Starting from Scratch

After years of neglect, zero-based budgeting is back in vogue. What’s behind the resurgence?
David KatzOctober 28, 2015

As PepsiCo’s second-quarter earnings call drew to a close in July, there was time for one more question. Asked Nik Modi, an analyst with RBC Capital Markets: Had the company thought about adding a zero-based budgeting program to its plan to save $1 billion over the next few years? “Every meeting I go in with an investor or an industry conference, the word zero-based budgeting comes up,” he noted.

CEO Indra Nooyi, a former CFO of PepsiCo, threw cold water on the prospect. “Nik, we are balancing top-line and bottom-line growth very, very judiciously,” she said. “When you embark on a zero-based budgeting program that [cuts] to the bone and jeopardizes your ability to grow the top line, I think that’s a formula for disaster.”

For a growing number of companies, however, the method may be a recipe for success. Unlike traditional budgeting, which uses the past year’s spending as a baseline and then merely adds to or subtracts from it, zero-based budgeting forces managers to start from scratch and justify practically every cost their units incur. One of its most prominent champions is 3G Capital Partners, a Brazilian private equity firm that has used it to slash costs in its portfolio companies, such as H.J. Heinz, which announced a merger with Kraft Foods in March, and Burger King, which 3G merged with Canadian chain Tim Hortons in 2014.

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Other growth-starved food and beverage companies have recently turned to zero-based budgeting to stay profitable. Coca-Cola, Kellogg, Campbell Soup, and ConAgra Foods have all publicly espoused the method. Meanwhile, experts say that health care is ripe for it, while companies as diverse as Boston Scientific, a medical-device manufacturer, and newspaper publisher Tribune Co. are using the budgeting tool.

To be sure, zero-based budgeting, which demands long-term commitment from senior management and an intense focus on slashing what some might consider minuscule expenses, may only be right for a small portion of companies. Although data on how many companies actually use the method is scarce, it’s 5% to 10% at most, some say. And its side effects can be considerable. It’s sure to upset some workplaces as jobs are slashed or redesigned, for instance. CFOs and the rest of the C-suite could lose precious hours to cost-cutting projects. And, as PepsiCo’s Nooyi suggested, the focus on cost may come at the expense of a loss of focus on growth and revenue.

If a company adopts zero-based budgeting, “you don’t take anything for granted. You don’t take a run rate on anything. You literally evaluate every category from the ground up,” warns Sherri Liao, enterprise performance management North America practice leader for The Hackett Group. “It’s not for the lighthearted.”

And yet, after nearly fading from view during the booming 1990s, the method has been experiencing a rebirth during the straitened economic times that began in 2008 with the financial crisis. “More and more companies are self-diagnosing that they want the end-state benefits of zero-based budgeting, which [include] a more flexible and scalable structure, because it meets some strategic objectives” besides simple cost cutting, says Paul Cichocki, a partner in Bain & Company’s Boston office.

Fads and Fundamentals
Part of the reason the method has gained so much attention of late, many agree, is that it’s simply the flavor of the month. “One thing that’s going on is just trends. There are fads and fashions in management just like there are fads and fashion in fashion,” says Donald Sull, a senior lecturer at the MIT Sloan School of Management.

At least on the surface, the trend is being driven by reports of 3G’s apparent success in using the method as a template of efficiency for private equity firms bent on wringing out overhead from their acquisitions. “When you talk about private equity, 3G Capital leaves a big wake [in employing] this tool to really drive up its synergies,” says Stephen Elliott, Hackett’s director of EPM transformation.

Wanting to “drive out costs in businesses they acquire,” he adds, other firms are “looking at 3G and thinking, ‘Why can’t we do the same thing?’”

But there are more fundamental factors, according to Sull, who posits what he calls a “very reductionist” theory. Companies can only increase their economic value in one of two ways, he says: “You increase customers’ willingness to pay so you can boost price, or you cut costs.”

Under current economic circumstances, many companies heavily dependent on consumer-spending power are finding it hard to differentiate themselves by boosting prices. “You’re in a market for disposable income where, for large swaths of the population, it has been stagnant or slightly declining, where you’ve got big-ticket items like education and health care that are increasing at a big clip,” Sull notes. “Where are you going to look for future growth and profit?”

The answer to that question depends on the industry you’re in. “The fundamental break point is whether your industry is competing largely on costs or differentiation in driving willingness to pay,” says Sull. In the luxury cruise line market, for instance, incorporating zero-based budgeting might make sense because prices are largely capped and companies seek to increase their profits by cutting expenses and increasing efficiencies.

In contrast, huge information technology outfits like Google or Facebook, which are encouraging innovation, “may want to waste some money on stuff that might not work out,” says Sull. “It’s a price you’re willing to pay to get that innovation because you’re looking for the next new thing.” For such companies, looking for savings in every nickel and dime of expense might too severely crimp their styles in their quest for customers willing to pay more.

But zero-based budgeting can appeal to some fast-growing tech companies in highly competitive markets. “I’m a true believer in zero-based budgeting, and it’s something that naturally applies in our case simply because of the pace of change that we go through in the company,” says Benoît Fouilland, CFO of Criteo, a Paris-based online advertising firm that has experienced impressive revenue growth since its initial public offering in 2013. Currently trading as a foreign private issuer on Nasdaq, the company’s revenue has risen from $358 million in 2012 to $612 million in 2013 to $902 million at the end of 2014.

Thus it isn’t so much cost reductions that Criteo seeks from zero-based budgeting as it is up-to-the minute knowledge of its outlays. The method “is very important in order to get a fresh view, [rather than] just to drive your budget processes on a prior-year view,” Fouilland says. “Our company is growing so fast that … you can’t rely just on knowledge from the past to build your budgeting.”

Criteo employs the annual method within the context of a three-year plan based on forecasts aimed at providing a long-term view of the business. “The zero-based budgeting applies to the annual budget-planning exercise, where you relook at everything every year,” says the CFO. “But with respect to the three-year plan, we look at market trends [concerning] where … the profitability of our model can be.”

True Believers Needed
To actually derive the benefits of zero-based budgeting, however, true believers like Fouilland are almost a prerequisite, proponents of the method insist. “A lot of companies are interested in the outcomes, but don’t actually fully commit to what it takes to get those outcomes,” says Bain’s Cichocki. The method “takes intestinal fortitude for the senior management team,” he adds, “because it is fundamentally disruptive and causes organizational pain.”

In its fullest applications, the process involves disruption for workers, who may find that their jobs have been completely restructured. It also demands hard work and long hours of senior executives, who must gather and analyze the requisite information, according to the consultant.

Although it may just involve “setting the table” for the hard changes to come, companies often expend a great deal of effort in finding how much pay is allotted to specific activities, sending out teams of managers “to find out what kind of work is being done today,” Cichocki says, noting that they need to assign their “A-level talent” to the task if it’s to succeed. Assembling those facts and applying dollar figures to them “becomes a project for the finance organization,” he adds.

Companies can spend years not only gauging how and where to cut costs, but also redesigning jobs, according to Cichocki. Rather than performing a single activity, many workers have jobs that are divided among a range of tasks. To properly budget for those activities in a zero-based budgeting context, companies need to assign cost figures to each task as if it were a full-time job, he explains. (The process is known as budgeting for full-time equivalents, or FTEs.)

Once those pieces of work are pulled apart for budgeting purposes, they need to be put together in ways that save on salary. For employees, that often involves a “change in the nature of the work they do,” Cichocki says. While that can be disruptive, workers might find the change to be an improvement, he adds, noting that an employee might be shedding rote labor for more analytical work.

To be sure, zero-based budgeting frequently results in the ultimate employee disruption: layoffs. On October 1, for example, ConAgra announced that it was dropping “approximately 1,500 positions or approximately 30% of the company’s global office-based workforce” in connection with its plan of “aggressively embracing zero-based budgeting.” In another recent instance, 3G’s model reportedly will spur 2,500 layoffs at the newly merged Kraft Heinz company.

A Microscopic Look
On a much more mundane level, companies using zero-based budgeting often take a microscopic look at their expenses in an effort to make the most productive use of them. Hackett’s Stephen Elliott tells of a client that decided that, instead of budgeting a block of money for trade show attendance in the coming year, it would determine who it really needed to send and then lay out the dollars accordingly — “the concept being that we want to make sure we’re getting the biggest bang for our buck, and that the dollars spent are really working dollars.”

Another Hackett client, wanting to curb printing costs and averse to “killing a lot of trees,” set limits on the number of copies that employees make and on the number of color copiers in the building, according to Elliott. “You have that low a level of detail, where it’s really an expense that’s not furthering any corporate objectives and is therefore not a good use of money.”

Focusing on such minutiae can lead to a certain kind of myopia, however, especially at companies that have offshored cost-cutting functions. Advising a company using zero-based budgeting methods to investigate a firm it was about to acquire, Elliott noticed that back-office employees in a non-U.S. location were questioning “why a plant in Syracuse, New York, had such high snow-removal costs as opposed to other plants around the country.” To foreign budget analysts homing in on such levels of detail, executives working for companies using zero-based budgeting may have to explain such things as “you’re in snow-belt land when you’re in Syracuse,” Elliott says.

Small as those concerns may seem, they’re often rolled up into a much more impressive cost-reduction figure in a typical zero-based budgeting program. At Bain, consultants launch programs by first advising clients to adopt a target of reducing sales, general, and administrative expenses by at least 25%, according to Cichocki.

Communicating that extreme-sounding goal to CFOs and the rest of the C-suite is necessary “to shake [them] out of a current state of mind to force them to be transformative,” he says. Considering the commitment they’re embarking on, such a cold slap in the face might be just the thing these executives need.