Historic V Zero Base Budgeting
There are 2 fundamental bases for the preparation of budgets.
historic or incremental budgeting
zero based budgeting
Historic or Incremental Budgets
Essentially this basis for budget preparation takes the actual performance of the current period and uses it as the "base" from which to predict the performance in the next budget period.
To prepare the budget, identify events that are predicted to occur in the next budget period, ie
sales price increases/material cost increases
new sales staff
withdrawal of old products
wage and salary increases
volume and inflation impact on costs
What is the impact of those events on performance in the current period? Use this information to predict the outcome of performance in the future budget period.
However, whilst this method is likely to produce a reasonable indication of the level of future performance, it has a number of deficiencies:
it assumes that all current functions should be continued in their present form, and therefore carries forward all the current weaknesses, as well as strengths
it assumes that performance in the current period is a reasonable basis for predicting the future regardless of any positive or negative factors (external or internal) that may have affected the current performance
it makes no attempt to assess what the potential is.
Zero Base Budgeting
As its title implies, zero based budgeting makes no assumptions based on historic performance. It questions every aspect of the organisation.
What products are being sold and why?
What is the potential for each product?
Is the organisation realising the potential for each product? If not, why not?
How many sales staff are there?
What is the level of returns, lost sales? Can they be reduced?
What is the purpose of each function?
Is it necessary in its present form and at the present cost? For what return?
Advantages and Disadvantages of Zero Based Budgeting
However, these disadvantages can be reduced by apply zero based budgeting selectively to key areas of concern to management; question the assumptions behind those areas one at a time.
The 2 bases for preparing budgets may give rise to significantly different levels of performance.
Based on historic performance, the budgeted sales of an item may be - 1000 units.
Using zero based budgeting, the potential may be assessed to be - 2000 units.
It is not appropriate to budget 2000 units until you have answered these questions:
Why are current sales only 1000 units?
What actions can be taken to increase sales to 2000 units?
When can those actions be implemented?
How quickly will the additional sales accrue?
A meaningful budget will identify the actions to be taken and realistically estimate the outturn from those actions for inclusion in the budget.