Interest in Zero-Based Budgeting (ZBB) is somewhat cyclical, rising in times of financial distress, nearly disappearing in boom-times. This can be attributed, in large part, to detractors instilling fear in managers by depicting it as a “slash and burn” cost-cutting, or downsizing, technique. This is a gross misrepresentation of the ZBB process.
ZBB is applicable to the public sector (various levels of government), private sector (not-for-profit and commercial businesses), and the very private sector (personal finances). Each sector is unique in its execution of ZBB, but the principle of aligning expenditure with purpose is consistent throughout.
This installment of “The Third Degree” describes the ZBB process in each sector, compares it to “traditional” budgeting, and explores its advantages and disadvantages. Alternative implementation strategies that facilitate matching the ZBB approach to an organization’s circumstances are also presented.
An individual’s income and expenses are relatively predictable and simple to track. A teenager’s allowance, a graduate student’s stipend, a professional’s salary, and a retiree’s pension are all stable sources of income. Likewise, most expenses are routine – mortgage or rent, utilities, food, clothing, etc. Effective budgeting allows an individual to meet these routine obligations while protecting against the unexpected.
Zero-Based Budgeting (ZBB) assigns every dollar of an individual’s income to a specific purpose. First, the essentials are deducted – housing, food, etc. Then, “quality of life” expenses are deducted – those that are not critical to survival, but the deprivation of which may cause an individual’s budget discipline to falter. Another way to think of this category of spending is as the rewards for discipline in creating and adhering to a planned budget. This could include a daily visit to Starbucks, a weekly Ben & Jerry’s binge, or other treat that reinforces the budget discipline needed for the person to achieve his/her financial objectives.
An additional category of discretionary spending may also be added. Entertainment, travel, and various hobbies may be budgeted here. This category is typically the first to be cannibalized when there is a shortfall or emergency expenditure.
The remainder is divided among savings objectives, such as a vacation, down payment on a house, or investments, leaving a zero balance. The amount allocated to each reflects the relative priority in the current budget period. As these priorities change, the allocations can be adjusted to achieve a savings goal on a desired timeline.
A schematic example of a personal zero-based budget is shown in Exhibit 1. The number of entries will vary, depending on an individual’s circumstances. For example, a mid-life professional may have several essential expenditures, while a teenager’s budget may have none, being split between discretionary spending and aspirational saving. There may also be multiple sources of income, each accounted for on its own line. Use of a spreadsheet minimizes calculation errors; formatting can provide visual cues that information is missing. Though the preceding discussion has referenced individuals for simplicity, a personal budget could also be created for a family, club, or other group.
While personal ZBB ends with zero, public- and private-sector ZBB begins with zero. Once obligations (essentials) are met, a personal budget is based on the individual’s (or group’s) preferences; there is no subsequent judgment of the priorities chosen. Government and commercial budgets, in contrast, are typically prepared by one group and reviewed and approved by another. Preparers must justify each expenditure in the budget in order for reviewers to accept it.
Public- and private-sector ZBB are very similar, bearing little resemblance to personal ZBB. Zero-Based Budgeting in commercial enterprises is the topic to which we now turn, followed by a discussion of its use in Government that highlights key differences.
Enterprises of all sizes frequently fall into a routine of using incremental budgeting to determine spending levels for the next fiscal period. Incremental budgeting applies a decidedly uncreative equation to establish a budget:
This period’s budget +/- x % = Next period’s budget,
where “x” depends on the economic outlook, market conditions, executive’s confidence, and other indicators that often remain undefined. Or, perhaps, a roll of an umpteen-sided die left over from the CEO’s days as a Dungeon Master (the Dungeons & Dragons type. C’mon!).
Traditional budgeting techniques like this answer first “How much should we spend?” and, only later, “What should we spend on?” Prior to answering “How much?,” ZBB requires definition of what should be funded and how funding decisions will be made.
Though it is unrealistic to expect past spending information never to enter the discussion (historical costs provide valuable inputs to estimates of future costs), ZBB is much more forward-looking than traditional budgeting processes. It rejects the “We’ve always done this” argument, requiring an answer to “Why should we do this?”
A four-step process is sufficient to define most ZBB implementations. A description of each step is provided below.
(1) Define Decision Units. A decision unit is a logical division of an organization in which expenditures are directed toward a common purpose. Grouping expenditure “types” simplifies creation and management of budgets, though these groupings may differ from the divisions that are familiar to most. Functional departments, business units, and product lines are divisions commonly used to manage an organization. However, a one-to-one mapping of these divisions to decision units is unlikely.
For example, a single production line may require several decision units to competently manage its budget. These could align with individual products or entire product families.
Decision units may also be defined by functions served by a department. For example, a production facility’s Engineering department may include Quality, Manufacturing, and Industrial decision units. Similarly, Accounting department decision units might include Payables, Receivables, and Delinquents.
It is important to note that both capital and expense budgets are represented by decision units. Also, decision units defined for a product line may provide inputs to several departmental budgets, depending on the structure of the organization. Whatever the set of decision units chosen, it is incumbent upon managers to structure budget requests such that information collection, presentation, and review are as efficient as possible.
(2) Generate Decision Packages. Decision packages are the “building blocks” of budgets, where answers to the “What?,” “Why?,” and “How much?” questions are proposed. A simple decision package template is shown in Exhibit 2.
Each decision unit may require several decision packages to adequately depict the budgeting options available. Each decision package contains the following information:
Defining the minimum level of service is critical to successful budgeting, as it ensures that managers understand their fundamental responsibilities as fiduciaries of their organizations. It also supports sound decisions regarding elimination and outsourcing of functions. The minimum level may reflect changes in Operations proposed in other decision packages or decision units, but always addresses the highest priorities of the decision unit.
The current level of effort is typically included as a baseline for comparison, though this should be done with caution. Unless operational improvements demonstrate that the current level of service can be provided at lower cost, this decision package may do little more than feed managers’ status quo bias, becoming the default option. When this occurs, a traditional budget is created, albeit with a veneer of objectivity provided by an ostensible ZBB process.
Additional reduced levels of effort, at lower cost than the current level, may also be defined. Similarly, multiple enhanced levels of service, in excess of the current level, may be considered. The highest level of service proposed (largest budget) is sometimes called the fully funded option.
Use of the terms “reduced” and “enhanced” is unfortunate. These terms reference the current level of spending, a key attribute of traditional budgeting that ZBB intends to abandon. As stated at the beginning of this section, it is unrealistic to expect current-period budgets to have no influence on next-period budgets, but these terms should be used – with caution – until better ones are devised. Use of these terms may make a paradigm shift from traditional to Zero-Based Budgeting more difficult for those that are already resistant to change or simply distracted or overwhelmed.
A graphical representation of a hypothetical decision unit’s potential levels of effort is shown in Exhibit 3. This type of display is useful for summary presentations and reports.
(3) Rank Decision Packages and Create Budget Proposal. All decision packages from all decision units are evaluated and prioritized to facilitate funding decisions. To streamline this effort, managers responsible for multiple decision units (e.g. leaders of departments that perform multiple functions) should rank their own decision packages prior to entering them in the organizational “pool.” Doing so makes it clear at all times which decision package from each subset is to next be scrutinized. This process is presented graphically in Exhibit 4. Only Engineering and Accounting departments, previously cited examples, are shown for simplicity. A real organization is likely to have many more decision units filling the pool.
(4) Prepare Detailed Budgets. Executives prepare pro forma financial documents to make operational decisions about future fiscal periods. Anticipated revenues and other financial projections and objectives are used to approximate the next period’s budget. With this limit in mind, the prioritized “stack” of decision packages are reviewed. If the justifications are valid – that is, the expenditures are aligned with the organization’s objectives – decision packages are approved up to the budget limit set. This is depicted by the “Budget” line in Exhibit 4D.
The diagram in Exhibit 4D depicts a scenario in which all decision packages below the budget limit are approved and all those above are rejected. While those above the budget limit will always be rejected, those below may or may not be approved. For example, the first enhanced service package for delinquent accounts (AD-ENH1, #15) may be rejected (disputed justification, misaligned objectives, etc.). This causes the Budget line to rise from #19 to, say, #21. However, #20 (AD-ENH2) is rejected by default because the predecessor it is built upon (AD-ENH1) has been rejected. For this reason, the Budget line ultimately rises to include, say, #22 (EI-CUR), avoiding service reductions in the Industrial Engineering group. This Budget line shifting process example is depicted in Exhibit 5, where it can be seen that the final two enhanced service packages (EQ-ENH2, EI-ENH) remain unfunded.
The final budget, as depicted in Exhibit 5, informs each decision unit of the decision packages that have approved. From this, a detailed operating budget can be generated for each unit to manage expenditures throughout the upcoming fiscal period.
ZBB’s greatest, or at least earliest, claim to fame is Jimmy Carter’s implementation, in the 1970s, as Governor of Georgia and, subsequently, as President of the United States. Or perhaps it is Ronald Reagan’s discontinuation in the early 1980s, beginning an era of ballooning federal spending that continues to this day.
The process required to implement ZBB in government parallels that for businesses, with some key differences in characteristics:
Dis/Advantages of Zero-Based Budgeting
Many times, an advantage to one is a disadvantage to another; they are two sides of the same coin. The label applied depends on one’s perspective or the role one plays in a given scenario. For this reason, characteristics of Zero-Based Budgeting are presented below without normative labels; the value of ZBB must be assessed by the reader.
The most effective and most sustainable implementation is one that is customized to an organization’s unique circumstances. Neglected or historically mismanaged units may be brought in line with organizational objectives prior to evaluating less problematic units, for example. There are five basic strategies for ZBB implementation with seemingly endless variations possible.
A small organization, with relatively few decision units, may choose an “All-In” strategy, where every unit conducts a complete ZBB process every fiscal period. This can be a risky proposition for larger organizations; the opportunities for error, “lazy” management, and political maneuvering increase exponentially with the number of decision units. These risks are in addition to the learning curve effects mentioned previously. Most organizations benefit from using an incremental strategy, not to be confused with incremental budgeting.
A “Top-Down” strategy considers expenditures at a divisional, business unit, or other high level. Detailed analysis of expenditures may not be completed; traditional budgets are often key inputs for initial decisions. Thus, it is more a portfolio review than a true ZBB process. Units that are deemed hopelessly unprofitable or otherwise misaligned with organizational objectives are divested, or left to languish, as funds are diverted to more promising ventures. Divestiture reduces the workload required to create a genuine Zero-Based Budget.
At the opposite extreme, detailed analysis begins at the task level. Nonvalue-added (NVA) activities are identified and eliminated or reduced, while efficiency gains are sought for value-added (VA) activities. Analysis then proceeds to, say, department-level activities and continues through the organizational hierarchy, identifying worthwhile expenditures and alternative methods at each stage. This “Bottom-Up” approach is highly compatible with lean initiatives; it is a continuous improvement strategy that may require several fiscal periods to progress through the entire hierarchy.
A “Middle-Out” strategy is one in which the starting point is somewhere between the Top-Down and Bottom-Up strategies. That is to say, it is a rather broad term. This implementation strategy is most relevant to a large organization in which projections cause concern for a specific unit. The situation of concern may be temporary in nature, but sufficiently impactful to warrant additional scrutiny.
The first unit analyzed is the “Middle;” the “Out” follows only when the process is deemed valuable. Successful implementation in the Middle fosters support for ZBB, increasing the likelihood that it will be adopted more broadly. This approach can be an effective alternative to the “all-or-nothing” divestiture decisions common in the Top-Down approach.
A “Checkerboard” strategy can be implemented in several ways. The most basic is to conduct ZBB in one half of an organization’s decision units in one period and in the other half the following period. Other, less literal, variations are also worthy of consideration.
Both the proportion of units and the number of periods in a cycle can be varied. To address concerns of a potentially overwhelming workload, a smaller proportion of units can be analyzed each period. This is a particularly attractive option in large organizations.
The two-period cycle may also be extended to correspond with the proportion of units being analyzed (e.g. one third of units analyzed each period; each unit analyzed every third period). As the planning horizon lengthens, however, the accuracy of projections declines; traditional budgeting practices may be used in the interim periods to compensate. Reintroducing traditional methods may jeopardize the sustainability of the paradigm shift, as discussed previously.
An adaptation of the Checkerboard approach can address concerns regarding workloads, learning curves, and planning horizons simultaneously. Initiating ZBB, in Checkerboard fashion, with a three-period cycle limits the workload while the organization ascends the learning curve. As each unit becomes proficient, its planning horizon can be reduced to two periods. As ZBB becomes ingrained in management and culture, a transition to an All-In approach can be executed, minimizing opportunities for traditional thinking and practices to imperil the new paradigm.
Hybrid strategies, such as combining the Checkerboard and Bottom-Up approaches, can be implemented, providing further flexibility. Any number of hybrids could be conceived to address market conditions, workload concerns, or other matters that influence the decision to pursue or forego ZBB.
ZBB is the most natural form of financial planning. We’re all familiar with the “starving artist” and “poor college student” tropes. What form of budgeting are they most likely to use? It seems obvious that resource-limited individuals default to Zero-Based Budgeting. They may not do it formally or even realize they are doing it, but “survival mode” is zero-based.
The notion of survival mode applies equally to businesses and other organizations, as the “cash-strapped startup” trope reminds us. An individual or organization that maintains this approach will never be subject to the excesses and the subsequent, reviled, cuts that so often become necessary when traditional budgeting practices are employed.
The subject of alternatives, though mentioned, has not been discussed in detail. This was less an oversight than an attempt to simplify the presentation of the decision package ranking process. If an alternative method of providing a certain level of service is approved, it replaces the original decision package in the priority stack. An example is shown in Exhibit 6. If the cost of the alternative is significantly lower than the current method, the Budget line may shift, reflecting the impact its selection has on total cost.
There is a substantial literature discussing ZBB, much of it discouraging its use, particularly in Government. While the motivations of some authors are suspect, others present valid concerns more objectively. Serious consideration of the pro and con arguments should be undertaken before passing judgment on ZBB. If implementation is ultimately pursued, a thorough understanding of these arguments facilitates the selection of an appropriate strategy.
Anti-ZBB rhetoric often focuses on case studies of poor, or failed, implementations. Such case studies are not definitive proof of the method’s deficiencies, however. More often, they serve as definitive proof of deficient planning and implementation and, thus, provide important lessons to improve future endeavors.
Aspects of failed implementations commonly cited are diminished revenues, damage to brand and culture, and stunted growth. These outcomes are sited to support claims of ZBB’s inferiority. In reality, however, such outcomes demonstrate that the organization’s objectives and the linkage of expenditures to those objectives were not well understood. Heeding the caveats provided in this treatise regarding learning curves and implementation strategies can prevent such outcomes or their recurrence.
Consequences of alternative strategies, particularly continued use of traditional budgeting methods, should also be considered. Imagine the impact of bankruptcy, precipitated by unchecked spending, on culture, brand, and growth!
One anti-ZBB tirade asserts that “government agencies are unlikely to benefit from an annual complete ZBB process, as returns would decrease significantly each subsequent year compared to initial savings.” Decreasing returns, in this formulation, provide compelling evidence that ZBB is achieving its intended purpose! Perhaps government agencies would not benefit, but their constituents probably would.
In this same work, the following claim is made: “More so than federal agencies, private corporations can afford the costs associated with… ZBB…” Revisit the “Government Budgets” section for a reality check.
Despite its disturbing tone, the piece provides a useful summary of ZBB’s key characteristics. It has been reproduced in Exhibit 7. To further elucidate the contrast between ZBB and traditional budgeting, a comparison of planning sequences has been reproduced in Exhibit 8.
Successful implementation of any strategy relies on the alignment of incentives to objectives. For example, executive bonuses with a significant component related to ZBB implementation provide substantial motivation to ensure that all members of the organization receive sufficient training and guidance to ensure success. Any policy that discourages “lazy” management – expending the least effort possible, simply maintaining the status quo – should be considered.
To reiterate, the terminology used in ZBB is unfortunate, as it continues to reference past or current spending levels. It doesn’t end there. “Rightsizing,” when used correctly, is a reasonable description of ZBB’s purpose – to match expenditures to performance. Unfortunately, this term has been tainted by its replacement of “downsizing” when that term became toxic. Likewise, “reorganization” may be necessary to align responsibilities with logical decision units, but this term also fell victim to the buzzword wars waged in the business press.
No matter the terms used or the implementation strategy chosen, successful Zero-Based Budgeting hinges on Executive commitment, incentive alignment, and continuous improvement. As the same elements can be used to define sound management in any context, the controversy surrounding ZBB is puzzling.
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[Link] “What is Zero-based Budgeting?” Anjali J.; The Investors Book, 2022.
[Link] “Zero-Based Budgeting: Zero or Hero?” Mark Hopkins; Deloitte Development LLC, 2015.
[Link] “Zero-Based Budgeting.” Peter A. Pyhrr. In Handbook of Budgeting, 6ed. William R. Lalli; Ed, John Wiley & Sons, Inc., 2012.
[Link] “Zero-Base Budgeting: Modern Experiences and Current Perspectives.” Shayne C. Kavanagh; Government Finance Officers Association, 2011.
[Link] “Five myths (and realities) about zero-based budgeting.” Shaun Callaghan, Kyle Hawke, and Carey Mignerey; McKinsey & Company, 2014.
[Link] “Management Tools 2017: An executive’s guide.” Darrell K. Rigby; Bain & Company, Inc., 2017.
[Link] “Zero-Based Budgeting: What It Is and How to Use It.” Julia Kagan; Investopedia, 2022
[Link] “What Is Zero-Based Budgeting?” Lauren Schwahn; NerdWallet, 2020.
Jody W. Phelps, MSc, PMP®, MBA
JayWink Solutions, LLC
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