Definition
Traditional budgeting involves using the previous year’s budget as a base and then adjusting it for the future period, usually by adding incremental changes due to predicted inflation or business expansion. Zero-based budgeting, on the other hand, starts from zero each budgeting period, reviewing every expense item, analyzing its necessity, and justifying what should be included in the new budget. This results in a more critical review of the costs, potentially leading to cost savings as all expenditures have to be justified each period.
Key Takeaways
- Traditional Budgeting is a method where the previous year’s budget is taken as the base, and then changes are made based on the new year’s plans. It is simple and quick to implement but may perpetuate previous inefficiencies.
- Zero Based Budgeting involves building a budget from scratch, i.e., starting from zero. Each cost must be justified, which encourages the efficient use of resources, but can be more time-consuming and requires a detailed understanding of resource needs.
- Each approach has its advantages and drawbacks: traditional budgeting could be less time-consuming, whilst zero-based budgeting is seen as more accurate. The best choice depends on the particular needs and context of a business.
Importance
The finance terms Traditional and Zero Based Budgeting are important as they represent two fundamentally different approaches to budget planning, each with their own advantages. Traditional budgeting is based on the premise of incremental adjustment and repetition.
It uses the previous budgeting period as a base and makes adjustments according to new goals or market conditions. This method is simple and time-efficient, but may perpetuate unnecessary or outdated costs.
In contrast, Zero Based Budgeting involves building the budget from scratch for each new period, justifying every single cost. This method enables more active cost control, encouraging efficiency and discouraging wasteful spending, but it can be more time-consuming and requires strong managerial commitment.
The choice between the two depends on a business’s specific needs, goals, and resources.
Explanation
Traditional budgeting and zero-based budgeting serve as distinct methodologies for planning and controlling business finances, each serving a specific purpose. Traditional budgeting, also known as incremental budgeting, is based on the assumption that future budgets will resemble past ones. The central premise involves adjusting prior budgets to account for inflation or changes in operations, making it effective in stable environments where businesses have predictable costs and revenues.
It offers the advantage of saving time since there’s no need to start the budgeting process from scratch each year. Yet, it may lead to inefficiencies by perpetuating potentially outdated spending habits. On the other hand, zero-based budgeting (ZBB) starts from scratch each financial period, hence the name “zero-based”. Every cost must be justified and approved instead of simply altering the previous year’s budget.
This method shifts the focus toward cost-benefit analysis, fostering efficiency as areas of waste are more likely to be identified and remedied. Although it tends to be more time-consuming due to the need for comprehensive review, it provides a deeper understanding of where and why money is being spent. While ZBB is used as a cost-cutting measure and encourages financial discipline, it’s important to note its suitability depends on the size and nature of the business.
Examples of Traditional vs Zero Based Budgeting
Government Budgeting: A traditional approach to budgeting is typically used in many government bodies. Every year, departments are given a budget based on the previous year’s spending, adjusting for inflation or other planned expansions. However, some government entities have adopted Zero-Based Budgeting (ZBB) to carefully analyze and justify each line item. For instance, the Carter Administration in the United States tried to implement ZBB during the 1970s, but it wasn’t entirely successful due to its complexity.
Corporate Sector: Many corporations start their budgeting process based on previous year’s expenses and profits, this represents traditional budgeting. However, other companies like General Electric and American Express have used ZBB to reevaluate their costs and expenses. These companies initiated zero-based budgeting in an effort to discontinue any unnecessary costs and to align expenses more closely with their strategic objectives.
Non-Profit Organizations: Non-profits often operate on a tight budget and need to account for each dollar spent, making ZBB a sensible approach. Each expenditure requires justification, ensuring that only necessary expenses are approved. Conversely, other non-profits may use traditional budgeting, basing their financial plans on what was spent during the prior period and simply adjusting it for the following cycle.
Frequently Asked Questions: Traditional vs Zero-Based Budgeting
What is Traditional Budgeting?
Traditional budgeting is a method of preparation of the budget in which previous year’s budget is taken as the base. Current year’s budget is prepared by making changes to previous year’s budget, such as adjusting for inflation, increase or decrease in revenue or expenses, etc.
What is Zero-Based Budgeting?
Zero-Based Budgeting (ZBB) is a method of budgeting where all expenses must be justified for each new period. The process starts from a “zero base” and every function within an organization is analyzed for its needs and costs.
What are the key differences between Traditional and Zero-Based Budgeting?
The key difference between traditional and zero-based budgeting is the process of budget creation. Traditional budgeting takes last year’s budget as a base and makes changes accordingly, while in zero-based budgeting every expense must be justified, started from a zero base. Another major difference is that zero-based budgeting allows for more scrutiny over all business operations and their costs, promoting efficiency.
What are the benefits of Zero-Based Budgeting?
Zero-Based Budgeting promotes efficiency by re-evaluating every business function, eliminates wastage and bloated budgets, and aligns business operations with strategic goals. It also ensures that every dollar is put to use wisely.
What are the disadvantages of Zero-Based Budgeting?
Zero-Based Budgeting can be time-consuming to implement, as every business function must be reviewed and justified. It may not be suitable for all types of businesses, particularly larger ones with more complex functions. It may also lead to short-term thinking if not implemented correctly.
When is it more suitable to use Traditional Budgeting?
Traditional budgeting may be more suitable for small and stable businesses where operations and expenses are predictable and don’t change significantly from year to year.
Related Entrepreneurship Terms
- Incremental Budgeting
- Cost-Benefit Analysis
- Performance Based Budgeting
- Fiscal Accountability
- Resource Allocation
Sources for More Information
- Investopedia: An American website that focuses on investment and finance education along with reviews, ratings, and comparisons of various types of brokerage accounts.
- CFO: A media brand that is tailored to meet the information needs of Chief Financial Officers (CFOs) and other senior finance executives.
- The Balance: A personal finance website that provides clear, practical, and straightforward advice to help its readers understand money and how to handle their finances.
- Corporate Finance Institute: An institute that provides online courses and certifications in finance, digital marketing, capital markets, investment banking, and more.
