What Is Zero-Base Budgeting?

Reviewing Finances From the Bottom Up

What Is Zero-Base Budgeting? - Reviewing Finances From the Bottom Up

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Start afresh with your budget every year.

Imagine that you're planning a household budget. You probably begin by compiling a list of all your expenses and estimating how much you spend on each one. You prioritize the necessities, such as monthly mortgage payments, groceries, fuel, clothes, and utilities, but you also want to plan for other costs, like dining out, gifts and holidays.

You can use the same principle when you prepare a budget for your team, department or organization, and this is called "zero-base budgeting." It is the process of compiling all your expenditure from scratch, rather than looking at what you can cut from or add to your previous year's budget.

In this article, we'll look at what zero-base budgeting is, we'll identify its advantages and disadvantages, and we'll explore the role that managers play in implementing it.

What Is Zero-Base Budgeting?

Peter A. Pyhrr developed zero-base budgeting (also known as "zero-based budgeting" or "ZBB") in the 1960s, and implemented it at Texas Instruments. In 1970, he wrote a Harvard Business Review article about it, and it quickly gained a following. After Pyhrr published his 1977 book, Zero-Base Budgeting, President Jimmy Carter invited him to the White House to establish ZBB throughout the U.S. federal government.

However, the tool was subsequently criticized for being impractical and time consuming, and it fell into obscurity. Despite this, increasing numbers of organizations have started using it over the last few years, and it has experienced a renewed popularity.

In ZBB, you review every dollar you want to include in your new budget from the bottom up, rather than focusing on what you can cut from or add to your existing budget. This encourages a workplace culture of cost management.

In traditional budgeting, you only need to account for increases or decreases in spending, compared with your previous year's budget. In ZBB, however, the process starts from zero every year and you must consider and justify each expense. In this way, you examine all expenditure, rather than just additional costs.

Why Is ZBB Important?

ZBB has recently experienced a renewed interest because it provides a clear way to focus on your priorities and business goals cost effectively. Organizations and their departments have to question and rationalize all their expenditure, which reduces unnecessary costs. ZBB isn't based on past activities, and it doesn't make assumptions such as, "We've always spent $XXX on XXX, so we'll continue to do so." With ZBB, you look at essential spending only.

Advantages of Using ZBB

There are many advantages to using ZBB with your team or department. These include:

  • Analyzing spending. ZBB requires you to identify your team's or department's activities, and to look for more cost-effective ways of doing them. This could include delegating tasks to freelancers or switching to offshore suppliers, for example. It also means that you have to analyze the effects of these different spending approaches.
  • Avoiding budget inflation. ZBB makes it difficult for managers to inflate their budgets artificially, because they must explain and justify their activities and expenses.
  • Increasing communication. ZBB encourages open discussion, because everyone must explain their expenses in relation to the organization's goals.
  • Eliminating waste. As part of this process, you have to review your activities, and decide which are necessary and which you could drop.
  • Focusing on goals. ZBB encourages you to determine your departmental goals and priorities, while evaluating your expenses.
  • Identifying duplication. The review process helps to identify activities that multiple people or departments may be working on. By dealing with such duplication, you can eliminate additional expenses.
  • Allocating resources effectively. Once you complete the ZBB review process, you can allocate funds to the areas that need them most.

Disadvantages of Using ZBB

Despite its benefits, ZBB also has several disadvantages. These include:

  • Requiring extra effort and dedication. ZBB takes a lot of energy and attention, since it's based on evaluating and reviewing every expense in an organization. It can also be very time consuming, particularly for managers who must add this task to their existing duties. As a result, some managers may be reluctant to use it, or only use it once every few years or when there are major changes in the company.
  • Increasing competition. Managers might feel driven to skew their budgets to ensure that they receive their "fair share" of the organization's resources.
  • Hard to justify. Some expenses are not as easy to define as others. Areas of a business that don't produce immediately tangible results, such as research and development, can be harder to justify.
  • Training needed. Organizations need to train managers in the ZBB process, which takes additional time and effort.

Note:

If you're interested in implementing ZBB, consider how you can make it more manageable. This could include looking at your budget on a regular cycle, or one team at a time. Alternatively, you could review it at certain times, during periods of change, every few years, or a combination of these.

Organizational Requirements

While ZBB happens largely at the management level, Matt Fitzpatrick and Kyle Hawke at McKinsey believe there are five conditions that organizations must have in place for it to work effectively. These are:

  1. Understanding cost drivers. Organizations need to be clear about the elements and activities that drive costs, so that managers can make better decisions.
  2. Implementing dual ownership. The budget owner should review the document with someone from a different department, who has the authority to challenge it. This helps to cut unnecessary expenses and reduce autonomy.
  3. Planning processes. ZBB requires a clear planning structure to work effectively. Targets and budgets should be set from the top down, and monthly checks should be made to ensure that managers address any overspending.
  4. Measuring performance. Organizations need to measure performance systematically, so that resources and goals are aligned.
  5. Creating the mindset. Managers need to think differently about their budgets in ZBB organizations. Instead of assuming that an expense should remain from the previous year's budget, they need to think objectively about why it ought to be included.

The Role of Managers in ZBB

As a manager, you have to be fully engaged with ZBB, and this needs to be part of your organization's culture. For example, adopting ZBB means that everyone must make room for cost management in their workday, and this may affect your productivity. However, this process gives individuals with no previous financial experience the opportunity to gain skills in this area, develop robust business cases, and ultimately progress their careers.

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You may also need to think differently. Rather than accepting past expenditure, you must question all of your expenses and activities, and make a thorough case for what you need. For example, you might ask questions such as, "Is this activity really necessary?" "What would happen if we stopped doing this?" or, "How else can we carry out this task?"

Once you've decided on the essential activities that you want to include in your budget, you should create a "decision package." This helps you identify different ways to perform tasks and find alternatives. The package should include the following:

  • The activity's cost.
  • Its purpose.
  • Alternative ways to achieve this purpose.
  • Performance measurements.
  • The consequence of not performing the activity, or of performing it differently.

Your organization's finance director will then rank all the packages from each department, in order of their benefit to the company and their alignment to corporate goals. This allows the company to decide how much to spend and where to spend it. It will then allocate resources based on priority order.

Key Points

Peter A. Pyhrr brought ZBB to public attention in the 1970s. Its popularity increased following its implementation in the U.S. federal government's administration, but it then declined. However, ZBB has enjoyed renewed interest in recent years because it encourages organizations to analyze spending, eliminate waste, and focus on goals.

ZBB differs from traditional budgeting because it works from the bottom up. Instead of cutting or increasing expenses from the previous year's budget, you start from zero and build a new budget based on evaluating and reviewing each expense's necessity to the department and the organization.

There are significant drawbacks to this system, particularly the time, effort and personnel required to carry out the enormous task it requires. However, if organizations have a clear and solid plan in place, ZBB can benefit them.