Zero-Based Budgeting (ZBB) For PMs: What It Is And How To Do
Truly effective zero-based budgeting energizes employees and spurs growth. - Bain
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What is zero-based budgeting?
In order to understand zero-based budgeting, the first thing one should understand is the various parts of a typical business budget.
Here are 3 primary things that a budget must meet:
Expenses determination: How much will you spend?
Revenue from the project: How much will you earn?
Profit prediction: The target profit you will require after all expenses?
As the name says “Zero-based budgeting” is an approach to plan and prepare the budget from the scratch. Zero-based budgeting starts from zero, rather than a traditional budget that is based on previous budgets. With this budgeting approach, you need to justify each and every expense before adding it to the actual budget. The primary objective of zero-based budgeting is the reduction of unnecessary costs by looking at where costs can be cut.
To create a zero-base budget involvement of the employees is required. You can ask your employees what kind of expenses the business will have to bear and figure out where you can control such expenses. If a particular expense fails to benefit the business, the same should be axed from the budget.
Differences between Traditional Budgeting and Zero Base Budgeting
In traditional Budgeting, the previous year’s budget is taken as a base for the preparation of a budget. Whereas, each time the budget under zero-based budgeting is created, the activities are re-evaluated and thus started from scratch.
The emphasis of traditional budgeting is on the previous expenditure level. On the contrary, zero-based budgeting focuses on forming a new economic proposal, whenever the budget is set.
Traditional Budgeting works on cost accounting principles, thereby, it is more accounting oriented. Whereas zero-based budgeting is decision-oriented.
In traditional budgeting, justification of the line items and expenses are not at all required. On the other hand, in zero-based budgeting, proper justification is required, taking into account the cost and benefit.
In traditional budgeting, the top management takes decisions regarding any amount that will be spent on a particular product. In contrast, in zero-based budgeting, the decision regarding spending a specific sum on a particular product is on the managers.
Zero-based budgeting is better than traditional budgeting when it comes to clarity and responsiveness.
How to decide what stays in the budget
ZBB is often seen as a time-consuming, resource-heavy process, but Gartner research shows that when implemented correctly, it takes, on average, five additional days relative to traditional budgeting approaches.
It is critical, though, to instill standard criteria to evaluate budget items. This helps to ensure that:
Activities are evaluated fairly.
Common biases in decision making are overcome. For example, the focus stays on the contribution the activity makes to business outcomes, and isn’t influenced by how well budget holders describe the urgency of their cost.
To evaluate whether items should be included in the zero-based budget, use a decision tree (see graphic below) and test budget items for:
Strategic alignment: Does the activity, its scope and cost being proposed for the budget align to and enable a strategic objective?
Efficiency: Is the activity and cost included in the budget sourced in the most cost-efficient way? Have you achieved the best price?
Immediately cut budget items that fail the first test. Challenge any that survive initially to ensure those costs can’t be optimized before earning a permanent place in the budget.
If adequate funds aren’t available for all qualifying activities and costs, you may have to conduct another round of prioritization to business outcomes. Any excess is reallocated.
The 5-step process for ZBB implementation
ZBB incorporates five prerequisites and follow-on activities to ensure the principles of ZBB are implemented successfully — and operationalized on an ongoing basis.
1. Ensure financial transparency
You need visibility into:
The relationship between activity (cost driver) and cost, so you can see which levers of cost are adding value and which aren’t.
Whether costs are variable, fixed, discretionary or nondiscretionary
The impact on costs if spend changes, e.g., contract penalties, severance costs
Without this level of transparency, you can’t see inefficiencies hidden within services/projects/initiatives and can’t identify behaviors that need to be managed to change costs.
2. Identify strategic business priorities and KPIs
Identify and cascade strategic business priorities into the budgeting process to ensure alignment and to identify key performance indicators (KPIs) by which to measure the success of investments.
Executive leaders must agree and communicate strategic priorities collaboratively and across functions. Without this consensus, zero-based budgeting can’t effectively prioritize spend in terms of business value and outcomes. The choice of metrics/KPIs should reinforce the strategic alignment.
Also make sure senior executives endorse the use of the zero-based budgeting approach vs. traditional budgeting methods, either across the enterprise or in the function(s) adopting it. Clearly communicate its purpose and principles to avoid pushback and gain buy-in from the budget holders who will need to examine their cost base. This smooths ZBB implementation.
3. Align, evaluate and optimize
Conduct the process of zero-based budgeting as a rightsizing exercise to align functional area spending priorities with desired business outcomes.
Especially amid the post-pandemic resetting of business strategy, this realignment ensures that approved budgets are focused on driving value, enabling a business priority/outcome.
Note that even though cost-cutting is not the primary objective of zero-based budgeting, cost reduction could be an outcome — although only if:
There are no value-adding priorities to which spend could be shifted.
The enterprise needs to return cash to the bottom-line for imminent survival.
4. Control and monitor the budget
Maintain a comprehensive and regular review of budgets, spending and variances, at least quarterly and maybe monthly, to stay aligned with business priorities and to contain variances.
Monitor budgets to ensure that spending and forecasts remain closely aligned to the activities and outcomes that were the original intent of ZBB implementation.
Use the chosen metrics and KPIs to measure and assess the value and alignment of spending to the strategic/desired business outcomes. Just because spending stays within budget doesn’t automatically mean the objectives of the spend have been met.
5. Value-based spending
Operationalize the concepts of zero-based budgeting through an ongoing process of value-based spending. If senior leaders focus too much on the procedural changes of ZBB implementation, functions may view it as just another budgeting method.
Instead, articulate and reinforce that budget holders don’t “own” approved budgets and value-based spending involves an active assessment of all spending — regardless of whether or not it has been previously agreed to in the budgeting process.
Senior executives should actively demonstrate and reinforce behaviors that are at the core of zero-based budgeting, such as:
Encouraging honest trade-off discussions, driven by alignment to business outcomes
Making tough resource sacrifices.
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