Zero Base thinking

ZERO BASE

ZERO BASE

John Stretch

How does it work?

Easy to define in concept, difficult to apply in practice, in a zero-based review everything an organisation spends is placed under the microscope and must be justified from scratch.

The review always starts from zero and requires the cost and benefit of every activity to be examined. There are no sacred cows.

Managers are challenged to justify their department’s existence, their activities, way of working, and their expenses. Or come up with a better alternative. They must re-look at their staffing, activities, projects and costs through new eyes with no reference to the past.

They need to ask “starting again in an ideal world, how would we go about this activity and to what would we give the highest priority”?

The practice came back into favour a few years ago when Brazilian privateequity firm 3G Capital used zero-base thinking to squeeze billion-dollar savings from food processor Kraft Heinz. But more of that later.

Zero-base budgeting first emerged in the 1970s when organisations asked managers to justify each line item in their budgets, and the underlying driver or activity, from scratch.

Zero base supporters have long questioned the merits of traditional budgeting, which they say involves increasing last year’s costs for volume and inflation.

Today, zero-based thinking can provide a structured and rational approach to cost management.

When done well, a zero base cost review can drive significant, sustainable savings and enable efficient resource allocation. But getting it right requires strong leadership to steer your people through their initial resistance.

The objective is to review and justify and control all planned expenditure so that money will only be spent if and when it is needed. The hoped-for outcome: costs will be based on the immediate needs of each department in the future and not on prior years’ or pre-COVID budget or expense level.

ZERO BASE

Resistance and trust

Successful implementation of zerobased thinking lies in convincing employees of the benefits. Companies with workers who place a lot of trust in upper management are more likely to succeed. Sponsorship from the top is essential.

Leaders need to move the hearts and minds of people in their organizations in the right direction. It can be

challenging for managers who have spent years investing and growing their business units, when expected funds are diverted elsewhere. People may say that in effect, they are being asked to re-apply for their own restructured jobs. They need to be convinced that zero base is less about cutting costs and more about value creation. Every Rand saved today will be reinvested in the future of the business.

Zero Base thinking is a tool for the control of everything a company spends money on It also applies in government and “not-for-profit” organisations, and doesn’t remove the need for detailed cost budgets.

Zero-base thinking can be applied everywhere - in direct manufacturing and sales operations, and to service and support departments.

Conflict and Control

The process usually creates conflict. You can’t expect every manager in the organisation to be happy to drop longstanding projects and let colleagues go, or to live easily with restrictive budgets that constrain every move.

After approval, even when everyone seems to be “on board”, the planned levels of expenditure need to be centrally enforced.

Control from the centre

Zero based budgeting – in the first year at least – must be followed by centralised authoritarian control of actual expenditure combined with detailed reporting and key performance indicators.

Without post-control, the whole process is a waste of time. Costs will creep up to previous levels and the credibility of the process will be lost.

A research report from Deloitte found that “poorly designed tracking and reporting” is a key factor in the failure of ZBB projects.

Renewed focus

The process requires a renewed focus on purpose, results and cost reduction. In a Zero Base world, past inefficiencies and legacy cost structures will be eliminated, changed or reduced. Creative thinking will result in a leaner, more agile business - a game changer when you are struggling to survive.

Long term and sustainable Zero Base savings result from clamping down on discretionary costs like travel and telephones, and also from doing things in different innovative ways. There is often an overlap between zero base thinking, technology and business process engineering.

For example, the banking industry have been automating their loan approval process aiming to eliminate human intervention. The whole "work from home" movement is a changed business process, a new approach to a traditional way of working. Zoom and Skype have impacted travel costs and the way we hold meetings.

Feasible choices

It’s also important to recognise that starting entirely from scratch is simply not feasible for most organizations. There will be pre-existing suppliers’ contracts, labour and union arrangements, entrenched (but not necessarily efficient and effective) business processes, and distribution channels that may take some time to re-design. Trade-offs will be required.

A caring culture

Zero-based budgeting challenges managers to answer the question: Can we do this better? Zero-based budgeting is much more than building a budget from zero. Good ZBB builds constant cost awareness throughout cost transparency, cost governance, cost accountability, and benchmarking. In this caring culture, people switch the lights off when they leave a room, keep their work areas and vehicles clean and tidy, empty their own waste baskets and conserve stationery, just as they would at home.

Prescribe the level of detail

The first goal in zero-based budgeting is to gain visibility into proposed spending. For example, for travel expenses, do you want budget owners to just plan the number of trips? Do you want to distinguish between domestic and international travel? How about meals and accommodation? Will you leave it up to the user to determine meal spending or develop a standard meal allowance? Think about all of the different nuances for the various cost categories, and issue standard working papers for managers to populate.

The key success factors in any zero-based budgeting project are

1. the original thinking in each department’s budget request,

2. the soundness of the adjudication process, and

3. the post-implementation controls.

Players

There are two player groups in the game: the department heads and the adjudicators. The people who do the spending (department heads) must have a chance to submit, motivate and defend their proposals for expenditure cuts, and another group are required to adjudicate these proposals, bring objectivity to the process, and make final decisions.

Consider the composition of the control group of adjudicators. They can be top managers, directors or stakeholders, or outside partners.

Shared Values

Whether you are a start-up or established business, involved in trading, construction, manufacturing, services, or contracting, your ZBB program builds a culture of cost management through shared principles and a common set of values.

These values are: all costs are visible and transparent, strong process governance , accountability for costs at all levels of the organization, incentives aligned to cost saving targets, and rigorous reporting, followup and control.

To achieve the benefit, the process must be professional, open and respectful. ZBB needs objectivity. In times of real crisis, a review of a company's spending processes and habits by external directors and consultants acting as benevolent dictators

– the Kraft-Heinz approachcan create more immediate value than doing it internally.

In the original US government version many years ago, the zero-base budget proposals were prepared by the department managers themselves, which took months and didn’t result in any cost reduction. Turkeys don’t vote for Christmas. Carter brought ZBB in, Reagan threw it out.

The 5 common sense steps for successful zero base thinking :

1. UNDERSTAND WHAT YOU ARE SPENDING NOW

1. Understand what you are spending now

Step 1 is to establish the facts - how much each department is spending now, on what, with which suppliers, for what purposes. You can’t do a Zero Base exercise without this information. Yet strangely enough, many companies can only partly answer these questions. Their accounting systems don’t break down costs in enough detail. You need more analysis to make your spending patterns visible and transparent.

2. Question everything you are doing now

1.1. Make all your costs visible

3. Decide what you want to change

4. Implement the changes

There are two possible sources you can use to begin establishing cost visibility: actual past results or your current budget for the year ahead.

5. Monitor to make sure it all happens

If you have a budget prepared over the past few months – pre or post lockdown – it will give you an insight into the organisation’s proposed spending at that time. If your budget isn’t in enough detail to work with, get budget owners to rework their budgets to the level of detail you need.

And while all this is going on, consult and communicate widely.

If you don’t have a budget, you need to build a data base of the past 12 months actual spending, by department and cost centre. It's backwards-looking but does give you a base to start with. You will need to spend time consolidating and cleaning data so that it's meaningful and actionable.

John Stretch

Integrity and consistency is paramount

The data is housed in a financial model. You can visualise a matrix of numbers – like a spreadsheet – with the departments and cost centres on one axis and the cost categories on the other, combining to give you the total actual or budget spending. As the project progresses, you will create an identical matrix, this time containing the new zero-base budget, then compare the two to establish the savings.

Smaller companies can do the exercise in Excel. Larger companies will need more sophisticated software.

You need to clean your data before you can work with it. Clever people figure out how to work the accounting system to hide their costs or charge them to other departments.

Investigate “Miscellaneous” or “General expenses” accounts with significant spend in them, and be alert for bad labelling - where the name of the account is not reflective of the costs in it.

The account coding may be inconsistent between departments and branches. For example, is the cost of an airfare to attend a training course charged to “training” or “travel”?

Also watch out for costs which are expensed in the system but are in fact prepayments, deposits, or inventory items. .

1.3. The level of detail

Accounting systems, even with drilldown capacity, do not reveal where, how, who, or why money is being spent. Costs sitting in buckets called Travel, Professional services, Training, Entertainment, Public Relations, need to be analysed down to individuals within each department, to identify the activities driving the expenditure.

1.4. How long does it take?

As long as you need to establish the truth. In every department and cost centre, and for every cost category (stationery, travel, training, maintenance, for example), you want to know

• Who controls the expenditure?

• Where is the money spent, on what goods or services, and who the major suppliers are?

• The reason for the spending

• The activities or events or cost drivers that create the need for spending.

Visibility is not just about financial information. The underlying drivers –the events and decisions that create and cause costs - are easier to understand and influence. For example, for travel, you should understand how many trips your organization takes, for what purpose and to which destinations..

For its recent ZBB project, pharmacy chain Walgreens set aside 16 weeks to assess its global cost base. “At the end of that 16 weeks, we will have enormous transparency and granularity, we will know who spends what on what. The ZBB team will develop deep visibility into costs and set detailed savings targets for the next budgeting cycle.”

Question everything you are doing now

2.1. Department heads will be required to:

•Explain how each line-item (general ledger account) in their department budget contributes to, and is necessary for, the department’s purpose and mission (Zero line-item thinking)

•Explain why each program or activity should exist, its benefits, perceived value and its costs (Zero service-level thinking)

2.2. Decide on your priorities

When deciding on priorities, the reviewers must question whether

• the organisation needs the particular activity at all

• the scope of the activity should be reduced (trim the fat)

• it should it should be done internally, or contracted out

• the same end result could be achieved in a more effective way.

• and – objectively – how much should it reasonably cost to deliver this service?

2.3. Benchmarking

For those organisations with a number of branches or similar operations, it’s very important to benchmark each cost item between business units, branches and departments right across the business, using the underlying business drivers for comparison – stationery costs per employee for example.

You may also be able to benchmark your spend against other companies in your industry, using information provided by an external partner. For example, facilities – how much are you paying per square metre for rent, rates, lights, teas and cleaning, and repairs across the business?

Benchmarking lets you set cost reduction goals and gives you a factual basis for negotiating reductions with business unit heads.

External partners – one of the big four accounting firms or big six consulting firms – have prior experience, bring objectivity to the process, and most important, can give you access to external benchmarking data.

2.4. Zero service levels

The focus in healthy organisations is normally on zero-line-item budgeting, looking at specific categories of cost. But the adjudicators are also required to look deeper and make some decisions in principle. This may be the right time to close down a struggling project or a new product about to be launched. Zero-service-level budgeting looks at activities as a whole. The adjudicators should stand back and consider different levels of future activity for every department and project:

• Close it down forever

• Mothball until the crisis is past

• Lights on – the minimum service level at which the department can still exist

• Current service level with zero base cost control

• Expanded level of activity, usually by taking over another department’s activities

Communicate the decision as soon as it’s taken.

Decide what you are going to change.

3.1. Certainty and uncertainty

Zero Base decisions are influenced by the degree of certainty you have about future revenue. In times of uncertainty, many companies order temporary cost freezes for items deemed non-essential, in order to avoid decisions with long term business impacts.

The scope of a ZBB exercise has to be based on a view of the future. Meet with your top team to review the state of the business, paint some scenarios, and agree a way forward.

This view provides the context for the ZBB exercise, helps you set priority cost categories for review, and determines the degree of intensity and direction of your ZBB.

It’s clearly vital to communicate what you are doing and why you are doing it, to staff at all levels. Good MD’s and CFO’s write regular e-mail letters and Zoom meetings with all staff.

The benefits from long-term supplier relationships are important in the "fat vs muscle" trade-off. With pressure on to meet the budget and cost reduction deadlines it's easy to adopt a "slash and burn" approach to cost cutting. Choosing a cheaper supplier with less reliability can destroy relationships that have taken years to build up.

The soft targets are usually the first to offer opportunities for revised approaches – advertising, travel, training, maintenance, consulting fees, communications. But beware – you may be throwing the baby out with the bathwater. Beware of interdependencies. Targeting selected service

departments only, will impact its internal customers.

At Boeing, investigators have questioned the quality controls and test intensity on flight software which led to the suspension of production of the 737 MAX, which remains grounded following two deadly crashes.

3.2. Volume decisions vs rate decisions

Where and what do you cut? Each line item needs to be justified in terms of its continued usefulness or necessity. You can cut a category of expenses like travel, or cut out an entire activity. To help with choosing where to focus spending and reductions it is helpful to put cost savings into two buckets: volume and rate.

Volume decisions are choices of less or more activity. Taking travel expenses for example, you could issue an instruction to reduce the number of car hire bookings by 30%. With less car hire transactions, some of the underlying activities tied to travel (customer visits, site inspections, employee training) just won’t happen.

Volume choices are often more difficult than rate choices.

Rate decisions continue an activity but at a lower cost. The activity continues (hopefully) in the same manner, but the organization pays a lower cost. Continuing the travel example, you might negotiate a preferred corporate rate with a car hire company lowering the cost of each trip. Therefore, the volume of trips continues at a lower cost.

The more rate savings initiatives the better since the organization doesn't have to reduce activity. Often rate decisions become new corporate policies. For example, you may create a policy that any airline tickets must be purchased within 14 days of travel to secure the lowest fare.

For each department prescribe the rules for who authorises, who reviews, who approves expenditure. Identify and clamp down where controls are slack. Have rules for emergencies where key people are not available. The team also ensures that systems and processes are in place for the detailed reporting, governance, and performance management needed for world-class ZBB. From a cultural standpoint, a company needs to ensure the tone is set from the top.

Leadership should meet with departmental managers to ensure they understand the importance of ZBB and are fully bought into the process. Leadership should allay staff concerns that the process will be time-consuming, and compensation will be tied strictly to the budget.

Instead, managers should understand that they’ll have the opportunity to motivate and justify their activities and projects, rather than have targets dictated to them from the top

When private equity firm 3G Capital bought ketchup maker H.J. Heinz in 2013, they implemented an aggressive form of ZBB that required managers to lay off people off and reduced investment in brand building, marketing, customer research and product innovation. Over the next two years Heinz dismissed 7,000 employees, closed six factories, and limited copier use to 200 pages per employee per month.

In 2017 3G announced that Heinz was the most profitable food company in its industry. Then in late 2019 the company suddenly announced a fourth quarter operating loss of $12.6 billion and wrote down the value of its Kraft brand by $15.4 billion, sending the share price down by 30%.

Aggressive cost reduction and stagnating sales played a key role in Heinz’s decline. While 3G was asking managers to justify paper clip expenses, its competitors were investing resources into product innovation and anticipating rapidly evolving consumer food trends.

“To keep up with shifts in consumer demand for food, you have to innovate. And to innovate you can’t use ZBB,” a competitor said.

Iron fisted monitoring and control

According to recent research by Deloitte, “poorly designed tracking and reporting” is a key factor in the failure of ZBB projects.

The purchase order and accounting systems need to track budget against actual throughout the year. Policy breaches and negative variances need to be clamped down hard. If they recur, find out the reasons and if necessary, change the policy.

You need to track non-financial compliance measures as well in your control monitoring. For example, you may have a list of preferred suppliers for certain legal services. You may need to track compliance with the preferred suppliers and take corrective action as needed.

Your learning from monitoring and controlling costs during this year will influence your approach to next year’s budget. Some areas of the organization may have fully embraced ZBB while others have not. Monitoring will highlight the opportunity areas, and the areas to watch, for next year.

About the author

John Stretch spent his professional career working with clients on financial planning projects, and presenting business education courses and workshops. He was a regular visiting lecturer at two of Africa's top business schools, the Wits Business School in Johannesburg, and the Graduate School of Business at the University of Cape Town, for over 20 years

Over the years he presented courses and workshops in Bahrein, Botswana, Dubai, Kuala Lumpur, Kuwait, Mozambique, Mauritius, Namibia, Singapore, South Africa, Swaziland, the United Kingdom and Zimbabwe.

Today he publishes online business education content, authoring and developing books, articles, short courses and case studies.

His books “The hidden balance sheet”, The power of foresight” and “Managing with rolling forecasts” are available on Amazon.com

www.johnstretch.com

stretch@global.co.za