As a small business owner, you know that the preparation of your annual budget is one of the most important financial processes you undertake every year. Your budget is your roadmap for planning your expenses, which govern all components of your business, including staffing levels and employee compensation, new business development and marketing campaigns, and even product and production costs. An accurate and comprehensive budget allows you to make smarter and more informed decisions.
But the question is: Are you better served preparing a traditional budget or a zero-based budget? Let’s dive in.
A traditional budget uses the previous year’s budget as a starting point. Figures on your new budget are adjusted to align with last year’s actual expenditures and income (vs. your budgeted figures). Further modifications are made to account for changes in the marketplace, inflation, and other factors that impact costs.
There’s a perfectly good reason why the traditional budgeting process is so common. You do not have to reinvent the wheel. You’re simply making adjustments to an existing budget without having to start from scratch. The process is expedient, simple, and logical.
But this advantage can also be a weakness of the traditional approach. By building off of an existing budget, opportunities to reduce costs may be overlooked. There is a tendency to stick with the status quo and not scrutinize expenditures to see if there is a better solution. In addition, without careful analysis, errors and unnecessary items can linger for many years before being noticed. In some cases, one-time expenses end up being incorporated into corresponding line items each year, even though they are no longer necessary.
Also, with a traditional budgeting process, there is little incentive for department managers to aim for cost savings, since this will likely result in their budgets being reduced the following year.
Zero-based budgeting does not rely on last year’s budget as a starting point. Like its name suggests, this approach begins with a clean slate each year. You may have an overall target number, but there’s no history to dictate how that figure is divided among the various departments and line items.
Using the traditional approach, the budget typically is developed by a senior executive. A zero-based budget, however, requires input and justification from department managers. Instead of just accepting the item as a necessary cost because it was on last year’s budget, managers must make the case as to why the expenditure is necessary, how it will benefit the business, and how the department or company might suffer if it is not included on the budget.
With zero-based budgeting, there are more opportunities to reduce costs because each expense is re-evaluated annually. This enables managers and executives to consider alternatives, which may involve renegotiating contacts, switching vendors, or opting for new solutions entirely. This method provides companies with the ability to respond quickly to new industry developments and technologies, market changes, consumer demand, and the current business climate.
And while zero-based budgeting offers greater flexibility, it also has drawbacks. For example, this process is far more complex than the traditional approach, and it takes more time and commitment. If you’re going to pursue a zero-based budget, be sure to allocate the time required and create a standardized process that can be followed by your department managers.
Additionally, using a zero-based approach may prioritize revenue-generating departments because their expenses are easier to justify. Some line items on your budget may not be direct money makers, but if underfunded, they could negatively impact your business. Before beginning the process, it’s important to clearly state your values and not to overlook or underbudget key areas of the business.
The Bottom Line
Having a clear idea of what it costs to run your company optimizes the profitability and overall value of your business. Investing the time and resources to craft an accurate budget, regardless of which method you choose, is essential to the growth and survival of your business. Working with an experienced and knowledgeable team – like the experts as the Peek Advisory Group – can help strengthen your company’s financial health and sharpen your budget development process.