Baseline Versus Zero-based Budgeting

Is your organization re-inventing the wheel each year when it begins its budget process? Organizations that implement zero-based budget methods may be doing just that. Instead of supporting managers with historical information, some organizations insist that the budget process begin anew each year.

One of the primary benefits of zero-based budgeting is that it forces preparers to think through their operations in order to plan for the upcoming year. Advocates believe that in the process, preparers become much more aware of the factors that have (and will have) an impact on their operations. The review process offers preparers the opportunity to examine each of the factors and, possibly, to discuss them with management.

Zero-based budgeting builds the preparer's knowledge of the company and its operations whether the preparer is a longtime veteran or a relative newcomer to the organization. In many cases, it can serve as a management tool to develop lower-level managers' skills and their motivation.

Proponents insist that preparers who start from 'scratch' in developing their budgets will be more likely to base their budgets on assumptions that are current and relevant. Many budget items do change from year to year. By re-considering each item in the budget, the preparer may be more likely to account for the effects of extraordinary or non-recurring items than if the calculations were based upon only a cursory review of historical data.

Despite its advantages, there are major disadvantages to zero-based methods. The most obvious is the amount of time and complexity involved in the process. Without the benefit of historical or budgeted data to base their assumptions upon, preparers may be forced to justify routine operations. That is to say that preparers may spend inordinate amounts of time essentially recreating the effects of cyclical trends in the business's operations.

Some businesses have very predictable operations that vary little over time. It is neither efficient or effective for a preparer to spend a great deal of effort developing data that could be obtained quickly and accurately by extrapolating historical data. Baseline budgeting offers the preparer the advantage of building upon the company's existing base of knowledge regarding its operations. Preparers are often able to analyze historical data and extrapolate cyclical or seasonal trends quickly. For many companies, this method is reliable and saves valuable time.

Baseline budgeting may actually improve the quality of the organization's budgeted information. Instead of recreating existing information, preparers can focus upon areas of the operations that may be exceptionally difficult to budget or represent opportunities to plan at an even greater level of detail. Analysis of historical data may remind preparers to factor into their budgets events or trends that they may have otherwise forgotten or overlooked. The availability of historical data also gives the preparer an opportunity to perform research quickly.

One of the most serious disadvantages to baseline budgeting is that managers will sometimes rely upon historical data without considering its relevance. If the preparer does not make the effort to determine whether the historical data includes extraordinary or irrelevant items, then the process becomes less valid (or invalid). Extrapolating historical trends without verifying the assumptions that underlie the data, risks compromising the integrity of the budgeted data. Management should establish controls, such as requiring assumptions, in order to ensure the information's relevancy. An iterative review process can also help management to monitor information quality.

Managers who are considering implementing or revising a budget process should consider several factors before selecting either a baseline or zero-based approach:

• availability and relevance of historical information
• organization's cyclical or seasonal trends
• likelihood of extraordinary or non-recurring budget items
• preparers' experience in developing budgets
• amount of research and analysis necessary to develop quality information

In addition to the aforementioned factors, managers should also consider how information will be distributed, collected, and compiled. Preparers will need plenty of support for their analytical and research efforts, as well as tools that are well-suited to the task of developing a budget.