zero-based-budgeting

What Is Zero-Based Budgeting? Zero-Based Budgeting In A Nutshell

Zero-based budgeting is a method of budgeting where all expenses must be justified for every new budget period. It is the brainchild of Peter Pyhrr, a former accounts manager at Texas Instruments during the 1960s. Zero-based budgeting is a budgeting process allocating funding based on program efficiency and necessity and not on budget history.

AspectExplanation
Zero-Based Budgeting (ZBB)Zero-Based Budgeting is a budgeting approach in which organizations start each budgeting cycle with a budget of zero dollars, and every expense must be justified from scratch. It is a method for optimizing resource allocation and prioritizing spending based on needs and value rather than historical budgets.
CharacteristicsBudget Reset: ZBB requires reevaluating all expenses, including fixed costs, each budgeting period. – Decision Packages: Expenses are categorized into decision packages, each requiring justification. – Resource Optimization: Resources are allocated to high-priority activities. – Incremental Changes: ZBB encourages critical examination of each expense. – Continuous Process: It’s an ongoing budgeting process.
Process1. Data Collection: Gather data on all expenses and activities. 2. Decision Packages: Create packages for each expense with cost details and justifications. 3. Ranking: Prioritize packages based on value and necessity. 4. Allocation: Allocate resources to approved packages. 5. Monitoring: Continuously monitor spending and adjust as needed.
AdvantagesResource Efficiency: ZBB allocates resources based on current needs. – Cost Reduction: It identifies and eliminates unnecessary expenses. – Alignment: It aligns budgets with organizational goals. – Transparency: Expenses are thoroughly examined and justified. – Flexibility: Allows for agility in resource allocation.
ChallengesResource-Intensive: The process can be time-consuming and labor-intensive. – Resistance: Employees may resist changes in budgeting practices. – Complexity: Complex organizations may find ZBB challenging to implement. – Short-Term Focus: It may not adequately address long-term planning. – Risk of Cuts: Some valuable activities may be cut if not justified well.
Implementation TipsClear Guidelines: Provide clear guidelines for preparing decision packages. – Engage Stakeholders: Involve relevant departments and employees. – Training: Train staff on ZBB principles and practices. – Pilot Program: Consider a pilot program before full implementation. – Communication: Communicate the goals and benefits of ZBB to all stakeholders.
SignificanceZero-Based Budgeting challenges the traditional incremental budgeting approach by requiring a fresh evaluation of all expenses. It helps organizations allocate resources more efficiently, eliminate waste, and prioritize initiatives that align with their strategic objectives. ZBB promotes a culture of cost-consciousness and accountability.
ConclusionZero-Based Budgeting is a budgeting methodology that promotes resource optimization and transparency by requiring justification for all expenses. While it has challenges, it offers significant benefits in terms of cost reduction and alignment with organizational goals. Its successful implementation requires careful planning and stakeholder engagement.

Understanding zero-based budgeting

The method starts from a so-called “zero base” where the needs and costs of every function within an organization are analyzed.

The budget itself is then built around what is needed for the upcoming period – regardless of whether it is higher or lower than the budget it is succeeding. 

Fundamentally, the zero-based budgeting method encourages businesses to spend their money wisely by giving every cent of expenditure a purpose.

For companies whose general and administrative costs exceeding their revenue, controlling expenses is critical to success.

While many businesses slash operating budgets and still expect the same amount of work to be performed, zero-based budgeting is a sustainable form of cost-reduction.

The method is a repeatable process which the business can use to manage financial performance every month. 

The most effective zero-based budgeting strategy relies on a deep understanding of cost drivers.

Using those insights, the business can set aggressive but credible budget targets and build a culture of cost management in the organization.

Zero-based budgeting and traditional cost-cutting

Following is a brief look at the general differences between zero-based-budgeting and the traditional cost-cutting approach:

Item evaluation

Traditional cost-cutting focuses on what to remove, while zero-based budgeting focuses on what to keep.

Scope

Traditional cost-cutting focuses on a narrower set of costs or cost reduction tools.

Zero-based budgeting examines every cost area for the broadest set of cost reduction tools.

Activities

Traditional cost-cutting seeks to improve activities through increased efficiency and effectiveness.

Conversely, zero-based budgeting considers which activities should be performed in the first instance and how they should be performed.

Planning

Traditional cost-cutting relies on the creation of initiative planning and execution.

Zero-based budgeting instead favors the development of comprehensive initiative design, planning, and execution.

Zero-based budgeting best practices

To get the most out of zero-based budgeting, businesses should keep the following best practices in mind:

Identify quick wins

To build momentum, it can be helpful to focus on larger and more stable business units struggling with profitability.

The same can also be said for areas characterized by indirect and poorly misunderstood expenses.

Starting with these elements first builds important early wins for zero-based budgeting and ensures the disruption to the organization is minimized.

Select the appropriate platform

Effective zero-based budgeting depends on an awareness of operational cost drivers such as productivity ratios, input costs, and activity volumes.

Traditional budgeting software does not consider these drivers –  which then have to be imported from elsewhere or combined in a spreadsheet.

This is a tedious approach prone to human error and miscalculation.

A better solution is an integrated financial planning platform such as Anaplan.

Sustainability planning

It is important an organization does not rest on its laurels after using zero-based budgeting on a single project.

The approach should be used in other areas wherever possible and can also be used to ensure cost-reduction initiatives on previous projects are maintained.

Collaborating with others

Zero-based budgeting relies on every activity being scrutinized to determine whether it can be ceased or at least performed more cheaply.

Assembling a cross-functional team is the best way to ensure the analysis is thorough, well-rounded, and based on expertise.

Alternatively, the business may choose to hire a third party to increase objectivity and negotiate inevitable budget compromises.

Zero-based budgeting example

To better understand the concept of zero-based budgeting, let’s take a look at the hypothetical example of a company called Telco that sells televisions. 

Telco has experienced rapid growth over the past two years thanks to pandemic stimulus money that consumers have spent on home entertainment.

A construction boom based on a promise by the federal government to increase immigration is also seen as beneficial.

Now, in 2022, Telco executives feel it is important to draft a new budget and rein in the company finances in preparation for the next round of growth.

Step 1 – Create a goal

Before the pandemic, Telco took on a $3 million loan with interest paid monthly and a lump-sum (balloon) payment due at loan maturity which will occur in 2025. 

Management set a goal to pay off the loan early and use the freed-up capital to build equity in the company.

Step 2 – Identify each source of revenue

For the sake of this example, we’ll assume that Telco’s only source of revenue is the sale of televisions to consumers.

The company believes its sales will increase in line with the increased immigration rate and subsequent construction boom.

Based on historical sales data and industry knowledge, management knows that, on average, each new home has 3 television sets.

They also have reason to believe that sales in 2023 will exceed 2022 data by 10%. This growth factor is then used to determine the estimated revenue and cost of goods sold (COGS).

Step 3 – Identify expenses

In the third step, Telco looks at its 2021 expenses sheet and determines how much each expense will rise in 2022.

Once expenses have been projected for 2022 in dollar terms, management analyzes each and justifies the projection. In Telco’s case, the list may look something like this:

  • Cost of goods sold (10% increase) – cannot be avoided.
  • Payroll (3% increases) – company already operating at minimum staffing levels with inflation-related wage increases awarded.
  • Benefits (2% increase) – based on federally mandated contribution amount. Cannot be avoided.
  • Store lease agreements (35% decrease) – based on a rejig of store layout to decrease footprint and also an increase in commercial real estate vacancies.
  • Office supplies (50% decrease) – surplus stock from the previous year, reduce expense.

Step 4 – Analyze and adjust expenses

Providing justification for each expense and reducing the cost of some of them are important aspects of zero-based budgeting.

Often, the justification for cost-cutting is only revealed once the business takes the time to plan and research each expense.

For example, Telco understands that store lease agreements are a necessary part of doing business.

But after careful analysis of lease costs, it is determined that the layout of each store can be altered to fit into a smaller space.

Management also realizes that the pandemic has caused many businesses to close.

This has caused commercial real estate vacancy rates to decrease, meaning Telco is in a stronger position to renegotiate leases with its landlords.

Step 5 – Allocate left-over resources

Now that the company has developed budget protections for 2023, it can project its estimated cash balance which management determines to be $1.7 million.

By comparing income statements and cash balances from this year and the next, they can determine how to best approach paying off the $3 million loan. 

In this context, Telco needs to consider its remaining cash balance and loan interest repayments across various strategies.

One strategy may leave the company with a small balance but save it more on loan interest, while another strategy to pay off less of the loan principle will increase interest payments but leave the company with more money in cash

Regardless of which strategy is chosen, however, each will contribute to paying off the loan and increasing equity. With management aware of the pros and cons of each option, they can act in the company’s best interests.

Case Studies

  • Personal Finances: A family realizes that their monthly expenses are exceeding their income. Instead of making minor cuts to their existing budget, they start from scratch. They list out all their sources of income for the month and then prioritize their expenses, starting with essentials like rent and groceries. All non-essential expenses, like entertainment or dining out, must be justified based on the remaining budget.
  • Startups: A tech startup, after its initial funding round, decides to adopt a zero-based budgeting approach for its next fiscal year. Instead of relying on previous budgets, every department, from marketing to product development, has to justify each expense. This helps the startup allocate funds to projects that align with their growth strategy and ensures they get maximum value from their limited resources.
  • Educational Institutions: A school, facing budget cuts, adopts a zero-based budgeting approach. Rather than making across-the-board cuts, they evaluate each program, activity, and class from a “zero base”. Programs that align with the school’s core mission and have a demonstrable impact on student outcomes are prioritized.
  • Government Agencies: In response to taxpayer demands for more efficient use of funds, a local government decides to implement zero-based budgeting. Each department must justify its entire budget request each year, rather than relying on the previous year’s budget as a starting point. This approach uncovers inefficiencies and redundant programs, allowing for better allocation of taxpayer money.
  • Manufacturing Sector: A manufacturing company facing stiff competition and shrinking margins decides to adopt zero-based budgeting. They scrutinize every process, from procurement to production to distribution, starting from a zero base. This helps them identify inefficiencies and areas where they can negotiate better deals with suppliers or adopt more cost-effective production techniques.
  • Non-profits: A non-profit organization, aiming to maximize the impact of donor funds, adopts zero-based budgeting. Instead of basing their budget on the previous year’s expenses, they evaluate every program and initiative from scratch, ensuring that donor funds are used in the most impactful way possible.
  • Retail Business: A retail chain, in an attempt to stay competitive and increase profitability, uses zero-based budgeting. They re-evaluate everything from store leases to marketing campaigns, ensuring that every dollar spent contributes to the company’s growth and profitability.
  • Event Planning: An event planning company, tasked with organizing a major conference, uses zero-based budgeting. They start by listing out all potential expenses, from venue rental to catering to marketing. Every expense must be justified based on the expected returns, ensuring that the event is both successful and profitable.
  • Healthcare: A hospital, aiming to provide the best care while managing rising costs, adopts zero-based budgeting. They evaluate every department and service, ensuring that resources are allocated in a way that maximizes patient outcomes and operational efficiency.
  • Agriculture: A farm, facing unpredictable weather patterns and fluctuating commodity prices, uses zero-based budgeting. They evaluate every expense, from seeds to equipment to labor, ensuring that they are investing in areas that will provide the best yield and profitability.

Key takeaways

  • Zero-based budgeting is a budgeting process allocating funding based on program efficiency and necessity and not on budget history. It was developed by Peter Pyhrr, a former accounts manager at Texas Instruments during the 1960s.
  • Zero-based budgeting relies on a deep understanding of cost drivers, with those insights used to set aggressive yet credible and sustainable operating budgets.
  • To get the most out of zero-based budgeting, the business should focus on particular areas to build quick wins and establish a culture of effective cost management. Selecting the appropriate platform and assembling a cross-functional team to perform item scrutinization is also vital.

Key Insights

  • What is Zero-Based Budgeting: A budgeting method where all expenses must be justified from scratch for each new budget period, focusing on program efficiency and necessity rather than budget history.
  • Origin of Zero-Based Budgeting: Developed by Peter Pyhrr, a former accounts manager at Texas Instruments during the 1960s.
  • Zero Base Analysis: The method starts from a “zero base” and analyzes the needs and costs of every function within an organization.
  • Purposeful Expenditure: Encourages businesses to give every cent of expenditure a purpose, ensuring wise spending and controlling costs for success.
  • Sustainable Cost-Reduction: Unlike traditional cost-cutting, zero-based budgeting is a repeatable process for sustainable cost reduction.
  • Characteristics of Zero-Based Budgeting: Focuses on what to keep rather than remove, examines every cost area, considers activities’ necessity, and involves comprehensive initiative planning.
  • Best Practices for Zero-Based Budgeting:
    1. Identify quick wins for momentum and disruption minimization.
    2. Select an appropriate financial planning platform like Anaplan for operational cost driver insights.
    3. Ensure sustainability by applying zero-based budgeting to other areas and maintaining cost-reduction initiatives.
    4. Collaborate with cross-functional teams or third parties for thorough analysis and objectivity.
  • Zero-Based Budgeting Example (Telco): A hypothetical example of a company using zero-based budgeting to set its budget for the next year, considering revenue sources, projected expenses, and cost-cutting strategies to pay off a loan and build equity.

Connected Business Concepts

Accounting Equation

accounting-equation
The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either though equity/capital or liability/debt).

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

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