Companies seeking better corporate governance increasingly need a structured approach to cost management with reduction and chargeback targets. These same companies are willing to implement OBZ in all areas, making the necessary investments in training, platforms, communication and change management.
What is Budget?
Before understanding what OBZ is, it is necessary to understand what a budget is and how important it is for a company.
Making a budget means planning the expenses, investment expenses and revenues of a company. The objective of the work is to evaluate the expected results and outline strategies to achieve goals taking into account the company's capacity and the economic scenario in which it is inserted.
One of its uses is for the calculation of free cash flow estimates necessary to implement the valuation model in the company and, most importantly, to assess the evolution of the company's value according to the established changes in the strategy.
Another important point of the budget is that through this tool it is possible to make financing/investment decisions for the execution of operational plans and provide a basis for a set of goals used to control expenses/costs and in the company's compensation plans.
What is Zero-Based Budgeting (OBZ)?
Zero-based budgeting (OBZ) is a budgeting method in which all expenses must be justified for each new period. The zero-based budgeting process starts from a “zero base”, and each function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the next period, regardless of whether each budget is higher or lower than the last.
What is the difference between OBZ and other budgets?
Usually, when budgeting their expenses, companies take into account the average expenses of the last years. This methodology is based on automated assumptions and does not eliminate excesses of good results and/or eventual mistakes from the past.
The Zero-Based Budget does not take into account the average expenses of the company in recent years, but budgets each cost center individually.
In the budget period, each area details all expected expenses, therefore starting from scratch and avoiding waste. In this way, managers do not fall into the comfort zone and thus it is possible to verify the excesses and the real needs for the company's operation.
This methodology is focused on cost reduction, the allocation of resources is based on objectives and goals seeking a careful evaluation of expenses, eliminating the feeling of infinite money that often exists in organizations.
The Zero-Based Budget methodology relies on two fundamental premises:
- A good budget should ensure the company's survival in the worst-case scenario and be able to take advantage of the opportunities arising from the best-case scenarios.
- Total fixed expenses should be close to the company's contribution margin in the worst case scenario. It is important for the company to define what is the worst possible scenario, but not necessarily a catastrophic scenario.
In addition to identifying unnecessary expenses, it is possible to eliminate unnecessary procedures, allowing resources to be directed to what is, in fact, important in the organization.
However, it is important to emphasize that the elaboration of a Zero Base Budget demands time, dedication and training of the team to have the necessary information for its elaboration.
After the budget, it is necessary to have effective control tools versus budgeted, setting reduction targets and seeking to engage the team in the new budget culture.
When to use OBZ
In newer companies, there's no escaping the OBZ. As there is no history, the only alternative to carry out the company's first Budget Planning is to start from a zero base and project the Revenues, Costs, Expenses and Investments based on your Business Plan and growth estimates.
In more consolidated companies, the ideal is to carry out a round with the Zero Base Budget every three or five Budget Cycles. For example, if your company carries out the Budget on an annual basis, a good alternative is to carry out the third with a Zero Base every two Historical Base Budgets. If the company carries out the Budget every six months, a good approach is to perform a Zero Base Budget round every four Historic Base Budget rounds.
Thus, we were able to combine the gains generated by the OBZ, with the ease and agility of using the history of previous years to base the budget.
But before defining the type of budget, it is necessary to understand the Economic Scenario in which your company is inserted, taking into account factors such as the volatility of the operating market, speed of change in legislation that governs the sector and even the dynamics of changes in behavior of your company's consumers, and thus choose when and how to use the methodology, always focusing on obtaining the best financial results for the organization.
How to apply the Zero-Based Budget (OBZ) in your company
A very common mistake is to believe that the OBZ only applies to Expenses and Expenses. On the contrary, the methodology can be useful and generate great gains at any stage of Budget Management, such as:
- Sales projection: when preparing the Sales Budget for the next period, it is common for commercial management to just replicate the results of the last year, applying a percentage of growth. This is an error that prevents a more detailed analysis of the Distribution Channels the company operates, missing opportunities to open new channels or even discontinue channels that are not performing well. The same goes for the Products marketed, which may be generating bad margins and even losing opportunities to increase the product line with more profitable items in line with market demand.
- Projection of Sales Deductions: here it is worth the detailed analysis of the Taxes paid, verifying if it is not feasible/advantageous for the company to act with another tax regime or if there are alternatives for tax credits or some other way to reduce the tax burden. There is also space to analyze Sellers' Commissions, in addition to analyzing the returns to check that there are no “swells” or anything that can be improved. Remember that as these percentages are applied to Gross Revenue, any small percentage reduction can generate large savings in Reais.
- Variable costs: many times the company assembles the technical sheets of its products, selects some suppliers for the raw materials and inputs and never comes back to check if there are alternatives to reduce production costs by exchanging raw materials for more economical alternatives that do not reduce the quality of the final product or even with the improvement of the production process.
- Personnel expenses: regardless of the company's size or sector, Personnel Expenses are usually one of the most representative expenses. AND the larger the company, the more inefficient the allocation of people becomes. At these times, the application of the OBZ can help to find gaps in areas of the company that are in need of personnel and, at the same time, underutilized employees. Bearing in mind that improving the efficiency of Personnel Expenses does not only mean reducing the staff (fire), but also allocating the company's human resources more effectively, in functions and activities that generate greater value.
- Operational expenses: you know that service paid every month, that nobody knows what it's for or who hired it? This is usually an effect of the Historic Budget, which replicates expenses from year to year and that the Zero Base Budget (OBZ) appears as the perfect solution for the cuts. After all, if the expense is really necessary, someone will soon appear to “claim it”.
- Operating Investments: the same is valid for the purchase of machinery, equipment, furniture, utensils, etc. The acquisitions must have a specific destination and the acquired assets have the function of supporting the operation and providing a basis for the company's growth. If the items aren't aligned with the strategy, they might not be that necessary.
Zero-based budget example
Suppose a construction equipment company implements a zero-based budgeting process requiring a closer scrutiny of manufacturing department expenses. The company finds that the cost of certain parts used in its final products and outsourced to another manufacturer increases by 5% each year. The company can make these parts in-house using its workers. After weighing the strengths and weaknesses of in-house manufacturing, the company discovers that it can manufacture the parts cheaper than the outside supplier.
Rather than blindly increasing the budget by a certain percentage and masking the cost increase, the company may identify a situation where it may decide to make the part itself or buy the part from the outside supplier for its final products.
Traditional budgeting may not allow identification of cost drivers within departments. Zero-based budgeting is a more granular process that aims to identify and justify spending. However, zero-based budgeting is also more complicated, so the costs of the process itself must be weighed against the savings that can be identified.
Advantages of Zero-Based Budgeting (OBZ)
One of the biggest advantages in the use of the OBZ is in the easy identification of unnecessary Expenses and Costs in companies that are based on history. By having to carry out the budget from scratch, the manager is obliged to analyze each Cost and Expense in detail, eliminating what is not necessary and freeing up the budget to invest in other points that could go unnoticed.
In addition, the Zero-Based Budget generates a huge expansion of the Strategic Vision of all managers in the organization, after all, each one will need to understand what the company's macro plans are to prepare its departmental plans and identify the resources (budget) that it will need to put these plans in place.
Other advantages and benefits generated by the methodology for your company are:
- Allows allocation of resources much more efficiently;
- Assists in the detection of inflated budgets;
- Eliminates processes that do not add value;
- Increases the motivation of managers by giving greater autonomy and responsibility for decision-making;
- Improves communication and coordination within the organization.
Disadvantages of Zero-Based Budgeting (OBZ)
As it is a strategic tool, the negative side of this methodology is that the process ends up demanding greater involvement of all department managers in the company. it ends up generate the need for greater dedication of time of all employees to prepare the budget.
The OBZ also forces the entire company (both the Planning and Controlling area and department managers) to leave their comfort zone. Depending on the company, this can generate a series of conflicts and several challenges to overcome existing cultural barriers.
In summary, the main challenges in carrying out the Zero-Based Budget are:
- More time consuming than traditional budgeting;
- It leads managers to think about (and justify) each budget item;
- Specific training of managers is required;
- It requires a higher level of honesty on the part of managers and trust on the part of management;
- In a larger organization, without an adequate Budget Management tool, the process involving many managers and huge amounts of information can be quite challenging.
History
The accounting manager of Texas Instruments , Peter Pyhrr created zero-based budgeting to facilitate the incorporation of high-level strategic objectives into the budgeting process, linking them to specific functional areas within the organization. Under their system, costs are pooled and measured against past results and current expectations, allowing management to allocate funds by current need rather than historical spending.
Author of Zero Based Budgeting: A Practical Management Tool for Evaluating Expenses , Pyhrr was appointed by the then governor of Georgia Jimmy Carter to manage the state budget process.
Use in the public and private sectors
Background
Zero-based budgeting in the public sector and the private sector is a different process. “The use of ZBB in the private sector has been mostly limited to general administrative activities (ie administrative expenses necessary to maintain the organization). In the United States, zero-based budgeting was developed in 1969 at Texas Instrument Inc. Jimmy Carter, then governor of Georgia, was the first to adopt the government's zero-based process for the 1973 fiscal budget. Three years later, sponsored by the president and Congress, the federal government for the first time implemented zero-based budgeting in the Act. of 1976 Economic Reform and Government Expenditure.
President Carter later called for the adoption of ZBB by the federal government during the late 1970s. “Zero-Based Budgeting (ZBB) was an executive branch budget formulation process introduced in the federal government in 1977. optimize results available at alternative budget levels. Under ZBB, agencies were expected to set priorities based on program outcomes that could be achieved at alternative spending levels, one of which was being below current funding.”
For most of the US government, the main users of OBZ are the legislative, executive and agency. The legislature includes Congress, the Legislative Assembly and the City Council, and they require more summarization and focus on public priorities and objectives. Agencies include the agency director and department managers and require more detailed information and focus on program implementation and efficiency. Finally, the executive includes the president, governors, mayor/city manager and they focus on the needs of the legislature and the agency. [4] While the legislature, agency, and executive have different focuses, they all need to address two standard questions:
- Are current activities efficient and effective?
- Should current activities be eliminated or reduced to fund new higher priority programs or reduce the current budget?
According to Peter Sarant, 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 that every program or activity be justified from the beginning. This is not true; the acronym ZBB is a misnomer. ZBB is a misnomer because in many large agencies a complete zero-based review of all program elements during a budgetary period is not feasible; would result in excessive bureaucracy and would be an almost impossible task if implemented.” In many ways, the aforementioned “common misunderstanding” of OBZ more closely resembles a “temporary review” process than a traditional public sector OBZ process.
Components of a public sector OBZ analysis
In an overview of zero-based budgeting, there are a total of three elements that make up the concept:
- Determination of the Decision Unit: the process of building the formulation of a budget structure.
- Decision Package Formulation: When compiling and packaging a quote request, this is the mechanism used.
- Ranking: This process requires more attention as it requires a company's manager(s) to prioritize a group of decision packages that are presented to them.
In general, three components make up the public sector OBZ:
- Identify three alternative funding levels for each decision unit (Traditionally this has been a zero base level, a current funding level and an enhanced service level);
- Determine the impact of these funding levels on program operations (decision unit) using program performance metrics; It is
- Rank the program's “decision packages” for the three funding levels.
In many cases, program staff were asked to look for alternative service delivery models that could deliver services more efficiently at lower funding levels.
O US General Accounting Office (GAO) reviewed previous performance budgeting initiatives in 1997 and found that the main focus of OBZs was to optimize available achievements at alternative budget levels:
Set priorities based on program results that could be achieved at alternative spending levels, one of which would be below current funding.
- When developing budget forms, these should be sorted sequentially from the lowest level organizations down to the department and without reference to a previous base.
- In concept, the OBZ sought a precise link between budgetary resources and program results.”
Additionally, ZBB illustrated the usefulness of:
- Define and present alternative funding levels; It is
- Expanding the participation of program managers in the budget process.”
The OBZ federal budget system had the following components: “Budget requests for each decision-making unit were to be prepared by its managers, who (1) would identify alternative approaches to achieving the unit’s objectives, (2) identify several alternative levels of funding, including a “minimum” level typically below current funding, (3) prepare “decision packages” according to a prescribed format for each unit, including budget and performance information, and (4) rank decision packages one by one. against others.”
The OBZ was officially eliminated from the federal budget on August 7, 1981. “Some participants in the budget process, as well as other observers, attributed to the OBZ certain program efficiencies arising from the consideration of alternatives. The OBZ has established in the federal budget a requirement for:
- Present alternative funding levels; It is
- Link (them) to alternative outcomes.”
This element of the OBZ budget process remained in place through the Reagan, Bush, and Clinton administrations before being phased out in 1994.
Defining the zero-based government program
As noted earlier, there is often considerable confusion about the meaning of zero-based budgeting. There is no evidence that the public sector ZBB included “creating budgets from the bottom up” and “reviewing each invoice” as part of the analysis. In ZBB discussions, there is often confusion between a ZBB process and a closure review process. In a final review, the entire function is eliminated unless evidence of program effectiveness is provided. This confusion eventually leads to the question: what is a zero base?
Sarant's definition of zero-based based on federal training experience is: “A minimum level is the level of base funding needed to keep a program alive. Therefore, the minimum level is the “program or funding level below which it is not feasible to continue a program… because no constructive contribution can be made to fulfill its objective.” Identifying this level of program funding has been subjective and problematic.
Consequently, “some states have selected arbitrary percentages to ensure that an amount less than last year's order is considered. They do this by stipulating that an alternative must be 50, 80 or 90% from last year's order." This is equivalent to looking at the impact on program operations of a 10, 20, or 50 percent reduction in funding as the “zero-based” funding level.
Importance of performance measures
Performance measures are a key component of the ZBB process. In essence, 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 won't work because decision packages cannot be ranked. To perform a ZBB analysis “alternative decision packages are prepared and ranked, thus allowing for marginal utility and comparative analysis”.
Traditionally, an ZBB analysis has focused on three types of measures. “They (federal agency program staff) should identify key indicators to be used in measuring performance and outcomes. These should be “measures of:
- efficiency,
- efficiency, and
- workload for each decision unit.
Indirect or proxy indicators could be used if such systems did not exist or were under development.”
Impact on government operations
According to the GAO, “the agencies believed that there was not enough time to implement the new initiative. The requirement to compress planning and budgeting functions within budget cycle timeframes proved especially difficult, affecting program managers' ability to identify alternative approaches to achieving agency objectives. Some agency officials also believed that the performance information needed for the OBZ analysis was missing.”
Furthermore, according to the National Conference of State Legislatures: “In its original sense, ZBB meant that no past decision is taken for granted. All past budget decisions are under review. Existing and proposed programs are on an equal footing, and the traditional state practice of changing almost all existing budget lines by small amounts every year or two would be eliminated. No state government has ever considered this feasible. Even Georgia, where Governor Jimmy Carter introduced ZBB into the state budget in 1971, employed a greatly modified form.
State programs are not, in practice, amenable to such radical annual review. Bylaws, obligations to local governments, federal government requirements, and other past decisions have often created state funding commitments that are nearly impossible to change much in the short term. Education funding levels are determined in many states in part by state and federal court decisions and state constitutional provisions, as well as statutes. Federal mandates require that state Medicaid funding meet a specific minimum level for Medicaid to exist in a state. Federal law affects spending on environmental programs, and both state and federal courts help determine state prison spending. Many state expenditures, therefore,
To the extent that ZBB has encouraged governors and legislators to look closely at the impact of incremental changes in state spending, it has produced a significant improvement in the state budget. But in its classic form – start all budget assessments from scratch – ZBB is as impractical as it ever was.”
Use in the Chinese public sector
The ZBB concept was first introduced in China in the early 1990s and was mainly focused on the area of Hubei Province, China. Just as the United States encountered many problems and failures with the ZBB, so did China. But even with the numerous problems and failures along the way, they have gradually adjusted accordingly since then to become more effective in using ZBB as budgetary reform. Western influence on the budget was non-existent in China prior to 1993. It was during the 1990s that China began to look for a new, modern form of budgeting for its country's national budget reform. They ended up settling on ZBB. A new policy was established to put ZBB into action, known as DBR, or Departmental Budget Reform. DBR and ZBB were first implemented in Hubei Province, China. According to Jun Ma, a professor at the University of Nebraska, the first few years of the ZBB in Hubei were a bit difficult as the DBR had not yet been implemented in all Hubei state departments. Only a few departments have implemented the budgeting system, and the results of several departments using various budgeting systems have not been good. Gradually it became clear that using ZBB in the traditional sense would not work. Hubei Province and DBR officials began looking for ways to incorporate the best parts of ZBB and form a new budget system that would meet their needs. The result of this change was a Chinese-style target-based budgeting system. This form of budgeting required bureaucracies and agencies to present a simple budget within a pre-established deadline. TBB, as a modified form of ZBB,
Issues ranging from the absence of a unified budget and certain expenditures that are somehow exempt from the OBZ process, to the influence or effects of political factors have been widely noted.
- Absence of budget unification – Although Hubei Province has developed a complete budget by combining off-budget expenditures and revenues into the budget, there are still certain types of expenditures that are still under the control of certain individuals other than the government's Department of Finance. Because of this, the difficulty of prioritizing all possible government programs becomes confusing.
- Influences of Political Factors - No matter what the term is or whose mandate it is, politicians have always had a certain plan or change that they would like to implement that would greatly influence the ZBB prioritization process. Certain political officials might say that they are very supportive of a particular program and would like the Finance Department to focus more money on that particular program, while other political officials would think otherwise. Therefore, any real changes or improvements will always face opposition unless they have unified political support.
- Expenditure Exemptions – Ranging from operating and staffing expenses to unfunded central government policies that start after the budget year, these are just to name a few things that are excluded from the ZBB process. By not including much of the spending in the ZBB process, the potential effectiveness of these reforms is greatly reduced.
Two notable reforms to the OBZ process include the submission of budget requests by departments and the use of expiry legislation.
- Budget Requests – These requests must reflect (1) a cut by a certain percentage, (2) the current level of spending, and (3) an increase by a certain percentage. This allows for the opportunity for trade-offs between departments of funding from a lower priority in one department to a higher priority in another.
- Sunset Legislation- This process puts a sense of urgency on certain programs implemented or currently being funded, as that program must be put under review to determine efficiency and effectiveness and to see if the public or government needs this program.
Use in the private sector
3G Capital has had success using ZBB in his company. Carlos Brito , protected from Jorge Paulo Lemann , “brought to the Anheuser-Busch the concept of 'zero-based budget', always supported by consultancy and best practices by consultant Vicente Falconi, from the consultancy that bears the same name. Which is defined by where each expense must be justified anew each year, not just the new ones, and the goal is to reduce it in the previous year” on Anheuser-Busch InBev as early as the 1990s. After its decade of lessons in ZBB, 3G Capital employed similar cost management concepts in its next acquisitions: Burger King , Tim Hortons , Heinz , Kraft Foods and Popeyes Louisiana Kitchen. The use of OBZ may have continued the subjective notion that this style of budgeting is a solution for companies trying to lighten the load of a new company. This concept has triggered measures as drastic as cutting hundreds of clerical jobs and scrapping corporate jets, even requiring employees to ask for photocopies. After the merger of Kraft and Heinz in 2015, some analysts and former employees blamed 3G Capital's use of ZBB for the company's poor performance.
OBZ's impact on shareholders
According to the Accenture , “examples of companies that successfully implemented ZBB… include a consumer goods company that managed to save 18% and a 20% increase in share price. Another case was that of a prominent commercial bank, which unlocked a large sum of money and reinvested it in 'going digital', and a healthcare company, which achieved savings of £1.2 billion (€1.36 billion) per three years." As a result, companies are vocal about using ZBB programs in their earnings calls, including Mondelēz International , Campbell Soup Company , Kraft Heinz , Anheuser-Busch InBev and Tesco . In its results for the first half of 2017, the Unilever even reported that ZBB was improving its marketing productivity and streamlining its advertising spend, while reducing overhead costs that didn't add much value. In another case, the use of ZBB within 3G Capital was profitable for shareholders. When 3G Capital quickly cut Kraft's costs, its share price rose by 36% as a direct result. That kind of budget allowed companies like Kraft to compete on price again with some of the leaner competitors who had previously lowered Kraft's prices. Zero-based budgeting helps more money flow to shareholders than to unused departments, overfunded programs, and wasteful spending habits.