Budgeting to Zero Before the Month Begins: Why & How Does it Work?

by Sherry Hao, Controller, U.S. Money Reserve

Zero-based budgeting sounds complicated, but it’s really not. Here’s how to do it right.

You have plenty of budgeting options available when it comes to managing your money. The trick with any budget plan is to make sure that it works for your needs and is easy to follow. One of my favorite budgeting tools is called zero-based budgeting or zero budgeting. Here’s everything you need to know about this unique budgeting approach and why and how it works.

What Is Zero-Based Budgeting?

Zero-based budgeting has been around since the 1960s and 1970s. It gained popularity in government during the presidency of Jimmy Carter. At the time, Carter promised the American people he would balance the budget in one term using a zero-based budgeting technique. It was a tool he’d used during his time as governor of Georgia. The idea behind this method is that an entire project’s budget needs to be approved each year, rather than just allowing for incremental changes from year to year, according to this report.

According to McKinsey, zero-based budgeting has seen a bit of a renaissance in recent years, thanks in large part to the rise of digital tools that allow both companies and individuals to track their expenditures in real time. Both individuals and companies can utilize zero-based budgeting as a budgeting tool because the foundational idea behind the practice is similar in both settings.

When applied at a company level, zero-based budgeting is a technique that allows a very granular look at budgets over a period of time. Most companies tend to use zero-based budgeting for year-long budgets. The idea is that each group at a company must present its case to increase, keep, or change the budget they want each year. As digital budgeting tools have become more commonplace, this technique has gained some traction as a good way for companies to ensure that they stay in the black from year to year.

When used on a personal level, zero-based budgeting offers users a way to “give every cent purpose” each month, according to a story at NerdWallet. The goal is to get your income and outflow to equal zero at the end of every month. That doesn’t mean you go on a spending spree every month — rather it means that all of your income is allocated to expenditures, savings, and investments each month. If you’ve heard of the envelope system of budgeting (whereby you put cash into envelopes that are allocated to different expenditures, savings, and investments each month), the zero-based budgeting method should be relatively familiar to you as it operates on similar principles.

How to Practice Zero-Based Budgeting in Business

Zero-based budgeting in business settings can be a great tool to help keep your company on target. There are some considerations to make, however, when considering switching to a zero-based budget plan.

As McKinsey points out, there are a few distinct stages of zero-based budgeting for business. They include:

1. Getting an idea of expenditures and categorizing them. McKinsey says that anywhere from 15 to 20 percent of expenditures are misclassified. This step helps develop transparency into where money is and where it goes for a business.
2. Identifying places for improvement. This can be as simple as reclassifying certain expenditures to be in the right “bucket” (category). This can also be as complex as shifting an expenditure to another group or business line within the company.
3. Redefine expenditure and investment goals and operational improvements. This is where managers of each of the budget items pitch their case for how they think the budget should be allocated for the year. These goals can be determined by the direction of the business, the company goals, or even economic and business changes and challenges.

When deciding if you should make the switch to zero-based budgeting for your company, it pays to take the pros and cons (listed below) into consideration. You don’t want to decide to make a shift and then suddenly discover that the technique doesn’t work for you, your employees, or your business.

It’s also important to know that zero-based budgeting for companies is best implemented over a period of a year rather than month to month. Larger companies with complex operations would be hard-pressed to try and operate on a zero-based budget each month, but with the right staffing, it could be done.

How to Practice Zero-Based Budgeting With Your Personal Finances

If you decide you’d like to give zero-based budgeting a try with your personal finances, here’s what you need to know. First, you need to know how much money comes in each month. That means income from work, dividends or investments, and other sources of income.

Once you have a grasp on your income, you need to track your expenditures for a few months to figure out just how you spend your money. You will then categorize your spending into types (or buckets), like home, insurance, communication, transportation, medical, and other categories. The categories you use should suit your spending and saving habits. There’s no need to use categories that aren’t relevant to your financial goals and behavior. That’s why it also makes sense to categorize your spending into three broad areas: needs, wants, and debts. Then you can subdivide these as necessary.

Once you’ve got an idea of your spending and saving habits over a few months, it’s time to start thinking about your goals and what you’d like to do with your money in the longer term. Are you trying to save to buy a house? Do you have kids you’ll need to put through college? All of these things will require you to save, but how much should you save? It depends on your timeline, income, and spending habits, but a good rule of thumb is the 50/30/20 rule. You divide your income into 50 percent for needs, 30 percent for wants, and 20 percent for debt, then allocate your income according to that formula. Your goal at the end of each month is to have no cash left that isn’t designated to one of your categories. If you do happen to have money left over at the end of each month, you can allocate it to another bucket.

How Does Budgeting to Zero Help You Manage Your Finances?

There are many pros and cons to using a zero-based budget, whether you’re implementing it at a company level or considering applying it to your personal finances.

Some of the pros of shifting to a zero-based budget for companies include:

1. More transparency across all sectors
2. More accuracy of cost and goal tracking
3. Cost savings over time thanks to the discovery of orphaned budgets and projects. McKinsey gives an example of a European utility company that switched to zero-based budgeting and found $150 million in baseline savings.

There are, however, some cons to shifting to this method of budgeting, too, especially if you’ve used another method for a long time.

1. Adjusting to zero-based budgeting often requires the implementation of new technology to track and manage budgets. This can have a significant cost and learning curve.
2. Starting a zero-based budget for your company can be complex and time-consuming for managers who may better serve the company by focusing their efforts elsewhere.

There are also some pros and cons to consider when it comes to using zero-based budgets for your personal finances. The pros of shifting to a zero-based budget for your personal finances include:

1. Transparency into how money moves in your personal life. Do you overspend? Oversave? Where can you get better at managing your cash?
2. Customizable to your needs. You can change the buckets you use or change how much of your income you allocate to each bucket based on your own personal needs.

There are some cons to consider when looking at making the shift to a zero-based budget for your personal finances, too, though. They include:

1. The process can be time-consuming and requires a lot of attention. If you’re already strapped for time, zero-based budgeting might not be the right fit for you.
2. This technique is difficult to use if your income varies from month to month. You may not be able to predict just what your income or outlay may be if you’re a contractor or freelancer.
3. It doesn’t account for variable expenditures. Say you break your phone, need a new computer suddenly, or have to take your kids to the doctor. Zero-based budgeting doesn’t necessarily account for these issues, and you might not have saved enough for these things. It always pays to have an emergency fund, which should be anywhere from three to six months’ worth of expenditures.

Whether you’re considering implementing a zero-based budget at work or at home, it pays to understand the system and how it might and might not work for you. Before you jump into any new budgeting system, it’s important to get the basics down and have some understanding of your attitudes and feelings toward budgeting. Some budgeting techniques can be better than others based on how you save and spend and on your attitude toward money.

Why Does Zero-Based Budgeting Work?

In simple terms, zero-based budgeting works because it forces you to take regular, close looks at your finances, whether you’re doing it for your company or for your family. This kind of attention to detail and awareness of how your cash flows can be really important when it comes to long-term financial stability. It also gives you an immediate insight into how you’re doing against goals you set for yourself or your company.

Tips for Sticking to a Zero-Based Budget

On a personal level, sticking to a zero-based budget (or any budget) can be a challenge. Here are a few tips to help you stick to a zero-based budget in your personal life.

1. Stay consistent. Track your spending using an app or your online bank account. Make sure you check in at regular intervals and allocate the spending accurately as it occurs in real time.
2. Don’t forget about irregular spending. Is someone’s birthday coming up? Are the holidays approaching? Do you have a vacation planned? What about that emergency fund? These are all expenditures that may come up from one month to the next. It’s important to try and capture all of your spending accurately so you can account for it in the zero-based budget system.
3. Give yourself some grace and be flexible. It’s also important to try not to be too hard on yourself if you make a mistake, overspend, or just miss-categorize an expenditure. Each month is a new opportunity to start fresh, so cut yourself a break when you’re starting out.

When it comes to sticking to a zero-based budget at a company, it really comes down to whatever decision the leadership makes. In many cases, a zero-based budget can become pretty easy to stick to once it’s fully integrated and implemented into a process.

The Bottom Line on Budgeting to Zero Each Month

While it may seem intimidating to implement a zero-based budget, whether you’re considering it for your personal finances or your workplace, it’s really quite simple once you break it down into component pieces. When implemented and integrated into a workplace or into your personal life, zero-based budgeting can be a real boon to finances. After all, who doesn’t like discovering found money each month or year? The real trick is to stick with the method for a solid few months or years and give it time to reap the rewards. Like any financial tool, zero-based budgeting can help give you a better sense of control of your finances and help make your future much more financially stable in the months and years to come.