and the expenditure.
The downside of zero based budgeting is that it may ignore historical data which has been gathered over the years. Plenty of justification and documentation is required in this approach. Managers may find it hard to define the purpose and quantify it precisely. It is both an expensive and time consuming process and at times, it may appear that the wheel is being reinvented. All managers need to be trained, experienced and capable of preparing these budgets. A dominant manager may find his budget approved, while a meeker counterpart may find his budget trimmed, although it may be that he is the one who needs it more. The volume of data required is extremely vast and hence zero based budgeting has to necessarily be a team effort and needs intricate knowledge of the organisation and the area of business in which it operates.