Historic V Zero Base Budgeting

There are 2 fundamental bases for the preparation of budgets.

bulletpoint.gif (896 bytes) historic or incremental budgeting
bulletpoint.gif (896 bytes) 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

bulletpoint.gif (896 bytes) sales price increases/material cost increases
bulletpoint.gif (896 bytes) new sales staff
bulletpoint.gif (896 bytes) new products
bulletpoint.gif (896 bytes) withdrawal of old products
bulletpoint.gif (896 bytes) wage and salary increases
bulletpoint.gif (896 bytes) 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:

bulletpoint.gif (896 bytes) 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
bulletpoint.gif (896 bytes) 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
bulletpoint.gif (896 bytes) 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

Advantages include:

  1. it identifies the potential of the organisation
  2. it represents a move towards allocation of resources by need and benefit
  3. it focuses attention on outputs in relation to value for money
  4. it creates a questioning attitude in place of acceptance of current practice
  5. it will lead to increased staff involvement which can be motivational.

Disadvantages include:

  1. it is time-consuming
  2. it can lead to over-optimism. Some weaknesses and underperformance will be carried forward and have to be considered.

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:

bulletpoint.gif (896 bytes) Why are current sales only 1000 units?
bulletpoint.gif (896 bytes) What actions can be taken to increase sales to 2000 units?
bulletpoint.gif (896 bytes) When can those actions be implemented?
bulletpoint.gif (896 bytes) 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.