A budget expresses thoughts with numbers. Numbers can be financial like income and cash flow or non-financial like time and volume. Expressing thoughts with financial and non-financial numbers can be done through a variety of methods. One method is zero based budgeting which like all methods has strengths and weaknesses. The purpose of this article is to examine the strengths and weaknesses of zero based budgeting.
An Overview of Zero Based Budgeting
A budget addresses activities that exist in companies. What are the activities that exist in companies? The answer is in two financial statements, the income statement and balance sheet.
The activities in the income statement are:
- Creating what companies sell which appears as cost of goods sold.
- Promoting and distributing what companies sell which appear as selling expenses.
- Supporting what companies sell which appears as administrative expenses.
The activities in the balance sheet are:
- Raising money which appears as long-term liabilities and stockholders’ equity.
- Acquiring assets which appears as long-term investments, fixed assets, and intangible assets.
- Conducting relationships which appears as current assets and current liabilities.
Zero based budgeting operates under an assumption which is activities begin anew. This assumption contradicts other budgeting methods in that other methods use prior period amounts that are adjusted upward or downward. Zero based budgeting does not use prior period amounts, zero based budgeting uses a base rate of zero. The base rate of zero represents a numerical foundation for thinking about how companies can accumulate wealth. Thinking about how companies can accumulate wealth through zero based budgeting is guided by a keyword.
The Keyword of Zero Based Budgeting
The keyword of zero based budgeting is justification; justification is defined as “the action of showing something to be right or reasonable.” Showing something to be right or reasonable is critical for companies to not only maintain but also enhance their existence. Companies maintain and enhance their existence by improving the well-being of their stakeholders. How companies improve the well-being of their stakeholders is through value propositions like accessibility, competence, courtesy, durability, and innovation. Value propositions are accomplished from execution, execution must be thought out, and zero based budgeting connects thoughts to execution through justification.
Maximizing the Strength of Zero Based Budgeting
The strength of zero based budgeting is justification.
Showing what is right or reasonable in creating, promoting, distributing, and supporting what companies sell affects profitability. Showing what is right or reasonable in conducting relationships affects liquidity. Showing what is right or reasonable in acquiring assets and raising money affects solvency. Notice how profitability, liquidity, and solvency are tied to what is right or reasonable. If companies do not improve the well-being of their stakeholders, the cause is the inability to justify their value propositions. Value propositions can be affected by competition, economics, and innovation. Failing to prepare for these effects will prepare companies to fail.
Note in the previous paragraph that justification extends to the balance sheet. In conducting relationships companies must justify credit terms with customers, purchases of merchandise or materials, in-house or outsourced conversion of materials to finished goods, credit terms with suppliers, and use of employees or consultants. In acquiring assets companies must justify investments in stocks or bonds, purchasing or leasing of fixed assets, and purchases of intangible assets. In raising money companies must justify issuing debt or equity. Justification through zero based budgeting establishes a connection from activities that affect the balance sheet to value propositions that improve the well-being of a company’s stakeholders.
Zero based budgeting is seen as a cost cutting method which is incorrect beyond comprehension. Zero based budgeting is about justifying activities that improve the well-being of a company’s stakeholders. Events outside the company can affect value propositions – accessibility, competence, courtesy, durability, and innovation – that requires base rates of zero. Base rates of zero are the foundation of zero based budgeting. By utilizing this method in financial planning companies will be better suited to answer two important questions:
- What are the reasons people have for buying what companies sell?
- How can companies satisfy these reasons?
Answering these questions through justification is how companies can maximize the strength of zero based budgeting.
Minimizing the Weakness of Zero Based Budgeting
The weakness of zero based budgeting is effort. Effort, a vigorous or determined attempt, has been a time-consuming process in whatever budgeting method companies use. Time periods as long as three months exist in budgeting and this amount of time creates strain in people/process/technology and obsolescence in budgets that are necessary to assess financial health. Attention to effort therefore must be addressed in order to minimize the weakness of zero based budgeting.
How can companies begin to minimize the weakness of zero based budgeting?
An answer is framing. From a psychology perspective framing is about how information is presented. There are two types of framing that apply to elements in budgets, narrow and broad.
Narrow framing focuses on specific ledger accounts. Examples of narrow framing for expenses are assembly labor, Google ads, gasoline for deliveries to supermarkets, and patent attorney compensation. Examples of narrow framing for assets are investments in technology startups, office computers, and logo trademarks.
Broad framing focuses on categories in financial statements. Examples of broad framing for income statement categories are cost of goods sold, selling expenses, and administrative expenses. Examples of broad framing for balance sheet categories are current assets, long-term assets, current liabilities, long-term liabilities, and stockholders’ equity.
Broad framing eliminates the effort of being precise with amounts applicable to specific expense and asset accounts. It is the effort of being precise that leads to strain and obsolescence.
Emphasizing flexibility over precision in thinking about how companies accumulate wealth can minimize the weakness of zero based budgeting.
Zero based budgeting is a method relevant for companies to improve the well-being of their stakeholders. It is relevant because it connects the justification of activities that are necessary to maintain and enhance value propositions. This connection is the foundation for FP&A professionals.