Professional accountants call it “zero-based’ budgeting and liken it to starting out with a blank piece of paper. But no matter what you call it, building a budget from the ground up is the best way to go for most small businesses.
One of the biggest benefits this approach provides is that starting at the lowest level of detail forces you to think about the need and relative importance of every expenditure your business makes, says Roger Kohl, a partner at B2B CFO, a company providing part-time financial professionals in Springfield, New Jersey. “You start by questioning the underlying basis supporting each individual item, and in coming up with the rationale for including it, you list all the alternatives you’ve considered,” he explains.
Some line items, such as rent, will be obvious, but analysis of even these seemingly straightforward expenses can be thought-provoking: Does your current location represent the best deal you can get? Could you run your business as well from a cheaper location? Could it be home-based?
The same analysis should be applied to all basic line items, including utilities, phone and Internet service, maintenance, etc. Some basic business services were once actual or virtual monopolies but now have competing providers, which is driving prices down in some areas. Zero-based budgeting helps you discover those potential cost savings.
Zero-based budget analysis can provide significant savings opportunities in more complex areas, such as IT system support, Kohl suggests. “You look at your budget and see you have earmarked a certain amount of money for, say, outsourced system support. But this approach forces you to consider all alternatives on a very micro level. Would it be cheaper to bring it in-house? If you have a new client that drives a spike in IT services usage but only a few times a year, maybe a combination of in-house and pay-as-you-go outside support is the most cost-efficient approach.”
The alternative to zero-based budgeting is incremental budgeting, a process by which current-year expenditures are allocated based on the prior year’s spending. If you are spending $500 on a particular item this year, you might budget $525 for next year to account for price increases and conclude that’s a reasonable amount. The problem with that approach is it assumes last year’s spending was fundamentally sound. “It often overlooks alternative remedies and casts a blind eye towards changing market conditions,” Kohl warns.
By pushing you to consider cheaper alternatives for all your business expenses, zero-based budgeting potentially frees up money that can be used for more strategic purposes, such as driving sales growth or expansion into new markets. Zero-based budgeting also encourages greater manager participation, fresh thinking, and responsibility in the budgeting process, and it promotes communication and awareness within the company, Kohl says.
Advocates of incremental budgeting might argue that it’s easier and less political—a consistent company-wide salary increase is easier to defend than individual merit-based bumps, which have to be justified case-by-case, for example—but in the end, it has the effect of promoting a “spend it or lose mentality” and discouraging valuable line item analysis at the lowest level.