Planning in advance is what propels countless company leaders into the upper echelons of business management. Whether it’s strategy, human resources, or your organisation’s all-important finances, you need to prepare well for your business’ future. When it comes to finances, budgeting is your best friend — providing a roadmap for resource allocation and a safeguard against over-expenditure.
Two prominent approaches are traditional budgeting and zero-based budgeting. While both aim to responsibly guide fiscal decisions, they differ in their philosophies. Here, we’ll look at the definitions of each, their similarities, and the differences that set them apart.
What is traditional budgeting?
Traditional budgeting is a widely practised method that leverages historical financial data to inform future financial planning. Using the traditional approach, organisations will begin by reviewing the previous period’s budget. Typically, adjustments will then be made based on a range of factors. Forbes writes that business owners should reflect on:
- Historical performance
- Marketing return on investment
- The economy
- Unforeseen circumstances
- Contingency plans
It’s important to note that traditional budgeting is done on an incremental basis, assuming that most expenses will continue at a fixed amount unless there’s a compelling reason for adjustment. This method makes it easier for organisations to predict future expenses, especially if they have stable revenue streams.
However, some financial thought leaders criticise traditional budgeting as an obstacle for innovation. As this technique is based on previous spending patterns, it may lead to organisations failing to explore new ways of allocating resources — and historical data cannot account for changing market conditions, limiting an organisation’s ability to adapt.
These limitations have led organisations to explore alternative budgeting methodologies, such as zero-based budgeting.
What is zero-based budgeting?
Zero-based budgeting is a modern accounting technique that operates differently from the traditional approach. SaaS procurement platform Vertice explains that zero-based budgeting “requires all expenses to be justified and approved for each financial period, starting from zero rather than a pre-existing spend. This supports budget consideration on a more granular level, lowering expenses and promoting fiscal responsibility.”
Zero-based budgeting demands a comprehensive approval process for each cost at the start of each financial cycle, regardless of a line item’s inclusion in previous budgets. This encourages businesses to regularly review their financial priorities and critically assess their needs, reducing unnecessary expenditures.
With zero-based budgeting, decision-makers are tasked to provide clear justifications for each penny spent — instilling a sense of discipline in spending decisions. Zero-based budgeting is praised as a powerful tool by Investopedia as it helps to keep legacy expenses in check and justify all operating expenses. Ultimately, this could enhance your organisation’s financial agility and improve budget management.
What are the similarities?
Traditional and zero-based budgeting will be suitable for different organisations with different priorities for their budget allocation. But what are the commonalities between these approaches?
1. Emphasis on resource allocation
Resource allocation refers to “the process of assigning resources in a way that optimises their utilisation and aligns with the organisation’s objectives”. Both approaches to budgeting aim to support the effective allocation of resources within an organisation, providing a framework for decision-makers to determine how funds should be distributed among different departments and projects.
2. Support for financial planning
Traditional and zero-based budgeting are both considered important tools for financial planning, helping organisations set priorities, allocate funds strategically, and align their spending with overall business objectives.
3. Organisational control
Both traditional and zero-based budgeting provide a mechanism which allows organisational leaders a more granular level of control over costs. They establish a structured process for reviewing and approving any spending that takes place, promoting accountability and spend visibility, which is vital as 10% of all company spending goes wasted.
4. Performance evaluation
Traditional and zero-based budgeting each contribute to the evaluation of departmental and organisational performance. By comparing actual expenditures against budgeted figures, financial officers can assess the company’s financial health and make informed decisions about its future.
What are the differences?
On the flip side, traditional and zero-based budgeting also have their differences in methodology and underlying philosophies. Here are the key differences between the two:
1. How calculations work
Traditional budgeting typically starts with the previous period’s budget as a baseline and makes incremental changes based on factors such as inflation, expected growth, or changes in business conditions. Zero-based budgeting, on the other hand, sets the budget’s baseline at zero for each financial period, adding each expense once justified and approved.
2. The focus on justification
Traditional budgeting assumes that existing expenses will continue at similar levels unless there is a compelling reason for an increase or decrease. This is usually informed by historical data and doesn’t tend to demand a reassessment of each individual expense. However, zero-based budgeting requires a comprehensive audit of each expense that bears adding to the budget — promoting a more rigorous examination of financial priorities.
3. Key philosophies
Traditional budgeting places emphasis on continuity and stability, which is why it tends to work better for companies with recurring revenue — like gas companies, or your local coffee shop. It assumes that ongoing operations and expenses will follow established patterns, with only minor adjustments made for changes in the business environment. Zero-based budgeting embraces a more dynamic philosophy, challenging the status quo by forcing a re-evaluation of every budget item upon each financial cycle.
4. The level of flexibility
While traditional budgeting may be less adaptable to changes in business conditions, zero-based budgeting encourages flexibility by requiring ongoing assessment of expenses. This makes the latter more responsive to changes in the business environment — which has been a welcome asset in recent years, following challenges like the pandemic and the cost of living crisis affecting business budgets.
Ultimately, plenty of businesses subscribe to and see success with either one of these two budgeting approaches. With the right level of organisation and foresight, either one can be a sensible choice depending on your business model — but it’s best to fully understand each of them before choosing a side.