Zero-Based Budgeting: An Efficient Approach to Cost Management

Zero-Based Budgeting: An Efficient Approach to Cost Management

I wrote this article at the peak of the summer holidays, taking some hours to ponder the activities of the biggest company managers as they return from their breaks. One key activity that will occupy several hours per week from September to October is planning the next year's budget.

As a company manager, you're constantly seeking ways to optimize your organization's financial performance. A friend of mine often says it’s a company “sanitization task” that ensures you remain competitive. My main goal with this article is to introduce a framework that is increasingly being considered, especially by private equity funds for their portfolio companies (Portcos): Zero-Based Budgeting (ZBB). Unlike traditional methods, ZBB requires you to justify every expense from scratch, ensuring each dollar spent aligns with your strategic objectives. In other words, your budget is designed to execute your strategy.

I plan to guide you through the implementation of ZBB, exploring its advantages and potential drawbacks, identifying which areas of business can benefit most from this approach and where it may be less effective. The goal is to bring to the discussion a tool that can potentially unlock significant cost savings and improve financial efficiency.

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What is Zero-Based Budgeting (ZBB)?

Zero-Based Budgeting (ZBB) is a financial planning method that requires you to rethink the cost structure according to the strategy and goals for the period were you are doing the forecast, starting from a "zero base". Unlike traditional budgeting, which typically uses the previous year's budget as a starting point, ZBB means each department must justify its entire budget for the upcoming period, demonstrating how each expense will help achieve the company’s goals. This approach can lead to better resource allocation, cost savings, and a more strategic focus on spending. It’s like ensuring every dollar you spend is working hard for you, aligned with your priorities and objectives.

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Core Principles of ZBB

The fundamental concept behind ZBB is that no cost or activity should automatically carry over from one period to the next. You must evaluate each line item and justify its inclusion in the budget. This process encourages you to:

  • Identify and eliminate redundant or obsolete activities
  • Discover cost-reduction opportunities
  • Align resources with strategic goals
  • Improve overall operational efficiency

The goal is clear: improving company performance and optimizing the bottom line without sacrificing the speed of execution. It’s not just a fat-trimming operation; it’s also an effective way to enhance company performance and reduce the noise around processes, products, and business activities that are not adding value.


The ZBB Process

Implementing ZBB involves several key steps, that are pretty close to a strategic plan execution:

  1. Define the organization's objectives, typically aligned with or part of the strategic plan.
  2. Identify and prioritize activities that support these objectives, focusing on strategic initiatives.
  3. Analyze the costs associated with each activity. One of the biggest issues I typically find in scale-ups is the lack of activity-based costing or equivalent, which brings visibility about the profitability of the division, product, and customer.
  4. Explore alternative ways to perform activities. Try to think outside the box. Typically, we are tied to the way we have always done processes and pricing. Seeing this with different lenses is very challenging, but often the main advantage in saving will come from a different way to perform certain tasks or challenge product assumptions.
  5. Rank activities based on their importance and cost-effectiveness. I always love putting things in a two-axis graph as the easiest way to see alternatives and opportunity costs.
  6. Allocate resources accordingly.

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I truly believe that by following this process, you can create a budget that truly reflects your organization's current needs and priorities, that can optimize your value chain, rather than simply adjusting historical figures.


Pros and Cons

Zero-Based Budgeting (ZBB) can be a powerful tool for cost management, but it's not suitable for every situation. Understanding when to implement ZBB and its advantages and drawbacks is crucial for company managers considering this approach.

Advantages of ZBB

ZBB offers several benefits that make it attractive to organizations seeking to optimize their financial resources:

  • Cost Reduction: By scrutinizing every expense, you can identify and eliminate unnecessary spending, potentially leading to significant savings.
  • Resource Allocation: ZBB allows you to reallocate funds to high-priority areas, ensuring that your budget aligns with your company's strategic goals.
  • Operational Efficiency: The process encourages managers to justify expenses, promoting a culture of cost-consciousness and operational efficiency throughout the organization.

Drawbacks to Consider

Despite its advantages, ZBB has some limitations that you should weigh carefully:

  • Time-Intensive: Implementing ZBB requires a substantial time investment, as every expense must be evaluated and justified from scratch.
  • Potential Resistance: Employees may resist the change, viewing it as a threat to their departmental budgets or job security.
  • Short-Term Focus: ZBB might inadvertently prioritize short-term gains over long-term investments, potentially hindering innovation and growth.


When to Implement ZBB

Consider implementing ZBB in the following scenarios:

1.???????? During periods of financial strain or economic uncertainty in a VUCA world, forecasting the next year's budget based on the previous year makes almost no sense; it’s a guessing exercise.

2.???????? When undergoing significant organizational restructuring.

3.???????? In industries with rapidly changing market conditions.


When not to consider implementing ZBB:

1.???????? ZBB may not be the best alternative for organizations with stable, predictable expenses. In this case, the cost of performing it will be higher than the benefits.

2.???????? For those lacking the resources to conduct a comprehensive budgeting overhaul.

3.???????? Also, ZBB may not be the best alternative for companies that focus on a couple of activities that are clearly profitable and carve out or spin off non-profitable activities.

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Some Real-World Examples

Several companies have embraced ZBB with remarkable results. For instance, Kraft Heinz implemented ZBB in 2015, resulting in substantial cost savings of $1.7 billion over two years. This allowed the company to reinvest in growth initiatives and improve profitability. Similarly, Unilever adopted ZBB in 2016, achieving €2 billion in savings by 2019, which they redirected towards digital marketing and e-commerce expansion. Texas Instruments also applied ZBB in the economic sector, enhancing procedures and boosting financial efficiency.

McKinsey published an article in October 2014 called "Five Myths (and Realities) About Zero-Based Budgeting," where they claim that “when properly implemented, zero-based budgeting can reduce sales, general, and administrative costs by 10 to 25 percent, often within as little as six months.”

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Myths Zero-Based Budgeting (ZBB)

Zero-based budgeting (ZBB) is often misunderstood, leading to several myths that may deter companies from implementing this effective cost management approach. Let's debunk some of the most common misconceptions surrounding ZBB.

ZBB is Too Time-Consuming

One prevalent myth is that ZBB requires an excessive amount of time and resources. While it's true that the initial implementation can be labor-intensive, the long-term benefits often outweigh the upfront investment. With proper planning and the right tools, you can streamline the ZBB process, making it more efficient over time.

ZBB Eliminates All Expenses

Contrary to popular belief, ZBB doesn't aim to slash all costs indiscriminately. Instead, it encourages you to scrutinize each expense and justify its necessity. This approach allows for strategic allocation of resources, ensuring that you invest in areas that drive value for your organization.

Actually, in my experience, traditional year-over-year budgeting is more about blindly cutting expenses.

ZBB is Only for Large Corporations

Many assume that ZBB is exclusively for large enterprises with complex budgets. However, businesses of all sizes can benefit from this methodology. Small and medium-sized companies can adapt ZBB principles to suit their scale and needs, potentially gaining even more significant advantages due to their agility and less intense “power and influence games”.

ZBB Stifles Innovation and Growth

Some managers fear that ZBB might hinder innovation by cutting funds for new initiatives. In reality, when implemented correctly, ZBB can actually foster innovation by redirecting resources from inefficient areas to more promising opportunities. It encourages you to think creatively about how to achieve your goals with optimal resource allocation. Based on my experience, traditional budgeting is more restrictive in terms of seriously promoting innovation.

ZBB is a One-Time Exercise

Another common misconception is that ZBB is a one-off project. In truth, it's an ongoing process that requires regular review and adjustment. By continuously evaluating your budget, you can adapt to changing market conditions and maintain a lean, efficient operation.


Conclusion

In conclusion, zero-based budgeting offers a powerful tool for managers seeking to optimize costs and align spending with strategic priorities. While implementation can be challenging, the benefits of increased transparency, efficiency, and strategic focus often outweigh the drawbacks. As you consider adopting ZBB, carefully evaluate your organization's needs, culture, and resources. This approach may be particularly valuable for companies facing financial pressure or undergoing significant changes. However, it may not suit all situations, especially where flexibility is paramount. By thoughtfully applying ZBB principles where appropriate, you can drive meaningful improvements in cost management and overall organizational performance.

Diego Afonso

Instituto Militar de Engenharia

2 个月

Hugo obrigado pelo post

回复

I am not a financial expert. But this is a concept that attracts me, especially for public administration. . Is it possible to create a zero-based budget in an organization facing difficulties and in absolute need of reducing costs (or austerity)? . In these circumstances, isn't it preferable to have a, sometimes more aggressive, top-down approach? . As you can see, I am applying this more to the public administration, so here is the last big question: is it possible to apply it to the State services?

Dr. Andrei Albul

EMBA Candidate at ESCP | Schneider Electric | Global Executive

3 个月

Thanks for sharing this Hugo. The ZBB topic is of large interest and definitely deserves an extra discussion: it would be great to know what exactly did the two mentioned companies reveal that was safe to let go and no longer invest in and whether this led to any unforeseen consequences afterwards.

Katie Atkinson

Digital Marketing Agency >> Paid Ads for SMEs and VC Backed Scale-Ups

3 个月

This is really informative Hugo Condesa Thank you so much for sharing it

Timo Maus

Risk Officer and Member of the Management Committee @ Wellington Management Europe | EMBA candidate @ ESCP

3 个月

Interesting article Hugo. For me a very reasonable approach for budget allocation and one that I think more companies should implement. Also liked the examples of Unilever and Heinz and its cost saving potential.

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