Zero-based budgeting (ZBB) is a method of preparing budgets in which each cost is built up from a base of zero, and every activity must be justified on its merits before it receives funding. Managers do not begin with last year's spending and add a percentage for inflation or growth. Instead, they ask what each activity achieves, what it would cost to perform at different levels, and whether it is worth doing at all.
The resulting plan is described under zero-based budget. This entry focuses on the budgeting process itself: how organizations carry it out, its history, and its strengths and weaknesses compared with incremental budgeting, the traditional approach of adjusting the prior year's budget.
How the process works
- Identify decision units: the activities, departments or cost centers whose spending will be reviewed.
- Prepare decision packages: for each unit, managers describe its purpose, the consequences of not funding it, alternative ways of delivering it, and the cost and benefit at several levels, such as a minimum level, the current level and an enhanced level.
- Rank the packages: senior management ranks all packages across the organization in order of priority, often using cost-benefit analysis.
- Allocate funds: resources are assigned down the ranked list until the available budget is used up. Packages below the cut-off are not funded.
- Monitor results: actual spending and outcomes are tracked against the packages that were approved.
Worked example
A company's marketing department spent $2,400,000 last year. Under incremental budgeting, it might simply receive $2,472,000, a 3 percent increase. Under zero-based budgeting, the department prepares packages:
| Package | Cost | Expected benefit |
|---|---|---|
| Core digital advertising | $900,000 | Drives about 60 percent of new customers |
| Trade shows | $450,000 | About 120 qualified leads a year |
| Print catalog | $380,000 | Declining response, about 2 percent of sales |
| Sponsorships | $300,000 | Brand awareness, hard to measure |
| Expanded social media program | $250,000 | Projected 15 percent rise in online leads |
| Agency retainer | $350,000 | Creative work, partly duplicates in-house staff |
After ranking, management funds digital advertising, trade shows, the expanded social media program and half of the agency retainer, a total of $1,775,000. The print catalog and sponsorships are dropped. The department's budget falls by $625,000 compared with last year, while money is shifted toward higher-return activities.
History
Zero-based budgeting is usually credited to Peter Pyhrr, who developed it at Texas Instruments around 1969 and described it in a 1970 Harvard Business Review article. Jimmy Carter introduced it as governor of Georgia and, after becoming president, ordered its use across federal agencies in 1977, though it was largely abandoned in the federal government budget process in the early 1980s. The approach was revived in the 2010s by private companies seeking aggressive cost cuts, most prominently the investment firm 3G Capital at companies such as Kraft Heinz.
Advantages and disadvantages
- It challenges spending that continues out of habit and can uncover waste and outdated activities.
- It reduces budgetary slack because managers cannot rely on last year's figure.
- It links spending to goals and encourages managers to think about alternatives.
- It is time-consuming and paperwork-heavy, especially in large organizations, which is why many use it only every few years or for selected areas such as administrative expenses.
- Benefits of some activities, such as research, training or brand building, are hard to quantify, so they may be cut unfairly in favor of short-term savings.
- Managers may game the process by making essential packages look expensive or inflating benefits.
Many organizations therefore use a hybrid approach, applying zero-based reviews to discretionary operating expenses while budgeting committed fixed costs incrementally, and studying the method as part of managerial accounting.