The Pros and Cons of Zero Based Budgeting for a Cost Effective Business
Zero based budgeting was a very popular way for companies to manage their funds during the 1970s. However, it has fallen out of favor with many organizations due to the high level of documentation, effort and time expended in properly tracking expenses. It can still be a smart way to determine which departments should be funded though. There are several pros and cons of zero based budgeting that need to be examined before considering using this program.
The Advantages and Benefits of Zero Based Budgeting
The pros and cons of zero based budgeting should first look at the advantages. This type of budgeting plan allows for an efficient allocation of resources based on need. It can help determine where the budget is inflated and drive employees to find more cost effective ways to improve their operations. This can be particularly useful for service based industries where the output is difficult to define. In addition, it increases opportunities for outsourcing and allows staff to have a greater stake in the decision making process.
The Disadvantages and Limitations of Zero Based Budgeting
There are also several disadvantages when looking at the pros and cons of zero based budgeting. For example, it is difficult to define the units used to determine need. This can be a time consuming and exhaustive process. Each department is also forced to justify every expenditure that they make. Staff must also be trained to properly be implemented, and they are relied upon to provide accurate results. If there is any exaggeration, the results may be skewed.
Why Zero Based Budgeting Works
With zero based budgeting, the assumption is that each year a new budget needs to be built from scratch without looking at last year’s figures or history. Managers are required to prepare their budget based on the cost of running their operations at the lowest possible level. They must then weight the benefits and costs of each decision and how it would affect the budget. Each of these decisions is known as a “decision package.” This allows senior company representatives to determine which departments have the greatest need for any funding.
Why Zero Based Budgeting does not Work
However, this creates practical difficulties for many companies. Traditional incremental budgeting is simple and easily understood by most managers. Meanwhile, zero based budgeting requires training and time consuming paperwork. It is also felt that zero based budgeting may be susceptible to political pressures or influences. Because of this it is not often used anymore outside of public industry or in personal finance.
The benefit of zero based budgeting is that it provides companies a way to allocate scarce resources by focusing on the underlying costs of the company rather than yearly cost increases. This system also does not use inflation or other indicators to determine what future costs will be based on estimates. Because it can be a very effective way to budget funds, it has frequently been used by governmental organization, health organizations and educational organizations to help trim budgets.