Return of zero-base budgeting

Directors of a certain age may recognise the return of an old friend - zero-based budgeting (ZBB), which was a novel concept in the 1970s.

According to a McKinsey & Co article, the tool, which has declined in popularity over the last half century, has resurfaced as “a repeatable process to rigorously review every dollar in the annual budget, manage monthly financial performance, and build a culture of cost management.

“What makes ZBB unique is not the budgeting methodology; it is the mindset shift that upends managers’ default assumptions”, McKinsey says.

The basis of ZBB is to review and budget each and every element, starting with a zero base (hence the name). This means not basing next year on the current year, but inspecting each and every element and determining whether it is the best use of resources.

According to McKinsey, there are five factors to building a cost culture for superior ZBB. They are:

1. Deeper visibility into cost drivers – for effective ZBB, what actually drives costs, and importantly who owns them?
2. Dual-ownership governance model – both the profit and loss owner and the functional cost centre must be responsible for the cost.
3. Rigorous processes for planning and monitoring – monitoring by both owners is vital.
4. Aligned incentives – ensures compensation is aligned to cost-management objectives.
5. Mind-set – managers need to buy in to the basis of ZBB and that each and every cost needs to be thought about in a new way.

The McKinsey article is explicitly concerned with ZBB as a cost-budgeting tool; however, it is implicit that each cost is reviewed in the light of the return it generates for the business. ZBB “can eliminate unproductive costs (often as much as 10 to 25 per cent of selling, general and administrative expense in six months), allowing owners to reallocate capital to growth, through marketing, sales, and M&A”.

The authors comment that it is a favoured technique for private-equity firms and is often the methodology used in start-ups through necessity rather than design.

Increasingly directors may use the ZBB mind-set of asking “is this the best use of our funds?” or “is this expenditure yielding the return we expect?” and be able to receive a granular explanation of exactly how it does, and who is responsible for achieving the result.

For more information, see ‘The return of zero-base budgeting’.