Every business needs a budget—a plan that lays out ways for your company to generate revenue, control costs, and maximize profitability. One time-tested approach to establishing a budget, particularly for expenses, is zero-based budgeting. This method relies on justifying spending during each budgeting period rather than automatically carrying over expenses from past budgets as the starting point.
Here’s what you need to know about zero-based budgeting and how to use it in your business.
What is zero-based budgeting?
Zero-based budgeting, or ZBB, is a business budgeting method that starts from scratch, resetting spending plans to zero at the beginning of each period. Rather than taking past spending levels and projecting those forward, each expense item is examined from a fresh perspective during each budget cycle. This method is best suited to companies undergoing significant changes, such as acquisitions or restructuring, as well as businesses with rising costs or declining profit margins.
The concept of zero-based budgeting originated in the 1970s at chipmaker Texas Instruments Inc., which was seeking a concerted way to find savings, reduce costs, and promote financial discipline throughout the company. The key point is that zero-based budgeting requires managers to justify every expense, helping businesses identify unnecessary costs and channel resources to the most profitable activities.
Zero-based budgeting vs. traditional budgeting
Zero-based budgeting is meant to allocate spending based on efficiency and necessity. Traditional budgeting relies heavily on history—how much a business spent in previous periods—as the building blocks for the new budget.
Traditional budgeting typically involves senior management taking previous budgets as a baseline and proposing incremental increases, then handing down the budget to department heads to implement. The process of creating a budget focuses primarily on new expenditures added on top of previous budgets.
Zero-based budgeting analyzes old and recurring expenses as well as new expenditures, starting from the bottom with teams and departments. Each department analyzes its current goals and costs, making little or no use of past budgets. Under this budgeting process, each proposed spending item is reviewed, and department heads must explain the need and how the spending would advance the company’s strategic goals. Managers can apply this process to cost of goods sold (COGS), operating expenditures, research and development, capital expenditures, debt payments, or any other cost category.
The side-by-side comparison below outlines the differences between the two budgeting processes:
| Zero-based budgeting | Traditional budgeting |
| Starts from scratch, without assuming prior budget amounts. | Uses prior budgets as a baseline, with incremental adjustments. |
| Expenses are reviewed and justified each budgeting period. | Existing expenses are often carried forward with limited review. |
| Useful for companies undergoing change, such as restructuring, new business lines, or margin pressure. | Better suited to companies with established revenue and predictable costs, or small businesses that want cost management without exhaustive planning. |
| Driven by strategic goals, such as reducing costs and increasing operating profit. | Driven by limiting spending growth from prior levels. |
| Bottom-up; teams and departments propose spending plans. | Top-down; management sets the budget and allocates spending. |
How zero-based budgeting works
- Review strategic objectives
- Gather relevant data
- Set cost categories to zero
- Evaluate all business functions
- Review fixed and variable costs
- Justify and allocate
- Monitor and adjust
Here is a step-by-step guide to zero-based budgeting:
1. Review strategic objectives
A business puts the zero-based budgeting process in motion by reviewing its strategic goals and objectives, helping to set spending priorities. For example, let’s say an online apparel retailer has an operating profit margin of 15% and its goal is to increase the margin to 25%. Or a provider of subscription-based services wants to increase annual recurring revenue by reducing its churn rate—the share of customers who don’t renew or cancel their subscriptions—from 40% to 20%. Different businesses have different goals, which affect their budgeting priorities and budgeting strategies.
2. Gather relevant data
Managers need to collect historical and recent performance data, both companywide and from each department, for evaluation. The latest industry data and trends in the company’s markets are also important, as well as changes in consumer spending and income. For example, budgeters might examine the past several quarters to compare sales growth to expense growth, or to compare total customer orders processed versus customer returns. They may also analyze external data, such as industry reports and data available from similar businesses.
3. Set cost categories to zero
Each expense category starts at zero, ensuring a fresh approach to budgeting. For example, assume an apparel retailer’s recent quarter showed $1.7 million in expenses, split equally between COGS and selling, general, and administrative (SG&A) expenses. While those figures provide context, they are not used as a starting point when the company builds the next quarterly budget from scratch.
4. Evaluate all business functions
Managers analyze each business activity to weigh which are essential functions that require funding in the next budget and which are non-essential or legacy functions, subject to reduction or elimination. Rigorous evaluation of functions—for example, the efficiency of the business’s inventory storage and stock rotation—is necessary for a workable zero-based budget.
5. Review fixed and variable costs
Typical fixed costs include rent, utilities, and management salaries. They are sometimes called non-negotiable expenses and aren’t immediately subject to cuts, so they go in the budget first. Other fixed costs may include supplier contracts and software subscriptions. Although these costs may not be negotiable for the current period, zero-based budget managers could look ahead for opportunities to reduce costs by planning for when leases, contracts, and subscriptions are up for renewal.
Variable costs, which rise or fall as a company’s production increases or declines, usually get closer scrutiny during zero-based budgeting. Materials and supplies, direct labor, logistics and transportation, marketing, and software and data-processing are expenses that a business may be able to reduce after review and analysis. An apparel retailer, for example, might find another garment maker that produces goods of the same quality at a lower cost.
6. Justify and allocate
After reviewing all costs, zero-based budgeting gets tougher when the responsible manager or department head must justify each expense item. Let’s say an apparel retailer had a marketing budget of $150,000 in the past quarter, consisting of $50,000 each for radio advertising, direct mail, email, and social media. The marketing manager proposes doubling the social media budget to $100,000, because more sales come through those channels, while eliminating $50,000 each for radio and mail marketing after determining that they are less effective. The net effect is a significant reduction in spending.
7. Monitor and adjust
Zero-based budgeting is a continuing process, not a one-and-done effort. A business must diligently track spending against revenue and make budget adjustments as its needs, goals, market, and economic conditions change.
Let’s say an apparel retailer has strong customer demand and projects a 20% sales increase to $2.4 million in the next quarter. There’s a risk, however, that expenses also rise in proportion, negating any profit increase. Using zero-based budgeting to control inventory and marketing costs, the business keeps total operating expenses at $1.8 million, just 6% higher than the prior quarter. The result is a doubling of operating profit to $600,000. That profit is equal to one quarter of the business’s $2.4 million in sales, meaning the company reached its goal of a 25% operating margin.
Without a zero-based approach, the retailer might not have found ways to better manage expenses.
Zero-based budgeting FAQ
What is an example of zero-based budgeting?
Consider a hypothetical ecommerce company with in-house inventory expenses of $200,000 in the current quarter. Instead of accepting that as the basis for next quarter’s inventory expense, the company starts from zero and determines what’s essential and what’s not. It finds that the inventory functions now performed in-house can be done by a third-party logistics (3PL) provider for $150,000.
What are the problems with zero-based budgeting?
Although it can help a business cut costs through a rigorous analysis of its activities and functions, zero-based budgeting may be challenging and time-consuming to implement. It can take more time and resources to perform than traditional budgeting, and its focus on cost-cutting might mean some long-term projects get underfunded. For example, a biotech company might need years of research and development spending before a marketable medicine is developed. A zero-based budgeting approach might slow its research efforts and put it at a disadvantage versus competitors.
When should zero-based budgeting be used?
Zero-based budgeting is most suitable for businesses undergoing change, such as expansion or reorganization, or facing challenges such as declining profit or falling market share. Such situations often lead a business to seek ways to lower spending (and boost sales). ZBB helps them take a systematic approach to managing costs.
