In 2022, businesses are continuing to be hit by COVID-19. With no definitive end in sight for the pandemic, experts are saying that businesses will need to adjust to the “new normal.” What does this mean for your business?
While there is no definition of the “new normal,” businesses will need to reconsider the ways things have been done before. As we know, the relevance of policies, procedures, and systems in place before 2020 were significantly disrupted that year. And disruption did not cease the following year and will likely continue in the upcoming years. As a result, businesses should consistently analyze their expenses to determine what is necessary, and what is not necessary, to handle the ever-increasing pressures related to profitability. Fortunately, there is a method for re-analyzing expenses that can help you adapt to the new normal: zero based-budgeting.
What is Zero-Based Budgeting?
Zero-based budgeting was developed in the 1960s by Peter Pyhrr, a Texas Instruments account manager. The budgeting technique was quickly adopted by Jimmy Carter, then Governor of Georgia, in preparation for the 1973 fiscal budget. So, what is this technique that has supported not only global corporations, but also state governments?
Zero-based budgeting is a technique that requires businesses to put all expenses under review each period. This directly contrasts traditional budgeting, which uses the previous period’s budget as a reference point. By starting with a base of zero, zero-based budgeting forces executives to reconsider what expenses are necessary right now. As a result, any expense included in the current period’s budget must be justified, regardless of whether or not it was included in the last period’s budget. This forces businesses to operate under current constraints, with budgets built on necessity rather than history.
Zero-Based Budgeting vs. Traditional Budgeting
Zero-based budgeting fundamentally contrasts traditional budgeting, also known as incremental budgeting. Below, we have listed the primary differences between the two techniques.
Difference #1: Reference Points
Traditional and zero-based budgeting differ based on the use of reference points. Traditional budgeting is based on the previous period’s budget. Specifically, departments will be allotted a set percentage to increase their budgets each period. This helps cover new expenses, as well as year-over-year inflationary expenses. But, what happens if a department doesn’t need a budget increase? Typically, departments will still be given a budget increase whether they need it or not — simply because that’s how traditional budgeting works. This can easily lead to overspending, hurting profitability. On the other hand, zero-based budgeting does not use the previous year’s budget as a reference point. Instead, budgets start with a zero base each period, meaning no expenses are assumed.
Difference #2: Expenses Analyzed
When developing a budget, executives need to determine what expenses to include. As traditional budgeting uses the previous period’s budget as a reference point, only new expenses tend to be analyzed. Recurring expenses are automatically added, with no justification required. Conversely, zero-based budgeting requires analyzing all expenses - old and new - to ensure every dollar added is necessary.
Difference #3: Level of Influence
Executives' level of influence is another point of contrast between traditional and zero-based budgeting. With traditional budgeting based on historical budgets, current executives have minimal influence on what is included on an upcoming budget. They may have strong influence over new expenses, but recurring expenses will have already been put in place by previous executives. On the other hand, zero-based budgeting gives more control to current executives, enabling them to build their desired budget from scratch.
Advantages of Zero-Based Budgeting
Zero-based budgeting can bring a wealth of advantages to your business. Below, we have compiled three reasons why you should consider using this budgeting technique.
Advantage #1: Higher Responsiveness to Market Conditions
The market fluctuates constantly, with some years better and some years worse. Therefore, budgets should change year to year. Zero-based budgeting encourages businesses to be more responsive to market conditions. Unlike traditional budgeting, zero-based budgeting forces you to look at budgets from a clean slate, determining which expenses are appropriate based on the current market conditions.
Advantage #2: Prevent Price Creep
Price creep is a phenomenon that occurs when prices rise gradually yet steadily. This causes buyers to get used to paying more and, therefore, become willing to pay more. When using traditional budgeting, your business can easily fall victim to price creep. As budgets are increased by a percentage each year, this can effectively mask any cost increase. However, zero-based budgeting can be used to hedge against price creep. By assessing budgets from scratch, you can reveal the true cost of each expense.
Advantage #3: Opportunity for Cost Reduction
If you’re looking for opportunities to reduce costs, zero-based budgeting may be right for your business. As the technique requires justifying every expense on your budget, you are forced to consider whether every dollar is really needed. Consequently, many businesses will be able to recognize a number of unnecessary costs, leading to significant cost savings.
Adopting Zero-Based Budgeting
After reading this article, your business may be ready to adopt zero-based budgeting. What does this process look like?
When transitioning from traditional budgeting, McKinsey & Company recommends establishing a central coordination team, who will be responsible for conducting a thorough investigation of all expenses, as well as setting savings targets for each period. Additionally, this team needs to ensure that you have the policies, procedures, and systems in place for governance and reporting. McKinsey also recommends dedicating 4-10 months to this transitional period, with full-time support from your business’s finance and IT departments.
Adopting zero-based budgeting can be a large undertaking. However, the cost savings can significantly outweigh the time, cost, and capital required to introduce this process to your business. Additionally, zero-based budgeting can lead to a cultural shift with cost management at the forefront. If you’re ready to introduce zero-based budgeting into your business, Parametric Pro Consulting is here to help. Book a free consultation call today.
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