Zero-based budgeting

Zero-based budgeting in the 1970s was primarily concerned with attributing a particular activity of a company to the decision packages, which involves ranking and evaluating the packages for the benefits and costs, and making sure the resources are distributed appropriately. ZBB is a process that can be repeated numerously to review every single dollar in the budget annually, establish a cost management culture, and also manage a financial performance monthly. (Fitzpatrick 2015)

ZBB is not a very complex process. Many businesses will budget and plan out things to maintain financials. In the past, businesses would only look at specific things and would assume that everything is already in place and does not need to be double-checked. However, in zero-based budgeting, everything that is to be budgeted needs to be approved. Since zero-based budgeting requires an approval for budgeting, this means that a budgets per year are started from a zero-base and is completely started over every year.

Zero-based budgeting can also be used as a personal way to budget money. The point of a zero-based budget is to make income minus the outgo equal zero spent. This means that money not only needs to be budgeted, but also that one must not spend money that is not there to spend.

Creator and Definition

As an accounting manager for Texas Instruments, Pete Pyhrr created zero-based budgeting. In an interview by People magazine, he stated that many line items were historically and traditionally budgeted regardless of the need for the item. Mr. Pyhrr was subsequently asked by Georgia governor Jimmy Carter to manage the Georgia budget process. Pyhrr authored "Zero Based Budgeting: A Practical Management Toll for Evaluating Expenses".[1]

According to Peter Sarant, former director of management analysis training for the US Civil Service Commission, ZBB is "a technique which complements and links to existing planning, budgeting and review processes. It identifies alternative and efficient methods of utilizing limited resources. It is a flexible management approach which provides a credible rationale for reallocating resources by focusing on a systematic review and justification of the funding and performance levels of current programs."

Zero-based budgeting is a method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a "zero base" and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period regardless of whether the budget is higher or lower than the previous one.

ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization. Costs can be first grouped, then measured against previous results and current expectations.

Misconceptions

There are five misconceptions about Zero-Based Budgeting that can make financial advisers shy away from using this type of budgeting.

1. The idea that zero-based budgeting is just starting your budget from a zero sum.

The reality is that zero-based budgeting uses an approach that can facilitate cost viability, cost governance, and cost accountability.Using zero based budgeting correctly can lead to better cost management.

2. Using zero-based budgeting is cutting a budget to ribbons.

The reality is that the amount of budget cutting depends on what the company/government body wants to do. This type of budget cutting also depends on the bodies top-down savings target.

3. Zero-based budgeting can bog down a business and stop it from doing anything else.

The reality is that yes, introducing a new cost management culture within a new business/government body can take some time, it does not always have to create stops. Having a team to implement this type of change can help make the transition easier.

4. Zero-based budgeting only focuses on Selling, General, and Administrative Costs (SG&A)

The reality is that this type of budgeting tool can be used in any type of cost. The main purposes of zero based budgeting is accountability, viability, aligned incentives, and a rigorous process and all of these can be important to any type of costs.

5. Zero-based budgeting was not created for growth oriented companies.

The reality is that zero-based budgeting can be used at any company/government body whether it is being used for cost saving or growth. Zero-based budgeting is not a full slash and burn budgeting technique it can be used in successful situations to have strong visibility within a body to create more success.[2]

Advantages

  1. Accuracy: This type of budgeting allows for company's to look over every department to make sure they are getting the correct amount of money. This can also help with cost reduction.
  2. Efficiency: This type of budgeting helps company's run better with cash flow, cost reduction, and helps accountants look at the running numbers and not historical.
  3. Reduction in wasteful spending: This type of budgeting helps remove redundant spending within departments that are only getting a budget because it is normal on the budget.
  4. Coordination and Communication: This type of budgeting allows for better communication and work from within departments. This can motivate employees to make smarter decisions within a budget.

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Disadvantages

  1. Bureaucracy: Creating ZBB within a copany can take enormous amounts of time, effort, and analysis that would require extra staff. This would cause the process to be counter productive in cutting down cost.
  2. Corruption: In using ZBB managers could attempt to skew numbers to make expenditures into vital activities, thus creating a "need for them. This would mean that companies would continue to waste money on things they don't need or could cut.
  3. Intangible Justifications: This type of budgeting causes departments to justify their budget, which can be difficult on many levels. Departments such as advertising and marketing would have to justify expenses they may or may not use in the next year due to the fluctuation of the market. This could cost them profits in the future due to not being able to justify a certain amount.
  4. Managerial Time: ZBB comes at the cost of time and extra training for managers. This means extra time every year to do the budget, make adjustments, and receive the proper training to understand how to do ZBB.
  5. Slower Response Time: Due to the amount of time and training is required to do ZBB, managerial staff will be less likely to revise the budget to fit the market that the company is in. This means that it will take onger for a company to come up to speed with market trends and moving money into departments that need it the most. ZBB could potential create a hole within a company because the money would not be there for a departments that needs it in a short amount of time.

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Use in the United States Public Sector

Background

Zero-based budgeting (ZBB) in the public sector versus the private sector is a different process. "The use of ZBB in the private sector has been limited primarily to administrative overhead activities (i.e. administrative expenses needed to maintain the organization.:51 In the United Stated Zero-based budgeting was developed in 1969 at Texas Instrument Inc. Jimmy Carter, Governor of Georgia was the first to adopt the process of zero-base into the government for the preparation of the fiscal of 1973 budget. Three years later, sponsored by the President and Congress the federal government for the first time implemented zero-base budgeting in The Government Economy and Spending Reform act of 1976. (Pyhrr 1)[5]

President Carter later required the adoption of ZBB by the federal government during the late 1970s. "Zero-Base Budgeting (ZBB) was an executive branch budget formulation process introduced into the federal government in 1977. Its main focus was on optimizing accomplishments available at alternative budgetary levels. Under ZBB agencies were expected to set priorities based on the program results that could be achieved at alternative spending levels, one of which was to be below current funding."[6]

For the most part in government, the main users of ZBB are the legislative, executive, and the agency. The legislative includes the congress, state legislature, and city council, and they require more summarization and focusing on public priorities and objectives. Agencies include the agency director and department managers and they require more detailed information and focus on program implementation and efficiency. Lastly, the executive includes the President, governors, mayor/city manager and they focus on the needs of the legislature and agency. (Pyhrr 1) Although the legislative, the agency, and the executive have different focuses they all have to address two standard questions:

  1. Are the current activities efficient and effective?
  2. Should current activities be eliminated or reduced to fund higher-priority new programs? Or to reduce the current budget? (Pyhrr 1)

According to Peter Sarant, the former director of management analysis training for the US Civil Service Commission during the Carter ZBB implementation effort, "ZBB means 'different things to different people'." Some definitions imply that zero-based budgeting is the act of starting budgets from scratch or requiring each program or activity to be justified from the ground up. This is not true; the acronym ZBB is a misnomer. ZBB is a misnomer because in many large agencies a complete zero-base review of all program elements during one budget period is not feasible; it would result in excessive paperwork and be an almost impossible task if implemented."[7]:3 In many respects the "common misunderstanding" of ZBB noted above resembles a "sunset review" process more than a traditional public sector ZBB process.

Components of a public sector ZBB analysis

In an overview of zero-based budgeting, there are a total of three elements that make up the concept:

  1. Decision Unit Determination
    1. This is the building process of the formulation of a budget structure.
  2. Decision Package Formulation
    1. When compiling and packaging a budget request, this mechanism is utilized.
  3. Ranking
    1. This process requires the most attention as it requires a company's manager(s) to prioritize out of a group of decision packages that are laid out to them.

In general there are three components that make up public sector ZBB:

  1. Identify three alternate funding levels for each decision unit (Traditionally, this has been a zero-base level, a current funding level and an enhanced service level.);
  2. Determine the impact of these funding levels on program (decision unit) operations using program performance metrics; and
  3. Rank the program "decision packages" for the three funding levels.

In many cases, program staffers were asked to look for alternative service delivery models that could deliver services more efficiently at lower funding level.

The US General Accounting Office (GAO) reviewed past performance budgeting initiatives in 1997 and found that ZBBs "main focus was on optimizing accomplishments available at alternative budgetary levels:

Set priorities based on the program results that could be achieved at alternative spending levels, one of which was to be below current funding.

  1. In developing budget forms, these were to be ranked against each other sequentially from the lowest level organizations up through the department and without reference to a past base.
  2. In concept, ZBB sought a precise link between budgetary resources and program results."[6]:6

Further, "ZBB illustrated the usefulness of:

  1. Defining and presenting alternative funding levels; and
  2. Expanded participation of program managers in the budget process."

The federal ZBB budgeting system had the following components: "Budget requests for each decision unit were to be prepared by their managers, who would (1) identify alternative approaches to achieving the unit's objectives, (2) identify several alternative funding levels, including a "minimum" level normally below current funding, (3) prepare "decision packages" according to a prescribed format for each unit, including budget and performance information, and (4) rank the decision packages against each other."[6]:6

ZBB was officially eliminated in federal budgeting on August 7, 1981. "Some participants in the budget process as well as other observers attributed certain program efficiencies, arising from the consideration of alternatives, to ZBB. Interestingly, ZBB established within federal budgeting a requirement to:

  1. Present alternative levels of funding; and
  2. Link (them) to alternative results."[6]:6

This element of the ZBB budgeting process remained in effect through the Reagan, Bush and early Clinton administrations before being eliminated in 1994.

→Defining the government program zero-base:

As noted earlier, there is often considerable confusion over the meaning of zero-base budgeting. There is no evidence that public sector ZBB has ever included "building budgets from the bottom up" and "reviewing every invoice" as part of the analysis. In discussions of ZBB, there is often confusion between a ZBB process and a sunset review process. In a sunset review the entire function is eliminated unless evidence is provided of program effectiveness. This confusion ultimately leads to the question: what is a zero-base?

Sarant's definition of the zero-base based on the federal training experience is: "A minimum level is actually the grass roots funding level necessary to keep a program alive. Therefore, the minimal level is the "program or funding level below which it is not feasible to continue a program... because no constructive contribution can be made toward fulfilling its objective."[7]:73 Identifying this level of program funding has been subjective and problematic.

Consequently, "some states have selected arbitrary percentages to ensure that an amount smaller than last year's request in considered. They do this by stipulating that one alternative must be 50, 80, or 90 percent of last year's request."[8]:52 This equates to analyzing the impact on program operations of a 10, 20 or 50 percent reduction in funding as the "zero base" funding level.

Importance of performance measures

Performance measures are a key component of the ZBB process. At the core, ZBB requires quality measures that can be used to analyze the impact of alternative funding scenarios on program operations and outcomes. Without quality measures ZBB simply will not work because decision packages cannot be ranked. To perform a ZBB analysis "alternative decision packages are prepared and ranked, thus allowing marginal utility and comparative analysis."[8]:52

Traditionally, a ZBB analysis focused on three types of measures. "They (federal agency program staff) were to identify the key indicators to be used in measuring performance and results. These should be "measures of:

  1. effectiveness,
  2. efficiency, and
  3. workload for each decision unit.

Indirect or proxy indicators could be used if these systems did not exist or were under development."[6]:6

Impact on government operations

According to the GAO:

"Agencies believed that inadequate time had been allowed to implement the new initiative. The requirement to compress planning and budgeting functions within the time frames of the budget cycle had proven especially difficult, affecting program managers' ability to identify alternative approaches to accomplishing agency objectives. Some agency officials also believed that the performance information needed for ZBB analysis was lacking."[6]:50–51

According to the National Conference of State Legislatures:[9]

"In its original sense, ZBB meant that no past decisions are taken for granted. Every previous budget decision is up for review. Existing and proposed programs are on an equal footing, and the traditional state practice of altering almost all existing budget lines by small amounts every year or two would be swept away. No state government has ever found this feasible. Even Georgia, where Governor Jimmy Carter introduced ZBB to state budgeting in 1971, employed a much modified form.

State programs are not, in practice, amenable to such a radical annual re-examination. Statutes, obligations to local governments, requirements of the federal government, and other past decisions have many times created state funding commitments that are almost impossible to change very much in the short run. Education funding levels are determined in many states partly by state and federal judicial decisions and state constitutional provisions, as well as by statutes. Federal mandates require that state Medicaid funding meet a specific minimum level if Medicaid is to exist at all in a state. Federal law affects environmental program spending, and both state and federal courts help determine state spending on prisons. Much state spending, therefore, cannot usefully be subjected to the kind of fundamental re-examination that ZBB in its original form envisions.

To the extent that ZBB has encouraged governors and legislators to take a hard look at the impact of incremental changes in state spending, it produced a significant improvement in state budgeting. But in its classic form – begin all budget evaluations from zero – ZBB is as unworkable as it ever was."

Use in Private Sector

3G Capital has become successful using ZBB within their company. Their merger with Kraft Foods Group in 2015 no doubt helped in making its' use successful. This use of ZBB might have continued the misconception that this budgeting style was only for businesses trying to lighten the load of a new company.[10] However, this merger did trigger the use of ZBB within the company and made Kraft Foods Group review and shave down things like cut hundreds of management jobs, jettisoning corporate jets, to requiring employees to ask to make photocopies.[11]

Impact of ZBB on stockholders

The use of ZBB within 3G Capital has been profitable for stockholders. Their ability to cut costs within Kraft fast caused their stock prices to soar 36% due to the news. This type of budgeting allows for companies like Kraft and others attached to 3G Capital to take out some of the leaner competition that can undercut their prices. Zero based budgeting helps more money to flow to stockholders then into unused departments, over funded programs, and wasteful spending habits.[11]

See also

References

  1. ↑ Kesmodel, David (27 March 2015). "Meet the Father of Zero-Based Budgeting" – via Wall Street Journal.
  2. ↑ Shaun Callaghan; Kyle Hawke; Carey Mignerey (October 2014). "Five myths (and realities) about zero-based budgeting".
  3. ↑ https://efinancemanagement.com/budgeting/zero-based-budgeting-meaning-advantages-disadvantages
  4. ↑ http://www.accountingtools.com/zero-based-budgeting
  5. ↑ Pyhrr, Peter A. "The Zero-Base Approach To Government Budgeting." PUBLIC ADMINISTRATION REVIEW, Jan. 1977. Web.           
  6. 1 2 3 4 5 6 GAO, Performance Budgeting: Past Initiatives Offer Insights for GPRA Implementation (March 1997).
  7. 1 2 Peter Sarant, Zero-base Budgeting in the Public Sector, A Pragmatic Approach (Addison-Wesley 1978).
  8. 1 2 Thomas D. Lynch, Public Budgeting in America (Prentice Hall, 3rd Edition, 1990).
  9. ↑ National Conference of State Legislatures, Fundamentals of Sound Budgeting Practices, June 1995 http://www.ncsl.org/IssuesResearch/BudgetTax/FundamentalsofSoundStateBudgetingPractices/tabid/12653/Default.aspx
  10. ↑ https://hbr.org/2016/06/zero-based-budgeting-is-not-a-wonder-diet-for-companies
  11. 1 2 http://www.wsj.com/articles/from-heinz-to-kraft-zero-based-budgeting-sweeps-across-america-1427308494
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