How to Prepare a Zero-Based Capital Budget

Written by: Richard Frykberg

A zero-based capital budget imposes an onerous challenge on management: a need to justify all expenditure in pursuit of the strategic vision. The intent is not to justify continued capital investment to replace the depreciating capital base from prior periods, but rather to deeply consider and apply scarce capital and human resources towards initiatives that will most rapidly help an organization achieve its strategic goals; serving as a great zero-based budgeting example.

In this blog we look at what goes into preparing a zero-based capital budget. From collecting the investment ideas, to analyzing their potential and then selecting the right projects to be incorporated into the capital budget. The zero-based budgeting advantages and disadvantages will also be explored throughout. The Zero-base budgeting disadvantage is purely that this front-end loading process is complex and can only be simplified through digital transformation solutions.

How to Choose Investment Opportunities for a Zero-Based Capital Budget

The stress of the budgeting cycle is due to making hard, and sometimes unpopular decisions. There is invariably more demand for funding of worthy projects than time and money available. Many organizations simply focus on the most urgent capital replacement needs, as these can easily consume the entire capital budget. However, capital investment opportunities should be gathered from several sources to ensure all potential investments are considered.

  • Long-Term Capital Planning

    For many organizations, long-term capital planning is considered part of asset lifecycle management. In addition to preventative maintenance schedules, replacement schedules are produced to track the technical obsolescence of equipment through time and usage. Impending asset replacements can thereby be extrapolated far into the future (sometimes as far as 30 years), and for many organizations this forms the basis of capital replacement budgets.

Of course, the arithmetic elegance of this approach conceals the strategic absurdity. Setting aside the practical matters of valuing replacement equipment far into the future, can we really assume its technical equivalence? Technology is advancing at such a rapid pace that both the nature of the items we’ll be producing in the future, and their means of production, may be vastly different from our operations today. Whilst there is merit in understanding the capital requirements for sustenance of business-as-usual operations, this needs a zero-based budgeting overlay.

As part of a zero-based budgeting approach, each component of equipment scheduled for renewal should be assessed with regard to the business unit’s strategic goals. Is the product the equipment produces still within the strategic focus of the organization? Will the means and method of production remain the same, or is there an opportunity for technological change, relocation or outsourcing of the capacity provided? Whilst an asset may be approaching the end of its theoretical useful life, is replacement now the most urgent investment priority?

  • Internal Innovation

    In addition to business-as-usual sustenance and organic growth initiatives there will be a number of internally generated ideas for business transformation. Whilst executive management may steer the strategic direction of the organization, they do not have a monopoly over ideas to get there. Progressive organizations invest heavily in opening channels for innovation. Engage employees to offer up their ideas without fear of ridicule or failure, and with confidence that they will be fairly evaluated, attributed, and rewarded.

  • External Innovation

    External forces also drive investment proposals. In the case of regulatory compliance, these may be mandatory. When competitors move, organizations will need to react quickly. External consultants may be retained to front the hard and yet inevitable pivots to a more lean and targeted operational model. And trusted business partners should be heard when they offer up solutions embodying new technologies, even when technical obsolescence of existing equipment has not been reached, if these new goods and services can produce an even greater commercial return.

Short Listing Investment Proposals for a Zero-Based Capital Budget

Once a complete listing of investment ideas is obtained from all sources, the nuggets of gold must be filtered from the chaff. Here are 4 steps to derive the short-list of candidate projects as investment proposals.

1.   Initiative Collection and Consolidation

Firstly, an effective method must be provided for easily capturing ideas and proposed replacements. This ideas register should ensure that all ideas are consistently recorded including assignment to a benefiting area, primary investment reason, and responsible person. Ideas should be secured from unauthorized access, but immediately accessible to management as required. To facilitate the rapid escalation of urgent and strategically imperative initiatives, it is beneficial to start scoring ideas on a simple urgency and strategy alignment scale to ensure that time critical initiatives are not forfeited.

2.   Workflow and Collaboration

As soon as possible, area managers should formally review idea submissions and approve worthy ideas for a more thorough investment proposal analysis. These workflow notifications should be instantaneous and easy for managers to interpret and make wise filtering decisions in line with their strategic goals. Each review and update should be systematically logged to provide a robust audit trail of provenance and to fulfill governance objectives and demonstrate probity.

When it comes to completing a more detailed investment proposal or business case, the responsible person should engage with domain specialists to validate and propose refinements and consider technical and commercial perspectives. Evidence of this collaboration and endorsement by specialists such as finance, engineering, and procurement will assist managers in making confident approval decisions.

3.   Evaluate and Score

To enable investment proposals to be ranked and prioritized, a standardized evaluation and scoring methodology should be applied. This provides a degree of objectivity, fairness and efficiency to the project assessment process. Some evaluations such as cost and financial returns may be expressed quantitatively, whilst others may only achieve a qualitative assessment at this stage. Nevertheless, it is beneficial to at least attempt an evaluation of critical initiative scoring dimensions including benefit, urgency, strategic alignment, and implementation risk. Any such scoring method will unlikely be prescriptive, but it will focus attention on initiatives at the margin, with clearly imperative and impractical initiatives promoted or scratched as soon as possible.

4.   Scheduling for the Future

Even if an initiative does not ‘make the cut’ in the first budgeting cycle or fiscal year, this ideas portal provides a very valuable resource for future consideration. What may not have seemed a priority a year ago, may seem urgent today given unrelenting environmental, technical, and competitive changes.

Assembling the Zero-Based Capital Budget

Once all potential investment proposals are collated, evaluated and scored, the tough zero-based budgeting process commences.

  • Be Smart

    Whatever the initiative, evaluation and scoring methodology can be wrong. You’ll know it through experience and gut instinct. Have the smarts to challenge unrealistic assumptions. Drill-down on the financial analysis and assess the reasonableness of all key numbers. Make sure calculations are consistent and eliminate uncontrolled spreadsheet models (which are notoriously full of formulae error). Assess the identified source of supply. Examine the supporting documentation. Review the collaboration and history. Capital decisions are tough – make sure you’re getting all the information you need.

  • Be Bold

    All endeavours worth doing involve a degree of risk. Manage the risk, don’t always take the easy road. If the strategic imperative is clear, and the initiative meets the objective, take decisive action. As much as there is risk in action, there is risk of inaction. Not doing what needs to be done will hurt eventually. So make the hard choices, even when they are unpopular. Just know what you’re getting into, have the data and insight to back you up, and go for it.

  • Achieve Greatness

    Remember, with zero-based budgeting there is no target number. The entire focus of the capital expenditure is to achieve your strategic goals as soon as possible. This means zero waste and zero regrets. Obviously, every organization has funding and resourcing limits, but within those, take on the project portfolio that delivers the greatest degree of success. If anything, do less. But make it count. Above all else ensure that every dollar is aligned to your strategy. This will invariably include some degree of investment in business as usual activities to sustain your organization through its strategic pivot. Replacement of critical productive and beneficial equipment is part of your strategy. But find capacity to do the things that need to be done. Even if you must absorb some inherent risk to your current activities to get you there.

Creating a more Efficient Zero-Based Capital Budgeting Process

An essential requirement in the effective and efficient application of zero-based capital budgeting concepts is being able to collect, score and select initiatives that achieve an organization’s strategic objectives sooner and at the lowest tolerable risk. Traditional budgeting approaches re-allocate funds in-line with prior expenditure to achieve similar predictable results in the future. Unfortunately, external forces in the operating environment demand radical change to adapt and succeed. Organizations of all types now require fresh and radical thinking to achieve their strategic goals. Zero-based budgeting is the method that demands all expenditure be justified based on the future, ignoring the past. Applying a zero-based budgeting approach starts with a blank page, then demands enormous ingenuity and bravery.

Traditional approaches to capital budgeting were applied because of complacency, lack of time and ineffective support systems. With a modern capital expenditure management system, however, you can achieve the promise of zero-based budgeting and rapidly transform your organization to achieve its strategic vision.