Zero-based budgeting is not a new concept. It was developed around five decades ago by Peter Pyhrr, an account manager at semiconductor firm Texas Instruments. After being taken up by US president Jimmy Carter in the 1970s, the method fell into obscurity. Recent years have seen it experience a revival in the food industry. In this series of articles, just-food examines zero-based budgeting and asks if it is a miracle diet for packaged food companies seeking a shapelier margin profile.
What is zero-based budgeting?
Zero-based budgeting (also known as zero-based costing) at its heart is an elegantly simplistic concept – but one that can be extremely complex to implement. Rather than the more common incremental budget method of using last year’s budget as a starting point and then adjusting up or down to formulate projections, zero-based budgeting requires expenses to be justified over each new budget period based on demonstrable business requirements.
Because the budget is not based on previous spending patterns, zero-based budgeting prompts managers to think critically about costs and aggressively eliminate expenses that cannot be rationally supported. The method can be applied to any type of cost: capital expenditure, operating expenses, SG&A costs, marketing costs, or cost of goods sold.
Zero-based budgeting is an analytical, data-based and repeatable process. On the one hand, it is about eliminating waste, on the other, it is about using resources more effectively. Outlining Kellogg‘s rationale for adopting zero-based budgeting methods, chairman and CEO John Bryant explained it provides a tool to identify savings within a company’s cost structure and ensure investment is being placed in areas where yields will be highest.
“It delivers savings but also provides a great tool and mechanism to challenge historical assumptions and to challenge in some areas where some investment was happening that were not getting the return and move it to areas that we are getting a good return. So it’s not always just the savings that comes out of it so much as the underlying methodology and driving and pushing on key assumptions,” Bryant said when Kellogg reported its first-quarter results in May.
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Zero-based budgeting – why now?
Zero-based budgeting has gained popularity in the food industry in recent years. As an accounting method it was drawn into the spotlight by private-equity groups 3G Capital and Berkshire Hathaway, which first took US ketchup giant Heinz private in 2013 and then merged the group with Kraft Foods Group two years later.
Kraft Heinz CEO Bernardo Hees, a partner at 3G, explained back in November 2015 the company’s private-equity owners were using zero-based budgeting, alongside an efficiency drive in the group’s manufacturing footprint, to “achieve and maintain best in class margins”.
“Zero-based budgeting, or ZBB, is a systematic approach, not a one-time event. It’s all about ownership and doing more with less. It drives accountability and encourages our employees to treat company dollars as if they are their own,” Hees said.
Zero-based budgeting dovetails with the return on capital investment approach favoured by the private-equity sector. 3G has implemented zero-based budgeting across a number of its portfolio companies – including the likes of brewing giant Anheuser-Busch InBev – and an investment cycle that is longer than the five-to-seven years typically favoured by private equity means 3G has time to fully benefit from its roll-out. In the case of Kraft Heinz, the method has the added advantage of delivering cost savings across an organisation that became overly complex when two large global entities merged.
The approach has contributed to an improvement in Kraft Heinz’s profit margins, which currently sit ahead of many food industry peers. For its most recent quarter, to 30 June, Kraft Heinz’s profit margin (calculated as net income divided by revenue) stood at 13.89%. This compares to a profit margin of 7.36% at Mondelez International, 10.47% at General Mills, 13.02% at PepsiCo and 8.57% at Kellogg.
While the 3G-backed Heinz, and then the 3G-backed Kraft Heinz, are credited as early adopters of zero-based budgeting, many other larger food industry corporations have followed suit. These include Brazil’s BRF, General Mills, Unilever, Kellogg, Mondelez International, the Campbell Soup Co. and ConAgra Foods.
All of these companies, coupled with other strategic initiatives, intend to use zero-based budgeting to strengthen profitability. Kellogg believes it can achieve a margin improvement worth 350 basis points by the end of 2018 – a revision on a previous target of 2020. Unilever wants to reduce costs across its portfolio by EUR1bn (US$1.1bn). General Mills hopes to generate annual savings of US$600m by 2018, up from its previous forecast of $500m. Mondelez has set an operating income margin target of 17% to 18% in 2018.
While 3G has played a role in setting a higher bar for margins through its control of Kraft Heinz, the rise of zero-based budgeting is also a reflection of the pressures in the current operating environment.
Packaged food companies are facing a period of disruption that has hampered sales growth and dampened profits. Increased competition and changing consumer preferences across developed markets have seen the pulling power of legacy brands eroded. New consumer understandings of value are placing pressure not only on pricing but also on quality and therefore margins, requiring large food multinationals to step up their efforts around innovation and renovation. Furthermore, the rise of the digital sphere and social media, has challenged the effectiveness of traditional media budgets. And economic headwinds and global political instability mean expansion into new and developing markets to fuel business growth is more challenging than ever.
In short, it has become more difficult for large food companies to organically expand. On the one hand, that challenge has led to increased consolidation and M&A in the food sector. On the other, it has placed the spotlight firmly on efficiency and resource allocation.
Cost reduction has historically been a common tactic for corporates who want to free up capital for reinvestment in growth. But many CPG management teams have specifically come to view zero-based budgeting as an answer to these unprecedented conditions. That is because restrictive budget practices such as zero-based budgeting afford the opportunity to mitigate risk, with aggressive cost reduction seen as supporting growth in both short- and long-term strategy in response to rising levels of market volatility.
The method is not, however, without its pitfalls. In the next instalment of our series on zero-based budgeting, we look at the risks and rewards associated with its implementation.