Don’t get burned by zero-based budgeting

As the coronavirus pandemic wreaks havoc across global economies, companies are cutting costs ruthlessly to survive. But it can be dangerous to do this if your staff do not have the right financial training.

A good example is zero-based budgeting (ZBB), a radical technique that some companies may consider adopting during the pandemic. With ZBB, managers must justify their entire budgets for each new period. But this approach is controversial.

It can lower costs by avoiding arbitrary assumptions in the budget setting process. But, unless handled carefully, it can also damage your business model and ZBB has been associated with a spectacular fall in share price value at food giant Kraft Heinz in particular.

ZBB was introduced around 1970 to solve the notorious problems associated with traditional budgeting techniques, especially in larger, more mature companies. At such firms, a tendency to accept the status quo often leads to inefficiency as they set budgets year after year for items that no longer create sufficient value.

Managers also often think ‘use it, or lose it’, so they find ways to spend their budgets without focusing enough on the return from that investment.

ZBB aims to counter this by challenging assumptions and making departments justify every penny of their budgets for each new period. It requires management to assess and prioritise activities in detail each time and agree only those that align best with strategy and value.

This approach may seem appealing during the coronavirus downturn and recovery as it encourages companies to be nimble in rapidly changing circumstances. It is evidence-based, analytical, and repeatable, so can help maintain a robust budgeting discipline over time.

But the danger is that it focuses only on easily identifiable costs and fails to address effectiveness in other more complex or intangible processes such as innovation, marketing, and customer services. These areas can create and maintain value in ways that take time and are harder to measure and therefore justify every year. This type of value may even be critical to long term sustainability.

ZBB can also fail to consider other complexities, such as sectoral or geographic differences in corporate divisions. A more successful strategy must include all these factors and account for more qualitative and intangible factors in setting budgets.

Notorious strategy

ZBB’s notoriety has increased in recent years thanks to its zealous use by Brazilian private equity group 3G Capital – a firm that partners Warren Buffet’s company Berkshire Hathaway. 3G has implemented ZBB in its portfolio of companies as an aggressive way of increasing shareholder value.

In 2015, Kraft bought Heinz to make the world’s fifth-largest food company. Buffet’s 3G team led the integration. But, this time, 3G’s fierce cost cutting strategy was to backfire and Kraft Heinz’s share price has fallen dramatically in recent years.

Slashing costs can increase shareholder value. But to maintain value in your brand, you must invest in it. The food industry has been changing rapidly and successful companies have invested in expansion to new territories, launching exciting new brands, and reinvigorating old brands. In contrast, Kraft Heinz focused on cost to the exclusion of other strategies, leading to missed opportunities for expansion and neglected brands.

It concentrated too much on issuing fat dividends rather than thinking long term, and Buffett – who is normally renowned for his investment wisdom – just let it happen.

Cost versus brand

To understand whether ZBB could work at your company, think about the two fundamental approaches to strategy, and which most applies to you. The first approach is brand differentiation, which tends to feature higher costs and profits. A good example is a luxury watchmaker.

The other strategy is cost leadership, such as we see at budget airlines. They understand that many customers want to travel as quickly and cheaply as possible, so they cut all frills and crush costs.

Many things you must do to be a brand differentiator are the opposite of those you must do to be a cost leader. ZBB is clearly intended for cost-led firms and can create a huge conflict if introduced into a brand-based business.

3G had used ZBB to boost profits at other companies. But doing this at Kraft Heinz undermined the food firm’s model in a changing market. We can illustrate the effect by comparing Kraft Heinz’s share price with Unilever – a firm with lower margins, but a focused manager and developer of its brand portfolio.

Ouch! Kraft Heinz versus Unilever share prices:

Instead of making ZBB your only mantra, you need a range of performance measures to incentivise staff and management.

Other companies use ZBB successfully by making it part of a broader strategic scorecard, rather than a singular focus. This includes Unilever, which has made ZBB work because its policy is to reinvest the savings in higher-value activities. It also uses a range of short and long term measures, with a focus on sustainability, to gauge performance and incentivise staff.

One of the best ways to help your staff understand such issues is financial training via online finance courses.

Our ‘Finance for the non-financial manager’ training course – which can be tailored and taken in the classroom or as e-learning – looks at budgeting techniques and the range of measures companies can use to measure value. For example, a balanced scorecard approach takes a more varied view with financial performance being just one of four perspectives – the others are around customers; internal processes; and learning and growth.

If you focus only on financial metrics, you will miss other crucial measures that boost performance, such as customer engagement and satisfaction. Indeed, as customers become increasingly powerful, so do these measures, so focusing on them will ultimately create more sustainable profits.

Using ZBB as your only strategy is like having a guitar with only one string. The tune will not sound good for long, and if you keep playing, it will break.