WELCH JACK

Zero base budgeting is a tool that should be handled with caution and selectively applied in these unique times of uncertainty. Until patterns of demand have stabilised, temporary freezing of discretionary expenditure and deferring irreversible decisions is most likely the preferred strategy. But the ground rules for ZBB thinking can start being applied right now.

Managers and CFO’s can use this period to develop deep visibility into their costs and their underlying cost drivers and develop aggressive yet credible targets. ZBB will help you decide which activities are truly mission-critical and which are secondary, and to identify redundant and non-value adding activities.

A ZBB program builds a culture of cost management through shared principles of

•            unprecedented cost visibility,

•            a unique governance model,

•            accountability at all levels of the organization,

•            aligned incentives,

•            and a rigorous and routine control process.

 

THESE ARE MY COMMON SENSE STEPS FOR SUCCESSFUL ZERO-BASE BUDGETING:

1.           Understand what you are spending now

2.           Question everything you are doing now

3.           Decide what you are going to change

4.           Implement the changes

5.           Monitor to make sure it happens

And while all this is going on, consult and communicate widely.

1.           UNDERSTAND WHAT YOU ARE SPENDING NOW

Step 1 is to establish the facts - how much each department is spending now, on what, with which suppliers, for what purposes. You can’t do a ZBB audit without this information. Yet strangely enough, many companies can only partly answer these questions. Their accounting systems don’t break down costs in enough detail. You need more analysis to make your spending patterns visible and transparent.

a.           Where do you find the data?

There are two possible sources you can use to begin establishing cost visibility: actual past results or your current budget for the year ahead.

If you have a budget prepared over the past few months – pre or post lockdown – it will give you an insight into the organisation’s proposed spending at that time. If your budget isn’t in enough detail to work with, get budget owners to rework their budgets to the level of detail you need.

If you don’t have a budget, you need to build a data base of the past 12 months actual spending, by department and cost centre. It's backwards-looking but does give you a base to start with. You will need to spend time consolidating and cleaning data so that it's meaningful and actionable.

b.           Where is the ZBB information kept?

The data is housed in a financial model. You can visualise a matrix of numbers – like a spreadsheet – with the departments and cost centres on one axis and the cost categories on the other, combining to give you the total actual or budget spending. As the project progresses, you will create an identical matrix, this time containing the new zero-base budget, then compare the two to establish the savings.

Smaller companies can do the exercise in Excel. Larger companies will need more sophisticated software.

c.           Integrity and consistency

You need to clean your data before you can work with it. Clever people figure out how to work the accounting system to hide their costs or charge them to other departments.

The account coding may be inconsistent between departments and branches. For example, is the cost of an airfare to attend a training course charged to “training” or “travel”?

Investigate “Miscellaneous” or “General expenses” accounts with significant spend in them, and be alert for bad labelling - where the name of the account is not reflective of the costs in it. Also watch out for costs which are expensed in the system but are in fact prepayments, deposits, or inventory items.

d.           How much detail is needed?

Accounting systems, even with drilldown capacity, do not reveal where, how, who, or why money is being spent. Costs sitting in buckets called Travel, Professional services, Training, Entertainment, Public Relations, need to be analysed down to individuals within each department, to identify the activities driving the expenditure.

e.           How long does this process take?

As long as you need to establish the truth. In every department and cost centre, and for every cost category (stationery, travel, training, maintenance, for example), you want to know

•            Who controls the expenditure?

•            Where is the money spent, on what goods or services, and who the major suppliers are?

•            The reason for the spending

•            The activities or events or cost drivers that create the need for spending.

Visibility is not just about financial information. The underlying drivers – the events and decisions that create and cause costs - are easier to understand and influence. For example, for travel, you should understand how many trips your organization takes and where the trips are to.

For its recent ZBB project, pharmacy chain Walgreens set aside 16 weeks to assess its global cost base. “At the end of that 16 weeks, we will have enormous transparency and granularity, we will know who spends what on what. The ZBB team will develop deep visibility into costs and set detailed savings targets for the next budgeting cycle.”

 

STEP 2. QUESTION EVERYTHING YOU DO NOW.

Department heads will be required to:

•Explain how each line-item (general ledger account) in their department budget contributes to, and is necessary for, the department’s purpose and mission (Zero line-item budgeting)

•Explain why each program or activity should exist, its benefits, perceived value and its costs (Zero service-level budgeting)

When deciding on priorities, the reviewers will question whether

•            the organisation needs the particular activity at all

•            the scope of the activity should be reduced (trim the fat)

•            it should it should be done internally, or contracted out

•            the same end result could be achieved in a more effective way.

•            and – objectively – how much should it reasonably cost to deliver this service?

 

STEP 3 –DECIDE WHAT YOU ARE GOING TO CHANGE.

What level of activity do you plan for?

ZBB like any other forecasting methods depends on how much certainty you have about future revenue. Today the main question for most businesses is - how fast will the post-COVID 19 recovery phases happen? Right now, temporary cost freezes may be the best approach in order to avoid decisions with long term business impacts. Unfortunately, for some businesses, survival might mean taking drastic actions today that you know are going to hurt the business going forward.

The authority to decide

Zero-based budgeting forces choices on where to spend, or more accurately where not to spend. Making the actual spending decision is the hardest part of ZBB. During the analysis you are likely to find several cost saving opportunities which are also good projects and have merit. Someone must decide which projects to fund and which projects to delay or re-scope.

Appoint and announce the decision-making authority early in the process. It can be a committee or an individual. The ultimate decider needs to be senior enough so that the organization will respect and follow the decision - easier said than done.

Volume decisions and rate decisions

To help with choosing where to focus spending and reductions it is helpful to put cost savings into two buckets: volume and rate.

Volume decisions are choices of less or more activity. Taking travel expenses for example, you could issue an instruction to reduce the number of car hire bookings by 30%. With less car hire transactions, some of the underlying activities tied to travel (customer visits, site inspections, employee training) just won’t happen. Volume choices are often harder than rate choices.

Rate decisions are choices to continue an activity but at a lower cost. The activity continues (hopefully) in the same manner, but the organization pays a lower cost. Continuing the travel example, you might negotiate a preferred corporate rate with a car hire company lowering the cost of each trip. Therefore, the volume of trips continues at a lower cost. The more rate savings initiatives the better since the organization doesn't have to reduce activity. Often rate decisions become new corporate policies. For example, you may create a policy that any airline tickets must be purchased within 14 days of travel to secure the lowest fare.

High impact priorities

Before making the final decision, it’s highly advisable to interview the key stakeholders who will be affected – usually the owners of the high spending activities. Come prepared having done your analytical homework. Try to understand the key drivers of the expenditure before interviewing the stakeholders.

Fat not muscle

The benefits from long-term supplier relationships are important in the "fat vs muscle" trade-off. With pressure on to meet the budget and cost reduction deadlines it's easy to adopt a "slash and burn" approach to cost cutting. Choosing a cheaper supplier with less reliability can destroy relationships that have taken years to build up.

When private equity firm 3G Capital bought ketchup maker H.J. Heinz in 2013, they implemented an aggressive form of ZBB that required managers to lay off people off and reduced investment in brand building, marketing, customer research and product innovation. Over the next two years Heinz dismissed 7,000 employees, closed six factories, and limited copier use to 200 pages per employee per month.

In 2017 3G announced that Heinz was the most profitable food company in its industry. Then in late 2019 the company suddenly announced a fourth quarter operating loss of $12.6 billion and wrote down the value of its Kraft brand by $15.4 billion, sending the share price down by 30%. Aggressive cost reduction and stagnating sales played a key role in Heinz’s decline. While 3G was asking managers to justify paper clip expenses, its competitors were investing resources into product innovation and anticipating rapidly evolving consumer food trends.

“To keep up with shifts in consumer demand for food, you have to innovate. And to innovate you can’t use ZBB,” a competitor said.

Jack Welch at GE had a performance measure which he called "Balance between short and long term" whereby each business unit had to spend a prescribed minimum amount on items like training and maintenance, which Welch regarded as long-term investments.

Beware of interdependencies. Targeting selected service departments only, will impact its internal customers. At Boeing, investigators have questioned the quality controls and test intensity on flight software which led to the suspension of production of the 737 MAX, which remains grounded following two deadly crashes.

 

STEP 4. INSTITUTE THE CONTROLS OVER FUTURE SPENDING.

For each department prescribe the rules for who authorises, who reviews, who approves expenditure. Identify and clamp down where controls are slack. Have rules for emergencies where key people are not available.

The team also ensures that systems and processes are in place for the detailed reporting, governance, and performance management needed for world-class ZBB.

 

STEP 5. IMPLEMENT THE CHANGES.

From a cultural standpoint, a company needs to ensure the tone is set from the top.  Leadership should meet with departmental managers to ensure they understand the importance of ZBB and are fully bought into the process.  Leadership should allay staff concerns that the process will be time-consuming, and compensation will be tied strictly to the budget.

Instead, staff should understand ZBB means they’ll have greater control in setting their own departmental goals rather than have targets dictated to them from the top.  Accountability for adherence to goals should be high.

STEP 6: MONITOR AND CONTROL

According to recent research by Deloitte, “poorly designed tracking and reporting” was a key factor in the failure of ZBB in 43% of cases.

The purchase order and accounting systems need to track budget against actual throughout the year. Policy breaches and negative variances need to be clamped down hard. If they recur, find out the reasons and if necessary, change the policy.

You need to track non-financial compliance measures as well in your control monitoring. For example, you may have a list of preferred suppliers for certain legal services. You may need to track compliance with the preferred suppliers and take corrective action as needed.