Zero based budgets

Zero-based Budgeting (ZBB)

Zero-based budgeting or ZBB is one approach to preparing budgets.

Zero-based budgeting

A method of budgeting that requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero'

It is suitable for:

  • allocating resources in areas were spend is discretionary, i.e. non-essential. For example, research and development, advertising and training.
  • public sector organisations such as local authorities.

Implementation of ZBB

There are four distinct stages in the implementation of ZBB:

(1) Managers should specify, for their responsibility centres, those activities that can be individually evaluated.

(2) Each of the individual activities is then described in a decision package. The decision package should state the costs and revenues expected from the given activity. It should be drawn up in such a way that the package can be evaluated and ranked against other packages.

(3) Each decision package is evaluated and ranked usually using cost/benefit analysis.

(4) The resources are then allocated to the various packages.

Advantages and disadvantages of ZBB

Decision packages

A decision package was defined by Peter Pyhrr (who first formulated the ZBB approach at Texas Instruments) as:

A document that identifies and describes a specific activity in such a manner that senior management can:

(a) evaluate and rank it against other activities competing for limited resources, and

(b) decide whether to approve or disapprove it.'

A decision package is a document that:

  • analyses the cost of the activity (costs may be built up from a zero base, but costing information can be obtained from historical records or last year's budget)
  • states the purpose of the activity
  • identifies alternative methods of achieving the same purpose
  • assesses the consequence of not doing the activity at all, or performing the activity at a different level
  • establishes measures of performance for the activity.

Pyhrr identifies two types of package.

(i)Mutually exclusive packages: these contain different methods of obtaining the same objective.

(ii) Incremental packages: these divide the activity into a number of different levels of activity. The base package describes the minimum effort and cost needed to carry out the activity. The other packages describe the incremental costs and benefits when added to the base.

For example, a company is conducting a ZBB exercise, and a decision package is being prepared for its materials handling operations.

  • The manager responsible has identified a base package for the minimum resources needed to perform the materials handling function. This is to have a team of five workers and a supervisor, operating without any labour-saving machinery. The estimated annual cost of wages and salaries, with overtime, would be $375,000.
  • In addition to the base package, the manager has identified an incremental package. The company could lease two fork lift trucks at a cost of $20,000 each year. This would provide a better system because materials could be stacked higher and moved more quickly. Health and safety risks for the workers would be reduced, and there would be savings of $5,000 each year in overtime payments.
  • Another incremental package has been prepared, in which the company introduces new computer software to plan materials handling schedules. The cost of buying and implementing the system would be $60,000, but the benefits are expected to be improvements in efficiency that reduce production downtime and result in savings of $10,000 each year in overtime payments.

The base package would be considered essential, and so given a high priority. The two incremental packages should be evaluated and ranked. Here, the fork lift trucks option might be ranked more highly than the computer software.

In the budget that is eventually decided by senior management, the fork lift truck package might be approved, but the computer software package rejected on the grounds that there are other demands for resources with a higher priority.

Priority-based budgeting

Priority-based budgeting is designed to produce a competitively ranked listing of high to low priority discrete bids for resources which are called "decision packages".

  • It is a method of budgeting whereby all activities are re-evaluated each time a budget is set.
  • Discrete levels of each activity are valued from a minimum level of service upwards and an optimum combination chosen to match the level of resources available and the level of service required.
  • The concept of ranking bids for capital expenditure is well known; priority-based budgeting applies a similar process to more routine expenditure.

It is similar to zero-based budgeting but does not require a zero assumption.

Created at 6/7/2012 4:27 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/14/2012 2:27 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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