Budgeting Devices
Incremental versus Zero-Base Budgets
Most organizations construct next year’s budget by starting with the current year’s budget, then adjusting each line item for expected price and volume changes.
Each manager submits a budget for the next year by making incremental changes in each line item.For example, the line item in next year’s budget for purchases is calculated by increasing last year’s purchases for inflation and including any incremental purchases due to volume changes and new programs.
Only detailed explanations to justify the increments are submitted or reviewed.
These incremental budgets are reviewed and changed at higher levels in the organization, but usually only the incremental changes are examined in detail. The base/core budget (i.e., last year’s base budget) is taken as given.
Under zero-base budgeting (ZBB), senior management mandates that each line item in total must be justified and reviewed each year.
Each line item is reset to zero each year. Departments must defend the entire expenditure yearly, not just the changes.
In a zero-base budget review, the following questions are generally asked:
- should this activity be provided?
- What will happen if the activity is eliminated?
- At what quality/quantity level should the activity the activity be provided?
- Can the activity be provided in some alternative way, such as outsourcing the activity to another organization?
- How much are other, similar companies spending on the activity (benchmarking)?
In principle, ZBB Opens in new window motivates managers to maximize firm value by identifying and eliminating those expenditures whose total costs exceed total benefits.
Under incremental budgeting, in which incremental changes are added to the base budget, incremental expenditures are deleted when their costs exceed their incremental benefits. However, inefficient base budgets often continues to exist.
In practice, ZBB is used infrequently, ZBB is supposed to overcome traditional, incremental budgeting, but it often deteriorates into exactly that.
Each year under ZBB, the same justifications as those used in the previous year are typically submitted and adjusted for incremental changes.
Since the volume of detailed reports rising up the organization is substantially larger under ZBB than under incremental budgeting, higher-level managers tend to focus on the changes from last year anyway.The focus on budgetary changes is especially true, if managers have been with the organization for a number of years and already know the ‘base’-level budgets.
ZBB is most useful and common when new top-level managers come from outside the firm.
The new managers do not have the specialized knowledge incorporated in the base budgets. New outside managers also bring changes in strategy. Prior budgets are no longer as relevant with each line item requiring justification in light of these changing goals and strategies.
However, ZBB is substantially more costly to conduct and is unlikely to continue once management has gained knowledge of operations and the budgets have encompassed the new goals.