Zero Based Budgeting

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Description of Zero Based Budgeting. Explanation.


Definition Zero Based Budgeting. Description.

Zero-Based Budgeting (ZBB) is a technique that sets all budgets to nil at the beginning of the year or period and requires from the departments that they justify all of their expenditures, not just those exceeding the budget. Money is allocated to the departments based on merit and not based on past results or on the previous year budget plus or minus some percentage such as in many traditional budgeting systems.

Its aim is to achieve is an optimal allocation of resources that incremental and other budgeting systems cannot achieve. Managers are asked to identify and justify their areas of work in terms of decision packages prior to starting the work.

ZBB was pioneered in the early 60s at Texas Instruments by Peter Phyrr.

Typical Steps in the Zero Based Budgeting Process

  • Identification of "decision units". A decision unit is any part or organ of the business that will operate independently with its own budget.
  • Break down decision units into decision packages: proposals with a detailed description of a specific activity (objective, funding needs, justification, technical viability, alternatives).
  • Ranking of decision packages according to their importance using predefined (quantitative and qualitative) criteria.
  • Allocation of funding to decision packages by top management.

Advantages of Zero Based Budgeting

  • The budget process focuses on a comprehensive analysis of objectives and needs.
  • Planning and budgeting are combined into a single process.
  • Managers must evaluate the cost effectiveness of their operations in detail.
  • Cost awareness and management participation in planning and budgeting is expanded at all levels of the organization.
  • Well suited to companies with small margins, like those in the fast-moving consumer goods (FMCG) sector.

Criticisms and drawbacks of Zero Based Budgeting

  • The huge amount of work involved.
  • May lead to micro management, offering less time and energy for the things that really matter.
  • There is a risk of short-term thinking in allocation of funds and of underinvesting in strategic (R&D) initiatives.
  • Fierce competition between units for funding may undermine employee morale (fear of loss of jobs, less feeling of belonging to the overall firm).

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Compare with: Beyond Budgeting  |  Balanced Scorecard  |  Activity Based Costing

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