Especially in economically challenging times, cost savings cannot always be avoided in order to bring a company back on the growth path. In the past, downsizing and outsourcing have been among the most frequently used cost-cutting measures across industries. While in the short-term staff cuts and contracting business functions to third-parties may be a very effective way to ensure the company’s survival, in the mid- to long-term it can have a negative impact on the company’s ability to compete in marketplace.
Little wonder then, that companies are increasingly looking for a more strategic approach to cost management. Zero-base budgeting, which was first developed by Peter A. Pyhrr for implementation at Texas Instruments in 1969, is such an approach. According to a large-scale international survey conducted by Bain & Company, the interest in zero-base budgeting has risen significantly in the recent past. While in 2012 only 10 percent of the surveyed companies were using it, the projected use for 2013 jumped up to an astonishing 61 percent.
How Does Zero-Base Budgeting Work?
The goal of zero-base budgeting is to lower costs and reallocate available resources according to the company’s strategic and operative goals. It stands in contrast to traditional incremental budgeting, as all expenses must be examined and justified for each new period. Just like when starting a new business, the budget is planned entirely from scratch with no pre-authorized funds. According to Peter A. Pyhrr, zero-base budgeting is done in three basic steps:
- Developing Decision Packages
The first step is to identify and analyze all current and planned activities and to describe them in one or more so-called decision packages. These serve the top management as a basis for decision making and should include the following information: the objective, purpose, activities, and performance levels of the decision unit, alternative methods (e.g., standardizing, centralizing, outsourcing, automation) and performance levels, the consequences of not approving the package, and the resources required.
- Ranking Decision Packages
The next step is to evaluate and rank all decision packages in order of importance on a cost/benefits basis. This is done in a bottom-up process starting with the lower management level going all the way to the top management which takes the final decision.
- Resource Allocation
Once ranking decisions have been made, the management allocates resources accordingly and detailed budgets are prepared.
Zero-base budgeting is a value-oriented, collaborative process. Successful implementation, Peter A. Pyhrr believes, requires support from top management, effective design of the system to meet the needs of the user organizations, and effective process management.
Advantages of Zero-Base Budgeting
The main advantage of zero-base budgeting is the integration of strategic and financial planning, which can lead to significant efficiency improvements and cost savings in the mid- to long-term. On one hand, the systematic and holistic approach enables companies to identify and eliminate any wasteful and obsolete activities focusing only on those that are really necessary in order to remain competitive under future market conditions. On the other hand, managers are forced to find cost-effective alternatives to improve operations as each and every program is subject to scrutiny.
Another important advantage of zero-base budgeting is the better alignment of the activities of the cost centers and employees with the overall corporate goals. Each cost center is required to rethink its mission and its relationship to the overall goals. At the same time, employees stay are more aware of the company’s current strategic direction.
Moreover the “green field” approach of zero-base budgeting enables business innovation by breaking up old structures and practices within the organization. The goal is to challenge the status quo and reinvent the company adapting it to the changing market conditions. This increases the agility of the company.
Last but not least, the involvement of employees in the planning and decision-making process can motivate them to show initiative and more actively engage in shaping the future of the company.
Disadvantages of Zero-Base Budgeting
The major disadvantage of zero-base budgeting is that due to its great complexity it is very time consuming and labor intensive. Often times it also requires additional training of managers and employees. Therefore, the approach is less suitable for achieving short-term operational cost savings or managing acute crisis situations.
As zero-base budgeting creates competition between departments and teams, it may also lead to conflicts and frictions within the organization.
Another disadvantage often mentioned in the literature is that it creates an overwhelming amount of data and information backing up the budgeting process. This challenge can be overcome, however, by using specialized software.
Zero-base budgeting is therefore not for everyone. It is a strategic tool intended for achieving mid- to long-term results. It is most useful in dynamic industries where changing market conditions force companies to make drastic changes to their budgets.