Contributed by: RVKS and Associates.
As we enter a new financial year, zero-based budgeting can pave the way for well-designed policy changes.
Planning is an essential tool for all businesses to provide direction, increase efficiency, reduce risks to an acceptable level, and facilitate decision-making. Financial budgeting, especially, is a critical component of planning. As Peter Drucker put it, “What gets measured gets managed.”
Start by determining the limiting factors such as the size of the market, production capacity, regulatory and environmental factors, sales demand, labour, and materials or operational constraints that you need to address as part of the business process.
The budget should facilitate the allocation of resources and monitoring of the proposed results to ensure there is no deviation from the objective.
The preparation of a budget would require a fair amount of analysis of the cost patterns of the organisation in terms of both variable and fixed costs. One of the best practices recommended is preparing the budget on “Zero Base” – that is, allocating resources based on programme efficiency and necessity rather than budget history (traditional budgeting).
In Zero-based budgeting, the organisation should review each expense, its function, needs, and costs to be incurred (fully justified) for cost optimisation and maximising business value.
For instance, let’s say there’s a company ABC Ltd, a leading automaker that procures components from various vendors for around ₹500 crores per annum. In the current financial year, ABC Ltd has set up its own plant for manufacturing the components and 40 per cent of the required components can be produced internally at an estimated cost of ₹125 crores, and the remaining 60 per cent will have to be procured from external parties at a cost of ₹300 crores (60 per cent of ₹500 crore).
While preparing the budget for the current FY, the company should mention only ₹425 crores as a component expense instead of reinstating previous-year figures, assuming that there is no increase in sales or costs.
Advantages of Zero-based budgeting
Zero-based budgeting helps in aligning strategic goals and their effective implementation in the budgeting process. It is one of the structured approaches to cost management for a developing business. Zero-based budgeting involves preparing a budget from scratch, forcing decision-makers to constantly monitor the business with a fresh mindset rather than getting influenced by past assumptions and targets.
Some organisations have the tendency to make a provision of 10 per cent additional based on the previous year’s figures. It is akin to conceding that if there was 25 per cent inefficiency in the system during the previous year, it will add another 10 per cent to it this year.
Flexible budgets, cost containment, focused operations, well-organised execution of activities, cost-benefit analysis, the efficiency of resource allocation, strategic growth and transparency are some of the merits. ZBB is also sometimes seen as complex and expensive, time-consuming, resource-intensive, and biased towards short-term planning. In the long term, once the process is understood, the benefits are worth the effort.
Zero-based budgeting is as relevant for SMEs as much as it is for larger entities. The budget prepared by any organisation should ideally be for a year, and in some cases where the uncertainties are high, say Covid, a rolling four-quarter budget could also be considered. It is also not out of place to consider a flexible budget to set a budget based on actual performances.
The budget prepared should be updated and brought to standards considering the volatility and uncertainty of external and internal factors.
A typical organisation would require the following types of budgets covering the entire business process, sales budget, production budget, manpower budget (number and costs), variable costs budget (functions of sales and production budget), selling and distribution budget (fixed and variable expenses), expenditure budget (fixed), capital expenditure budget, cash flow budget, profitability budget including a projected balance sheet.
Another benefit of preparing detailed budgets is it enables organisations to come up with well-designed policies in terms of all key functions starting from marketing, human resources, purchases, and finance, to capital expenditure.
Post-preparation of the budget, the organisation should put in place an effective monitoring mechanism so that if any cases of deviations are observed, they can be addressed effectively. The deviations could be due to material changes in the assumptions or the actual performance itself. If it is the former, it is not out of place to prepare a revised budget to reflect the correct position.
Note: The writer is CA Article Assistant RVKS and Associates, Chennai.
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