Zero Based Budgeting

COMMENTARY

Peter Burgess

Idea Zero-base budgeting

Once upon a time a business's annual budget was drawn up on the basis of the previous year's budget. To each item that appeared last year, managers would add a certain percentage. The percentage would be determined more or less arbitrarily, although it would probably be related in some indeterminate way to the rate of inflation, the company's overall strategy and the manager's frame of mind that day.

For many years it was acknowledged that this was not an ideal way to allocate a company's scarce financial resources. It encouraged managers to focus on the cost increases from year to year rather than on the underlying costs themselves. It also inadequately took account of the changing environment in which a company operated. For example, increasing last year's expenditure by the rate of inflation “plus some” was, at some stage, sure to have left a business way behind its rivals.

Nobody came up with anything better until Peter Pyhrr, a manager at Texas Instruments (TI) in Dallas, developed the idea of zero-base budgeting. Each year he prepared his budgets as if last year's figures had not existed. Every assumption had to be rethought from scratch and then justified. It was not acceptable to use last year's expenditure as a benchmark for this year's budgeted costs, and then only to have to justify the increase in that expenditure. In effect, zero-base budgeting treats all claims on financial resources as if they were entirely new claims for entirely new projects.

A basic requirement of zero-base budgeting is that managers prepare their budget for the cost of running their operations at the lowest possible level. They are then required to calculate the costs and benefits of making a particular business decision that would lead to an incremental increase from that level. Breaking the budget down into different decision packages in this way makes it easier for senior managers to make choices among competing claims on scarce resources.

Other companies rapidly adopted the idea. It has also been used extensively by local and national governments and by health and education authorities, areas where the budgeting process has traditionally rolled over from one year to the next with its underlying assumptions rarely questioned.

Criticism of zero-base budgeting focuses on the practical difficulties of implementation, and on the fact that it is very time-consuming. Traditional incremental budgeting retains the great advantage of simplicity. One author has claimed that “recent history has indicated that zero-base budgeting is very susceptible to political influence and pressures”. In recent years it has largely fallen into disuse, at least outside the public sector.

Further reading

Pyhrr, P., “Zero-base Budgeting: A Practical Management Tool for Evaluating Expenses”, John Wiley & Sons, 1973; reprint, 1977