ZERO-BASED BUDGETING

Today’s business environment is a living organism, an ever changing tapestry where we never know what’s going to happen next. Past strategies cant be taken for granted as it's underlying assumptions are drastically changing. Organizations worldwide understand the importance of understanding this fact and have continuously looked at their strategies to remain competitive. The definitions of various strategies have changed, short term is really short and long term is no longer fixed. Strategist and consultants have started re looking at concepts they took it for granted in the past, never before in the history of strategy has there been so much of introspection, redesigning and importance given to strategies.

Let us see an example of the result of such introspection,

Organizations worldwide have always used Incremental budgeting year after year for their budgeting purposes. Incremental Budgeting uses a budget prepared using a previous period’s budget or actual performance as a base, with incremental amounts added for the new budget period. This framework is flawed as it assumes that the underlying factors responsible for such a budget last year has not changed over the next. The change in the environment is taken into consideration for the new component only.

New Budget = Old budget +/- Budget due to changes in environment

This kind of an attitude leads to “spend it or lose it” mentality and inefficient planning processes. This improper planning at the department level will create an Bull whip effect at the top level of the organization as each department would start quoting more as they find that their planning process is inefficient. Instead of finding the real reason behind their budget planning failure, departments will start hiking up the budget assuming that it will solve the issue.

This is one of the biggest problems faced by the organizations. Wrong diagnosis of the problems will lead to wrong solutions which pressurizes the managers to take more hasty steps leading up to the doom of the firm. This is the reason why many successful and profitable firms have failed due to small diagnosis problems which takes the bull whip effect to affect the bottom line of the firm in a big way.

The solution to solve the incremental budgeting problem is the Zero based accounting method. It is a technique of planning and decision-making which reverses the working process of traditional budgeting. In this method, every department instead of justifying the need for the excess or reduction should actually justify the entire budget (i.e.) environmental changes is taken into consideration for the entire budget and not for the change in budget.

New Budget = Budget required in the new environment

This method ensures continuous evaluation of environment in budgeting by the department as well as benefits the department through the proximal and distal benefits of planning.

Advantages of Zero-Based Budgeting

1. Efficient allocation of resources, as it is based on needs and benefits.
2. Drives managers to find cost effective ways to improve operations.
3. Detects inflated budgets.
4. Municipal planning departments are exempt from this budgeting practice.
5. Useful for service departments where the output is difficult to identify.
6. Increases staff motivation by providing greater initiative and responsibility in decision-making.
7. Increases communication and coordination within the organization.
8. Identifies and eliminates wasteful and obsolete operations.
9. Identifies opportunities for outsourcing.
10. Forces cost centers to identify their mission and their relationship to overall goals.

Disadvantages of Zero-Based Budgeting

1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.
3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.
5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.

References:

• Small business accounting guide (2007). How Zero Based Budgeting Will Help Add Extra Cash to Your Bank Account. Retrieved September 09, 2008, from http://www.small-business-accounting-guide.com/zero-based-budgeting.html
• Small business accounting guide (2007). Learn The Relevance Of Incremental Budgeting To Your Small Business. Retrieved September 09, 2008, from http://www.small-business-accounting-guide.com/incremental-budgeting.html
• Allinterview (n.d.). Retrieved September 09, 2008, from http://www.allinterview.com/showanswers/56989.html