Zero Based Budgeting – A Comprehensive Guide
When did you last look at your business expenses and ask whether each one still earns its place in the budget?
Software subscriptions, supplier costs and everyday overheads can become routine. When a new financial year arrives, it is easy to carry those expenses forward without considering whether they still reflect what your business needs.
Zero based budgeting provides a way to review spending from the ground up. This guide explains how it works, its advantages and disadvantages and how you could apply it in your business.
What Is Zero Based Budgeting?
Zero based budgeting is a budgeting method that requires every expense to be reviewed and justified for each new budget period. Previous spending does not automatically qualify for future funding.
A simple way to define zero based budgeting is: building your budget around what you need now, with a clear reason for every cost.
The “zero” refers to the starting point for approving expenditure. It does not mean your business should have zero profit or an empty bank account.
For example, if your business spent $12,000 on software last year, you would review which subscriptions are needed, how many people use them and what they cost. The resulting budget might be lower or higher, depending on your requirements.
How Is It Different from Traditional Budgeting?
Traditional incremental budgeting uses the previous budget or actual spending as a starting point, then adjusts for expected changes. Zero based budgeting requires a fresh justification for expenditure.
|
Budgeting question |
Traditional incremental budgeting |
Zero based budgeting |
|
Where do we start? |
Last period’s figures |
Current activities and requirements |
|
How do we assess software costs? |
Adjust last year’s total for price changes |
Check required tools, users and subscription levels |
|
How do we assess marketing costs? |
Adjust the existing allocation |
Cost the activities needed to achieve current goals |
|
Can previous figures help? |
They form the starting budget |
They provide evidence for new decisions |
Both approaches can be useful. A business with predictable costs may prefer a simpler annual update, while a business with changing operations may benefit from a more detailed review.
Zero Based Budgeting Advantages and Disadvantages
The main benefits are closer scrutiny of costs and clearer spending priorities. The main drawbacks are the time involved and the risk of undervaluing activities whose benefits take longer to appear.
Advantages of Zero Based Budgeting
1. Identifies unnecessary spending
Reviewing individual expenses can reveal unused subscriptions, duplicate services or purchases that no longer serve a purpose. For example, a business might discover it is paying for separate booking software when its existing system already includes that function.
2. Connects spending to business priorities
A budget can make room for a planned change, such as introducing a new service. Each proposed cost can be assessed against the work required, the customers it will serve and the expected benefit.
3. Makes decisions easier to explain
Documenting the reason for an expense helps everyone understand what has been approved. A training allocation, for instance, can specify the skills needed and who will use them.
4. Encourages a closer look at alternatives
Before renewing a service, the business can compare different plans or ways of doing the work. The cheapest option may not be the most useful, particularly if it creates more administration.
Disadvantages of Zero Based Budgeting
1. Takes time to prepare
Gathering quotes, checking usage and discussing requirements creates work. Reviewing a $100 annual subscription should not take as much effort as assessing a $30,000 supplier contract.
2. Depends on reliable information
Decisions become harder when records are unclear. If nobody knows which team uses a subscription or what it supports, cancelling it may cause problems that were not apparent during the review.
3. Can encourage excessive cost cutting
Training, maintenance and marketing may deliver benefits over time. Assessing them only against immediate savings can lead to cuts that affect future capacity or demand.
4. Cannot remove existing commitments
A fresh budget does not cancel a lease or other contractual obligation. Some savings may only become available at renewal, so the timing needs to be recorded.
Zero Based Budgeting Examples
Example 1: Reviewing Business Overheads
The following hypothetical example shows how a small service business could rebuild part of its annual overhead budget. Figures are illustrative and exclude GST where applicable.
|
Expense |
Previous annual spend |
Revised annual budget |
Reason |
|
Software subscriptions |
$6,000 |
$4,200 |
Remove unused licences and overlapping tools |
|
Phone and internet |
$3,600 |
$3,000 |
Change plans to match actual usage |
|
Printing and stationery |
$2,400 |
$1,200 |
Reduce printed documents |
|
Staff training |
$2,000 |
$3,500 |
Fund training required for a new service |
|
Total |
$14,000 |
$11,900 |
$2,100 lower overall |
In this example, the business increases its training budget while reducing other costs. Each allocation has a reason connected to how the business intends to operate.
This is a review of selected overheads. A full zero based budget would apply the process across the business.
Example 2: Rebuilding a Marketing Budget
Suppose a business previously spent $18,000 a year on marketing. Its next budget could be built around specific activities:
- $8,000 for campaigns promoting its most profitable service
- $5,000 for website content and improvements that help generate enquiries
- $3,000 for customer retention activity
- $2,000 to test a new channel
The total remains $18,000, but the owner now has a documented purpose for each allocation. Before approving it, they would assess expected results, past performance and how outcomes will be measured.
How to Create a Zero Based Budget
1. Choose the Period and Scope
Decide whether you are preparing an annual budget or reviewing a particular area. For a first attempt, a manageable group of expenses can help you understand the work involved.
2. Set Your Business Priorities
Write down what the business needs to achieve during the period. This might include maintaining service standards, improving margins or preparing for a new employee.
Estimate revenue realistically, allowing for quieter periods and uncertainty.
3. Gather Your Information
Use accounting reports, supplier agreements, invoices and usage records to understand existing costs. Previous figures remain useful evidence, even though they do not guarantee the same allocation.
4. Assess Each Proposed Expense
For each item, record:
- What it pays for
- Why it is needed
- How the amount was calculated
- Whether there are suitable alternatives
- What would happen if it were reduced or deferred
A short explanation is usually enough for straightforward expenses.
5. Check Affordability and Cashflow
Compare proposed spending with forecast revenue and your profit goals. Then check when money will actually come in and go out.
An annual budget can look affordable while a particular month faces a cash shortage. Allow for payment timing, tax payments, loan repayments and major purchases in your cashflow forecast.
6. Monitor Actual Results
Compare actual spending with the budget regularly. Investigate meaningful differences and update forecasts when circumstances change.
For example, higher delivery costs could reflect more sales, a supplier increase or inefficient ordering. Understanding the reason helps you choose an appropriate response.
Frequently Asked Questions
What is zero-based budgeting?
Zero-based budgeting means reviewing and justifying expenses for a new budget period instead of automatically carrying forward previous allocations. In a business, the aim is to establish what activities are needed and what they should cost.
What are the pros and cons of zero-based budgeting?
The main advantages are better visibility of costs, more deliberate spending decisions and opportunities to remove waste. The main disadvantages are the preparation time, the information required and the possibility of cutting worthwhile longer-term expenditure.
Its usefulness depends on whether the decisions it improves justify the effort involved.
Can a small business use zero based budgeting?
Yes. A small business can use a spreadsheet to record proposed expenses, their purpose and the calculation behind each amount.A practical starting point is to review a few categories where spending has become difficult to explain. This uses zero based budgeting principles without requiring a full review of every business activity immediately.
How often should you review a zero based budget?
Choose a review cycle that suits your business. You could rebuild the budget annually, compare actual results monthly and update forecasts when sales, costs or business plans change.
Need Help with Your Business Budget?
At Drumm Nevatt & Associates, we can help you review business costs, prepare budgets and cashflow forecasts and set up reporting to track your progress.
Contact our team to discuss a budgeting approach that suits your business.
