Zero-Based Budgeting Is Not a Wonder Diet for Companies

Published July 25, 2016

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?

ZBB has been around for decades, but is currently enjoying a revival driven by powerful investors like 3G Capital Partners, the force behind the 2015 merger of Kraft Foods and H.J. Heinz. Such high-profile exposure has prompted more companies to view ZBB as a fresh “wonder diet” for achieving radical corporate leanness. ZBB’s resurgence is further fueled by the uncertain markets hindering many companies’ efforts to attract fresh capital, as we see venture capital and private equity funds increasingly pushing ZBB on their portfolio companies, in the hope of securing a more rapid and profitable exit on their investments.

Yet for all the promise of ZBB, many companies that try it soon grow disenchanted. They find that the process is a distraction to their people, that it does not deliver all the cost savings they anticipated, and that many of the costs they do eliminate soon creep back in, making the whole effort feel futile. One might conclude from such failures that implementing zero-based budgeting is simply too ambitious. We believe the exact opposite to be true. Most ZBB implementations are not ambitious enough.

Traditional ZBB implementations focus almost exclusively on simple SG&A, in part because SG&A benchmark data is far more readily attainable than are relevant data from the core functions of comparable companies. In comparison to other methods (such as Six Sigma or activity-based costing), ZBB typically does not address operational excellence in core processes (marketing, sales, supply chain, procurement, manufacturing) or fundamental cost drivers such as portfolio complexity, organizational complexity, customer complaints, and quality issues. Also, ZBB does not challenge existing process design, which can now be completely re-thought and often drastically improved through digitization.  Rather, the most visible outcomes of many ZBB efforts are burdensome policies (such as travel cost restrictions) that fail to address the underlying fundamentals (such as who needs to travel, why, and when). The result is a superficial and simplistic focus on “policing” costs versus substantive cost  prevention.

A related issue is that ZBB is often executed exclusively within organizational silos. When cost packages are analyzed in isolation, ZBB completely overlooks the substantial cost reductions attainable at the interfaces between functions.

To realize larger and more lasting value from zero-based budgeting, companies must take a more substantial and ambitious approach. That means blowing up the boundaries that have confined ZBB and taking a true end-to-end view of what drives business value.

This broader approach to ZBB leaves nothing out of scope, pursuing fresh efficiencies in contracting practices, make-versus-buy tradeoffs, demand reduction, requirement simplification, operational efficiency, applied analytics, rules and policies, and much more.

Companies must attack costs not just within organizational silos, but those that reside at the intersection of functions as well, bringing into scope a whole range of costs not addressed in typical ZBB implementations.

Finally, while traditional ZBB typically imposes budget targets based on benchmark data, then leaves the organization largely on its own to determine how it might comply, this more ambitious version of ZBB mobilizes the organization to systematically attack costs using rigorous, time-tested tools and methodologies, with the various initiatives prioritized, coordinated and supported by a business transformation office. The incentive model is also adapted to support aggressive pursuit of the target budget, and a dedicated budget governance structure prevents costs from creeping back in.

This form of ZBB implementation includes many classic features of performance improvement initiatives, but the aggressive ZBB targets can inspire extraordinary effort. For example, when we identified a substantial logistics cost gap in a large consumer goods company, the supply chain director told us: “It’s impossible to solve. We have tried. Nothing worked. We just have to live with it.” He argued that labor cost was the main issue, and the union was strong enough to block any cost reduction initiative. It was apparent that others in the company shared this view. Simply imposing a cost-reduction target and walking away would accomplish little here, so we engaged finance, logistics and the senior leadership team in pursuit of a creative solution. As the dialogue progressed, it became clear that while the intractable labor cost was an important factor, so were truck utilization, margin negotiation, and service-level agreements with freight companies. We then structured a simulator to test various scenarios for negotiation with freight companies. Freed from their longstanding “there’s nothing we can do about it” mindset, the company soon optimized the budget by 14%, exceeding the target we had initially proposed by four percentage points.

In another company, commercial discounts were essentially a black box for the finance chief and CEO. Although it was not a cost budget (the typical focus of ZBB), we applied cost-to-serve and net profitability analyses to better define and more rigorously formalize the company’s discount policies, which in turn fostered transparency and alignment toward a targeted adjustment of more than 15%. This significant cost reduction would have been considered “out of scope” in most ZBB implementations.

Implementing ZBB on this much larger scale is more demanding, but zero-based budgeting is always a big bet. The first and most important key making that bet pay is to go big. Only a substantial, ambitious approach that can deliver sustainable cost transformation on a scale that makes all the effort required to implement zero-based budgeting worthwhile.
(Source:  AICPA – CPA Letter Daily - Harvard Business Review – July 1, 2016)