Zero-based budgeting and Beyond Budgeting: rethinking the annual budget

At a technical wholesaler, indirect costs have been rising slightly faster than revenue for years. Nobody can say exactly why. Every autumn each department submits its budget: this year's amount, plus inflation, plus a few wishes. Management strikes out some of the wishes and the rest becomes the new budget. So very little changes, and that is exactly the problem.

The pattern is widely documented. McKinsey analysed 1,500 companies over 20 years and found that 90% of the money ends up where it was the year before (source: McKinsey, August 2018). Zero-based budgeting and Beyond Budgeting both try to break that pattern, each in its own way.

What grates about the annual budget

The traditional budget has to do three things at once: set an ambitious target, give a realistic forecast and allocate resources. BCG and the Beyond Budgeting Roundtable call these aims incompatible. Anyone who wants budget forecasts cautiously; anyone judged on a target negotiates it down; and a forecast fixed for a year is out of date within a few months.

Writing in the Journal of Management Accounting Research, Hansen, Otley and Van der Stede described two routes that emerged in practice: improve the budgeting process, or abandon the budget altogether. Zero-based budgeting belongs to the first route, Beyond Budgeting to the second. To keep the debate in proportion: in a survey of 558 North American organisations, 79% used budgets for control, and 94% of those had no plans to stop (source: Libby and Lindsay, 2010).

Zero-based budgeting: justifying every euro again

Zero-based budgeting (ZBB) was developed by Peter Pyhrr at Texas Instruments and described in Harvard Business Review in 1970. The idea is that a budget does not start from last year's amount but from zero. Every activity, existing or new, has to be justified. Pyhrr worked with decision packages: for each activity, a description of what it delivers and costs at different levels of effort, so that management can choose what it does and does not want to pay for.

After a period of little interest, ZBB made a comeback, not least at companies bought by private equity firms. According to McKinsey, ZBB can remove unproductive costs, often 10 to 25% of selling, general and administrative expenses within six months (source: McKinsey, August 2015). McKinsey finds that it works best where management is willing and able to change, for example in the first budget round after an acquisition or when results are disappointing. Nor is the approach confined to overheads: it applies just as well to marketing, capital spending and the cost of goods sold.

There are caveats as well. Deloitte points out that ZBB is risky when the savings are uncertain, and may be too costly for organisations with limited resources. McKinsey notes that a one-off cost review is possible without full ZBB, and that anyone who wants to do it every year needs a good digital budgeting tool.

1. 01

   Divide costs into categories, each with an owner

   For example travel, IT, premises, marketing and external advisers, each with an owner who is responsible across the whole company, alongside the heads of department.

2. 02

   Establish the minimum for each activity

   What is needed to carry out the activity at a minimum acceptable level? What does each level above that cost, and what does it deliver?

3. 03

   Rank and choose

   Put all the packages in order of importance for the strategy and the bottom line, and draw a line at the amount you want to spend.

4. 04

   Set the rules

   Savings only last if there are agreements behind them: who may order what, which standards apply to travel or software licences, and how you monitor compliance.

5. 05

   Track it every month

   Include the cost categories in the management report and discuss variances with each owner.

Example: a wholesaler's indirect costs

The wholesaler from the introduction applies ZBB to five cost categories. For each category, the owner builds the budget up from zero and puts the choices forward.

Fictitious Firmfocus example.

Look at the marketing line. ZBB is not an across-the-board cut: the marketing budget goes up, because the money goes to activities that support the strategy. The difference from the usual budget is that every euro needs a reason, including the euros that were already there last year.

Beyond Budgeting: managing without a fixed annual budget

Beyond Budgeting goes a step further. The model was developed in 1998 and is championed by the Beyond Budgeting Roundtable; Jeremy Hope and Robin Fraser brought it to a wide audience with their 2003 book. The central argument is that the fixed annual budget is too slow and too political for an environment that keeps changing. The Roundtable set out twelve principles, six on leadership and six on management processes.

Firmfocus summary based on the principles of the Beyond Budgeting Roundtable.

The best-known examples come from Scandinavia. According to BCG, the Swedish bank Handelsbanken works without fixed targets and aims for a higher return on equity than the average of its competitors, which BCG says it has achieved every year since 1972 (source: BCG, September 2021). The Norwegian energy company Equinor translates its goals through its Ambition to Action management system and updates its forecasts as soon as new information comes in.

BCG surveyed 174 finance executives who apply elements of Beyond Budgeting: 59% reported higher revenue, 56% significant cost savings in the budgeting process itself, and 41% were able to free up resources that had previously been held back (source: BCG, September 2021). The main obstacles were concerns about higher costs, the risk involved in implementation and limited support from the board. Bjarte Bogsnes, chair of the Beyond Budgeting Roundtable, warns that implementations often stop at a rolling forecast, whereas the value lies in the interplay of all the principles.

Zero-based budgeting or Beyond Budgeting?

What does this mean for SMEs?

Full ZBB or Beyond Budgeting is too heavy for most small businesses. The ideas are still useful.

• Start from zero every few years: go through your fixed costs line by line once, as if you had to buy them all again. Subscriptions, licences, insurance and contracts often turn out to be outdated. There are more tips under cost reduction.
• Separate target and forecast: alongside the budget, keep an honest expectation of where the year will end. The gap between the two is your assignment.
• Relative targets: compare your margin and costs with last year and with similar businesses. The profit and cost benchmark shows where you stand compared with your sector.

SMEs and large organisations

Both methods are variants within the broader cycle of planning and control. If you want to improve the traditional budget without abolishing it, start with how to make a business budget.