Zero-Based Budgeting – Piece of Coal to Rising Star
Zero-based budgeting has been the unwanted stepchild of the financial planning and analysis (FP&A) world for decades. Chief Financial Officers would lie to their friends about how they budget and say they do cool things like rolling forecasts, beyond budgeting or at the very least incremental budgeting at cocktail parties but NOT zero-based budgeting which was so last decade.
At least that was true up until recently. Then the word started to spread that Brazilian-based private equity group 3G Capital has used it to orchestrate amazing investor returns in mega-mergers such as Heinz and Kraft and Burger King’s takeover of Tim Hortons. Mckinsey noted in a recent article that in 2015 over 90 companies had mentioned zero-based budgeting on quarterly earnings calls. Now, this sleepy back road budgeting process is getting a second look as potentially cool to use again.
The fact of the matter is, it should have never gone out of style to begin with. No budgeting and planning process is ever good or bad, it is how they are used that makes them effective or not. Does using a zero-based budgeting process for a two-year-old development stage software-as-a-service company make a lot of sense? Maybe not, but if your organization is in a mature industry, with growth in the single digits and sales in the $ billions then zero-based budgeting probably makes a bunch of sense.
What is Zero-Based Budgeting?
Conventionally, many businesses perform some type of incremental budgeting process whereby they increase or decrease their budget year over year, based on a percentage determined by management keeping in mind industry trends and past performance. Conversely, some businesses opt for zero-based budgeting. Zero-based Budgeting is a cost management mindset that was introduced to the public in a 1970’s Harvard Business Review article titled, “Zero-Based Budgeting”. It is a great tool for evaluating expenses and found its way into use at many government organizations, where expense management, as opposed to revenue maximization, is a top priority.
In simple terms, zero-based budgeting requires redoing the budget at every budget cycle assuming you have no resources and asking the question: What do I need (costs) to meet my objective (output). Each year, a new budget would be created asking the same question and not using the previous year’s budget as a baseline, but considering projections for the forthcoming period.
When planning for the coming financial year, zero-based budgeting means each item on the budget must be justified. This ensures only important expenditures remain on the budget and any unnecessary spending is curbed. A zero-based budget helps make managers more accountable and responsible for the performance of their departments, and at the same time, they are asked to focus on efficiency and plan strategically to ensure the budget covers their expenditures.
Benefits of Zero Based Budgeting
Zero-based budgeting aims to make business owners and their executive staff accountable for the expenses incurred month after month. This minimizes capital waste and ensures that each dollar is allocated to the proper teams and projects that need it. This also frees up capital to invest in growth projects in areas in that show greater promise of a positive return on investment (ROI). Every budget cycle a project, department and/or any other measure must be evaluated and justified to ensure it is still meeting operations, financial and strategic objectives.
Overall, zero-based budgeting aims to drive value for a company by improving not just profits, but costs as well. Another key benefit of implementing a zero-based budgeting method is it enables top-level strategic objectives to be integrated into budgeting activities. This is done by wrapping them around specific functional departments of the company whereby expenses can first be categorized and then compared to past performance and future expectations.
5 Steps To Help Implement Zero-Based Budgeting
1 Assess Your Operations
Moving to a zero-based budget does not mean you must compromise on key functions and it does not mean that you should shred every part of the budget every year. Staying competitive should be the end goal, keeping the current state of the industry in mind. After an initial implementation, a continuous monitoring process of your operations from top to bottom that helps to identify the activities and resources which are expendable and placed on a rotational zero-based budgeting schedule may be best to meet overall business objectives. The key to making this work is eliminating only those costs which will not affect overall performance.
2 Define a Cost Target
Once you have defined which activities you will be optimizing from operations, you need to work towards setting a cost target. To motivate performance and boost creative thinking the budget should not be set at zero but at a negative number under the assumption that the next year’s performance will incorporate efficiencies or other gains. The amount of the negative can be tied to capital investment. For example, if you are focusing on Selling, General and Administration (SG&A) function such as tax and in the current year, they had requested capital for complex tax software that they claimed will increase efficiency, then that should be shown in either headcount savings or other cost savings.
Most likely you are utilizing some type of driver-based budgeting process as well. If this is the case, that is great! Instead of setting an inflexible negative dollar amount to begin the zero-based budgeting process with, use a lower driver. This will accomplish the same goal and give the department or business unit more flexibility in building their budget as volumes will dictate total spend.
You must keep a target in mind which you want to spend over the coming period to maintain current performance and move towards growth. This includes creating a strategic vision of your business’ future. Where do you want to be at the same time next year? If the cost target allows sufficient breathing room and will enable you to reach the goals you have set, you are good to go.
3 Analyze Staffing Needs
Perhaps the biggest component of any business’ spending is staff salaries. You must be tactful and determine your staffing needs for the coming year and with human resources most likely make up most an organization’s costs. If any full-time positions can be filled by part-time employees without sacrificing efficiency, those options should be considered. Similarly, the evaluation of salaries staff bearing in mind that you are working from a zero base, and will disregard the previous year’s budget.
What people sometimes forget is that paying people more is often cheaper than paying the wrong people less. The old adage “If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur” is certainly true. Instead of hiring several low-level staff or part-time workers can you hire one full-time or senior person? How much oversight, management and time will untrained workers need as opposed to experienced, educated and trained workers? Human resource optimization is critical to all businesses and too many times I have seen many managers, executives and business owners be penny wise and pound foolish when it comes to staffing needs, so be careful.
4 Make a Checklist
I love checklists! I use them all the time. I often put items on a checklist just to cross them off because it gives me a sense of accomplishment in my day. Have each area make a checklist of the key goals, identified resources, activities, and employees they will keep and eliminate. This checklist should be accompanied with the submitted budget.
The checklist is the reference point for the changes each wish to make and should be approved by senior management before implementation. Against each item on the list, they should write down reasons explaining their decision with an executive summary at the top. This checklist should be no more than one page and is the basis in which they will be held accountable. This checklist is crucial because without it, sustaining the cost savings will be hard and that will be the critical component to long-term shareholder value.
5 Strategize and Evaluate
Based on the accumulated checklists, and consolidated budgets strategize the usage of available resources and look for ways to optimize and recommend allocation of resources to the areas where they will add the greatest return.
Following these 5 steps, you can make the zero-based budgeting process easier for FP&A, you and the business.
What is your take on zero-based budgeting? Do you do it in your organization and is it successful?
