Traditionally, we budget expenses by looking at actual expenses in the previous period, then add/subtract a percentage to it depending on the forecast. Zero Based Budgeting(ZBB) challenges this notion and requires us to start clean and justify planned expenses. This leads to expenses that align with our strategy and allow us to develop a cost saving culture. ZBB can be done not only for businesses, but also for individuals.
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.
So from this example, we can see that adding/subtracting based on actual spending can backfire.
Introducing Zero Based Budgeting(ZBB)
Harvard Business Review (HBR)’s description to ZBB:
Zero-based budgeting (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?
Investopedia’s description to ZBB:
Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified for each new period. 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 the budget is higher or lower than the previous one.
Based on the descriptions, we can conclude that in the simplest of terms, ZBB means that you need to breakdown your expense, and justify each expense. Do not assume that all expense will reoccur.
Originally, ZBB is developed by Pete Phyrr in 1969. Jimmy Carter, Governor of Georgia, was the first to adopt the process of zero-base into the government for the preparation of the fiscal of 1973 budget. Three years later, sponsored by the President and Congress the federal government for the first time implemented zero-base budgeting in The Government Economy and Spending Reform act of 1976. (Pyhrr, Peter A. “The Zero-Base Approach To Government Budgeting.” PUBLIC ADMINISTRATION REVIEW, Jan. 1977.)
Facts on ZBB
- It can be used for growth-oriented company
- Although Selling, General, and Administrative(SG&A) Expenses are the prime target to start your effort in using ZBB, all spending can be budgeted using this tool
- It’s not a one time effort
- Example of companies that are using ZBB:
- Campbell Soup Co
- Kellogg Co
- Oreo cookie maker Mondelez International Ltd – Delivered $1B in savings with Accenture
- Kraft Heinz
- Cheniere Energy Inc
- Huntington Bancshares Inc
- Baxter International Inc
- Ford Motor Co
- Expenses that are aligned with strategy
- Cost savings benefit (According to McKinsey, when properly implemented, ZBB can reduce SG&A costs by 10 to 25 percent, often within as little as six months)
- Improves operational efficiency
- Increasing visibility of costs, and lessen chance of corruption or money embezzling (According to Accenture, usually 20 to 35 percent of costs can be reallocated, which means that either people are not using the chart of accounts properly, or the accounts are simply not granular enough)
- Identifying areas that are a growth potential
- Creating a culture of cost management
- Ownership of cost
- Using ZBB will increase the time necessary for your budgeting cycle
- May be disruptive to organization’s operations
- May be costly to implement
How do you start with ZBB?
You have 2 options, if your business operations is big, with thousands of people, I’d recommend getting a consulting firm to help. If you are a Small Medium Business, or you want to try this for your personal budget, here’s how you start (assuming you already have most stakeholders’ support):
- Define what your strategy is for the next year, and what will you focus on. For example, digitalization effort, maintaining market share while minimizing costs, or growth focus.
- 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.
- Define the timeframe of your budget, are you defining it for monthly budget? Quarterly? Or yearly?
- Ensure your expenses are recorded properly with the right description and amount, to the right account. This might require cleaning up your data.
- Baseline the budget with actual expenses. Keep in mind that this is just a baseline, and will not be used “as-is”
- Ask which of the previous expenses will be recurring, and whether it is necessary
- 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.
- Record expenses properly with the right description and amount, to the right account.
- 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
- Political challenge – Without buy-in and full support from the leadership team, there will be challenges on why the team should do this.
- Workload challenge – Who will be doing the ZBB implementation and keep track of it. The process will lengthen the budgeting process and will add workload on departments as they need to make a more detailed budget with justifications.
- Change management challenge – As ZBB will lead to cultural changes in how the organization see costs, it will lead to dissatisfaction due to the changed processes, and (most likely) new cost cutting policies
ZBB offers a chance for individuals and companies to budget efficiently and create a cost saving culture, but the path to fully utilize ZBB requires massive effort and support from all levels of the organization, especially the leadership team.