How starting budgets from zero avoids those quietly creeping costs

29 October 2015

Over time, many costs for most organisations have a tendency to creep up. As most annual budgets are put together by taking last year, making a few adjustments and rolling forward, those tend to creep up too. The increases can arise for a wide variety of reasons (some valid such as changes in the market, some not like inefficiencies and lack of control), but it’s often challenging to quickly and precisely identify where excess is creeping into the overall operations of a large industrial businesses.

Not surprising, all this is because the highest proportion of costs by far in most industrial businesses are variable – typically around 80% - so that’s where the majority of focus is.  And of the 20% of fixed costs, more than half is manpower, which is also visible and focused on.  But the remaining 5-10% of the cost base, made up of components such as maintenance, support services, travel, IT and so on tend to get little focus. Worse, the non-manpower fixed costs are distributed across a wide variety of activities and functions, and likely to be spread across multiple contracts, so controlling them and pinning them down in the annual budgeting process is difficult.

Zero-based budgeting offers a solution. Rather than accepting the costs from last year as the basis for agreeing the budget for next, zero-based budgeting as the name implies, builds the costs associated with any area of the business from the bottom up, starting with a blank sheet of paper.  In theory, that seems a straightforward enough exercise. However, putting it into practice is a much more challenging prospect. Truly effective zero-based budgeting requires a painstaking, detailed approach to examining each line of cost, assessing its contribution and understanding where it’s possible to make reductions without damaging the performance of the process in question, and the business overall.

Given the challenges of moving forward with a zero-based approach it’s perhaps unsurprising that we typically see its use in cases that offer a compelling and immediate rationale. That could include a change of ownership or control, where the new management wants to establish a clearer view of its cost base and understand the actions it needs to move forward practically. It might be in cases where the business is under severe pressure and has an urgent requirement to cut costs substantially – for example where covenants are in danger of being breached. However, such a ‘burning platform’ should not always be a prerequisite for adopting a zero-based approach. All industrial businesses should be able to benefit from a more rigorous and detailed assessment of their costs today, and the steps they can take to improve.

In my experience, there are four main ways in which costs can be addressed: doing things differently, doing less, doing things more cheaply and ceasing certain activities altogether. By looking at activities in this way, it’s almost always possible to identify significant savings. We’d typically expect to be able to reduce 25% of today’s costs through carrying out detailed, line-by-line analysis and rebasing activities going forward. Of course, it’s one thing to identify savings and another to ensure that they are sustainably implemented. And to make sure that happens requires a number of elements to be in place. The first is the commitment from the top of the organisation. In addition to senior management buy-in, middle managers also need to be empowered to make sure that they are able to make and implement what can be difficult and unpopular decisions. And, critically, communication of why the change is needed and how it can be made to stick is essential. 

In the next blog in this series, we’ll be looking at the steps required to identify baseline costs –the fundamental first step for a successful approach to zero-based budgeting.

Mike Clements |  Director, Consulting
Email |  44(0)113 289 4493

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