Anyone involved in the budgeting process knows that budgets can be prepared the easy way or the hard way:
- The easy way is to simply apply a factor to the previous year’s actual expenditure in line with inflation and growth expectations.
- The harder way, generally referred to as zero-base budgeting (ZBB), is to justify the planned expenditure in more detail.
Is the ‘harder way’ worth it? This blog considers both methodologies of budgeting and ultimately why Zero-base budgeting delivers greater value.
What Is Zero-Base Budgeting?
Put simply zero-base budgeting is a practical management tool for evaluating all expenditures to ensure that they are cost effect and relevant to delivering organizational goals. Zero-base budgeting can be applied to all forms of expenditure include capital expenditure. Key elements of the process include decision unit determination (the formulation of a budget structure), decision package formulation (compilation of a budget request) and ranking of packages.
In relation to capital expenditure, zero-base budgeting is commonly the term used to describe an annual capital budget that is comprised of a list of discreet project initiatives as opposed to a summary capital budget ‘bucket’.
Where Did Zero-Base Budgeting Originate?
Zero-base budgeting is not a new concept. In fact it was developed at Texas Instruments in 1969, and popularized by Peter Pyhrr in his book “Zero-base Budgeting: A Practical Management Tool for Evaluating Expenses” published in 1977. The process was first adopted in government by Governor Jimmy Carter of Georgia for the preparation of the fiscal 1973 budget.
Is Zero-Base Budgeting Used Today?
Yes, however implementations have been modified to some degree due to its time-consuming effort. The specific process promoted by Pyhrr has enjoyed adoption in both the public and private sectors. However, the high degree of effort to complete a full zero-based budget across all expenditure streams, for every period has proven too onerous for many organizations.
5 Reasons Why You Need Zero-Base Budgeting
A summary capital budget based on prior years’ expenditure is obviously quick and easy to produce. However, here are 5 good reasons to opt for a more detailed capital budgeting process.
1. Strategic Alignment
A key purpose of zero-base budgeting is to focus first on the strategic objectives of the organization, then to identify the critical investments required to achieve those goals. Whilst operating expenditures are predominantly incurred in business-as-usual activities, capital expenditure is required to fulfill new strategic directions.
A capital budget based on prior investments and depreciation can be reasonably allocated for sustenance of the existing organizational asset base. But there is no ready basis for ‘bucket’ funding of strategic and compliance initiatives. The required investment level will be directly related to the degree of change required. For these investments, the capital budget will need to be justified based on specified initiatives and approved explicitly by the ultimate stakeholders.
2. Optimization of Funding
Where capital budgets are viewed as ‘buckets’ with capital allocated incrementally to projects until the budget is exhausted, there is a significant risk that the budget allocation is sub-optimal. In most organizations, the demand for capital funding will invariably exceed the available capital and human resources. Many good investments may simply not be commercially feasible due to:
- More urgent items to address
- Projects with even higher rates of return
- Mandatory compliance projects to complete first
Only by considering the complete portfolio of likely project investments will decision makers be able to prioritize the most important initiatives.
3. Alignment of Managers
Practically, organizations are structured into areas of responsibility. If each manager was simply assigned a capital budget based on historical expenditure, there is a risk that the timing and priority of projects selected departmentally are not aligned for effective and efficient cross-functional service delivery.
By contrast, a zero-base budgeting capital program budget helps ensure that projects are strategically aligned, optimally prioritized and cascaded for component delivery organization wide. For example, an organization seeking to enhance its online sales channel may require supporting projects in information technology, in warehousing and distribution, in manufacturing and in marketing.
4. Expectation Management
A key objective of having a capital budget is to align stakeholder expectations with funding requirements and operational performance. In a steady-state environment, simply replenishing the depreciating capital base should provide predictable returns.
The operating environment is, however, increasingly unstable. Technological change and globalization require organizations to invest for the future or go backwards. Community expectations including climate change and development goals are imposing new demands, while compliance and regulation impose new constraints.
To be able to forecast its operational targets to the satisfaction of all stakeholders requires an organization to make tough investment decisions. Only by agreeing the projects portfolio through zero-base budgeting will an organization be able to reasonably predict its likely results and cashflow needs.
5. Probity and Control
Budgets perform an essential control function. As opposed to reviewing every transaction, management teams are able to manage by exception by tracking variances between budgeted capital investment costs and expected returns and actual expenditure and results. The more granular the capital budget, the more effective the control. Using Zero-base budgeting to justifying each project, helps ensure that essential planning is performed.
By contrast, simply allocating capital budget ‘buckets’ based on previous expenditure introduces an additional moral hazard. It encourages over-spending to ensure that budget allocations are not depleted in future years.
6 Steps to Achieving a Zero-Base Budgeting Process
If the advantages of zero-based budgeting are compelling, why isn’t everyone doing it? Because using traditional manual spreadsheet-based systems, the capital budgeting process can be challenging. It can take too long and consume too much effort. Digital transformation of the capital budgeting process can, however, make zero-base budgeting a practical reality. Here are 6 steps to achieving a practical zero-base budgeting solution:
1. Define Capital Management Responsibility Areas
The effective allocation of capital should be aligned to an organization’s strategic emphasis and supporting management responsibility areas. This investment program structure forms the backbone of an effective budgeting process and should not be constrained by existing legal entity, geographic or cost centre structures. This framework will allow strategic objectives to be cascaded down through all areas of the organization to enable everyone to be aware of the organization’s goals and to align each and every investment initiative accordingly.
2. Classify Investment Reasons
Differentiate the types of capital initiatives the organization will be undertaking. The nature of information gathered, the process of review and the evaluation methodology will vary according to these project types. Typical classifications will include:
- Strategic reasons
3. Enable Efficient Initiative Submission
A zero-base budgeting process relies on broad-based and efficient data input. Ensure that your capital budgeting process allows for all participants to easily access and contribute ideas and investment proposals for consideration in the project portfolio planning. Sometimes the best and most critical initiatives are identified by those closest to the action, so an undue reliance on senior management to come up with all the best suggestions independently will undervalue your most value asset: your people.
4. Standardize Scoring And Evaluation
Improve the efficiency, effectiveness, and objectivity of initiative evaluation and ranking by adopting appropriate scoring metrics. Key dimensions to consider for capital investment initiatives include:
- Urgency of action
- Benefit of realization
- Strategic alignment
- Confidence of implementation
Appropriate scoring metrics should be defined for each dimension. For example:
- Risk matrices are commonly applied to assess urgency
- Financial metrics are commonly used to evaluate benefits
- Rating scales applied to strategic alignment dimensions
At early stages of assessment, qualitative scoring matrices may be sufficient. Final business case justifications may require more quantitative input. Scoring models define the assessed dimensions and applicable scoring methodology at each stage of initiative development and are applied to investment reasons. A specific zero-based budgeting example would be how financial return metrics are not applicable to compliance initiatives. Sustenance initiatives are heavily weighted towards inherent risk assessments.
5. Perform Effective Financial Analysis
For Growth and Saving initiatives, a financial return is normally required. Key financial metrics include Net Present Value (NPV), Internal Rate of Return and Payback period. The consistent and accurate calculation of these key metrics is essential to valid initiative ranking and selection. Spreadsheets are a convenient mechanism for the development of financial business cases, but tend to contain significant formula errors and inconsistencies, and can take significant effort to review. More structured business case models:
- Reduce the error rate
- Improve efficiency in preparation and review
- Enable more dynamic reassessment of expected results when common assumptions (such as interest, exchange rate and inflation) can be varied during scenario planning and simulation
6. Automate Project Portfolio Optimization
Investment initiatives are complex to assess and present challenging trade-offs regarding risk and reward. All organizations are constrained by both capital and resources. Selecting the optimal portfolio of projects is not as simple as ranking and allocating funding and people accordingly. It is quite normal that several smaller projects can outperform a larger project in terms of both risk and rate of return.
Factoring-in the inter-relationship between projects adds a further degree of complexity, as some projects are either mutually exclusive or co-dependent. This is where the real value of a modern capital budgeting solution comes to fruition. The system can do the hard work for you: by specifying your optimization goal (eg NPV), the system should help you understand the efficient frontier of portfolio options. Best value outcomes for each investment level increment to help management make an informed choice as to the optimal level of investment, to achieve the maximum value.
Transition to a Zero-Base Budgeting Process
Capital budgeting based on historical expenditure is no longer sufficient in a time of unprecedented environmental uncertainty and global competitiveness. To prosper, all organizations need to deploy their constrained financial and human capital more effectively and efficiently. Technology has been our biggest enabler of achieving streamlined results in complex processes.
Whilst capital funding buckets may be sufficient for sustenance of the existing capital base, it is highly recommended that zero-base budgeting concepts are adopted for discretionary capital funding. This funding should be determined utilizing project portfolio planning concepts to accelerate the achievement of organizational strategic goals. Stratex Project Portfolio Management supports this transition, don’t miss out on our effective zero base budgeting solution.