Budgeting, budgeting, budgeting! It seems like we talk about it a lot, and yet even though it’s one of the most important processes for any business—big or small—to undertake, it is often one of the most daunting and difficult tasks to refine… Which is why many organizations default to using the prior year’s budget as a starting point for building the budget for the new year. This method of traditional budgeting, while efficient from a time standpoint, has its flaws. For one, traditional budgeting makes it easy for a company to operate at the (a hush falls over the room; eyes widen; looks of disgust prevail) status quo.
Right, because we’re all aiming for status quo.
Traditional budgeting: the good and the bad
Because traditional budgeting relies heavily on the prior year’s budget, there is less emphasis on creating cost savings, and so opportunities to reduce costs may be missed. For example, if the shipping department of a company is given the same budget year after year, they may not evaluate other carriers or make the switch to one that offers better rates. Incentives are everything and because they are not incentivized or pressured to make any changes, they don’t. This can cost a company huge amounts of money in the long-term.
Second, traditional budgeting does not require justification of expenses each budget cycle. This can allow expenses that were meant to be one-time allocations to remain embedded in the revised budget (for example: an increase to the budget for new computers isn’t necessary every year). If the budgeted amounts aren’t removed before the new budget is crafted, the budget is unnecessarily inflated.
Finally, traditional budgeting often links growth goals with growth in expenditures. For example, if a company wants to increase sales, they generally will increase expenses by an amount proportionate to the desired increase. This type of thinking can lead to waste, because it maintains the assumption that the expenses of the prior budget remain necessary and that they are not taking advantage of economies of scale as they grow.
Zero-based budgeting (ZBB): the blank slate approach
Zero-based budgeting (ZBB) is a system of budgeting where the business owner, accountant or, in larger companies, the budget manager starts the budget from scratch each time and justifies each dollar spent based on the strategic goals of the company. This creates the opportunity for companies to capitalize on inefficiencies and to find creative ways to reduce costs. While more time consuming, ZBB better ensures that the resources used are going toward furthering the company’s stated goals.
The defining factor of ZBB is that each budget for the financial year in question is a blank slate. So, each expense in the budget must be justified and clearly linked to the stated strategic goal of the entity. Where do we see this style of zero-based budgeting most often? Most recently, food businesses. 3G-backed Kraft Heinz was an early adopter of ZBB, followed by General Mills, Unilever, Kellogg, Mondelez International, the Campbell Soup Co. and ConAgra Foods. More recently, companies like Boston Scientific, Alcoa, and Quicksilver have begun utilizing this approach to heighten their focus on cost, as well as to hold different functional groups accountable for the company resources they plan to use.
As Kellogg CEO John Bryant said in November 2015, zero-based budgeting “provides the opportunity to challenge how we have done things and drive activity out that isn’t benefitting the customer.” When companies take the time to challenge assumptions that have informed budgets in the past, it allows them to truly evaluate whether those expenditures are justified under the current environment and strategic direction of the company.
Advantages of zero-based budgeting
Better cost control
One of the biggest advantages of ZBB is its ability to effectively control costs, create accountability surrounding the cost allocation process, and hone in on the most important initiatives to the company. ZBB can also challenge the organization to uncover more effective ways of adding value or accomplishing goals.
For example, a business may spend a big chunk of its marketing budget every year on direct mail offers, never stopping to actually evaluate their effectiveness. With zero-based budgeting, the marketing team would have to prove the efficacy in order to continue spending on that channel next year, which may prompt them to look into other more cost effective methods of marketing, such as SEO or email marketing.
Better alignment of company resources to goals
By questioning old methods, ZBB can also improve the services themselves, which provides the end customer with a better overall experience. For example, management decides that a company priority for the coming year is to improve the customer experience. In order to do this, the marketing team decides to budget an additional $250,000 (an increase to the prior budget of 25%) to increase the user friendliness of the company’s web site. This type of expenditure would typically be difficult to justify, but due to management’s stated goal of improving the customer experience, it is more likely to gain approval.
More focused discussions
Additionally, budgeting becomes more focused and meaningful under ZBB. When managers have clear direction strategically and are tasked with crafting a budget from scratch, discussions stay focused on what the people responsible need to do to accomplish the objectives. Rather than simply increasing the budget by 5% over last year, more thoughtful conversations arise and those involved in the process feel more connected to the outcomes.
If, for example, a snowboard company uses marketing dollars to attend snow sports conferences, but management directs the department to improve sell-through, they may decide to move the funds related to convention attendance into more direct support at their most profitable retailers. Creating additional sales support in the form of eye-catching displays would be more in-line with management’s stated goal.
Disadvantages of zero-based budgeting
So far, we have mostly discussed the various advantages of ZBB, but what are the disadvantages?
Zero-based budgeting takes time… lots of time. The process starts anew each cycle and each expense needs to be justified, which requires thought, collaboration, and communication, not only within each department, but first and foremost with senior management to make sure the goals of the organization are clearly defined and understood.
ZBB necessitates employee/constituent buy-in. People are often resistant to change and learning how to do an old task in a new way is intimidating, especially when the new skill you are being asked to learn will increase your workload.
Finally, due to the fact that the goal of ZBB is to reduce or eliminate inefficiencies and justify expenditures, layoffs may be deemed necessary as part of this newly adopted budgeting mantra. While it may make business sense to lay people off, there is a human cost involved and that must be weighed against the potential for savings. In a public company, layoffs may feel justified due to the company's need to provide value for shareholders, but in an employee-owned private company, this type of decision is more difficult.
Is zero-based budgeting used in my industry?
ZBB is well-suited for companies in mature industries where growth has stagnated and it’s necessary to pursue cost efficiencies. Some examples of industries where ZBB can be effectively implemented include: financial services, online retailers, marketing firms, and the healthcare industry. Hospitals and healthcare providers, for example, are typically focused on increasing the efficiency and affordability of care, which means eliminating unnecessary, extraneous costs is key.
On the other end of the spectrum, zero-based budgeting might be a useful budgeting tool at a tech startup. Many earlier stage companies are in constant testing and validation mode so their expenses, revenues, and short-term goals are more flexible and fluid. And, they may actually budget more frequently than a more established company to keep up with the evolution. At Paro, for example, we create monthly budgets akin to zero based budgets, as they are built from the ground up and take into account the priorities of the coming months.
Is zero-based budgeting right for my business?
Budgeting is already an intimidating undertaking. Add to that the risk of lost opportunities or wasted resources and the task can become daunting. Budget too much and leave your company open to waste, budget too little and create the possibility of missed opportunities.
ZBB can be a great exercise to ensure that your company’s resources are being managed effectively and make a big impact to your company’s bottom line if:
- It is implemented under the right circumstances.
- You have buy-in from your employees.
- You have communicated your company’s strategic vision and top priorities with clarity and purpose and your employees understand the context and reason behind your stated goals.
But you should probably already be doing that anyway…
This article originally appeared on Paro's blog.