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ICWAI | CMA Important notes on Zero-based budgeting

ICWAI | CMA Important notes on Zero-based budgeting – Many companies use some form of zero-based budgeting, which is a budgeting process where no amounts carry over from prior years and no programs are considered pre-approved. In this lesson, we’ll learn why companies do this and how the process works.

ICWAI | CMA Important notes on Zero-based budgeting

What Is Zero-Based Budgeting?

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CMA Important notes on Zero-based budgeting – Zero-based budgeting is a budgeting method where every expenditure must be justified every budget cycle. When the company begins a budget process, they start from zero. Each department must request funds via a detailed plan describing what each allocation of funds will be used for and what benefits the company will receive from it.

Let’s take a look at an example.

Example

Every business uses budgets to curve spending and accomplish financial goals. These budgets are often based on the previous year’s budget and spending figures. This makes sense for managers looking for a benchmark to set spending goals. They can easily look at the prior year’s budget and adjust it a few percentage points up or down.

Sometimes companies’ budgets and spending are so out of control that entire company cost structure needs to be reviewed. In this case, it doesn’t make sense to look at last year’s budget. The entire budget needs to become completely redone. This kind of drastic change is referred to as a zero-based budget.

Let’s assume that Bill’s construction company is struggling to makes ends meet. Bill has no idea where his company is losing money, so he decides to start analyzing every aspect of his business. This is commonly called starting at a zero base.

Bill doesn’t use last year’s activities as a benchmark for this year. Instead, he looks at the current year’s numbers to see where costs can be cut and what can be run more efficiently. Based on what Bill’s analysis turns up, he will create a budget and allocate funds to each department and activity according.

CMA Important notes on Zero-based budgeting | The Zero-Based Budgeting Process

What will actually happen when the time comes to plan for next year?

The first step: you’ll be asked to put together a budget for your department for the upcoming year. It will need to include all costs for your department including salaries, travel, and supplies. You’ll also need to justify these costs by explaining exactly what the company will get from those expenditures. Perhaps you’ll assemble 50 cars? Or sell 20,000 widgets? Or provide financial statements each month and make sure all employees are paid accurately?

The next step: once you’ve turned in your budget, you’ll probably be asked to present it to a group including senior management and the budgeting staff. You’ll present your numbers and justification, and then you’ll answer questions about the amounts you’re requesting. Sometimes, companies will reduce or eliminate line items during the meeting if management doesn’t feel the expenses are necessary.

The final step: once all the meetings are done, the budget staff will adjust budgets based on direction from senior management. They will then provide a final consolidation to management for approval. Once it’s approved, the budget for your department will be sent back to you, and you can begin planning based on your final approved plan.

CMA Important notes on Zero-based budgeting

Advantages and Disadvantages of Zero Based Budgeting

Advantages of Zero-based budgeting

  1. The first and foremost advantage of zero-based budgeting is that any departmental head cannot justify expenses on the basis of past expense or record, so if in the past due to some extraordinary expense the departmental budget is high in one year than departmental manager cannot claim budget equal to or more than previous year budget in the case of zero-based budgeting.
  2. Another benefit of zero-based budgeting is that in case of normal budget methods departmental head get complacent because they know that they will get the budget equal to or more than previous year budget which is not the case in zero-based budget where departmental heads are on toes and looking for justifying each and every expense so as to get the desired budget.
  3. Another advantage of zero-based budgeting is that top management can identify the areas or departments where there is wasteful expenditure because if budget to department were given on incremental basis then it could have resulted in wasteful expenditure getting overlooked as only criteria for passing the budget in incremental basis system is to add certain percentage of previous year budget and give it to the department concerned which leave the scope of wasteful and unnecessary expenses on the part of department leading to loss for the company.

Disadvantages of Zero-based budgeting

  1. The biggest disadvantage of zero-based budgeting is that it is very time consuming because every year department has to prepare the new budget and top management also has to devote time so as to verify and pass the budget which in turn lead to wastage of time on the part both department as well as top management.
  2. As far as implementation part of zero-based budgeting is concerned it faces tough challenges in the form of lack of acceptance by the employees, in some departments like research and development, it would be difficult to justify every expense, ignoring expenses which are good for long-term and so on.
  3. Another limitation of zero-based budgeting is that it can be a tedious task to justify all the expenses and non-justification of expense even though it is genuine may lead to rejection of the budgeted expense which ultimately will affect the company’s performance.

Must Read : ZERO BASED BUDGETING IN INDIA-ITS RELEVANCE TO PUBLIC ENTERPRISES

CMA Important notes on Zero-based budgeting

A List of Benefits of Zero-Based Budgeting

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In zero-based budgeting, a company draws up its budget from scratch every year, requiring managers to justify every dollar they plan to spend. Traditional “incremental” budgeting, by contrast, uses the previous year’s budget as a starting point, and managers must explain only why they need more or less money this year than last.

Encourages Efficiency

The chief advantage of zero-based budgeting is that it promotes efficiency. Incremental budgeting essentially assumes that the previous year’s budget figure was the “correct” amount, and therefore the budget needs only to be adjusted based on projections for the coming year. But it never asks whether last year’s budget was spent wisely or effectively. By forcing managers to go back to square one and justify all their projects as if they were brand new, zero-based budgeting encourages them to seek the most efficient, most cost-effective solutions.

Makes Room for New Projects

When a company that uses traditional budgeting wants to pursue a new initiative — coming out with additional products or services, for example, or expanding into a new geographical location — it must try to “find money” in the existing budget. That means fighting with entrenched interests that want to maintain their slice of the pie. With zero-based budgeting, new projects are placed on par with old projects and can compete for financing on a more or less equal basis. Managers of existing projects will want to protect their own funding, of course, but they will be forced to mount a vigorous defense of their own merits.

Focuses the Mission

It’s not uncommon for a company to spend money on long-running projects or departments that no longer serve its core mission and don’t contribute to profits in any significant way. When budgets are prepared incrementally, such spending continues from year to year through simple inertia — “We spend money on it because we’ve always spent money on it.” Zero-based budgeting puts this spending under a microscope, allowing the company to examine whether it would be better off shutting down these non-essential operations, selling them off or, in the case of such things as maintenance or payroll services, outsourcing them.

Eliminates Redundancy

The larger a company gets, the more likely it is to experience redundancies — different departments or people doing the same job. These redundancies may remain hidden in incremental budgeting but will become evident during the thorough, top-to-bottom review that comes with zero-based budgeting. Once management identifies redundant functions, it can save money through consolidating them. Instead of, say, six different workers handling purchasing for different departments, the company may create a separate, centralized purchasing department hat needs only three workers, cutting labor costs in half.

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