Under zero-based budgeting (ZBB), expenses must be justified for each new budget period based on demonstrable needs and costs, as contrasted with the common practice of using the past year's budget as your starting point and then adjusting up or down. ZBB is a proven way to aggressively strip out costs that cannot be rationally justified --and so is often among activist investors' first demands. Zero-based budgeting was integral, for example, to the 2015 merger of H.J. Heinz and Kraft Foods, led by the private equity firm 3G Capital. Such high-profile applications have prompted many boards and CEOs to consider implementing ZBB pre-emptively, before it is forced upon them.
There is certainly merit to being proactive. Zero-based budgeting is a powerful methodology, but when implemented without careful forethought, it can do as much harm as good. Many companies that implement ZBB soon stop using the approach after they see it significantly disrupting the business, yet failing to deliver the results they anticipated. In contrast, when a company implements ZBB on its own initiative, the board has time and opportunity to help the company reap full benefits from the effort, without slowing profitable growth.
When ZBB goes wrong, the company will usually face three undesirable outcomes:
* People throughout the organization dread ZBB and are in essence paralyzed by it.
* ZBB does not deliver the magnitude of cost savings the company anticipated, causing further disillusionment with the approach.
* Many of the costs that were successfully eliminated soon creep back in, making all the effort that was required to do ZBB appear futile.
In its oversight role, the board can guide the company toward a far more fruitful ZBB experience. For example, a key flaw in many ZBB implementations is overreliance on executive mandate. The executive team imposes a new budget from above, based on external benchmarks, without inviting the people of the organization to also inform the targets, which is of course essential to earning their full commitment. Absent that chance to help set the targets, the people who must fulfill them may see them as arbitrary, irrational--even punitive.
Worse still, the results realized from this brand of ZBB frequently disappoint, because mandating targets alone does not address the underlying ways people work. Once the top-down pressure has been lifted, even costs that were successfully reduced (at great pain) may quickly...