I’ve spent a lot of time over the years building and managing budgets, and I’ve used a lot of different approaches, usually mandated by the corporate finance management team to do so. I don’t really have a favorite method – whatever gets the job done is usually fine with me – but I have observed a few things about how accurate a budget can result and how efficient the process that creates it can be.
There’s been quite a lot of attention paid lately to the idea of “zero-based” budgets (ZBB) – due in large part to the fact that 3G Capital, Warren Buffett’s Brazilian investment partners, use the approach as a cost-management tool in the companies they acquire. As I am sure you know, ZBB works by starting with no assumptions about what it will take to run and grow the business for the next 12 months (or whatever the planning horizon actually is) and building up a cost structure from scratch.
Past history may be used as a guide in working out what you need. But it’s not used to set the presumed starting point for a budget element – the initial assumption is always that there is no budget, so you have to justify each time what it will take to deliver what that part of the business needs to do for both spending and profitable revenues.
This annual re-examination is a healthy discipline. But it can be time consuming and is arguably wasteful for some areas of the budget where a company has no choice but to meet externally mandated reporting or regulatory minimums. Here the question is “are we doing this as efficiently and effectively as possible?” rather than “should we be doing it at all?” That does help us to understand what we need to do, why we are doing it, and how we will work to get it done.
There are other benefits. Because nothing is funded for more than one budget cycle, you tend to get smaller initiatives and projects with more manageable risks and quicker delivery of benefits. Or you get to see more quickly that the benefits aren’t there or aren’t worth the risk or cost – which lets you shut things down early. You also get a tighter operational focus. Strategy is still important, but operational budgets are more likely to match agreed priorities. Inflated budget proposals are still possible, but harder to justify and less likely to be approved.
The downside can be that funding longer term programs can be difficult. Some ideas take time to develop and need a strong commitment to carry them through – particularly if employees and managers have stepped out of their mainstream career model to work on them. Here the ZBB process is more focused on reconfirmation of the strategic rationale and on any needed re-balancing of the portfolio than on operational justification. But the discipline is the same: Does this idea still make sense as an investment? Can we get to benefit faster? Are our relative priorities intact? Are we on track?
There’s also likely to be more data and analysis required to justify the budget, implying better tools and data management disciplines will be needed. But that’s no bad thing either.
ZBB can be pushed a little further, using a technique I first saw in widespread use at GE. Managers and employees who pay close attention to how work is done should see ways to do things better over time – a variation on the Kaizen approach of continuous incremental improvements. To incentivize this kind of thinking, the budget doesn’t start at zero. Instead, it begins at some “negative number” based on the assumption that next year’s performance should be better than last year’s, if only because of a year’s additional practice. Managers must first work out how to deliver this level of improvement rather than construct a budget to do so.
One additional process tweak I have found useful, whatever budget setting process is used, is the quarterly reforecast. This is more than just applying actual spending and revenue numbers to the initial budget. It’s focused on: (a) Where are we off plan? (b) Why? (c) How should we adjust for the rest of the cycle?
Although that periodic adjustment can be troubling for those who prefer to “plan the work, then work the plan” it’s possible to show that the more dynamic approach produces better outcomes. After all, a lot can change in a year, and ignoring the reality of change seldom works well.
Whether or not you start from zero or below.