A brief understanding of Zero Based Budgeting

What is Zero Based Budgeting (ZBB)?

According to HBR: ZBB is elegantly logical - Expenses must be justified for each new budget period based on demonstrable needs and costs, as opposed to the more common method of using last year’s budget as your starting point, then adjusting up or down. ZBB is a straightforward, intuitively simple way to aggressively strip out costs that cannot be rationally justified. Who would argue that a business should not eliminate unjustifiable costs?

According to Investopedia: ZBB is a method of budgeting in which all expenses must be justified for each new period. The process of zero-based budgeting starts from a "zero base," and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether each budget is higher or lower than the previous one.

ZBB methodology has received a lot of press, sometimes negative, for creating an aggressive cost cutting culture. However, the extent to which you as a business embrace cost cuts is a choice; and the way that the ZBB methodology is implemented lends itself to informing this choice.

ZBB methodology starts the budgeting process with a clean slate (from zero) and builds the future costs up from the lowest possible level, creating visibility in the process. This enhanced transparency enables companies to make informed decisions unlike in a standard/traditional cost reduction programme where targets can be arbitrary and savings projects ad hoc.

The Typical Way to Budget

Usually, when we budget expenses, we look at the previous period’s actual expenses, and add/subtract a certain percentage of it for the next year. For example, we forecast next year’s sales to grow 10%, then we expect our expenses to grow by 10% as well.

The good thing about this method is that it’s sensible. If I spend X to get Y, then if I want 2Y, then I will spend 2X. But on the other hand, not all expenses will grow the same amount. Some expense component might even decline.

For example, we forecast overall sales to grow 10%, but the company is undergoing massive ecommerce and digital sales effort, it makes sense for sales expenses to decline, as online sales can be done with lower sales expense (no store cost, less salespeople number). But if we use the traditional way of budgeting, and just budget revenue to grow 10% and expense to grow 10%, the company’s staff will be encouraged to spend all of the budget even if the expense is not necessary. And the staff might also push marketing and sales efforts in traditional channel to force it to grow, offsetting the effort done to push the online channel sales.

From this example, we can see that adding/subtracting based on actual spending can backfire.

So, how visibility is the linchpin of a successful ZBB programme and how it can help you make right choices?

ZBB requires you to assign costs to the smallest product or activity at the lowest level possible. For example, usually marketing budgets are based on brands or countries. Each year the budget is set as a blanket adjustment to prior year. However, under ZBB, the marketing department will be required to to build the budget up from zero for the various marketing activities such as agency, digital media, events etc, for each brand and each country.

Once costs are categorised this way, we can challenge assumptions and drivers at each level.

• Is the spend required? What value does it drive? For example, is the reach large enough to justify spending on digital media?
• Is there scope to flex quality and frequency of spend? For example, can we reduce online media spend and update the website less frequently?
• Change price through renegotiation, tender or consolidation of suppliers
• Adjust demand such as by extending lead times which often comes at lower price etc

The outcome is a long list of cost reduction opportunities and then you can decide how far you want to go.

For example a global food manufacturing company used this methodology for its marketing budget across various cost categories. Below we have a sample output of the opportunities in events and digital media categories. This opportunity list is created by asking the above questions.

In addition to challenging the assumptions, we can benchmark the cost categories internally (across brands and countries) as well as externally to answer following questions:

1. What is the best performing brand or country (in terms of budget versus output/value), and what can we learn from it – for example if the media budget for a brand is smaller for the same reach, what is the reason for this and can this practice be shared across the firm
2. How does this categorisation compare to industry best practice?
3. Is the budget allocation across the categories optimal – for example, can the budget for online media spend be increased and that for events be reduced for a larger reach.

The toughest decisions however are around the need for a budget or reducing the budget based on returns on investment type calculation. It is precisely these choices that determine how far your company extends ZBB and how much you change your corporate culture. As an example, in an extreme cost reduction scenario, you may completely remove the events budget. However, in another extreme you may choose only to adjust budget for event giveaways marginally. For each of these scenarios, it is visibility that creates the ability to make a choice best suited to your company’s culture and values.

Possible steps to start ZBB

Assuming that the business has already had most stakeholders’ support.

1. Define what your strategy is for the next year, and what will you focus on. For example, digitization effort, maintaining market share while minimizing costs, or growth focus.
2. Define the scope of your application of ZBB, do you want to use it for the whole budget, or just for certain part, such as SG&A.
3. Define the timeframe of your budget, are you defining it for monthly budget? Quarterly? Or yearly?
4. Ensure your expenses are recorded properly with the right description and amount, to the right account. This might require cleaning up your data.
5. Baseline the budget with actual expenses. Keep in mind that this is just a baseline, and will not be used “as-is”
6. Ask which of the previous expenses will be recurring, and whether it is necessary
7. For new items that are planned for each department, examine whether it is necessary, and add those expenses to the budget in the correct account.
8. Record expenses properly with the right description and amount, to the right account.
9. Track your expense properly and compare it periodically to your budget.

• Are you spending as planned?
• Are there unforeseen spending item that happened? Should the budget be adjusted to take into account the future spending item?
• Get feedback on your team on the effectiveness of the budget

What makes for a successful implementation of ZBB?

Companies are experiencing increased financial pressure and consequently there is an increased focus on cost reduction. If you are looking at cost reduction, ZBB might be one of the solutions.

ZBB methodology starts the budgeting process with a clean slate (from zero) and builds the future costs up from the lowest possible level. This gives true visibility of cost base and its drivers, and subsequently helps to create consistent tracking KPIs and a culture of cost consciousness.

Every successful ZBB programme relies on the following crucial pillars:

• Visibility - budgeting for smallest product or activity at the lowest cost centre level to enable transparency and ability to challenge
• Accountability - budget owners at all levels responsible for managing spend appropriately
• Governance - routine monitoring and reporting to keep costs from creeping back in

Visibility

Companies often budget top down at aggregate levels that hide details and therefore cause them to miss opportunities for cost reduction and even risks of under budgeting. Building budgets upwards from zero, for each activity and each business unit, helps bring visibility at all levels and enables comparison and internal benchmarking. Importantly it improves a company's ability to take informed decisions and achieve stakeholder buy-in.

We looked at ￡20m maintenance budget across 20 plants for a global food manufacturing company. Using the more common budgeting method of extrapolating historic trends, the budget was in line with inflationary expectations. However on closer inspection, there was room for 10% reduction in budget overall and a better allocation of budget across sites. This disproportionate budget split across sites was also an effective evidence to achieve the team buy-in for a cost reduction program.

Accountability

A further problem with budgeting top down at aggregate levels is that it creates lack of ownership. How many times have you heard a demotivated budget owner shun the responsibility of meeting targets because he/she did not create the budget in the first place? It is easy for a budget owner who was involved in its creation to take ownership and equally to hold him/her accountable.

In the above example of maintenance budget for food manufacturing business, budget owners when prompted, themselves identified areas of overspend and initiated a project to revise contracts and budget.

Governance

After all of above, a well-planned budget is still susceptible to uncertainties and businesses need to be agile to proactively manage any headwinds during the year. You can achieve good governance through disciplined monitoring and standardised reporting.

For example, when there was an unanticipated and unavoidable overspend in the maintenance budget, an avoidable spend in another area was postponed for next year. The judgement on which spend is unavoidable and which can be postponed came from the ultimate budget owner who had also created the budget in the first place and therefore held this knowledge.

Implemented this way, ZBB creates the right environment for cost reduction. Most importantly, if everyone embraces the three pillars and uses them consistently, it can drive behaviour change, encouraging everyone to prioritise their expenditure and enable cost reduction.

#ZBB #zero_based #budgeting #cashflow #cost #reduction #expense #strategy #SG&A #visibility #governance #accountability

---

Disclaimer: This article is compiled of contents from various sources, for information purpose only, I am not the original publisher of these contents. For more information, kindly search in the respective sources listed below.

Sources: pwc.blogs.com, investopedia.com, hbr.org, medium.com