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.

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:

  1. Item evaluation – traditional cost-cutting focuses on what to remove, while zero-based budgeting focuses on what to keep.
  2. 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.
  3. 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.
  4. 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.

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.

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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