The pros and cons of zero-based budgeting in a small business

It could be a good option if you’re looking for ways to improve profitability

Are you dissatisfied with the performance of your small business but stuck for new ideas about how to increase profitability?

Your company may generate decent margins — but perhaps that’s the problem. You’re sure they could be even better if the techniques and mindset were in place to deliver that. But some of your team have become a bit complacent. And you don’t want your business to be good enough — you want it to be the best it can possibly be.

Alternatively, you might be struggling to break even. You’ve investigated all the ways you can think of to cut your business costs but it’s not enough and you urgently need to find more savings.

Whatever the case, it could pay you to consider zero-based budgeting.

What is zero-based budgeting?

Here’s a definition of zero-based budgeting from global accounting firm Deloitte:

Zero-based budgeting (ZBB) is a budgeting approach that involves developing a new budget from scratch every time (i.e., starting from “zero”), versus starting with the previous period’s budget and adjusting it as needed. In theory, this forces decision makers to constantly look at the business with fresh eyes, free from the limitations of past assumptions and targets. [1]

In other words, at the start of each annual budgeting cycle, managers are asked to justify, from scratch, every penny they want to spend in the following year. That’s in stark contrast to a traditional budget process, which generally plans next year’s expenses on a ‘last year plus x%’ basis.

Some people assume that zero-based budgeting can only be applied to SG&A costs but that’s not the case. The technique can be used to plan and control any expense, including direct overhead costs and even supplier procurement costs. It can also be applied to capital expenditures.

Zero-based budgeting isn’t a new idea. The concept was developed in 1969 by Peter A. Pyhrr while he was working at US technology firm Texas Instruments [2]. Its popularity has waxed and waned over the years without ever going completely out of fashion and many companies use it successfully to this day.

The advantages of zero-based budgeting over traditional budgeting

There are a number of advantages of zero-based budgeting over traditional budgeting. Here are some key reasons why the technique can be effective.

Past errors are no longer waived through unchallenged

The traditional budgeting approach takes last year’s plan and adjusts (normally upwards) by inflation or some other metric. This means that only a tiny fraction of each year’s budgeted spending may be scrutinised for its desirability and effectiveness. The share inherited from the prior year — commonly more than 90% of the total — is often approved largely without query.

This implicitly assumes that last year’s budget was appropriate. But if bad budgeting decisions were taken in prior years, traditional budgeting may lock those bad decisions in place in perpetuity. Waiving through most of each year’s planned spending unchallenged may not be a recipe for efficiency.

In a downturn, zero-based budgeting flushes past excesses out of the system quickly

When economic times are good and profits are rising rapidly, cost control tends to weaken. If profits are going to rise strongly anyway, there’s less need to be disciplined. It’s easier to allow budget holders to spend what they want — it avoids having difficult conversations.

This tendency is reinforced by the management optimism that reigns during boom times. Budget holders paint a persuasive picture of the results they could achieve if only they were allowed to increase their spending budgets, hire more staff and so on.

Because everyone else in the room is feeling optimistic too, nobody challenges the logic.

So during the good times, spending budgets ratchet upwards.

When the economy turns down, this excessive spending needs to be flushed out of the system. Tough times normally call for a quick and radical re-set of expectations. This sort of reset won’t easily originate from a system where the starting point is a bloated cost base.

Zero-based budgeting can be more effective than demanding (say) a 25% spending cut relative to last year — which sounds savage but actually isn’t. When you need to be radical, asking everyone to justify everything can be very effective.

It can enable companies in dynamic industries to be more agile

One of the key features of zero-based budgeting is that it can make your company more agile and responsive if you operate in a dynamic or emerging industry where conditions are changing quickly.

All strategies, business plans and budgets are based on assumptions about the future. Yet some of those assumptions will inevitably turn out to be wrong. When your industry starts to take a different path to the one you expected, it’s vital to recognise that and react accordingly. When the facts change, we must be willing to change our minds.

Zero-based budgeting makes it easier to execute such pivots by fostering the fresh debate about spending priorities you need at such times. And if you do need to adapt where you spend your costs, the zero-based budgeting process will ensure that it happens automatically every year.

Zero-based budgeting is particularly good at defending against the psychological sunk cost fallacy by prompting you to take decisions looking forwards. If you’re half way through a two year project, zero-based budgeting disregards the half of the money you’ve already spent and forces you to ask: should we carry on with it? Will the second half of our spending generate a positive return or are we just throwing good money after bad?

Traditional budgeting makes you more likely to continue spending on things that are no longer important. Zero-based budgeting will tend to redirect spending more quickly from projects that are losing relevance to more promising avenues of growth. Done right, it should keep you at the forefront of any transformational changes that are occurring in your industry.

It fosters a culture of continuous cost discipline

An intangible benefit of zero-based budgeting is that it fosters a culture of continuous cost discipline among budget-holding managers. Your managers will better appreciate that they don’t have an automatic right to the company’s resources via a default annual budget allocation. Instead, they will understand that they must justify their team’s resources every year.

This will tend to make them think more frugally. If they want to pursue a project next year, they will know that they will have a better chance of securing approval for it if they can reduce the funds they are requesting.

It eliminates the perverse incentive to ‘hoard’ budgeted costs

One of the key weaknesses of traditional budgeting is that it provides only limited incentives to budget holders to cut their costs. How many managers will search for ways to help their staff work more efficiently if the resulting cost savings are harvested by central management and their ‘reward’ is to see their spending budget cut the following year?

In practice the opposite often happens. Managers who don’t need all their allowed costs find ways to spend the unused amount before year end in order to ‘use up’ their budget and justify keeping it in the following year. Zero-based budgeting avoids these perverse incentives by eliminating the annual budget roll over to begin with.

It makes it harder for managers to cover up cost problems

At its worst, dysfunctional incentives like these can result in a manager building up a surplus cost budget that can be used for purposes other than those for which it was intended. For example, if failures occur within a team (e.g. a project goes over budget) it might be possible to absorb them without the hit showing up in the team’s aggregate annual costs.

Yet it’s vital that problems are visible in order that their underlying causes can be diagnosed and remedied. If problems are disguised they will keep recurring. Managers should also, of course, be properly accountable for the performance of their teams or business units.

And zero-based budgeting has worked for many companies

The final argument in favour of considering zero-based budgeting is that it can work very effectively. Global consulting firm McKinsey reports that its clients have reaped large cost savings from applying the technique:

When properly implemented, ZBB can reduce SG&A costs by 10 to 25 percent, often within as little as six months. [3]

The problems with zero-based budgeting

While it’s clear there can be advantages of zero-based budgeting over traditional budgeting, the technique also has drawbacks that you should carefully consider. Here are some of the main ones.

Zero-based budgeting is time consuming

A zero-based budgeting process takes longer to complete than traditional budgeting. That’s precisely because you evaluate all of your planned spending each year rather than assuming most of it is justified because it’s what you spent last year.

It’s not possible to quantify how much longer a zero-based budgeting process will take compared with traditional budgeting. The answer will depend on factors like your industry and your company’s business model. However the additional time absorbed is likely to be significant.

If your company has an inefficient cost base that you’re seeking to reduce or it’s been prone to lax budgeting in the past, this extra time may be a very good investment. But if your company is already highly profitable and has a lean cost base the extra call on your time may not generate much return.

If you work in a stable industry with low growth and a low rate of technological evolution, your cost budget might not need to change much from year to year. Under these conditions, once you’ve got your costs to an efficient level, annual inflationary increases may be sensible and efficient. In such a company, zero-based budgeting might involve reinventing the wheel every year.

It can undermine long-term growth potential

Growing companies that use zero-based budgeting must ensure they don’t use the technique in a dogmatic manner. Just because you start each annual budget process from zero doesn’t mean you should think about your spending only from a short term perspective.

Importantly you should avoid cost savings that harm your long-term growth prospects. If you need to spend money this year on a project that will yield nothing in year 1 but should pay off handsomely in 2-3 years’ time, cutting the funding would be counter-productive. Long-term growth initiatives generally require continuity of funding from year to year.

It can worry or demotivate managers and staff

Zero-based budgeting should not lead to the development of a slash and burn mentality. The technique should instead build a culture in which everyone is conscious of costs and is willing to support tough decisions to improve a situation when things aren’t working.

If managers and staff worry that their team or their job could be eliminated at a moment’s notice, their days may be consumed by anxiety. This is demotivating and bad for productivity. It may also make people more risk-averse, which stifles beneficial innovation.

So don’t make staff feel as if they’re reapplying for their own job every day. Communicate the purpose of zero-based budgeting clearly and openly. Emphasise that the programme is not an emergency measure and the company’s solvency is not at risk.

It might exacerbate tension between managers

Debate and argument are an essential part of coming to good decisions — if a meeting takes a decision unanimously then you’ve not really debated the issue at all. But too much argument can become a bad thing. When tempers fray, productive working relationships break down.

If there’s a tendency in your company for debates to be carried out in the wrong way, zero-based budgeting may magnify the problem. Why is that? Because instead of debating only the annual increment to a budget-holder’s cost or capex budget, you begin by asking whether there should be any spending at all. The amount ‘at risk’ is much higher than under a traditional budgeting process.

Of course, that’s not a reason for avoiding debate. It’s a reason for debating things the right way — in a collegial atmosphere where disagreements are about issues and individuals are not competing against each other.

Some may also think that zero-based budgeting rewards managers who are good at arguing rather than ones with good spending proposals. This is also true in traditional budgeting processes but zero-based budgeting may magnify the effect. Having said that, the ability to put your case effectively is part of being a good manager in the first place.

Conclusion: For the right company, zero-based budgeting can open up new ways to improve profitability

Zero-based budgeting can open up new ways to improve your business profitability. But it works better for some companies and in some circumstances than others.

The technique can be successful in organisations that operate in a fast-changing industry environment and which benefit from a collegial culture. If managers are comfortable being agile and pivoting rapidly in response to evolving priorities, zero-based budgeting could help you be nimble.

Instead of that, perhaps you’ve taken over the leadership of a company with a history of poor cost discipline. Perhaps some of your managers are obstructing efforts to find savings from their budgets. If you’ve exhausted traditional approaches to cost control, zero-based budgeting could be a good way to shake things up.

Zero-based budgeting is not likely to be such a good idea if you lead a well managed company that operates in a very stable industry where the extra time required for the process is not likely to yield material cost savings.

It could also flop in a company where the top managers will struggle to adapt to the more dynamic requirements that come with the process.

In any event don’t use zero-based budgeting as blunt instrument to slash and burn your cost base. If you do find yourself in need of drastic cost savings, think carefully how to proceed. Zero-based budgeting can certainly be used as a tool for shaking things up. But if your business is deeply loss-making, merely cutting costs may not be sufficient.

At the tactical level, zero-based budgeting might help you cut some costs by 20% or even more. But bringing a loss-making business back into profit might require more fundamental changes. In these cases, you should probably carry out a full strategy review first (e.g. you should address whether to completely drop unprofitable product lines or customer groups).

Once you’ve completed your review, you can proceed with zero-based budgeting in a way that is complementary to your improved top down strategy. Without the strategy review you might cut spending that is critical for the competitiveness of your business and thus do more harm than good.

So proceed carefully and only go ahead once you’ve identified a holistic plan that’s right for the unique circumstances of your business.

[1] https://www2.deloitte.com/us/en/pages/operations/articles/zero-based-budgeting.html [2] Pyhrr later elaborated on his concept in his book: Pyhrr, P. A. (1977) Zero-base Budgeting: A Practical Management Tool for Evaluating Expenses. John Wiley & Sons Inc. [3] https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/five-myths-and-realities-about-zero-based-budgeting