As the world emerges from a year of crisis brought on by a global pandemic, business leaders throughout the world have expressed optimism about future growth. Indeed, economic indicators appear positive, and the world seems to finally be returning to a sense of normalcy.
Nevertheless, for business managers, cost-containment continues to be a priority, as companies are emerging from the crisis with a greater commitment to budgetary discipline. According to insightsoftware’s 2021 Finance Team Trends report, 38 percent of decision-makers in the finance department consider cost reduction to be a priority after the pandemic.
In light of this, many business leaders are turning to zero-based budgeting, which dispenses with the idea of baseline values built up from prior years’ numbers. Instead of starting with a simple uplift percentage across the board and refining a budget from there, many managers are calling for a more thoughtful approach that scrutinizes and justifies each line based on the business value that it creates.
Most people mistakenly think of zero-based budgeting simply as a “start from zero” philosophy. In fact, it is built around a structured methodology that enhances overall cost visibility, financial governance, and accountability throughout the company, while aligning incentives around an organization’s top strategic priorities. In this respect, zero-based budgeting is far more effective than most other budgeting methods for allocating costs based on an organization’s highest priorities and well-defined outcomes.
How Zero-Based Budgeting is Different
Zero-based budgeting is often regarded as a tedious and time-consuming process because it requires greater scrutiny to each line item, as well as cost justification that calls for expenses to tie directly back to the organization’s strategic priorities. To some extent this is true; zero-based budgeting can be more labor intensive. But with the right tools that align budgeting around a structured process with effective collaboration, it doesn’t necessarily need to be so.
Consider the traditional method of budgeting, in which you apply a standard percentage uplift across the board, after which you fine-tune the budget to fit the business’ priorities. That is, in essence, a shortcut; it establishes a default budget in which every expense line starts out at more or less the same level as the prior year. It is easy enough, then, to focus attention on the larger line items that have a greater impact on the bottom line. However, if a number is small enough to avoid scrutiny amid the scramble to complete the budget on time, then it may remain in the budget for years, even if it falls far short of delivering strategic value for the company.
You usually build those kinds of traditional budgets using spreadsheets. And although spreadsheets have many virtues, including their flexibility and familiarity, they lack the robust collaboration capabilities, version control, and purpose-built features aimed specifically at the planning and budgeting process. Spreadsheets struggle to manage the granular data needed to effectively implement zero-based budgeting.
With the right tools, zero-based budgeting becomes a discipline—a well-thought-out methodology for ensuring your business remains lean and effective, regardless of external economic conditions.
Implementing Zero-Based Budgeting in Your Organization
To gain greater control over costs with zero-based budgeting, finance leaders should begin with an intentional approach based on the following key activities:
Create Financial Transparency
Zero-based budgets are all about cost accountability. Consider the process that typically happens when you make an internal proposal at your company. You have an idea, and then you build a business case around it. You outline the costs, staffing requirements, expected benefits, and potential risks. You pitch the idea to management, where you hope for its approval.
The unfortunate reality is that in many organizations, there is insufficient follow-up to determine whether or not the business case turned out as expected. Were project sponsors held accountable for the promised results? Were the costs in line with initial expectations? Was there any unexpected impact that had not been considered when you proposed the project?
For stakeholders throughout the organization to answer those questions, they need visibility to information and insights. They need to be able to measure costs and results clearly and effectively, without undue effort. Having the right financial reporting tools in place is absolutely essential as a prerequisite to any successful zero-based budgeting effort.
Although zero-based budgeting calls for greater scrutiny and cost justification, that doesn’t necessarily mean that managers must spend an equal amount of time on each category of expenses. It can be helpful to begin with the breakdown of cost into discretionary and non-discretionary expenses, for example. Certain line items may be non-negotiable because they fall under existing contractual commitments, or because you simply cannot change them. Taxes and fees relating to compliance, for example, simply cannot be omitted from the budget. Utility costs, likewise, have little flexibility unless the company decides to shut down facilities or invest in energy efficiency.
Some costs may be fixed, others variable, and still others may be stepped costs, which tend to function more like fixed costs, but may increase in significant increments as the business grows. By categorizing these costs in advance, it is easier to determine where staff time and energy should be focused when you ultimately build the detailed budget.
Align Around Strategic Priorities
Ultimately, zero-based budgeting is about scrutinizing each expense line in the budget and asking the questions “Is this necessary?” and “Does this help to advance us toward our strategic goals as an organization?” To do that, the organization must have clarity as to what strategic objectives are and their relative importance. What are the three to five primary objectives for the coming year? It’s important to stick to these priorities. After all, if everything is important, then nothing is important. Staff members who participate in the budgeting process must understand the organization’s strategic priorities and ensure that budget items are evaluated based on their conformance to those priorities.
Build Your Budget
The next step is to begin the detailed work of assembling, developing, and refining the budget numbers. This is the hard part. Department heads must identify specific requirements that fit with the company’s strategic priorities, attach cost estimates, and build a business case into which each of those expenses can fit.
Although this is indeed the most difficult part of the process, it can also be the most valuable because it compels managers to explore the detailed factors that drive their expenses. For companies adopting zero-based budgeting for the first time, this is also the stage at which they discover the low value of numerous expense items and scrap them in favor of more important priorities.
Control and Monitor
This is when financial transparency becomes critically important. Remember that in step four, department heads were called upon to justify their expenses by laying out a clear business case that aligns with the company’s overall strategic objectives. Zero-based budgeting calls for accountability to the commitments made during the budgeting process. It demands that the same scrutiny applied during the budgeting process also be applied after you finalize the budget.
In effect, this brings us full circle and back to the first stage in the process, financial transparency. Quality guru W. Edwards Deming, a great advocate of data-driven decisions, famously said “In God we Trust, all others bring data.” In this respect, powerful financial reporting and analysis tools provide the essential foundation upon which to build zero-based budgeting.
To be successful with this approach, managers must scrutinize initial estimates closely and be willing to hold people accountable to the estimates they provided during the budgeting process. Over time, this will help the team to judge each business case more accurately, eliminating bias in the process of evaluating which expenses should stay, and which should go.
Zero-Based Budgeting is Not Necessarily an All-or-Nothing Proposition
It is not uncommon for organizations to avoid a shift to zero-based budgeting because it appears overwhelming. For many, it is too big a change to consider. Managers understand its value, but often prefer to put off adopting zero-based budgeting until some point in the future. That’s unfortunate, because this approach truly offers a compelling case for change, and with the right financial planning and budgeting tools, it does not need to be overwhelming at all.
Nevertheless, many organizations may prefer to take an incremental approach to adopting zero-based budgeting. Some have chosen to pilot the zero-based budgeting process within a single department or business unit. Innovative managers within the organization often see opportunities to roll it out as a departmental initiative, or within a region or subsidiary. By starting with a smaller subset of the organization, you can adapt your base budgeting incrementally and easily make the case for wider adoption throughout the company.
If you would like to explore the possibility of adopting zero-based budgeting in your business, we invite you to download our free ebook, The CFO’s Guide to Zero-Based Budgeting, to learn more.