What is Zero-Based Budgeting (ZBB)?
Zero-Based Budgeting (ZBB) Definition
Zero-based budgeting is a method of budgeting that starts each department’s budget at “zero”and requires each line of a business’s expenses to be justified.
This budgeting method stands in contrast with traditional budgeting, which relies on past budgets and only justifies changes to historical budgets.
The term “zero-based budgeting”originated from Peter Pyrrh’s 1970s book, Zero Based Budgeting: A Practical Management Tool for Evaluating Expenses, however the term has taken on a new meaning in personal finance in recent years thanks to Dave Ramsey.
When used in a personal budgeting setting, ZBB means that every dollar of one’s income must be assigned, bringing the total unassigned dollars to “zero.”
If there is money left over after all of the essentials are budgeted for, this money needs to be diverted to debt repayment, savings, or investment account.
The Steps of Zero-Based Budgeting
While zero-based budgeting is a useful tool for both businesses and personal use, the steps to implementing it are a little different.
Companies should follow these steps:
- Step One – Start with Zero: Don’t look at last year’s or last quarter’s spending as a guide.
- Step Two – Set Goals: Which costs will help your company reach their income and growth goals for this new year?
- Step Three – Prioritize and Justify Spending: Not only does each expense need to have a purpose, but a business needs to give priority to expenditures that will have the most impact on their goals.
Personal Budget Steps
For a personal budget, the steps would be:
- Step One – Start with Your Income: Begin with the funds that you are guaranteed to start your zero-based budgeting plan.
- Step Two – Prioritize Essentials: Your rent or mortgage, food, utilities, and transportation expenses should be the first items deducted. Remember to plan for the new month. For example, if the holidays are coming, expect to spend more on food or transportation, depending on your plans.
- Step Three – Justify Other Spending: Once your essentials are covered, decide which other expenses are a good fit for your lifestyle and financial goals. If you love your costly gym membership, you don’t necessarily have to get rid of it. However, if you do not have money to pay debt minimums or to add to savings, a costly gym membership might not be justified.
- Step Four – Don’t Forget to Plan Ahead: Some months come with predictable spending increases, such as when your property tax is due or buying gifts and decor for a holiday. Don’t let these predictable expenses derail your budget. Plan to set aside a little bit of money into a separate fund each month when you justify your expenses.
Zero-Based Budgeting vs. Incremental Budgeting
Many businesses rely on the past year’s expenses to establish a budget for the new year.
They also account for a small percentage increase to cover employee wage increases and inflation.
While traditional budgeting is faster than ZBB, it can also leave gaps for business growth and savings.
Incremental or traditional budgeting would blankly say, “We spent $50,000 on advertising last year, that is how much we are going to spend this year.”
This might be a futile way of spending if the company’s growth goals would benefit from spending on an app or product development more than advertising.
Similarly, traditional personal budgeting looks at past spending to determine future expenditures.
With a traditional budget, a person might say, “I always spend $500 on food, that is how much I will spend this month.”
However, this person did not consider that they would have increased food expenses this month due to hosting guests for an extended time.
Example of Zero-Based Budgeting
Let’s use a locally-run coffee shop as an example of how zero-based budgeting can work with small businesses and large businesses.
Some yearly expenses a small coffee shop might have include:
5 Part-time Employees: $90,000
Rent and Utilities: $40,000
If this business just repeated its budget each year based on past spending, it would miss many savings and growth opportunities.
For example, maybe this coffee shop got more involved with social media with the help of an eager employee, or they agree to give away coffee coupons to listeners of a local radio station.
This could drive down their advertising cost to $2,000.
Similarly, a new local bakery opening up in town might give this coffee shop an opportunity to reduce product costs while displaying new baked goods for sale.
While this is a simplified zero-based budgeting example, the principles are the same for all businesses.
It is the practice of researching and justifying how much to spend on specific business needs rather than blindly assigning a number to them.
Zero-Based Budgeting Pros and Cons
Not sure if zero-based budgeting is right for your business or personal finances? Here are the top advantages and disadvantages of ZBB.
- A Thorough Look at Spending: Since ZBB looks at every expenditure on a granular level, it is easier to find which expenses have been misclassified or misspent in the past.
- Savings Potential: While the primary goal of ZBB is to give every dollar a job, budgeting this way can save money since no funds are wasted. Unlike traditional budgeting, companies and individuals aren’t left wondering where the money went and how they can cut back expenses.
- Growth Potential: Zero-based budgeting allows individuals and businesses to prioritize goals and devote the right funds to these goals.
- Time-Intensive: Whether creating a zero-based budget for yourself or your company, this type of budget will take longer to produce. You will also be researching cost-saving and income-growing methods before you assign a budget to each spending category.
- Focuses on Short Term: Ideally, businesses would be able to implement ZBB while hitting growth goals. However, it is possible to get stuck in short-term spending versus long-term investing and growth with this budgeting model.
Zero-Based Budgeting Final Thoughts
Zero-based budgeting is not the perfect solution for every business or individual, but it is a reliable tool that can help many save money and better allocate their funds.