Zero Based Budgeting

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(Refer our High Quality Management Encyclopedia at: http://management-universe.blogspot.com/)
Refer: for other finance and accounting related topics at: (Activity Based Costing- ABC) http://activitybased-costing.blogspot.com/, (Cost Management) http://cost-management-control.blogspot.com/, (Cost of Quality- COQ) http://cost-of-quality.blogspot.com/, (Financial Ratios and Financial Ratio Analysis) http://financial-ratios.blogspot.com/

Budgeting: Planning and Control System

Budgeting is a management planning and control system.
Budgeting process consists of deciding the objectives of an organization for a defined period, say one year and breaking them down into detailed objectives and activities required to meet them. Activities throw up the requirement of resources.
Based on this, the yearly financial plan is made. It is calculated as to how much money will be needed to perform the desired activities for achievement of the objectives.
These plans are made at every departmental level and then integrated at the organizational or corporate level.
Entire process aims at justification of the financial allocations for every objective and every job.
The budgets thus drafted are studied for viability of the expected profitability in the organization and finally, new draft of budget is prepared by making necessary changes in the budget. The final budget is then approved by the management.
The actual expenditure is then compared and controlled throughout the year so that it remains within the approved budgets and predicted profitability is achieved.

Conventional Budgeting

Departments prepare their budgets based on the previous year's budgets.
Departments justify only the increases in the expenses required for the current year; they need not have to justify the expenses/budget already approved in the previous year.
It is taken for granted that the previous year's expenses will have to be made in any case to maintain the regular business level.

Zero Based Budgeting: Unconventional

In contrast to conventional budgeting, zero based budgeting system in unconventional.
It is not based on previous year's budget.
It is not formulated by just incrementing the previous year's expenditure for the current year.
It starts with zero base. It's a clean slate approach.
Departmental objectives are decided within the frame work of corporate or organizational objectives and then broken down into detailed objectives and activities/tasks.
The resources and therefore, the expenses required to acquire and use those resources are calculated at the current market conditions.
Additionally, at every step, questions are asked whether the activities to be undertaken to achieve the objectives are value adding and the scopes of improvements in business, administrative and technical processes are thought of.
Overall cost control and cost management are the important key aspects in drawing the zero based budget.
The budget thus formulated may be lower than or equal to or higher than the previous year's budget. But looks like, that it is necessary to allocate and use that kind of money for better performance and better profitability.
This kind of budget seems more realistic and more precise.
The expenditures can now be controlled and profits as predicted realized with lot more surety.

Advantages of Zero Based Budgeting

It questions the current budgets/expense levels, the effectiveness and efficiency of current processes.
Thus, overall cost management/control is in-built.
It focuses on corporate or organizational objectives and within them, the departmental objectives. Thus budget supports their achievements; it supports the overall business very effectively.
It drives the departments' plans and so, the planning process starts right away with the formulation of the budgets right at the beginning of the year.
Ultimately focuses on value for money (VFM).
It is based on current market and business realities and therefore, more realistic.

Disadvantages of Zero Based Budgeting

More time and effort are required in zero based budgeting as compared to the incremental or conventional budgeting.
Questioning the current ways of doing business may be threatening to some people within the organization.
Deciding the departmental objectives within the frame work of organization objectives necessitates top down communication of these objectives with lots of clarity. This is often not done.

Tuesday, May 26, 2009