What is Zero-Based Budgeting (ZBB)?

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Definition:

Zero-based budgeting involves building a new spending plan from scratch rather than from previous spending levels.

🤔 Understanding Zero Based Budgeting

Zero-based budgeting (ZBB) is the process of building a new budget from scratch rather than starting from spending levels in the previous period. The ZBB process forces a review of each dollar of expenses, so every line item is justified. ZBB can promote savings and efficiency, but can also be time-consuming, hurt morale, and create conflict. Modern uses of the ZBB approach don’t technically start from zero but still focus on cost management. The ZBB process can work for personal finance, small businesses, corporations, and government agencies.

Example

Think about your personal finances. You probably have some recurring expenses, like rent, groceries, and a gym membership.

Say you need to reduce your monthly spending from $5,000 to $4,500. Traditional budgeting would have you look at current expenses and consider what to cut. Maybe that means canceling your gym membership or reducing online shopping. Zero-based budgeting would challenge every dollar you spend, building up your expenses from zero until you reach your limit. Using this approach, perhaps you realize you’re paying for a few subscriptions to streaming services you haven’t used in over a year.

Takeaway

Zero-based budgeting is like decluttering your home

Instead of looking for things to throw away, a tidying expert recommends the opposite approach: Put everything you own in a pile, and decide whether each item deserves to stay. ZBB does the same thing for your budget.

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What is zero-based budgeting (ZBB)?

Zero-based budgeting (ZBB) is a cost management strategy that requires starting the budgeting process from zero. Those in charge of the budget evaluate the cost and benefit of each item before adding it. Funding for an item is based on the value it creates. Nothing receives funding without continuous review and justification. This process requires examining every dollar in the budget, without regard to spending in previous periods.

What is the difference between ZBB and traditional budgeting?

In a traditional budgeting process, spending from the previous period serves as a base for the next one. Those overseeing the budget start by assuming that a given business unit, agency, or spending category needs the same amount of money as before. They then consider changes to that base.

For example, if the marketing department wants to launch an advertising campaign, it might ask for an increase of $1M to its base budget. Or if a city wants to expand the number of police officers, it might request an addition to its base budget.

Zero-based budgeting (ZBB) starts from a different premise. Rather than assuming that previous spending levels should stay the same, it assumes that every dollar should be justified.

The different framing changes the way you perceive a budget item. Rather than seeing it as a potential loss of something you already have, ZBB makes you view each item as a new expense you might not be able to afford. Under traditional budgeting, once something becomes part of the base budget, it’s difficult to remove. In many cases, the spending is never questioned again. ZBB reevaluates expenses, given the current financial situation. Nothing slips through the cracks unchallenged.

Consider the need to reduce your budget by $50 a month. From a traditional budgeting approach, you must ask yourself, “Can I live without cable?” But from a ZBB approach, you start with the assumption that you don’t have cable and ask, “Given my current financial situation, can I afford to add it?”

Who uses ZBB?

Zero-based budgeting (ZBB) originated with a guy named Pete Pyhrr, who successfully used the approach as a manager at Texas Instruments, a semiconductor manufacturer, in the 1960s. Some businesses still use the ZBB approach, or some version of it, today. However, ZBB is now more about building a cost-conscious culture than it is about literally starting from zero.

According to McKinsey, a ZBB strategy can lead to a 10-to-25 percent cost reduction in sales, general, and administrative costs. Companies can use those savings to drive growth, reduce debt, acquire assets, or pay more substantial dividends.

After the Harvard Business Review published Pyhrr’s influential article about his ZBB method, Jimmy Carter, then governor of Georgia, reached out to him about applying the method to his state budgeting process. When Carter became president in 1977, he brought the ZBB process to the federal budget. The idea spread to other levels of government as well.

High rates of inflation in the 1970s, followed by a significant recession in the early 1980s, rattled most public spending. The ZBB seemed to fall out of favor when the economy recovered. It regained a foothold in the aftermath of the Great Recession of 2008.

There have been various efforts to use ZBB to manage public finances since then, although the process is not truly zero-based in most cases. In current public finance discussions, ZBB refers to avoiding automatic incremental increases to a base budget. While it rarely involves truly developing a budget from zero, it does ask leaders to consider the costs and benefits of budget items to determine spending levels. That means budget reductions can be targeted rather than across-the-board.

ZBB can also work for a personal budget. Dave Ramsey, a popular personal finance guru, applies the principles of ZBB to everyday expenses. In the context of personal finance, ZBB is about ensuring that your money goes toward the things you value the most. It’s about balancing your spending and savings goals against your income, rather than simply spending your money until it is gone.

What are the advantages and disadvantages of ZBB?

Zero-based budgeting is a more involved process than traditional budgeting, and it comes with pros and cons.

Advantages

The main benefit of ZBB is the cost savings it creates. When you evaluate every line item in the budget, nothing receives funding without scrutiny. Expenses that are ineffective or no longer needed won’t receive continued funding. The process can root out wasteful or redundant costs. By reallocating funding from less productive areas to more productive ones, the entire organization can become more effective.

ZBB also ensures that spending matches current needs and financial realities. Traditional budgeting may limit the ability of a company to adapt because it anchors itself to history. Budget categories can become siloed from each other. With ZBB, employees can communicate current needs and changing circumstances, often across different business units.

Disadvantages

ZBB can be time-consuming. The effort can be so cumbersome that it costs more to implement the process than it saves. The paperwork, training, support staff, and consultants required to conduct a ZBB process could add up to significant costs. If the process doesn’t generate considerable savings, it may feel like wasted effort.

The ZBB process can also reduce morale or create conflict over competition for resources. Directors might attempt to justify expenses by hiding or misrepresenting the costs and benefits of items in their budgets. Managers might feel as though they are not trusted and are being micromanaged. Employees might become agitated by the prospect that they are not valued and may lose their jobs — Defending the value they create could be viewed as a personal attack. All of these factors could undermine the process, making the advantages of ZBB more theoretical than practical.

The ZBB process also puts more weight on things that directly contribute to revenue generation. That could result in moving funding from areas like human resources, which is less directly linked to growth, toward marketing, sales, and production. In the end, that could end up reducing efficiency or result in costs down the line. In cases where value creation is hard to quantify, ZBB could end up undermining some of an organization’s goals, especially in nonprofits and government agencies.

How do you create an organizational zero-based budget?

Creating a zero-based budget means different things to different people these days. In the original context, it might have meant ripping up the current budget and starting from scratch. A management team or lawmakers would evaluate every item as a new request for funding. Today, that process is typically considered too cumbersome to be effective. Instead, ZBB today is more about challenging costs than literally starting from zero.

Modern ZBB requires two steps: First, divide the functions of the organization into smaller groups called decision units. Each has an objective and receives separate funding. For example, in a government, one decision unit might be in charge of road maintenance.

Second, develop options, called decision packages, for each decision unit. Each decision package has a different cost and generates different results. The zero-funding package is implied, as it produces no results. The lowest-cost decision package, sometimes called the base package, is the minimum funding level to provide any positive outcome.

A second decision package represents the current funding level. That package sets the expectation for the baseline cost and outcome. There can be other options between the base level and the current level. In the case of a road service decision unit, the outcome might be some measure of road quality.

If a value between 0 and 100 describes how many potholes are on the roads, perhaps the base package results in an outcome of 50 for a cost of $100M. Maybe the current package costs $250M and results in a score of 80. And perhaps there is a middle-low package for $150M that gets a score of 70. There should also be at least one enhancement package. For instance, maybe for $500M, they could get that value up to 95.

The budgeting team would look at these options, consider the current financial circumstances, and choose the package that best aligns the prioritization of funding with the expected outcome. This process is regarded as ZBB because the funding level is not merely last year’s funding, plus some requests for incremental support. Instead, it approaches the budget like a cost-benefit analysis (weighing the expense of something against the positive results it creates).

How do you create a personal zero-based budget?

Zero-based budgeting on a personal level is a little easier but relies on the same concept. Essentially, you need to ensure that your spending and income are equal in your budget, leaving zero dollars unaccounted for.

Start by listing your total monthly take-home income. On the expenses side, add up the cost of food, utilities, housing, transportation, and other necessary costs. Next, add other expenses, including savings and investments. You can only add more expenses until you reach your income. At that point, you need to prioritize. Adding money for one item requires subtracting that money from somewhere else. This process provides you with a spending plan, which can make it easier to reach your goals.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.