If not carefully managed, the implementation of zero-based budgeting can lead to a decrease in morale, particularly among those employees whose departments or projects are facing cuts. Moreover, the requirement for staff to justify every expense can create a sense of distrust or suspicion, which could damage the employer-employee relationship. Zero-based budgeting (ZBB) aligns seamlessly with a company’s Corporate Social Responsibility (CSR) strategy.
Is Your Company Budgeting for Capital Expenditures Correctly?
The leadership team needed to step right in and be the ones who did the cross-category ownership. It’s a form of governance that makes cost management and resource allocation really part of everyone’s job rather than just finance. ZBB may reward short-term perspectives in the company by allocating more resources to operations with the highest revenues. Areas such as research and development or those that have a long-term horizon, may be overlooked as a result. Operating expenses are costs that a company incurs just to keep up and running.
By incorporating changes in management into the budgeting process, companies ensure that the budget remains relevant and adaptable, supporting new goals and addressing evolving challenges. Clearly defining an organization’s strategic priorities is essential in zero-based budgeting. By aligning the budget with these goals, companies ensure financial resources are directed to the most significant impact areas.
Automating and Streamlining ZBB Processes
- Artificial intelligence and machine learning are enhancing ZBB processes.
- They start with a clean slate, regardless of previous budgets.
- Organizations looking to optimize their financial performance should consider this innovative budgeting method.
- In traditional budgeting, companies start with the previous period’s budget as a template and then build upon it.
ZBB may be undertaken as a «rolling process» spread over several years so that only a limited number of departments or business functions are affected each year. In traditional budgeting, legacy costs may not be examined for years until there is some sort of economic shock that forces the company to take extreme actions. Expenses have a tendency to grow over time, with each department protecting its budget from cuts. This approach can be myopic and, over time, it can lead to significant misallocation of resources. If done correctly, zero based budgeting forces managers to zero-based budgeting can prevent this from happening.
The first process approved spending for “business as usual,” which could include no incremental reinvestment—and that freed up about 22 percent of their total fixed-cost base. The second process was established for all incremental spending and reinvestment that were centrally reviewed across business units—think Shark Tank for a large corporation. The result was visibility into spending, clear linkage to strategic priorities, and ultimately margin expansion driven by thought-filled and deliberate discussions. People being people, this dynamic plays out in corporate settings as well.
Step 2: Analyze Existing Expenses
This could potentially hurt a company because these areas are often key to remaining competitive over the long term but they won’t be generating revenue in the near term. It generally doesn’t matter if the new budget is higher or lower than the one preceding it. This can lead to significant misallocation of resources over time.
A second ingrained behavior is status quo bias, otherwise known as the “path of least resistance.” One illustration is the organ-donation rate in Germany and Austria. Zero-based budgeting is primarily used in business but it can be used by individuals and families, too. Business owners might want to do a trial run on paper first, at least for a little while, before jumping in with both feet and committing to the process of zero-based budgeting. Pete Pyhrr developed the idea of zero-based budgeting in the late 1960s to early 1970s while he was an account manager at Texas Instruments. Many Fortune 500 and private equity companies have since adopted this budgeting technique. This article explores what is zero-based budgeting, how it works, and the pros and cons of a based budgeting strategy.
As businesses seek more efficient financial management, ZBB continues to evolve. Managers might cut costs that could be beneficial in the long run. People may be uncomfortable with the increased scrutiny of expenses. Change management strategies are crucial for successful implementation. This human capital element of ZBB must surely be the Achilles heel to its implementation in the public sector without even considering available skills and competencies levels. Your learning from monitoring and controlling costs during this year will influence your approach to next year’s budget.
Managers Must Justify All Operating Expenses
Until that time, review and revise your zero-based budget and relax or tighten the controls until we reach a ‘new normal’. Incredible advances in technology and data and analytics (D&A) capabilities have alleviated the primary roadblock to ZBB adoption. Traditional budgeting may not allow cost drivers within departments to be identified but zero-based budgeting is a more granular process that aims to identify and justify expenditures. Zero-based budgeting is also more involved, however, so the costs of the process itself must be weighed against the savings it might identify. ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization. Costs can then be first grouped and then measured against previous results and current expectations.
Step 1: Identify Business Goals
In traditional budgeting, companies start with the previous period’s budget as a template and then build upon it. Usually, each new budget increases incrementally compared to the previous period’s budget, and companies only need to justify new expenses. Zero-based budgeting (ZBB) is like solving a financial puzzle.
Mangers Must Justify All Operating Expenses
- Expenses have a tendency to grow over time, with each department protecting its budget from cuts.
- While zero-based budgeting is beneficial in many ways, it also presents challenges that organizations must be aware of.
- One normal human bias is loss aversion, also known as “the endowment effect.” This phenomenon—our ingrained preference to avoid losses more than to acquire equivalent gains—is deeply rooted in human evolution.
- Lowered costs may result because zero-based budgeting may prevent the misallocation of resources that can happen over time when a budget grows incrementally.
- Designating a new status quo helps unleash previously untapped creativity and frees managers to invest more time and attention in exploring alternative, digital options—and makes cost discipline the path of least resistance.
Zero-based budgeting offers a fresh approach to financial planning. It can lead to significant cost savings and improved efficiency. However, it requires careful implementation and ongoing commitment. It’s critical to understand that while ZBB typically generates cost savings, it’s not just about cutting costs.
And sometimes just giving the managers the words, or even the sales reps. “How do I talk to my clients and my customers now when I have this new meal allowance I have to adhere to? ” You can say to them, “Let’s role-play a little” and talk about how do you explain to them that “this is where the company’s going. We didn’t write policies where you had the haves and the have-nots—if you were this level or above, you could still retain this benefit or this service, and if you’re this level and below, you could not. If we really are going to be serious about the idea that every dollar matters, it matters no matter what level you’re at in the organization.
The process is helpful for aligning resource allocations with strategic goals, although it can be time-consuming and difficult to quantify the returns on some expenditures, such as basic research. The zero-based budgeting process is a strategic budgeting approach that mandates a fresh evaluation of all expenses during each budgeting cycle. Unlike traditional budgeting, where previous spending levels are typically adjusted, ZBB requires individuals or organizations to justify every expense from the ground up. The aim is to optimize resource allocation by ensuring funds are allocated to activities that align with strategic objectives and generate the highest value. Zero-based budgeting is a financial planning method that requires each department to start its budget from scratch, ensuring that every expense is fully justified, regardless of past spending.
By focusing on strategic execution, zero-based budgeting aligns resources with strategic objectives, enhancing operational effectiveness. In addition, the process can be gamed by savvy managers to get more resources into their departments. If this happens, it can lead to a change in culture where there is a decreased spirit of cooperation in the company, as workers feel expendable. It’s important for the leadership team to make these thoughtful choices early on in the program, communicate them to the organization, and keep an open mind to adapt and adjust as it learns along the way. While following these dos and don’ts will not guarantee a successful ZBB program, we believe that they do set an organization on the path to achieving significant and sustainable savings.