Zero-Based Budgeting, What is it?
Zero-Based Budgeting, What is it?
What is Zero-Based Budgeting? While the answer is simple, the execution is hard. Zero-Based-Budgeting means you start with a completely blank slate. No dollar amounts or other numbers for revenues or expenses. You literally start with zero.
Why would a company create a Zero-Based Budget? By starting with zero, you force yourself to think about and make a choice about every expense the company will need in order to hit its objectives for the year and run the company. Every startup that creates a budget before the business begins is preparing a Zero-Based Budget because they have no choice; they don’t have any historical data to start with. The potential trap for all companies doing a Zero-Based Budget and especially so for brand new ventures is that you might not include an expense you actually will need to incur. For example, while you might think about and include the cost of business cards for the founders, will you remember to include the legal costs to start the company and keep it in good standing with the Secretary of State each year?
If your company has been running for 1 or more years, it’s likely starting point for your next budget (or for that matter long term forecast) is some combination of the previous year’s budget and actuals. The benefits of this are that it saves you time in building your next budget and makes it much less likely that you will forget to include an expense, like annual Secretary of State filing fees, that you will actually incur.
So why would a company that’s been around at least one year choose to do a Zero-Based Budget? If your company is either young and/or small, you need every dollar you can find to invest in generating sales, improving your product, keeping the lights on and having enough cash in the bank to meet payroll. If your company is more developed and/or more profitable, you still want to make as many dollars as possible available to generate even more sales, improve your product further or just have a higher Net Income and profit margin at the end of each month, quarter or year. Zero-Based Budgeting can help you accomplish this. Here’s one example of how:
Say your company has been spending $10,000 per month on a combination of Search Engine Optimization (SEO) and digital advertising. Without a Zero-Based Budget, you might simply budget $10,000 per month for digital marketing making the tacit assumption that it seemed to work last year so let’s keep doing it. However, with Zero-Based Budgeting, that thought process is not allowed. Whether you have a VP of Marketing proposing a marketing budget or you’re the CEO/CMO rolled into one, Zero-Based Budgeting forces you to think about what your marketing goals are and the most cost-effective way to accomplish them. Taking it a step further, you might say that your goal is to generate an additional $10,000 in monthly recurring revenue each month through digital marketing. You determine that the average sale is $2000/mo, that you close 30% of your sales opportunities and that your cost of acquisition of each true sales opportunity is $200. This data and a little math tells you that to generate $10,000 in new monthly recurring business each month, you actually need to spend $3,333 per month to achieve your $10,000 sales goal.
- Sales Needed: $10,000 / $2,000 = 5
- Leads Needed: 5 Sales / 30% close ratio = 16.67
- Required Marketing: 67 Leads x $200 Cost of Acquisition = $3,333
With an expense that has a direct correlation to sales, you could choose to spend $10,000 for digital marketing and budget for $30,000 month in new recurring monthly revenue. Before you do this, you need to consider whether your operational team can handle that much at a time and whether you will have the working capital to support such a big increase.
Either way, the Zero-Based Budgeting method forces you to ask yourself the tough questions rather than just continuing what you’ve done before. When you’re considering overhead expenses that don’t generate additional revenue, such as Office Supplies or Postage expense, Zero-Based Budgeting can help you find line items where you can spend less which will provide more dollars for sales, product or current year profit.