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Grow Your Business Finances

What is Zero-based Budgeting?

zero-based budget, budgeting
Credit: NAN728 | Shutterstock

Zero-based budgeting is a method of managing cash flow in which all expenses must be justified in each new period rather than basing financial decisions on the previous year's funding. Zero-based budgeting forces companies to scrutinize and justify all expenses in a never-ending goal to redesign cost structures and boost competitiveness. An organization watches its spending and challenges the costs it creates through expenses and employee activities, attempting to identify inefficiencies and necessities to reduce corporate spending and increase market competitiveness.

The focus on reducing overhead while still increasing performance proves helpful in aligning resource allocations to company strategic goals. Zero-based budgeting places the emphasis of cost analysis on identifying the activities that need to be performed at what levels and frequency. After that, a company must answer the question of how these activities can be better performed — whether it is through streamlining, standardization, outsourcing, offshoring, automation or simple fiscal conservation.


How zero-based budgeting works

When a company adopts zero-based budgeting, a massive shift in mindsets is required. Management must be willing to make sacrifices and cut expenses traditionally viewed as necessary to help in the goal of reaching a bottom line of zero.  The company first re-envisions its business and asks what activities and resources are needed to remain competitive under current and future market conditions. Once the necessary items are identified, the company then sets clear cost targets and strategic visions that share in this goal.

Company management should justify every activity needed to continue with the company's function, while at the same time making concessions in removing unnecessary expenses and activities. In the end, resetting budgets and full-time employee levels, redesigning the organization and implementing the zero-based budget initiative prove the most time consuming parts of the process.

The benefits of zero-based budgeting

The main goals behind zero-based budgeting are to save money and improve services. However, in addition to these main benefits, the strategy also impacts the restraint of management and employees when developing budgets.

With a traditional budgeting strategy, companies generally have one goal: to have money left over at the end of each month or fiscal year. This creates a mentality of entitlement where employees and management alike feel justified in spending money, provided expenses don't exceed income. Rather than letting money pile up to protect against slow economic seasons or unexpected company-wide expenses, many organizations spend more than is necessary, both on purchasing equipment and performing activities that waste profit and reduce company efficiency.

When the mentality of entitlement is removed, expenses likewise reduce and budget discussions then become more meaningful.

The negatives of zero-based budgeting

While the strategy behind zero-based budgeting is well intended, it causes some adverse impacts on company culture and expenses. Preparing budgets becomes even more time-consuming because of the amount of justification needed for each expense. The use of zero-based budgeting may even prove too radical of a strategy for a company and may cause more harm than help.

How companies use zero-based budgeting

Zero-based budgeting forces management to overcome conventional thinking and instead challenge every expense and assumption, no matter how sacred. In the event of acquisitions or mergers, this strategy proves even more appropriate as it helps align resources with mission functions and strategic imperatives. The main goal, however, is to reduce wasteful expenses without reducing company value.

For example, a software development company may be using the a third-party organization to purchase IT services to reduce staffing overhead and free up existing company resources to focus on production-related activities. However, they are paying a significant fee each month for unlimited access to the service's support department, a feature they use no more than once a year. By removing this monthly cost and instead paying for the occasional and infrequent fee of a support call, the company makes significant strides toward reaching a bottom line of zero.