Zero-based budgeting


Zero-based budgeting is a method of budgeting in which all expenses must be justified and approved for each new period. Developed by Peter Pyhrr in the 1970s, zero-based budgeting starts from a "zero base" at the beginning of every budget period, analyzing needs and costs of every function within an organization and allocating funds accordingly, regardless of how much money has previously been budgeted to any given line item.

History

As an accounting manager for Texas Instruments, Peter Pyrrh created zero-based budgeting to facilitate the incorporation of top-level strategic objectives into the budgeting process by tying them to specific functional areas within the organization. Under his system, costs are grouped and measured against previous results and current expectations, enabling management to allocate funds by current need instead of by historical expenditures.
Author of Zero Based Budgeting: A Practical Management Tool for Evaluating Expenses, Pyhrr was appointed by then-Georgia governor Jimmy Carter to manage the state's budgetary process.

Advantages

  1. Accuracy: This type of budgeting helps companies to look over every department to make sure they are getting the correct amount of money.
  2. Efficiency: It helps judge the actual needs by focusing on current numbers instead of past budgets.
  3. Reduction in wasteful spending: It can remove redundant spending by re-examining potentially unnecessary expenditures.
  4. Coordination and Communication: It allows for better communication within departments by involving employees in decision-making and budget prioritization.

    Disadvantages

  5. Bureaucracy: Creating ZBB within a company can take enormous amounts of time, effort, and analysis that would require extra staff. This could cause the process to be counterproductive in cutting costs.
  6. Corruption: In using ZBB, managers could attempt to skew numbers to make expenditures into vital activities, thus creating a "need" for them. This would cause companies to continue wasting money on things they don't need.
  7. Intangible Justifications: This type of budgeting requires departments to justify their budget, which can be difficult on many levels. Departments such as advertising and marketing 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.
  8. 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.
  9. Slower Response Time: Due to the amount of time and training is required to do ZBB, managerial staff could be less likely to revise the budget in response to a changing market. This means that it will take longer for a company to move money into departments that need it the most at the time. ZBB could potentially leave gaps in a company because the budget might not react to departments' sudden needs.

    Use in public and private sectors

Background

Zero-based budgeting 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. 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 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.
President Carter later required the adoption of ZBB by the federal government during the late 1970s. "Zero-Base Budgeting was an executive branch budget formulation process introduced into the federal government in 1977. Its main focus was on optimizing outputs 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."
For most of the United States 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. 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 reduce the current budget?
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." 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: the building process of the formulation of a budget structure.
  2. Decision Package Formulation: when compiling and packaging a budget request, this is the mechanism is utilized.
  3. Ranking: this process requires the most attention as it requires a company's manager to prioritize out of a group of decision packages that are laid out to them.
In general three components make up public sector ZBB:
  1. Identify three alternate funding levels for each decision unit ;
  2. Determine the impact of these funding levels on program 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 levels.
The US General Accounting Office 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."
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 identify alternative approaches to achieving the unit's objectives, identify several alternative funding levels, including a "minimum" level normally below current funding, prepare "decision packages" according to a prescribed format for each unit, including budget and performance information, and rank the decision packages against each other."
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. ZBB established within federal budgeting a requirement to:
  1. Present alternative levels of funding; and
  2. Link to alternative results."
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 the grassroots 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." 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 is considered. They do this by stipulating that one alternative must be 50, 80, or 90 percent of last year's request." This equates to analyzing the impact on program operations of a 10, 20 or 50 percent reduction in funding as the "zero bases" 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."
Traditionally, a ZBB analysis focused on three types of measures. "They 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."

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."
Also, according to the National Conference of State Legislatures:, "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 the Chinese Public Sector

The concept of ZBB was first introduced to China at the beginning of the 1990s and was primarily focused in the Hubei Province area of China. Just as the United States encountered many problems and failures with ZBB, China ran into them as well. But even with the numerous problems and failures along the way, they have gradually adjusted appropriately since then to become more effective in using ZBB as a budget reform. Western influence on budgeting was non-existent in China before 1993. It was during the 1990s that China began looking out for a new and modern form of budgeting for their country’s nationwide budget reform. They ended up settling on ZBB. A new policy was set in place to put ZBB into action, known as the DBR, or the Departmental Budgeting Reform. The DBR and ZBB were first implemented in the Hubei province of China. According to Jun Ma, a professor at the University of Nebraska, the beginning years of ZBB in Hubei were a bit rocky as the DBR had not yet been implemented into all the state departments in Hubei. Only a few departments implemented the budgeting system and the results of multiple departments using multiple budgeting systems were not good. It slowly became clear that using ZBB in a traditional sense would not work out. Officials in the Hubei province and the DBR began looking for ways to incorporate the best parts of ZBB and form a new budgeting system that would work for their needs. The result of this change was a Chinese-styled Target-Based Budgeting system. This form of budgeting required bureaucracies and agencies to submit a simple budget within a pre-set time limit. TBB, as a modified form of ZBB, has worked out moderately well for the Chinese government in Hubei over the years, but many problems still face the budgeting system.
Some number of issues ranging from the absence of a unified budget and certain expenditures that are somehow exempt from the ZBB process, to the influence or effects of political factors have been widely noted.
  1. Absence of a Budget Unification- Though the Hubei Province has developed a thorough budget by combining expenditures and off-budget revenues into the budget, there yet remains certain types of expenses that are still under the control of certain individuals other than the government Finance Department. Because of this, the difficulty of prioritizing all the possible government programs becomes confusing.
  2. Political Factor Influences- No matter what the term or whose term it is, political officials have always had a certain plan or change that they would like to implement that would greatly influence the prioritizing process of ZBB. Certain political officials could say they greatly support a certain program and would like the Finance Department to focus more money on that particular program whilst other political officials would think otherwise. Therefore, any real changes or improvements made will always face opposition unless they have unified political support.
  3. Expenditure exemptions- Ranging from operating and personnel expenses to central government policies that are unfunded that start after the budget year, these are just to name a few things that are excluded from the ZBB process. By not including a large portion of spending into the ZBB process, the effectiveness potential of these reforms becomes greatly reduced.
Two notable reforms to the ZBB process include having departments submit budget requests and the use of sunset legislation.
  1. Budget requests- These requests are to reflect a cut of a certain percentage, current level of spending, and an increase of a certain percentage. This allows the opportunity of trading between departments of the funding of a lower priority of one department to a higher priority of another.
  2. Sunset legislation- This process places a sense of urgency on certain programs implemented or that are currently being funded as that program shall be placed under review to determine efficiency & effectiveness, and see whether the public or government need this program.

    Use in Private Sector

has become successful using ZBB within their company. Carlos Brito, a protege of Jorge Paulo Lemann, "brought to Anheuser-Busch the concept of “zero-based budgeting,” wherein every expense must be newly justified every year, not just new ones, and the goal is to bring it lower than the year prior." at Anheuser-Busch InBev as early as in the 1990s. Following their decade of lessons in ZBB, 3G Capital employed similar cost management concepts at their next acquisitions: Burger King, Tim Hortons, Heinz, Kraft Foods, and Popeyes Louisiana Kitchen. The use of ZBB might have continued the subjective notion that this budgeting style is a fix-all for businesses trying to lighten the load of a new company. This concept triggered measures as drastic as cutting hundreds of management jobs and jettisoning corporate jets, to as simple as requiring employees to ask to make photocopies. Following the 2015 merger of Kraft and Heinz, some analysts and former employees blamed 3G Capital's use of ZBB for the company's poor performance.

Impact of ZBB on stockholders

According to Accenture, "examples of companies that have successfully implemented ZBB...include a consumer goods company that was able to achieve 18 percent savings and a 20 percent increase in the 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 that achieved savings of £1.2bn for three years." As a result, companies are vocal about their use of ZBB programs in their earning calls including Mondelēz International, Campbell Soup Company, Kraft Heinz, Anheuser-Busch InBev and Tesco. In its 2017 first-half results, Unilever even reported that ZBB was improving its marketing productivity and streamlining its advertising spend, while also reducing overhead costs that weren’t bringing much value. In another case, the use of ZBB within 3G Capital has been profitable for stockholders. When 3G Capital quickly cut costs within Kraft, their stock prices increased 36% as a direct result. This type of budgeting enabled companies like Kraft to compete again on price with some of the leaner competition, that had previously undercut Kraft's prices. Zero-based budgeting helps more money to flow to stockholders than into unused departments, over-funded programs, and wasteful spending habits.