SUBSCRIBE TO OUR NEWSLETTER

    SUBSCRIBE TO OUR NEWSLETTER

    Corporate Performance Management
    Zero-Based Budgeting: with the Covid-19 emergency is it time to re-evaluate it?

    The Covid-19 is a trend booster just like the digital revolution or the general changes in the way we do business.

    This change evokes the way of rethinking one’s activities and Zero-Based Budgeting is back in vogue due to the fact that it requires a continuous and radical rethinking in relation to the acquisition and allocation of resources in the company activities, avoiding to proceed in continuity with a historical experience now far from the new context in which the company moves.

    When did Zero-Based Budgeting start and what is it about?

    Lo Zero-Based Budgeting (ZBB) non è certo una novità, essendo stato concepito negli anni 70 da Peter Pyhrr come strumento di allocazione delle risorse disponibili basandosi su un concetto a prima vista semplice: ogni volta che si elabora un esercizio previsionale si riparte da zero, ossia non si procede con aggiustamenti rispetto all’ultima previsione di budget, né si parte da dati storici. 

    Si tratta di un metodo che si basa sull’analisi del conto economico e in particolare sui ricavi di periodo da cui partire per capire l’entità dei costi che un’azienda si può permettere. Nella sostanza, in sede di ogni budget, se non addirittura di sua revisione, occorre individuare e quantificare i costi ritenuti essenziali lungo la catena del valore aziendale per verificarne la copertura da parte dei ricavi correnti. La copertura di tali costi, anche rinunciando, ovviamente non indefinitamente, ai profitti di periodo è fondamentale per garantire una crescita dei ricavi correnti. Solo ove residuasse un margine dopo la copertura di tali costi l’azienda potrebbe sostenere anche altri costi utili, ancorché non essenziali, mentre quelli che non creano valore o lo fanno in modo risibile andrebbero necessariamente tagliati.

    Lo ZBB si concentra quindi sui ricavi correnti e sul come accrescerli attraverso la leva dei costi. Nel far questo non trascura gli investimenti –  che sono il principale motore di crescita aziendale – il cui costo (le quote di ammortamento) deve trovare anch’esso copertura economica nei ricavi correnti, prima ancora che in quelli prospettici attesi.

    Zero-Based Budgeting (ZBB) is not something new, it was introduced by Peter Pyhrr in the 70’s as a tool for allocating available resources based on what initially may seem like a simple concept: every time a financial year is processed we start over again from zero, that is, no adjustments are made with respect to the latest budget forecast, nor do we start from historical data.

    It is a method that is based on the analysis of the income statement and in particular on the revenues for the period from which to start to understand the costs that a company can afford. Basically, in each budget, if not even in its revision, it is necessary to identify and quantify the costs considered essential for the corporate value chain to verify if they can be covered by the current revenues. The coverage of these costs is essential to guarantee growth in current revenues, even if one waivers, in a non-indefinite way, the profits for the period. Only in the case in which a margin remains after covering these costs, could the company also incur other useful costs, even if not essential, while those that do not create value or do so in a risible way should necessarily be cut.

    The ZBB therefore focuses on current revenues and how to increase them by leveraging costs. In doing this, it does not neglect investments – which are the main engine of a company’s growth – the cost of which (the depreciation rates) must also find economic coverage in current revenues, even before the forecasted ones.

    Pros and cons of Zero-Based Budgeting

    Although the limitations given by a tool that focuses on economic and not financial-asset dynamics is visible, the ZBB offers a valuable contribution when it pushes one into rethinking the cost structure on a daily basis to ensure maximum performance and efficiency.

     

    This should not be conducted occasionally, but continuously given that companies operate in a highly dynamic context and it is necessary to promptly correct the aim where necessary. It represents a managerial style, if not a cultural model.

    The ZBB forces the management to constantly question if the cost item is:

    • Cost-Effective, that is, if by supporting the cost it will help increase revenues and therefore the profits
    • Cost-efficient, that is, if the level of cost for an element deemed essential is fair and competitive

    To sum up, costs are measured with reference to current results and future expectations, allowing management to allocate funds according to current needs rather than on the basis of historical experience. It follows that every expense must be justified on a yearly basis. The justification is therefore not required only for the new costs given that the goal is to eliminate unnecessary expenses that are the result of uncritical relaxation, consolidated behaviour and flattening out on historical data.

    How to apply the ZBB method

    The message is quite simple: every cost that absorbs more value than what it creates must be eliminated.

    Applying the theory is not as simple as it seems, since it is not always easy to verify, especially in the presence of costs that give benefits that are not easy to measure and do not have an immediate return (e.g. advertising, research, training, …). Furthermore, there are correlations between the cutting of some costs (e.g. maintenance) which imply an impact on other optimized ones (factory plants).

    Even if it proves to be difficult to verify, it does not mean that it must not be done.

    That is why it is necessary to follow these 4 steps:

     

    1. Verify the business model

    As the competitive environment changes, it is necessary to rethink the activities and resources necessary to compete in short-term and in perspective. The ZBB is closely linked to the corporate strategy which is adapted from time to time to the changing scenarios of the market. In other words, it is about maintaining a close link between strategic vision and the acquisition and allocation of resources to business activities.

    1. Analysis of the current situation

    Before focusing on the strategic path to follow, it is necessary to have a clear understanding of the current situation, that is how company resources are allocated and consumed by the various profit centres. The focus is on the control dimension carried out by the planning and control function; in fact, it is necessary to assess whether the costs incurred in the past have then produced benefits. If not, they should be rethought, starting from scratch.

    1. Zero-Based Budgeting as an organizational model

    The focus now shifts to the planning dimension carried out by the planning and control function but starting each time from scratch, that is, rethinking the allocation of resources and activities based on the review of the business model and starting from the awareness of the current situation. To sum up, the cost structure will reflect upon a new allocation based on the allocation of resources primarily to the most profitable businesses.

    1. Development control

    The last step consists in checking the progress of the aspiring business model and, if the conditions are met, to adjust the actions in progress.

     

    When it comes to Zero-Based Budgeting, it is therefore not a question of implementing a wild cost cut, but of reallocating the limited resources available to the most profitable activities that change over time and often rapidly within the business portfolio.

    In other words, the ZBB is the antithesis of the infamous linear cuts.

    In doing this, an in-depth overview of the company is required and information limitations must be removed in order to have the necessary transparency for an effective allocation of resources. These conditions are not always present in reality, but the ZBB is an organizational model even more than a planning and control tool.

    Operational problems may also arise, or in the absence of adequate IT tools, the application of the ZBB can be excessively expensive in terms of time and money, so much so as to discourage a continuous use of this approach.

    However, from the 70s up until now, many steps forward have been made in terms of modelling capacity through Business Performance Management tools, therefore an approach that has the undeniable merit of promoting continuous critical and in-depth rethinking can come back into vogue about the allocation of company resources and their costs.

    CONTACT US

    If you desire to get in touch with us and get more information, please fill out the form below