As the year slowly draws to a close, CFOs also start their annual haggling over costly...
Zero Based Budgeting
We’ve all come across checkpoints in our personal lives where we commonly think about or use phrases such as “let’s take a few steps back”, “I need to reset things” and “let’s start all over again”. These reflections either run through our minds or perhaps, received as advise from somebody who’s relatively close to us. This normally happens during times of stress, when things seem to become overwhelmingly uncontrollable and it appears to be like an appropriate time to stop and reassess or rethink everything that revolves around us. We then go through the process of executing this stage probably by taking a good long break to free ourselves from the environment causing the stress and start the process of ‘soul searching’ and end it with a plan to move forward and do things that are relevant and important.
Ironically, this entire conceptual process of ‘resetting’ as mentioned above is aligned with this idea called “Zero Based Budgeting (ZBB)” in the world of Finance. Organizations also go through similar stages in their life cycle and do need to take a few steps back to recalibrate and reassess their actual expenditures and targets occasionally. ZBB is generally the concept of budgeting from ‘ground zero’ where all components of the budget are somewhat zeroized and new budgets are set, based on cost or revenue drivers that are only relevant for the new budgeting period. Everything is assessed, to some extent, as though the business is starting up afresh, without any past year’s numbers as a guide (ideally).
Traditional budget setting on the other hand, basically adds an incremental growth over actual (or forecasted) expenses of the preceding year. It’s no doubt a much easier approach to budget setting, and not to mention still very relevant, but it does carry some risk of either over or under budgeting for the new year, and this could somewhat negate growth or profitability if it’s not checked. In good times, organizations could live with this, but in tough times, especially in a competitive market, it can be the differentiating factor.
Having said this, it becomes imperative for organizations to know at which point of their business, a reset or ZBB exercise will need to be conducted. Very commonly, most organizations do this when profits seem to be on a downward trend or have been stagnant for some time. This is difficult since, at this point, there is a risk of rushing a ZBB exercise, which could cause more harm than good, where cost-cutting initiatives may result in expenses that are critical in supporting growth is optimized, essential marketing expenses left out and even retrenchment of key personnel.
Thus, it has become increasingly more important for an organization to institutionalize ZBB, by having a structured approach to detect faults early and execute ZBB, and lay out effective plans to manage the organizations’ performance keeping it aligned to its overall strategy. Early warning signals such as detailed performance ratios, which track expenditure against expense drivers such as units produced or sold, headcount, cost centres etc., need to be monitored and presented to Management frequently. There should also be limits set to these warning signals that will trigger a need to analyse further and probably initiate a ZBB exercise within the organization.
ZBB can be a costly and time-consuming exercise if it’s done across the organization. If it’s a small organization, it’s probably much easier as compared to large corporates that could possibly have multiple business sectors, subsidiaries or even regional and global presence. Therefore, it is imperative for Management and the planning team to understand and to execute ZBB as a targeted exercise depending on the need to do so. Sound Management Reporting framework and processes come extremely handy here for such decisions to be made, especially in these large corporates.
Notwithstanding this, there are areas within any organization, be it a large or small one, where ZBB is worth doing on a yearly basis. Such expenditure related to capital and marketing expenditures, need to be aligned to the flavours of the next year (and future), thus, having a fresh set of initiatives which is aligned to the overall corporate and business strategies is essential. This will allow all relevant parties to relook at their business objectives, reassess its alignment to overall strategy and spend accordingly. A central team to evaluate these planned expenditures with Management team is necessary so that only corporate level expenses that are of priority are approved.
Henceforth, it’s worthwhile for most organisations to have a blended budgeting exercise where traditional and ZBB is employed to achieve an optimal outcome. This entire exercise will need to be planned well by the planning team so that time is spent effectively. Organizations could also have plans to ensure all parts of the organization go through a staggered ZBB exercise over a period of a few years to ensure there some sort of hygiene in the organization’s finances. This is extremely vital especially with the current speed of changes organizations are facing in the world economy, particularly with the onset of the digital economy.
Having said all the above, ZBB can only be effective if the organization’s Management fully supports it. The entire exercise is tedious and time-consuming, and times create animosity among employees within the organization. This needs to be managed and communicated effectively across the organization, making it clear that such exercises are to benefit the organization and employees, making it more sustainable.
ZBB will also test the organization’s Management’s commitment and determination to make tough but right decisions which could make them seem unpopular in the short term. Such decisions could range from exiting projects, contracts, shutting down operations and entertainment plans, venturing into new businesses and reallocating resources.
In a nutshell, it is extremely healthy for organizations to incorporate ZBB into their budget setting cycle, as it gives them an opportunity to trim off unnecessary ‘fat’ expenses that could have been accumulating over the years and stay lean and toned. This entire exercise needs to be focused and aligned with the strategic direction of the organization. It must be communicated well, and any changes dealt with appropriately through effective change management strategies. This will minimize resistance among employees, allowing energy to be channelled to much more productive activities within the organization.