Zero-based budgeting: Five things that you might be doing wrong

Dr Jon Richards, pictured, is a Director in the Global Strategy Group at KPMG in the UK

The new tax year has begun and, more than ever, businesses are opting for zero-based budgeting, which focusses on allocating resources based on program efficiency, necessity and value, rather than any historic budgeting. But, when companies wipe the budget slate clean and start from scratch at each period to drive down costs, there are five big mistakes that many financial directors can sometimes make.

The rise of zero-based budgeting

Before we look at the mistakes, it is important to understand why zero-based budgeting has been propelled back into the collective consciousness of business leaders. Zero-based budgeting is where all costs and expenses must be justified for each new accounting period. Its rise can be accredited to rapidly changing business models, a drive for more radical and creative approaches to delivering value, advances in smart data analytics and the need for agile and smart deployment of resources.

Fundamentally, this is where the true value of zero based cost management lies. It is about driving trade-offs between risk and value and sending resources quickly to where they have the greatest strategic work. Done well, zero basing can help to drive the most granular level of cost transparency, introduce new levels of cost conscious behaviour and aggressively reallocate both funds and capacity towards those areas where they can deliver the greatest value.

However, the practice of zero basing fell out of favour following its introduction over 40 years ago, with some executives at the time increasingly seeing it as unwieldy, labour intensive, highly disruptive and ultimately not delivering to the bottom line. A potentially powerful process was falling foul, it seemed, of basic failings in application.

There are some early and disconcerting signs of what we regard as similar mistakes being repeated which, if not countered, could likely result in a comparable fall from grace. That’s why we are sharing what those mistakes are and how they can be avoided:

The five mistakes of zero-based budgeting 

Not prioritising human factors over a technical process

It is important to challenge established protocols and ways of working whilst taking bold decisions on value trade-offs demands authentic engagement of ‘hearts and minds’. Zero basing is an emotional and often difficult journey for leaders and staff; plan to provide coaching and support in the process, timely decision making and effective resource reallocation. Private equity firms, for example, are skilled at embedding experienced operators alongside existing leadership to provide the challenge and support; zero basing requires the same.

Focusing too ruthlessly on value creation

The scale of the challenge often makes it difficult to know where to start. Effective zero basing must begin with a laser-like focus on where the material value opportunity sits. As such, avoid attempting to zero base everything and risk delivering nothing. Instead, prioritise areas based on a combination of size, the level of discretionary activity, risk and importance, and those that can deliver greater ‘bang for the buck’. 

Not starting from the bottom

At the heart of the process is the tension of balancing what to give up, set against the risk of stopping or changing the activity. The highest standards of objectivity are required to make these trade-offs. They should also be supported by financial rigour and governance to ensure decisions are unencumbered by established politics, historical decisions and cultural constraints that frustrate effective zero basing. Zero basing means zero basing; so, start with the legal and regulatory minimum and work from there. Then you can create the right tension rather than making negotiated compromises away from today’s position. 

Failing to understand risk profiles

Managing shifting risk profiles is key to effective zero basing. Embedding governance, process and a data-led process is essential to avoid value-creative ideas being blocked lower down the organisation. It is particularly important to manage the shifting risk profiles created by changes in service levels or the removal of certain activities. Private equity firms manage away the ‘gold-plating’ by having a clear separation between creating options and making decisions, with decisions only being taken at the leadership level where risk trade-offs are best understood.

Short term cost cutting distractions

Many business leaders have been attracted by value/ risk trade-offs and affordability thresholds as a way of injecting a one-off ‘shot in the arm’ to their businesses, but few appear to be casting their gaze further out to acknowledge its long-term value. Continuous, staggered ‘waves’ of zero basing focused on ‘hot spot’ areas minimise disruption but create a constantly refreshed portfolio of cost initiatives.

Furthermore, structured training anchors a more commercial culture in a set of newly learned behaviours, and an eye towards enabling processes, systems and incentives to ‘lock in’ these ways of working and encourage teams to think like an external investor every day. This long-term perspective is the most difficult to crack, yet the most important. The pace at which long-established business models are now changing demands far greater agility, not only in predicting these shifts, but in rapidly reallocating resources in response. Furthermore, the frequency of these changes creates a state of more constant disruption as executives seek to realign, and realign again.

So, what should you do to make zero-based budgeting a success?

A new approach is required, one that builds on the principles of how the private equity industry creates value. It applies a relentless focus on engaging with leadership to own and drive results, testing historical attitudes to risk and prioritising resources to activities that create the most value.

Put simply, leadership teams need to re-think their organisation through the eyes of an external investor. Hardwired into this are a set of core principles which can help drive a compelling and differentiated approach:

— aligned leadership and a clear and compelling case for change

— a focus on evidence-based decision-making to build consensus

— conduct quality analytics to remove emotion in politically charged board rooms

— the highest standards of rigour in governance to drive pace and cadence.

These same principles must also be placed at the heart of zero based budgeting if the approach is to succeed this time. And this is where the future positioning of zero basing becomes so crucial.

Gone are the times when an annual cycle of budgeting using zero basing was adequate to reboot the internal cost management machine. The requirement for new levels of commercial and organisational agility put an ongoing, long-term, continuous process of challenging resource allocation at the heart of true competitive advantage.

Doing this drives a fundamentally different conversation and perspective on how the work gets done and increases the likelihood of successfully applying it in today’s business environment.