COVER STORY

COVER STORY

Zero-based Budgeting
A Step Towards Competitive Strategy
Zero-based Budgeting (ZBB) is a financial planning tool which integrates management structures with the budgeting exercise. In conventional budgeting, the current years budgets are prepared based on past performance. ZBB, on the other hand, questions set assumptions and provides a tool for systematic review of the planning parameters. The ZBB process consists of identifying decision packages and then ranking them in order of importance through a cost-benefit analysis. Therefore, ZBB can be used for activities, functions or operations where a cost-benefit relationship can be identified, even if this evaluation is highly subjective. According to the ZBB system, justification of the expenditure may be required on the basis of expected output. So, while ZBB may be applicable to only a portion of the total budgeting effort in an enterprise, those areas to which it is directly applicable are usually the hardest to plan and control. Thus, ZBB is more applicable in the discretionary cost areas. The term decision packages used in ZBB focuses on the analysis of each activity in the manufacturing process according to the incident of the relevant cost and the importance of that activity in the overall cost structure of the organization. Thus, in essence, decision packages refer to not only the cost but also the benefits of an activity in a process. The optimization of ZBB can be achieved through its phased introduction. It can be initiated in less complex areas and after building up skills and experience of people working on it, move towards more complex segments. The use of ZBB has to be contained in activities that are truly discretionary.

Santanu Ray

eter A Pyhrr, who introduced ZBB in Texas Instruments, defines it as: An operating and budgeting process which requires each manager to justify his entire budget request in detail from scratch (hence zero-base) and shifts the burden of proof to each manager to justify why he should spend any money at all. This approach requires that all activities be identified in Decision Packages (DPs), which will be evaluated by

2006 The Icfai University Press. All Rights Reserved. November 2006

Zero-based Budgeting

systematic analysis and ranked in order of About the Author importance. Zero-base refers to a nil-budget as the Santanu Ray, Director, The Icfai Business starting point; as the activity is budgeted, costs School, Kolkata. The author can be are objectively budgeted. It starts with the reached at santanuray@ibsindia.org premise that the budget for the next period is zero as long the demand for a function, process, project or activity is not justified for each rupee. The assumption is that without such a justification no spending will be allowed. The onus lies with each manager to justify why the money should be spent at all and to indicate what would happen if the proposed activity is not carried out and no money is spent. In effect, each manager or functional head is required to carry out the cost-benefit analysis of each of the activities under his control, and for which he is responsible. History ZBB was first introduced by Peter A Pyhrr, a Staff Control Manager at Texas Instruments Corporation in the USA. He developed this technique and implemented it for the first time during 1969-70 in Texas in the private sector and popularized its wider use. He wrote an article on ZBB in the Harvard Business Review (November-December, 1970) and later on wrote a book in 1973 (Zero-Base Budgeting by Peter A Pyhrr, John Wiley and Sons, New York 1973). Jimmy Carter, the then Governor of Georgia, read about ZBB and requested Pyhrr to help him to apply the same in the State of Georgia. When Jimmy Carter became the President of the US, he strongly supported the use of ZBB in the state budgetary control machinery. This technique appeared so fascinating to President Carter that during the first year in office he mandated the use of ZBB throughout the Federal Government in the Fiscal Year 1987. Why ZBB In conventional budgeting, the current years budgets are generally arrived on the basis of past figures; say, by adding some percentage to the previous years figures. Very often complaints have been voiced that there is no relationship between the expenditures made and the results obtained; that there is no control over the inputs to the system and the outputs obtained. Thus, there may be lack of objectivity in the process of formulation of budgets under the conventional budgeting techniques. Also, past few years expenditure is justified just on the basis that it is already there. ZBB overcomes these limitations by starting with zero and then by objectively determining the budget figures. ZBB questions set assumptions and provides a tool for systematic review, rseprioritize and maybe withdraw from long-term activities that no longer conforms with an organizations objectives. Is ZBB a New Technique? The concept of ZBB first appeared in the 1960s. Needless to say, the dissatisfaction with an incremental approach is one of the many factors that has led to finding a budgeting process that serves the purpose and objectives of an organization. ZBB is, of course, not an absolutely new budgeting system. The approach is, by and large, adopted when an enterprise formulates its first budget or a set of budgets immediately after a thorough reorganization and regrouping of its activities. However, barring such experiences for brief periods only, most of the firms continue to frame their budgets on the conventional incremental b udgeting method.
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COVER STORY Methodology and Steps Jimmy Carter, who introduced ZBB for resources allocation and control in government explains, In ZBB, the budget is broken into units called DPs which are prepared by managers at each level. These packages include an analysis of purpose, cost, measures of performance and benefits, alternative courses of action and consequences of not performing the activity. Then all packages are to be ranked in order of priority. After several discussions between department heads and the chief executive, the rankings are finalized, and packages upto the level of affordability are approved and funded. In more specific terms the ZBB methodology as well as the sequential stages in its introduction may be outlined as follows: Defining the Decision Units (DUs) within the firm: A DU is a tangible activity or group of activities for which a single manager is responsible for successful performance. The DU concept is akin to that of the responsibility center. A traditional cost center, a group of people or even a project may be a DU. Defining objectives of each DU: In clear and specific terms and in conformity with the enterprise objectives and goals. Identifying activities in the form of DPs: The term DPs focuses on the analysis of each activity in the manufacturing process according to the incident of the relevant cost and the importance of that activity in the overall cost structure of the organization. Thus, in essence A Decision Unit is a DPs not only refer to the costs but also the benefits tangible activity or group of an activity of process. For instance, in the case of a make or buy decision or in the case of a of activities for which a decision to outsource a particular activity of single manager is process, a decision package can be used as a tool responsible for successful for decision-making either for optimizing cost or for maximizing benefits. Similarly, during a performance portfolio balancing exercise, a company can review the performance of the cash cow, star, question mark and dog category products in the portfolio with the help of DPs and can also resolve to the product pruning decision by eliminating the dogs. For any given activity there may be several alternative DPs, each describing a different level of effort and cost-benefit relationship. There are two types of DPsmutually exclusive packages and incremental packages. Ranking of alternative DPs in the order of decreasing benefit to the organization, using cost-benefit analysis technique: Large volumes of DPs are a valid concern in the early years of ZBB. We can overcome this problem with computer routines. Alternatively, this problem can be reduced by concentrating on marginal priority packages. This is because ultimately all the packages presented for funding would generally fall into three categories: (1) those with a high priority and high probability of funding; (2) those with a marginal priority and which may be funded or not funded depending on the resources available, and (3) those with a low priority and low probability of funding. Those DPs in category two warrant greater scrutiny than the others. Superior officers could profitably allocate their time for this.
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Forwarding the ranked DPs to the next higher organizational units, for review, merger with other comparable DPs and for re-ranking (as the DPs are consolidated and reranked, the perspective and objectives are broadened). The consolidation and re-ranking should preferably be done by a committee comprising all managers whose DPs are being considered and a chairman selected from the next higher organizational level. Finalization of the budget proposal as well as preparation of budgets for each DU have to be finally approved by the top management. Before according approval the top management is guided, on the one hand, by the principle of allocating resources to the DPs showing higher benefit to cost ratios, and the question of affordability, on the other.

Follow-up As in the case of any other effective procedure, monitoring and follow up of ZBB is essential. Unlike traditional budgeting, monitoring ZBB will assure monitoring achievement of objectives. Application ZBB is nothing but a budgeting process and, therefore, can be used as a tool in the hands of the management. Thus, there are two basic requirements for the application of ZBB: There must be a budgeting system within the organization; and Managers must develop quantitative measures for use in performance evaluation. The ZBB process consists of identifying DPs and then ranking them in order of importance through a cost-benefit analysis. Therefore, ZBB can be used for activities, functions or operations where a cost-benefit relationship can be identified, even if this evaluation is highly subjective. In its practical application, however, managers do not have to budget from zero, but can start from their current level of expenditure and work downwards asking themselves what would happen if any particular aspect of current expenditure and current operations were removed from the budget. In this process, a cost-benefit analysis is carried out on every aspect of the budget and the selection of better alternatives encouraged. Industry ZBB is applicable in the following areas: Administrative

Technical, e.g., Research and development Engineering Laboratories Quality control Maintenance Production planning Commercial, e.g., Market research Technical support

Transportation and distribution, etc. Thus, ZBB is more applicable in the discretionary cost areas. Direct manufacturing costs such as direct material, direct labor and variable manufacturing overheads are better controlled through the standard costing technique as in these cases, the
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COVER STORY relationship between the inputs and outputs can be determined, and standards and deviations of the actual from those standards can measured. Where standards are determinable, the costs associated with the inputs should be controlled through the use of standard costing. On the other hand, if the output as a function of the input cannot be specified, then other means of cost control must be used. ZBB is a planning resource allocation and control tool. According to the ZBB system, justification of the expenditure may be required on the basis of expected output. So, while ZBB may be applicable to only a portion of the total budgeting effort in an enterprise, those areas to which it is directly applicable are usually the hardest to plan and control. Government ZBB can be readily adapted to all government activities and agencies since the government is a service organization that supposedly provides some benefit to the taxpayers. It may be stated that when ZBB was first used in the State of Georgia, in the US, it was applied to all 65 budgeted agencies (e.g., health, highways, education, agriculture, public safety, game and fish, family and childrens services, etc.) In case of government agencies, use of ZBB may move funds from low priority current programs to high priority new programs to achieve the objectives of the agency. Experts are of the opinion that the introduction of ZBB should be a gradual process. In the State of Oklahoma, in the US, ZBB is being introduced in two departments and some relevant agencies each year. It is estimated that the introduction of ZBB in the entire department would take as long as eight years and, hence, review of the ZBB introduced in each department can be done only after eight years. Benefits and Uses The successful implementation of ZBB is dependent on the commitment, skills and thus effective involvement of all executive managers. Introduced in proper perspective and in a systematic manner, ZBB can benefit in different ways: ZBB fosters a culture of efficiency and cost-effectiveness and, for that matter, inculcates cost consciousness among managers. ZBB allows for quick budget adjustments during these periods when revenues fluctuate widely. ZBB improves budgeting process by focusing on objectives, priorities and needs. ZBB will provide an objective basis to prune or zero-out programs that have outlived their utility and expand high-impact programs. Effective ZBB demands that those walls of Jericho between planning and budgeting must come down and that the two functions must be linked. ZBB ensures participation from all concerned and facilitates coordination in planning and control. Responsibility accounting system can become more effective under ZBB. Allocation of resources is made according to the needs and benefits derived. Lastly, and most importantly, an organization can even benefit from the ZBB process itself, even if the system is not formalized the exercise is creative and, therefore, challenging and, of course, rewarding. The US experience with ZBB generally reveals that ZBB has not resulted in major budget cuts but it has, in nearly every case, stimulated the redirection of resources from less productive to more productive activities.
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Zero-based Budgeting

Limitations and Problems There are several success factors of ZBBorganizational, attitudinal and operational that are not so easy to obtain, particularly in Indian organizations. Some of these are: Top managements personal involvement and commitment; Creative energies of the managers involved, in order to identify innovative DPs and also rank the alternatives; A wholly new mental attitude and management style throughout the organization; Climate of trust and mutual confidence between the top management and the operating managements; A climate of delegation;

Adequate feedback to the managers about reasons for their DPs being accepted or rejected. ZBB also presumes the availability within the organization of skills in cost accounting, cost analysis and performance measurement. Systematic use in particular of the technique of cost-benefit analysis and cost-effectiveness is the bedrock of ZBB. All these requirements can pose a lot of problems. There may be a greater amount of paperwork associated with ZBB system than with conventional systems, particularly during the initial periods of its introduction in an organization. There are also the problems associated with orientation training, developing operational infrastructure for ZBB itself, etc. The process of preparing budget proposals so far has been largely ritualistic. In addition to this, the multiple levels of decision-making, labyrinthine procedures, poorly developed methods of communication, information and retrieval of data, erratic transfers of key officials, are some other organizational deficiencies which are likely to pose serious problems in the successful implementation of ZBB in India, particularly in government departments. Concluding Remarks Budgeting for any activity has two dimensions, inputs and outputs. Where the relationship between the inputs and outputs can be determined, standards can be set and deviations of the actuals from those standards measured. The costs associated with the inputs can be controlled through the use of standard cost system. On the other hand, if the output as the function of the input cannot be specified and quantified, then other means of control must be used. It is in this area where ZBB tends to be effective. Performance Budgeting (PB) is also meant for similar situations where outputs are not financially quantifiable. The main difference between these two concepts (leaving aside the methodology part) is that while PB emphasizes the performance part (the outputs of the budgeting system) ZBB places greater emphasis on the cost part (the inputs in the budgeting system) under identical situations. If applied intelligently ZBB is a potentially very useful tool and can offer a number of advantages. The main focus of attention is on the actual resources that are required to produce an outcome or output rather than an increase or decrease in percentage compared to that of the previous year. The use of ZBB has to be contained in activities that are truly discretionary.A

Reference # 09M-2006-11-02-01

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