Zero Based Budgeting

ZERO - BASED BUDGETING DEFINITION •

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The term ‘zero based budgeting’ is sometimes used in the personal finance to describe the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward’ Zero Based Budgeting is a technique that sets all budgets to nil at the beginning of the year or period and requires from the departments that they justify all of their expenditures, not just those exceeding the budget. Money is allocated to the departments based on merit and not based on the previous year budget plus or minus some percentage such as in many traditional budgeting systems. Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. No reference is made to the previous level of expenditure. By contrast, in zerobased budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases. Zero-based budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. The zerobase is indifferent to whether the total budget is increasing or decreasing. Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing.

AIM Its aim is to achieve is an optimal allocation of resources that incremental and other budgeting systems cannot achieve. Managers are asked to identify and justify their areas of work in terms of decision packages prior to starting the work. 1

IMPORTANCE • •

Zero-Base-Budgeting was pioneered in the early 60s at Texas Instruments by Peter Phyrr. ZBB is a financial and management strategy to help policy makers achieve more cost- effective delivery of public services.

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The concept of zero-base budgeting has been utilized successfully by private corporations and recommended for application to the federal budget for government use, this planning and budget techniques endeavors to redirect efforts and funds from lower priority current programs to higher priority new programs efficiency and effectiveness, and reduce spending.

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Traditionally, most government budgets have been constructed by adding to the current expenditure level such amounts as seem warranted by circumstances jurisdictions, expenditures for the coming year will exceed those of the current year. For this reason, most attention is directed to the “increments” that have been added to this year’s expenditures to reach the proposed budget total. A major flaw in incremental budgeting is that it assumes the current year’s expenditure level is justifiable and this may not be true. It may be either too low or too high.

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Zero-base budgeting, on the other hand, is a detailed and concentrated study of those activities that might be considered costly or ineffective and that continue to be funded primarily because they are never examined.

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It may be useful for one or more government programs to be subjected to zero based budgeting analysis every year. In such an analysis it is not assumed that the present spending for a particular program is justified. On the contrary, the wisdom of spending any money at all on the program is examined. These questions are typical for analyses of this type: 2

• Is there any measurable evidence of the value of the program under review? • Are the goals and objectives of the program important enough to warrant the expenditures being made? • What would happen if the program were not provided at all? • Are there other less costly and more effect objectives? • Where would the program fit in if all programs were displayed in order of importance? •

Would the benefits be greater if a portion of the funds spent on under review were used instead for other programs?

An important element of this budgeting procedure is that it forces prioritization of government programs and activities. With the prospect of insufficient revenue for matching the demand of spending, it is useful for the government to have a ranking of programs and activities based on proven effectiveness as well as suggested alternatives to expensive or ineffective programs.

STEPS OF ZERO- BASED BUDGETING There are two steps to the process of zero based budgeting. The first step is to develop what is called as “decision packages”. The second is to rank the decision packages. The decision package is a document that identifies and explains the specific and goals and objectives, measurement of performance, costs, benefits and alternative courses of action. Ranking of decision packages is then accomplished at each management level until a comprehensive agency wide ranking is obtained. Conceptually, zero-base budgeting is a systemic logical approach to allocating resources where they will do the most good.

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THE PROS AND CONS OF ZERO-BASED BUDGETING Zero-based budgeting requires that the existence of a government program or programs be justified in each fiscal year, as opposed to simply basing budgeting decisions on a previous year’s funding level. Zero-based budgeting is often encouraged by fiscal watchdog groups as a way to ensure against unnecessary spending. Zero-based budgeting, or some modified version of it, has been used in the private- and publicsectors for decades. Indeed, it is my understanding that the first use of zero-based budgeting in government has been tracked back to Gov. Jimmy Carter’s use of it in Georgia in the early 1970s. As with most policies, there are both benefits and costs to be taken into account when considering zero-based budgeting. Case studies about businesses and governments that have adopted zero-based budgeting, or some hybrid of it, generally report some improvement quantitatively or qualitatively. That is, the process has either saved money, improved services, or both. In addition to saving money and improving services, zero-based budgeting may: • • •

Increase restraint in developing budgets; Reduce the entitlement mentality with respect to cost increases; and Make budget discussions more meaningful during review sessions.

On the cost side of the equation, zero-based budgeting: • • •

May increase the time and expense of preparing a budget; May be too radical a solution for the task at hand. You don’t need a sledgehammer to pound in a nail; Can make matters worse if not done in the right way. A substantial commitment must be made by all involved to ensure that this doesn’t happen.

Zero-based budgeting can be useful for shaking up a process that may have grown stale and counterproductive over time. But I must offer three serious warnings. First, the success of such a change like this hinges strongly on leadership that is dedicated to the task. If those appointed to conduct budget reviews are unwilling to truly assess every item 4

in their budget, word will get out quickly that this new budgeting technique is more symbolism than substance. Indeed, it is incumbent upon proponents of zero-based budgeting to ensure that those reviewing the budget do not have a pecuniary interest in maintaining the status quo. Allowing people who will be most affected by the elimination of programs to conduct their own reviews may be counterproductive, since most people are quick to defend their own interests. Second, don’t attempt to do zero-based budgeting for every department, every year. Such a move may prove impossible to manage. Instead, choose several departments and/or agencies, and rotate through every facet of state government over time. In Oklahoma, which has recently adopted zero-based budgeting, officials are applying the method to two departments and several agencies each year. Once those reviews are complete, the same departments and agencies will not see another zerobased review for eight years. Third, ensure that each review is conducted by referencing all aspects of a department, agency or program to what its goals are. This makes the very purpose of the entity being reviewed transparent, and can increase the opportunities available for making objective measurements of a department, agency or program’s success rate. As with most programs or reforms of programs, it must be done right, or it should not be done at all. For example, department, agency or program directors who feel endangered by this kind of scrutiny will be delighted to be placed in charge, so that they can do it wrong, waste everyone’s time, and give a cutting-edge management tool like zero-based budgeting a bad name, all at the same time.

ADVANTAGES OF ZERO-BASED BUDGETING •

The budget process focuses on a comprehensive analysis of objectives and needs.

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Planning and budgeting are combined into a single process.

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Managers must evaluate the cost effectiveness of their operations in detail.

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Cost awareness and management participation in planning and 5

Budgeting is expanded at all levels of the organization. Drives Managers to find cost effective ways to improve operations •

Efficient allocation of resources, as it is based on needs and benefits.

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Detects inflated budgets.

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Municipal planning departments are exempt from this budgeting practice.

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Useful for service departments where the output is difficult to identify.

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Increases staff motivation by providing greater initiative and responsibility in decision-making.

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Increases communication and coordination within the organization.

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Identifies and eliminates wasteful and obsolete operations.

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Identifies opportunities for outsourcing.

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Forces cost centers to identify their mission and their relationship to overall goals.

CRITICISMS AND DRAWBACKS OF ZEROBASED BUDGETING •

The huge amount of work involved.

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May lead to micro management, offering less time and energy for the things that really matter.

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Does it really lead to a material shift in the use of resources?

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Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.

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Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.

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Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to 6

administer and communicate the budgeting because more managers are involved in the process. •

In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.

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Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.

MODIFIED ZERO-BASED BUDGETING Service-level budgeting is a modified zero-base budgeting approach. This matches spending levels with services to be performed. Under zero-base great deal of effort can be devoted to documenting personnel and expense requirements that are readily accepted as necessary. Modified zero-base can avoid this by starting at a base that is higher than zero. An appropriate starting point for a jurisdiction might be 80 or 85 percent of current spending levels. High-priority requests above this level could be identified to restore part or all of the current year’s service. Desirable new programs could also be considered for funding. As a result, a legislative body might be presented the choice of reducing some operations in favor of some new programs. Thus a new program might be funded out of savings incurred by reduction of an existing program. The phrase “service level budgeting” is in some cases a better description of this process.

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