Zero Based Budgeting: How it Works & Possible Advantages

By Myles Leva

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Last Updated: May 23, 2022

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We touched on the concept of zero-based budgeting in another recent article.

This budget is most often employed by businesses. Young businesses normally have difficulty maintaining healthy margins. Expenses can be unpredictable and difficult to control at times. However, the same concepts can be applied to households, and even to individuals.

As an individual, if you’re serious about saving and ready to sacrifice some comforts to get there, keep reading “Zero-based Budgeting Example (Personal Finance)”.

 

 

What is a Zero Based Budget and How Does it Work?

A zero-based budget is also known as a zero-sum budget. The idea is that you set aside all your money to get your income to expenses, savings, and down payments equal to zero.

Income – Expenses ≥ 0

This is often used as a new budget meant to get your expenses under control. However, particularly in business, the process takes a lot of time and/or is meant to replace traditional budgeting.

The process is to have a starting value of zero and to analyze every potential expense. Your new budget will be created and based on your expected needs for the coming month. If you continue, the budget will still normally be applied on a monthly basis.

Zero-based budgeting is an alternative to traditional budgeting. We will go over the differences shortly.

Managers usually oversee zero-based budget initiatives in companies when they want to lower their expenses. In business, it is usually part of a strategic goal. Similarly, a household can engage in a similar, but less complex process.

 

 

How Zero-based Budgeting Works in Business

The strategic goals of a company are applied to the budgeting process of the company. The budget is tied to the different areas of the business. All proposed projects, expenses, etc. must be justified through cost-benefit analysis.

In organizations of any scale beyond very small businesses, zero-based budgeting is a long-term project that can take months or years to achieve. Timeframes can vary and depend on the complexity of the organization. Each area of the organization will need to be reviewed and addressed individually.

The cost savings of a zero-based budget come when they enable an organization to lower costs by not engaging in blanket budget increases or decreases. The alternative, cost-based traditional budgeting, is much faster and simpler.

Within a large company, zero-based budgeting is more applicable to the areas of the company most directly attached to revenues. Production, service delivery, and sales are more applicable areas because incomes and expenses are more simply understood and justified.

It can be more complex to apply the same practices to research, customer service, and other areas where quantitative metrics are more obscure or simply not possible to determine.

 

 

What is the Difference Between Traditional Budgeting and Zero-based Budgeting?

Traditional budgeting takes the last year’s budget as the baseline for the next year’s budget. This is why it’s also known as cost-based budgeting.

When you use a zero-based budget, all financial activities are assessed from scratch. Previous performance is not a baseline for future planning or performance.

Traditional budgeting uses previous expenses as the existing proposal for an updated budget. It works on general accounting principles, whereas zero-based budgeting takes into account line items, and all expenses, and requires justification of costs and benefits in each area.

Overall, zero-based budgeting is better at creating clarity and action. Traditional budgeting is more accounting-based.

 

 

Zero Based Budgeting Example (Personal Finance)

The first step is to take into account every item that requires justification. This includes every expenditure in the proposed budget.

Start by listing your monthly income and all expenses.

Next, segregate all identifiable activities into categories. For the sake of simplicity, let’s use personal budgeting items:

  • Savings
  • Food
  • Utilities
  • Rent/mortgage
  • Transportation
  • Household essentials
  • Specific, non-continuous expenses
  • Other (mostly entertainment or “wants”)

Subtract your expenses from your income. Make sure the result is zero.

If you don’t land on zero immediately, revisions are necessary. Again, zero is your baseline, improving on previous performance is not a goal you should have in mind.

If you have anything left over, use it to save or invest.

Of course, a business version of the above would be far more comprehensive and time-consuming. Regardless, at this point you will start tracking your expenses all month long, accounting for all of them and justifying where you do spend money.

Don’t make any exceptions, record all your spending.

Income must be categorized as well. For example, if you make more money than expected with a side hustle, add it to your side hustle income (as a separate category).

Lastly, you will study and revise your budget each month (or any other time period that works). Your budget may not change much, but this is a necessary part of zero-based budgeting. It’s also an important step to account for one-off, non-recurring expenses.

 

 

Conclusions: What is the Advantage of Zero-based Budgeting?

Traditional Budget: Calculating the new budget by using the last period’s performance as the base. The approach is based on historical (existing) information.

Zero-based Budget: Calculating the new budget with zero as the base. The approach is based on estimations.

Overall, traditional budgeting is easier to prepare and engage in, but the results it produces won’t provide you with a complete picture.

If your main concern is cost efficiency, however, zero-based budgeting is the clearly superior approach. However, the effectiveness of either approach to budgeting depends on the person doing the budgeting, while traditional budgeting also relies on the quality of historical information.

Photo by Tima Miroshnichenko

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