Zero-based budgeting

What it means

Zero-based budgeting is a method of preparing a budget that does not start from last year's actuals plus a percentage; instead every cost line must be justified afresh. The starting point is zero, and each manager explains why the cost is needed, what value it brings and what the alternatives are.

Traditional incremental budgeting tends to preserve costs that have lost their purpose, because they roll over automatically from year to year. Zero-based budgeting breaks this inertia. For each activity it asks whether the company needs it at all, at what scale, and whether it could be done more cheaply or differently.

The method is used most often for overheads and support functions such as administration, IT, marketing or travel, where the link to output is indirect. For direct production costs that depend on volume, norms and standards are used instead.

How it works in practice

The process begins by dividing the company into cost centres or activities. For each activity, scope options are prepared, such as minimum, current and expanded, with costs and benefits. Management then ranks the options by priority and, within available resources, chooses what to fund.

In practice zero-based budgeting often uncovers forgotten software subscriptions, unused licences, duplicate services, excessive insurance or contracts that renew automatically. Savings can be substantial, especially the first time. It also helps keep OPEX growth under control.

Because the method is laborious, many companies do not apply it to everything every year. A proven approach is to do a zero-based review every few years or for a different part of costs each year, using ordinary budgeting and a rolling forecast in between. It is worth linking the results to performance indicators.

What to watch out for

The biggest risk is the administrative burden. If zero-based budgeting is done in too much detail, managers spend weeks defending trivia and the savings do not cover the cost of the process. Focus on large, controllable items and use a simplified approach for small ones.

Cuts made without regard to long-term consequences can do harm. Reducing spending on training, maintenance or development brings short-term savings but weakens the company in the future. Decisions should weigh not just costs but also what the company would miss if the activity were dropped.