The process of budgeting in most organizations follows the logic that the next year budget will be same as this year with only a few minor changes.
The sales budget will follow this logic as well as any production, marketing or operational budget.
Is anything wrong with this budget development approach?
The answer is yes and no. Pretty much the same activities will be performed the next period as they are performed this period whether it is a month, quarter or year. The way production, operations, delivery, marketing, sales, safety, customer service, etc. are executed – we assume are the most effective tactics we have developed over the years.
As a result, traditional sales manager will take the revenue from last year and use it as a baseline, the marketing manager will develop the budget by using the same approaches from last year, the production manager would do the same…
By using traditional budget strategy we cannot really expect any drastic changes in our business because everything will hopefully work the same way as it was before.
Now let’s focus on the other side of the argument. In order to understand the pitfalls of the traditional budget process let’s step back and rethink the purpose of budgeting.
Budget is simply a financial plan. This financial plan should follow and support your overall business plan, strategy and objectives. However by following the same way of doing business and using the same resources, tactics and processes your results would pretty much be the same – a little bit better or even worse as the market and competitors change.
For organizations in business which are growth oriented and focused on developing competitive strategies and advantage, the zero based budget is an effective tool. Zero base budget uses a different logic which basically is that every item on your budget should be evaluated regardless of whether it’s new or how much cost we have allocated to each item in the past.
By doing that, managers start with a fresh perspective and evaluate what works and what doesn’t work for the business and where should we allocate the costs based on a cost-benefit analysis and potential value of each of the budget items.
In other words, no substantial change in product development, revenue growth or quality improvement will happen unless we change something in the way we do business or in our activities which will result in changes in the budget from last year to this year.
While compared to traditional budgeting, zero-based budgeting takes more time and resources, it offers the benefits of cost allocation based on the business strategy, goals and objectives. In addition, it motivates management to be more creative and productive in the planning as well as in the execution phase of the budget plan.
Zero based budgeting helps companies get rid of the activities which are not productive and ignores the logic of ‘that’s the way we do business’. Those activities which are more productive will be pushed while less productive activities will be cut regardless of how much we spent last year – but based on how productive they are and how much value they create for the company.
As a conclusion, each and every manager should think about it and use the logic of zero budget regardless of the company size and age. Simply evaluate each budget item just like you would for a brand new startup business.
The following questions will help you reevaluate your budget and improve the planning process:
- How much is this item valuable for the company?
- Do we really need this item? What items should be cut?
- What items should be added based on the latest business strategy and targets?