As many companies watch growth in sales, general, and administrative (SG&A) costs outstrip increases in revenue, controlling expenses has become an even greater priority. As a result, executives are under ever-increasing pressure to deliver productivity improvements, and almost all companies have sought to reduce costs, whether through traditional programs such as outsourcing, offshoring, and strategic sourcing or other one-off cost-reduction events.
But in many cases, these are still not enough. Executives need bigger savings that can be sustained over time.
Unfortunately, the typical approach to identifying cost-reduction opportunities — examining operating expenses in the aggregate — is poorly suited to driving realizable, lasting and significant benefits.
The findings are often too high level to link clearly to the actions required to unlock the savings. Moreover, managers can avoid action by refuting the underlying data or citing unique business needs. Given such constraints, when savings are required, executives often feel they have no choice but to slash and burn, making arbitrary budget cuts without any changes to the underlying work, regardless of how prudent or sustainable those choices may be.
Fortunately, there is a sustainable alternative to cost management appropriate for many companies: zero-based budgeting (ZBB). We have heard of many versions of ZBB, including the literal interpretation of the words: “a technique for building a budget from zero.” While that is certainly a fundamental part of ZBB, our experience has shown that effective ZBB is much more than that.
Zero-based budgeting is a repeatable process that organizations use to rigorously review every dollar in the annual budget, manage financial performance on a monthly basis and build a culture of cost management among all employees. A world-class ZBB process is based on developing deep visibility into cost drivers and using that visibility to set aggressive yet credible budget targets.
The annual budgeting process does in fact start from zero and is very detailed, structured and interactive in order to facilitate meaningful financial debate among managers and executives. Throughout the year, multiple owners are tasked with managing performance and continuing the healthy debate on cost management. Through new system and process controls, and aligned incentive programs, all employees make cost management a part of their daily routine.
One company recently realized 11% savings in its operating budget within the first four months of a new ZBB program. In this instance, immediate savings came from increasing visibility into labor costs and executing new approval thresholds to control demand for contract labor, relaunching procurement initiatives to renegotiate prices and changing “make versus buy” decisions.
More than 40 percent of the savings were strategically reinvested in new teams and sales staff who spent all their time with customers. While this company chose to reinvest those savings in the customer-facing parts of the business, other companies use the savings to fund and therefore amplify the next wave of productivity. And, of course, some let the savings fall to the bottom line.
When properly implemented, ZBB can reduce SG&A costs by 10 to 25%, often within as little as six months. Just how ZBB is capable of delivering and sustaining these results remains a bit of a mystery for many executives. The opaqueness of the term and the dire tone of the media stories can be intimidating, sometimes causing ZBB to be avoided as an option for improving productivity.
What follows is an attempt to explore some common myths, debunking them and highlighting how a well-run ZBB program can drive sustainable impact in leading organizations.
Zero-based budgeting is much more than building a budget from zero. World-class ZBB efforts successfully build cultures of cost management throughout the organization by using a structured approach to facilitate cost visibility, cost governance, cost accountability and aligned incentives. Fortunately the culture shift isn’t left to chance. We believe that there is a proven, step-by-step approach to implementing successful ZBB programs, and when this implementation is done well, ZBB makes cost management a part of the way every employee works on a daily basis.
Although very little has been written recently about zero-based budgeting, the published content that exists often associates it with cutting costs to the bone, using any means necessary (for example, eliminating mini refrigerators in office kitchens to save electricity). While this may sometimes occur, it is by no means necessary. Simply put, the degree (and aggressiveness) of each company’s cost cutting reflects the size of its top-down savings target. For instance, in the most aggressive situations, we’ve seen 30% reduction targets in year one versus other situations that aim for 10% reduction targets with an agreement to reinvest half of that into more productive areas, therefore only taking 5% to the bottom line.
Recently, one executive we met with said, “I simply cannot afford to ask the entire company to stop what they’re doing for the year to implement ZBB.” The idea that ZBB requires dedicated focus from every employee for a year or more is simply not true. While it takes time to embed a new cost-management culture into any organization, the setup and rollout of a new ZBB program has much more limited requirements.
During the initial setup, a central coordination team develops deep visibility into costs and sets detailed savings targets for the next budgeting cycle. That team also ensures that the company’s systems and processes are in place for the detailed reporting, governance and performance management that a world-class ZBB requires. In our experience, this setup period could take anywhere from four to ten months and is primarily led by full-time support from finance and IT, with part-time involvement from profit-and-loss owners and cost-category owners across the company.
Organizations that are unsure about ZBB’s upside are well suited to pilot the process. There are many ways to build these pilots, each of which can be customized to meet the company’s objectives. One company, for instance, is piloting a ZBB rollout across its global finance function. This approach builds capabilities within the team that will help drive the program across the enterprise while having the added benefit of helping team members achieve their existing budget targets.
The fundamental elements of a ZBB program — governance, accountability, visibility, aligned incentives and a rigorous process — form a comprehensive cost-management tool kit. However, certain adjustments need to be made when using this tool kit in particular areas. For example, when ZBB is applied to variable costs (such as cost of goods sold, variable distribution) the budget needs to be volume adjusted in monthly performance reports. When ZBB is applied to capital expenditures, costs are categorized by discrete investment choices rather than types of expenses, as they are with operating expenses.
Zero-based budgeting is a powerful tool for any company, whatever its orientation. Even if the organization’s primary focus is on growth, profit, or talent retention, cost management remains crucial to its success. Eliminating unproductive costs allows the company to be redirected to more productive areas. As we mentioned in the earlier example, back-office costs can be redirected to customer-facing activities.
ZBB is not a slash-and-burn exercise that cuts costs without regard for the expense. With deep visibility into costs, changes can be made to surgically cut the fat and help build up organizational muscle.
Zero-based budgeting can drive significant and sustainable savings, but it is much more than simply building a budget from zero. World-class ZBB programs build a culture of cost management through unprecedented cost visibility, a unique governance model, accountability at all levels of the organization, aligned incentives and a rigorous and routine process. ZBB frees up unproductive costs and allows those savings to be taken to the bottom line or redirected to more productive areas that will drive future growth.
Shaun Callaghan is a consultant in McKinsey’s New Jersey office; Kyle Hawke is a consultant in the Atlanta office, where Carey Mignerey is an associate principal.The authors would like to acknowledge Greg Kelly’s contribution to this article.
This article was originally published by McKinsey Quartlery. Copyright © McKinsey & Company. All rights reserved. Reprinted by permission.