What Is Zero-Based Budgeting, How Does It Work

What Is Zero-Based Budgeting?

Zero-based budgeting is a financial planning method where every dollar of your income is intentionally assigned a role, whether it’s covering necessities, discretionary spending, savings goals, or debt repayment. The objective is simple: by the end of the month, your income minus your expenses should equal zero. That doesn’t mean you’re spending everything, but rather that every dollar is accounted for.

Unlike living paycheck to paycheck, zero-based budgeting ensures that all your financial needs are covered in a structured way. You can stick with the same categories and amounts each month, or adjust them based on changing priorities.

This method shares similarities with the envelope system, where you allocate specific amounts to different categories, either physically or digitally, to control spending. If you end up spending less in a category, you can redirect the surplus to savings, an emergency fund, or roll it into next month’s plan.

If you’re just starting your financial journey and want to understand the basics, check out our guide: What Is a Budget, Understanding Budgeting?

Who Developed Zero-Based Budgeting?

The concept of zero-based budgeting was introduced in 1969 by Peter A. Pyhrr, who was serving as an account manager at Texas Instruments in the United States at the time. He later expanded on his ideas in the 1977 book Zero-Base Budgeting: A Practical Management Tool for Evaluating Expenses, which became a foundational text on the subject.

Zero-based budgeting gained public attention when Jimmy Carter, then Governor of Georgia, became the first government official to implement it during the preparation of the state’s 1973 fiscal budget.

How to Start a Zero-Based Budget

Before diving into zero-based budgeting, it’s important to lay the groundwork to make your plan as accurate and effective as possible. Here are the key steps to get started:

1. Calculate Your Total Income
   Begin by adding up all sources of income you receive each month, this includes your paycheck, benefits, side gigs, or any other consistent earnings. This gives you a clear picture of how much money you have to allocate.
2. Track Your Spending Habits
   Review your expenses over the past few months to see where your money typically goes. This helps you understand your financial habits, spot overspending, and identify areas where you might want to reallocate funds.
3. Organize Your Expenses by Category
   Break down your spending into categories, including essentials (like rent, groceries, and utilities), discretionary expenses (such as dining out or entertainment), debt payments, and savings goals, like building an emergency fund or planning for future investments.
4. Decide How Much to Allocate
   A helpful starting point is the 50/30/20 rule: devote 50% of your income to necessities, 30% to wants, and the remaining 20% to savings and debt repayment. Adjust these percentages based on your unique goals and financial situation.

With this structure in place, you can begin assigning every dollar to a purpose, so that by the end of the month, your income minus expenses equals zero.

Zero-based budgeting example

Let’s say you make $2,000 per month. Your budget might look like this:

Advantages and Disadvantages of Zero-Based Budgeting

Advantages of Zero-Based Budgeting

Zero-based budgeting offers several benefits, especially for businesses looking to manage resources more efficiently:

• Evaluates Spending Needs from the Ground Up: It helps organizations determine if each department is receiving the appropriate level of funding, based on current needs rather than historical patterns.
• Encourages Present-Focused Planning: Managers are encouraged to base budget decisions on present circumstances and goals, rather than simply rolling over figures from previous budgets.
• Eliminates Wasteful Spending: By requiring justification for all expenses, it can help cut out unnecessary costs.
• Improves Internal Communication: Involving team members in budgeting decisions can enhance collaboration and transparency across departments.

Disadvantages of Zero-Based Budgeting

While powerful, zero-based budgeting also comes with its challenges:

• Doesn’t Guarantee Savings: Success depends heavily on how the process is executed; without discipline and accurate data, cost reductions may not materialize.
• Time-Consuming and Complex: Creating a budget from scratch each cycle requires significant effort and can become administratively burdensome.
• Resistance from Management: Some managers may push back, especially if they feel their budgets are at risk or if they’re uncomfortable justifying every line item.

To improve the process, it’s crucial to maintain open communication and involve team members at all levels, this not only builds buy-in but also ensures the budgeting process is more accurate and effective.

Already familiar but unsure what’s fact or fiction? Don’t miss our myth-busting post: Debunking 10 Budgeting Myths.