Zero-based Budgeting

Wednesday, July 1, 2009 - 09:33

Popular in the US in the 1970s, this budgeting technique is starting to make a comeback as the economic downturn bites. By Melissa Wilkinson

Although weathering an economic downturn can be tough, difficult market conditions do force companies to become smarter about how they do things. Businesses must get sharper about how they allocate resources because, if they do it well, it can lead to valuable gains in overall efficiency.

One tool starting to make a comeback in sectors that have been hit hard by the recession is zero-based budgeting (ZBB). ZBB is currently being embraced in industries such as financial services and manufacturing, where controlling costs in a slowing environment is most critical.

Popular in the US during the 1970s, ZBB is a systematic and rigorous method of budgeting. Under this approach, managers are required to create their budgets from scratch. In order for the practice to succeed, every single line of expenditure needs to be critically assessed, regardless of how much money may have been spent during earlier periods.

ZBB is different from traditional budgeting processes. Rolling budgets, for example, typically involve managers simply adding on a percentage figure to account for inflation and, sometimes, a bit extra to account for unknowns. This can lead to the inevitable 'budget creep' and, in some cases, budgets simply being spent in order to ensure that the funds are replenished again in the next budget period.

The issue with rolling budgets is that they encourage managers to focus on cost increases from year to year, instead of looking at the need for the underlying expenditure. Managers must only justify the incremental increases to their budget plans; they don't need to explain how this extra expenditure is going to help the business achieve its objectives.

In contrast, under ZBB nothing is sacred and all costs are challenged. Managers start with nothing in terms of budgeted dollars and then they have to argue a business case for each project.

Under the ZBB system, managers must develop a 'decision package' for each project. This includes an analysis of the project's purpose, proposed cost, alternate courses of action, measures of performance, expected benefits and consequences of not performing the activity. These decision packages are then ranked in order of importance to the business.

This type of tool is useful in current market conditions when businesses have to be much more careful about investing in projects that don't deliver sufficient returns. Instead of simply increasing a budget by three per cent, managers must consider whether there are alternate and more efficient ways of doing the same activity. For example, a manager will have to weigh up the costs and benefits of doing a project in-house, rather than outsourcing it.

With a prioritised list of projects, ZBB should make it easier for managers to choose which projects are going to deliver the most returns. ZBB helps to shine the light on any unnecessarily inflated budgets. It should also help with identifying and eliminating areas of double up and wasted resources. This means that when the market eventually recovers, firms will be in a leaner and meaner position to compete.

Some commentators suggest that ZBB practices tend to have the most impact in large organisations, such as government departments, that have entrenched cultures. It can also be used as a change-management tool in order to shift employee thinking about the way company money is spent.

While the theory of ZBB is sound, in practice it may be quite tricky to implement due to the time and effort involved. It does require considerably more
work than that needed for rolling budgets, for which managers rely on historical figures to estimate their future expenditure. As a result, there is likely to be some resistance from managers because the burden of proof is now firmly placed on them.

One solution could be to introduce ZBB in the current financial year. Then, after managers have used the system for 12 months, shift to a rolling budget for the next two to three years.