What is Zero-based Budgeting?

Posted by Thai Pham on

It is safe to say most businesses would resort to cost cutting initiatives in a time of tight margins and high risksHowever, a research by McKinsey shows that only 26% of those cost-reduction programs, still yield effective results after four years. CFOs, therefore, are increasingly turning to zero-based budgeting, ZBB, as a more sustainable approach to cost reduction.  

Read more: How to Turn Budgeting into a Value-Adding Process 

zero based budgeting

What is Zero-based budgeting? 

Zero-based budgeting refers to a budgeting approach where: 

  • Projected expenses must be forecasted from the baseline of "zero" (thus the method's name) 
  • Projected expenses should have no reference to and causal relationship with the actuals stated on the past financial records 
  • Every bit of expenditure must be justified based on the level of its relevance and significance to the project and/or the business
These qualities make zero-based budgeting a rigorous, and comprehensive approach to budgeting, which entails not only substantial and profit-driving benefits but also a few major drawbacks.  

In that very respect, zero-based budgeting is diametrically opposed to the traditional incremental budgeting. 

What are the differences between zero-based budgeting and incremental budgeting? 

The 5 fundamental differences between zero-based and incremental budgeting approaches are depicted as follows: 

[infographic] what are the differences between zero based budgeting and incremental budgeting

5 key tactics to effectively carry out a ZBB program

The success stories from companies that have successfully implemented ZBB for the last decade, indicate that it takes more than the efforts from just the finance function. The organisation, as a whole, must work towards mutual goals and make decisions with the benefits of the organisation come first in mind. 

Read more: What is Investment-based Budgeting and Why It Matters 

McKinsey has studied and put together 5 key aspects of a successful ZBB program: 

Go big 

In comparison with the traditional way of cutting costs, zero-based budgeting quantifies the cost drivers from the bottom up, without being influenced by multiple anchors – attributes like this year’s budget and previous years’ spending. As financial professionals are now able to access the financial data, they can separate productive from unproductive spending.

Based on the data and new technologies, information is constantly updated allowing leaders to set new financial-productivity goals and reassess much more frequently. Backed up by insights and data of how much they should spend and what costs to cut, leaders are free to set new spending levels that can be much bolder than the traditional “cut x per cent” mandate. 

Specifically, setting the goal for the fiscal year to move 20 per cent of advertising spend to digital channels can appear to be ambitious in the start of the year, yet, by April, this goal can become too conservative goal if a new social media campaign suddenly explodes. 

In contrast; if sales rate falls in line with TV spending levels, then the goal is now unachievable. Depending on the context, the financial leaders are able to have their own evaluations and re-assess their decisions accordingly. 

Read more: It’s Time to Replace your Spreadsheets with Planning and Budgeting Software 

Go deep 

The governance structure that controls the entire program, is one of the key aspects that contribute to the success of the new cost management strategy. In the traditional practice, the budgeting programs are founded on temporary-formed teams, such as project-management offices or delegated to the heavy-burdened finance function. Meanwhile, in order to conduct a successful ZBB program, it takes a new and strengthened governance structure, forming a permanent part of the ongoing business. 

First, an experienced leader – the ZBB director is crucial to guide everyone heading towards one mutual direction. As the ZBB program’s role is to fuel the company’s strategic priorities, it is essential for the leader to stress on the importance of the program and steer through the challenges it brings.

Read more: What to look for in a planning and budgeting solution 

Secondly, the leader needs a small team of Finance, IT, HR, and Finance professionals - also called the “centre of excellence” (COE) group, to help keep the tactical and the discipline of the entire ZBB program in place.  

Finally, a sustainable, continuously-improved ZBB program must involve the role of the cost-category owner (CCO), functioning as a monitor of the related subcategories of expenses. This role is typically delegated to the highest-performing individuals in the organisation, those that are able to set the targets and guidelines, and challenge their peers to reach the goals, roll out the best practices across the business, and drive steady improvement in spend efficiency.

Go long 

If you want to establish a ZBB program that can last with the development of the organisation, you need to build it into new performance-review practices. Since ZBB creates major changes to the organisation, it should be carried out carefully. The program must ensure that the incentives fully align with the organisation’s demands—which change over time as its experience with ZBB deepens. 

Organisations can decide on their own approaches and adjust their performance metrics to confirm people’s responses.  Either offering an individual bonus to those who overperformed the targets, or an organisation-wide bonus if the company surpassed the targets would work depends on your aspired outcomes.

Penalties for those who underperformed against their targets are also needed for the ZBB program to have full effect. Yet, over time, in order to stimulate innovation and improvement, individual bonuses seem to be more effective and important to the business.  

Read more: Getting rid of Excel in financial planning and budgeting: modern trend for CFOs 

Go wide 

Re-investments are as important as the budget-cutting process. The progress of identifying, prioritising, and proving reinvestments, can be seen as an opportunity to fuel growth, spark productivity for the business, and ignite people’s enthusiasm to work toward their mutual goals.

The employees’ proposals on reinvestment practices are also highly valued. ZBB leaders must clearly state that the transformation was not only about cutting costs, but about freeing up funds to realign spending with strategy as well. The more transparent this process is, the better it ensures your employees that the new approach is working and lasting over time.

Read more: The Changing Role of CFOs in Digital Transformation 

Go all in 

Lastly, the final element that adds to the success of the ZBB is making the changes visible and tangible to everyone in the organisation. For example, launching a campaign on social media to publicise the new approach, with available tools like hashtags and viral-video contests. Internally, it is also important to provide support to the employees at every level – the ones that are making crucial decisions, and making the ZBB works for the organisation. 

As the ZBB’s budget is transparent, the ROI calculations are more robust, allowing the decision-makers to be more confident in signing off on investments with longer-term pay-outs. The adjustments that were made in the effects of the ZBB program, making it a long-term practice across the organisation, applying to every aspect of the business from monthly, yearly to become an annual routine of every individual in the company. 

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Topics: Planning and Budgeting, CFOs, Financial Accounting Management Software

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