Published: 01 July 2020
Analyst(s): Stewart Buchanan
Zero-based budgeting is increasingly imposed by executive leaders to rebudget existing costs, because business cases are needed only for new project spending. But the way many organizations apply ZBB to cost often misses the realization of business value. Without value, cuts must continue.
Executive leaders and their teams struggle with the workload of applying zero-based budgeting (ZBB) to every item of spending, and risk driving poor business outcomes for their organization.
Some teams still view costs as absolute, while others see cost as controlled by separate supply chain, procurement and vendor management teams who have already negotiated hard with suppliers.
Unfocused ZBB exercises risk becoming opportunistic, seeking out any opportunity to spend less without concern for the business impact. Business users are rarely consulted about the value of spending.
Business units deprived of valuable technologies may have no choice but to source them independently of the IT budget, often with less control over cost, and sometimes at far greater cost to the enterprise.
As an executive leader who needs transparency in planning and budgeting, you should:
Adopt value-based budgeting (VBB) in the budgets you oversee by deliberately targeting spending to maximize the flow of business value. Prove VBB effectiveness at funding innovation and growth without waiting for permission.
Prioritize spending at a business level, not at the line item purchase level by budgeting for expensive inputs, but by budgeting for the most valuable business outcomes.
Build a team of executive sponsors that hold business leaders accountable for identifying and reducing budget for low-yield business activities, for redirection to the most valuable opportunities.
Develop dynamic budgets for business-driven costs by iteratively reconciling outgoings to the income they enable. Focus on inbound investment and other initial sources of income ahead of the resulting revenue.
Organizations that budget by business value instead of cost will enable over 30% more profitability or market share growth than cost-focused zero-based budgeting by 2023.
Executive inquiries about ZBB have nearly doubled since last year, and they often reveal misunderstandings. ZBB regularly comes up in discussions about cost optimization. Yet only half of organizations implementing ZBB have realized the savings or margin improvements they anticipated (see ). This is not only due to implementation, but also because of a fundamental misunderstanding about ZBB.
Value-based budgeting is more clearly defined and intuitively understood. Budgeting to deliver value can take the form of a value stream, as shown in Figure 1. A traditional linear value stream is depicted as an arrow containing all the necessary resources and organizational structures. The net outcome is far more important than how the inputs are organized, as shown by the income and outgoing arrows below.
Gartner is often asked where to start with ZBB, because it is a concept more than a methodology. The concept starts from zero with an empty spreadsheet, without assuming that any previous expenditure will be continued. This breaks with the traditional way many organizations budget for last year’s costs, plus an allowance for growth or a reduction by some arbitrary savings target. Budgeting works best when organizations deliberately choose what to spend on the business results or strategic outcomes they want.
Unfortunately, the name “zero-based budgeting” seems to be the cause of many misunderstandings. ZBB is sometimes criticized as a fantasybecause many costs cannot be reset to zero at the start of a new budgetary period. That’s because most organizations make contractual commitments to pay employees and suppliers during future periods. Purchasing and supply specialists are often given incentives to make large, long-term cost commitments in return for a lower price they can recognize as a cost saving. This cost saving doesn’t necessarily facilitate or result in a budget reduction.
Distracted by past spending commitments, ZBB can then degenerate into a search for ways to spend less. This often shifts focus away from budgeting for results to purchasing and supply. These specialist roles manage external providers to avoid conflicts of interest in many enterprises and government agencies. Gartner categorizes the following approaches as “buy smart”:
Procurement-led approaches start with vendor contracts and invoices.
Category management analyzes expenditure by category to develop strategic sourcing plans.
Service sourcing approaches focus on service management comparisons with external providers.
Process sourcing compares internal business processes against outsourced provider offerings.
Vendor management approaches challenge suppliers to justify the value delivered on expenditure.
Even when clients consider smarter spending, they use the term “ZBB” in increasingly diverse or ambiguous ways. Underfunded clients are using ZBB to justify spending more, not less, for example. Gartner believes it’s time to introduce a more targeted term for clarity. Value-based budgeting (VBB) has been used by organizations such as Sydney Water and in many countries worldwide. This research explores how to implement best practices in the evolution of ZBB into VBB through technology expenditure examples.
A common misunderstanding about ZBB is that it requires a full business case for every single item of expenditure in the budget. It’s extremely difficult to cost-justify spending outside its full business context. This sad case of “a business case for every item” is expensive. In some organizations, it can take as much effort and resources to develop a business case for approval as to implement it to deliver actual benefits.
Even with external help, ZBB for every line item creates a daunting amount of work for everyone involved, including the expenditure review board or investment committee. An excessive ZBB workload can then result in dangerous delays such as the postponement of value-enabling activities and new revenue streams. Failure to innovate should never be an unintended consequence of ZBB.
A common way to reduce the overhead of ZBB is to focus on selected items to rebudget. Unfortunately, many organizations continue with the same cognitive biases. They select the same areas for budget reduction, which deliver diminishing returns. VBB can be more effective because it spans functional and organizational silos. Only one value map, business case or business plan is needed for one value stream. Some organizations simplify this mapping further, as shown in Figure 2. They budget for the cost and value contribution of shared services such as HR, IT and finance directly within the value stream.
Personnel costs can be totaled independently of the business units that employ them, for example.
Business leaders only become stakeholders when the financial stake they have in these services is identified. If business stakeholders fail to sponsor valuable services, they risk cuts damaging their business performance. Without the help and support of business stakeholders, the leaders of shared services cost centers would have to work a lot harder on budget explanation and justification. The workload is lighter when shared with business leaders who engage, lobby for and justify budget spent valuably on their behalf. VBB budgets for the level of expenditure at which the business creates the most value. This is how VBB creates the least extra work of all ZBB approaches. VBB maximizes realizable business value.
Some enterprises treat ZBB as a competitive sport, like a competition for limited financial resources between different roles or silos and their executive sponsors. Business unit leaders with a good understanding of the costs in their value chain find it easier to make a business case for their line of business. Shared services leaders find it harder to explain the need for indirect costs outside their business context. A central committee or group of executives typically sits in judgment to approve or reject budget requests and business cases. The existing balance of power on that committee is unlikely to result in a change in spending priorities or approach, so additional experts will need to be appointed.
Every team or committee needs a leader or chairperson, but that person should facilitate, rather than dominate, budgetary effort. Some enterprises turn ZBB into an inquisition, led by a chief prosecutor in cost cutting who achieves results in only one of the following domains:
Financially led approaches focus on budget variance and benchmarking against other organizations.
Supply chain and purchasing experts review spending with external suppliers and their contracts.
HR approaches examine requirements for talent and the way it is organized across the enterprise.
Asset-management-led approaches tend to focus on inventory, utilization and maintenance costs.
Process management targets the standardization, downskilling and efficiency of business processes.
Enterprise architecture examines design choices, while program management optimizes execution.
Technology specialists are needed to focus on areas that require high levels of domain expertise.
Constantly repeating the same effort in one individual area is unlikely to yield better outcomes. Combining disciplines enables shared data to be analyzed and optimized together within a multidisciplinary team. Experts in value, ideally from business-related disciplines, are often underrepresented. Narrow approaches can create false savings that move costs or create additional costs elsewhere in the enterprise. To avoid false economies, VBB activity must take an enterprisewide 360-degree view of the income from expenditure.
Other ZBB approaches can cut value, not just spending. When an item of expenditure is cut, so are the benefits of that item. This loss of value can result in further cuts and a spiral of decline. VBB focuses on value in relation to cost, sometimes described as value for money. VBB is sometimes criticized as inapplicable to nonprofit organizations, but this is where VBB is needed the most. It is written into the constitution of many nonprofits that budgeted spending must align with their mission and enable measurable value objectives.
Executive leaders don’t need enterprisewide agreement to start taking their own steps in VBB. Every leader can start taking action now to stop their budgets becoming a repeat victim of costs that are driven elsewhere, beyond their control and without concern for value:
Develop joint teams that take collective control of costs, rather than span multiple budgets.
Demand participation in your budget, even if other decision makers forget to involve you in theirs.
Denote the value contributed by every team and budget to shared business outcomes.
Drive budgeting by present and future business outcomes, not past input costs.
There’s no business case for a resource, only for the business purpose for which resources are used. The business purpose of a resource cannot be understood in isolation from all the other associated costs needed to create a business outcome that enterprise leaders will all consider valuable. There are often better ways to achieve a more valuable outcome and the lowest cost option is rarely the most valuable.
An end-to-end approach to budgeting is essential to make business sense of enterprise spending. Gartner calls this a business view, showing the input cost items in relation to the business outcomes they enable. Cost is justified by a positive value contribution to business outcomes. These outcomes can be visualized using business processes, business capabilities, product lines, value streams and other executive views of business activity. These views can be used to develop budgets, not solely to minimize the cost, but to optimize the business value or financial returns enabled from existing services.
Where value is diminishing, it becomes a candidate for improvement. Only where a cost is growing without value does it become a candidate for reduction. Remember that some lines of business may be loss leaders that enable greater profits to be recognized elsewhere. VBB cannot afford to be simplistic and siloed, value-based budgets should be developed by working closely with all stakeholders in their business content. Value is credible when business leaders manage their stake in the value of budgeted expenditure.
Executives make VBB exercises more successful by following these best practices:
Relate the business value of each business activity, division or product line to all of its costs.
Manage the risk that the value of spending will diminish by planning to adjust costs accordingly.
Gather data to continuously test how expenditure increases value in proportion to risks and costs.
In 1Q20, inquiries about ZBB doubled against the same period in 2019, which were already up significantly from 2018.
The limitations of ZBB are outlined in “Financial Policy and Management Accounting,”2012.
The U.K. Department for International Development’s annual evaluation shows value optimization is applied to continually improve and maximize the impact of spending.
Guiding Principles on Independence and Objectivity.