What Is Zero Based Budgeting in Capital Budgeting

Anyone involved in the budgeting process knows that budgets can be prepared the easy way or the hard way:

1. The easy way is to simply apply a factor to the previous year’s actual expenditure in line with inflation and growth expectations.
2. The harder way, generally referred to as zero based 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 based budgeting delivers greater value.

One clarification before we start, because the term carries two meanings. In personal finance, zero based budgeting means assigning every dollar of monthly income a job so that income minus outgoings equals zero. In corporate finance it means: every proposed expenditure, including every capital project, starts from a clean slate of zero and must be justified on its own merits rather than carried forward from last year’s allocation. This article is about the second. Everything below concerns capital budgeting in organizations, not household budgeting.

What Is Zero Based Budgeting?

Zero based budgeting is a method in which every expenditure is evaluated from a base of zero each cycle, so that funding is justified by what it delivers now rather than by what was spent last year. Zero based 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 based 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’. Zero based budgeting in capital budgeting therefore has a specific and testable meaning: no capital project holds a claim on funding because it was funded before, and no budget line survives a cycle without being re-argued. Corporate zero based budgeting is applied at the level of the individual investment proposal, which is what separates it from the household practice that shares its name.

Where Did Zero Based Budgeting Originate? The History of ZBB

Zero based budgeting was developed at Texas Instruments in 1969 by Peter Pyhrr who set the method out 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.

Three points are commonly confused:

1. The sequence runs from private sector to public, not the other way around, which is the reverse of how the method is usually described.
2. Pyhrr was a working manager solving an internal capital allocation problem, not an academic proposing a theory, and the technique was built to survive contact with a real budgeting cycle.
3. The Georgia adoption was an application of an existing corporate method rather than its origin, and Carter later carried it into federal budgeting during his presidency.

The order matters because it explains what the method was designed to do: choose between competing investment proposals inside an organization that had more good ideas than capital.

Is Zero Based Budgeting Used in Corporate Finance Today?

Zero based budgeting is still used in corporate finance today, most consistently where discretionary capital competes for a constrained budget and each request has to be argued on its current merits. It was built to rank capital requests against each other when the requests exceeded the funds available, which is the same problem capital budgeting solves today.

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. In corporate practice the pattern is now selective rather than universal: organizations apply zero based budgeting to discretionary and strategic capital, where the funding decision genuinely is open, and continue to use a baseline allocation for sustenance of the existing asset base, where it largely is not. Zero based budgeting for companies is therefore less often an all-or-nothing commitment than a decision about which parts of the budget are genuinely up for renegotiation each cycle.

5 Reasons Why Organizations Need Zero Based Budgeting

Five things improve when a company budgets from zero rather than from last year: strategic alignment, how funding is optimized, how managers are held to their numbers, how expectations are set, and how spending is controlled.

1. Strategic Alignment

A key purpose of zero based 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. However, 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 projects 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 based budgeting capital program budget helps ensure that capital 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 capital projects portfolio through zero based 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 based 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 in the Corporate Zero Based Budgeting Process

Running zero based budgeting in a corporate capital process takes six steps, from defining who owns which capital decisions through to optimizing the portfolio against a funding limit. Run manually on spreadsheets it takes too long and consumes too much effort. Digital transformation of the capital budgeting process can, however, make zero based budgeting a practical reality. Here are 6 steps to achieving a practical zero based budgeting solution:

1. Define Capital Management Responsibility Areas

The effective capital allocation 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 center 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 projects 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:

• Sustenance
• Growth
• Savings
• Compliance
• Safety
• Strategic reasons

3. Enable Efficient Initiative Submission

A zero based 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 valuable asset: your people.

4. Standardize Scoring And Evaluation

Improve the efficiency, effectiveness, and objectivity of initiative evaluation and ranking by adopting appropriate project 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 rate, 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.

Stratex Online runs the sixth step as portfolio optimization against a funding limit, so a budget built from zero can be tested at several investment levels before one is committed to.

Transition to Zero Based Budgeting in Your Capital Process

Moving to zero based budgeting starts with the discretionary portion of the capital budget, leaving sustenance funding on its existing basis until the method is established. Sustenance spending keeps the existing asset base running, so the question it answers is how much, and a funding bucket answers that adequately. Discretionary capital is different: those projects compete against each other, and it is where carrying last year’s allocation forward conceals the most.

For that discretionary portion, replace the bucket with a ranking. Every request is justified from zero, scored on the same basis, and ordered by the contribution it makes to strategic goals, so the projects that get funded are the ones that advance those goals soonest rather than the ones that were funded last year. Once the discretionary portion runs this way, extending the method to sustenance categories becomes a decision about effort rather than about principle.

Where this sits in the wider process. Zero based budgeting is one of two decisions an organization makes about how its capital budget is built. The other is whether the budget is assembled top down from an executive allocation or bottom up from what operating managers identify, and the two decisions are independent of each other. The comparison between incremental and zero based approaches, and how to build a capital budget from the bottom up, is set out in how to build a capital budget. For the decision that comes before all of it, start with the allocation framework.