Financial modelling terms explained

Zero-Based Budgeting

Zero-based budgeting is a method for planning and controlling a company's expenses. It begins by breaking a company's projects into tasks and then determining the required amount of resources for each task

What Is Zero-Based Budgeting?

Zero-based budgeting (ZBB) is a budgeting approach that starts from scratch for each new period rather than building on the previous period's budget. Every function within the organization is analyzed and justified independently, with costs and benefits weighed to determine whether the function should continue to be supported. This approach can be used to improve financial performance, make better use of resources, and create a more disciplined budgeting process.

What Are the Benefits of Zero-Based Budgeting?

Zero-based budgeting is a budgeting system in which all expenses must be justified for each new period, rather than using the previous period's budget as a starting point. This system can have a number of benefits for businesses, including:

1. Increased clarity and accountability: With a traditional budget, it can be difficult to track exactly where money is being spent. With a zero-based budget, every expense must be justified, which makes it easier to see where money is being wasted or where cuts can be made.

2. Easier to identify and cut wasteful spending: In order to justify their existence, every expense must be shown to provide some value. This can help businesses identify and cut wasteful spending, such as spending on unnecessary supplies or salaries for employees who are not adding value.

3. Increased focus on key priorities: A zero-based budget can help businesses focus their resources on their key priorities. By forcing departments to compete for funding, a zero-based budget can help ensure that the most important initiatives receive the resources they need.

4. Encourages creativity and innovation: By requiring departments to justify their expenses, a zero-based budget can encourage creativity and innovation as employees look for new ways to do more with less.

5. Helps identify under-performing areas: A zero-based budget can also help businesses identify areas that are under-performing or need improvement. By tracking expenses over time, it can be easier to see which areas are not meeting expectations and need to be addressed.

What Are the Drawbacks of Zero-Based Budgeting?

There are several drawbacks of zero-based budgeting. Firstly, it can be very time consuming to create a zero-based budget from scratch, particularly if the organisation is large and complex. Secondly, it can be difficult to stick to a zero-based budget in the long term, particularly if there are unforeseen changes in the business environment. Finally, it can be difficult to measure the success of zero-based budgeting in the long term, as there is not necessarily a direct correlation between reduced costs and improved financial performance.

What Are the Common Mistakes to Avoid When Doing Zero-Based Budgeting?

There are several common mistakes to avoid when doing zero-based budgeting:

1. Not starting with a clean slate. Every expense should be evaluated, regardless of how "necessary" it seems.

2. Underestimating or forgetting about discretionary expenses. These can be a major contributor to overspending.

3. Focusing too much on cutting expenses and not enough on increasing revenue.

4. Underestimating the time and effort required to complete a zero-based budget.

5. Not revisiting the budget regularly and making necessary changes.

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