Demystifying zero-based budgeting | M&M Global

Demystifying zero-based budgeting

Simon Foster, managing director of MUSE, explains why the surge towards zero-based budgeting may not be such a bad thing for agency partners. 

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What can companies like Campbell Soup, Coca-Cola, Diageo, Heinz, Kellogg and Unilever learn from Jimmy Carter, the 1970s US president? Not much you might think. Not so. Carter was the first state governor and the first US president to implement zero-based budgeting. After his experience of using it at state level he insisted it was used as the basis for federal budget setting in 1976.

Fast forward forty years to 2016 and Diageo’s new general manager for GB, Ireland and France announced that zero-based budgeting is now the “new normal” for business and described it as “a requisite of being a world class organisation”.

This comes on top of Unilever’s announcement in January that they would increasingly use zero-based budgeting. Under Unilever’s zero-based budgeting approach, marketing teams have to justify spending on all new brand activity rather than budgets being based on the previous year’s spend. Coca-Cola, Kellogg, Campbell Soup have all talked about adopting zero-based budgeting.

Zero-based budgeting (ZBB) is not only used by global conglomerates. Some its biggest supporters are private equity and venture capital funds that want to drive better shareholder returns by encouraging management teams to think harder about how they invest shareholder funds.

3G Capital, which partnered with Berkshire Hathaway to buy Heinz in 2013, is a big supporter of ZBB. As we see more companies and brands being backed by PE and VC funds we are likely to hear yet more about ZBB. This in turn forces publicly quoted companies to demonstrate that they too are overhauling the way they set budgets. It’s not often the private sector learns from the state, but in the case of ZBB, that’s exactly what has happened.

So, with these announcements in mind and with the Brexit debate continuing to dominate the budgetary thinking of many UK marketers, I thought it might to useful to review the different types of budgeting available and explain in detail how ZBB can work for marketers.

First, let’s take a look at some of the weakness of the more traditional approaches: last year’s base, affordability and share of turnover.

Last Year Base

Last year’s base budgeting involves pinning the amount to be spent this year to the amount spent last year. This type of budgeting whilst relatively easy to construct has a number of down sides. At best, it is backward looking and takes little account of market change or how marketing objectives will be delivered and at worst it can cause organisational damage by encouraging corporate inertia and maintenance of the status quo.

Affordability

In this ‘marketing comes last’ scenario, marketing budgets are set after allocations have been made to other areas of the business; production, distribution, facilities and human resources. Clearly this is not a market orientated or task-related budget setting method and demonstrates a deprioritisation of marketing activities. By definition it doesn’t take into account what needs to be achieved, how it will be delivered and how much that delivery will cost.

Percent of Turnover

Unfortunately, percent of turnover bears no relation to what needs to be achieved by marketing. It simply reflects the company’s ability to afford a certain level of marketing spend. The issue here is that whilst your turnover based budget might be £1m, the required marketing objectives may be delivered with just £500k, or they may actually require a budget of £5m.  In this approach there is no consideration of what actually has to be delivered, or how much it will cost. Hitting objectives becomes more of a game of chance than the result of implementing a carefully thought through marketing plan.

Share of Voice and Share of Market

In this approach, the proposed marketing budget is based on a share of the category marketing spend. If your market share is 10%, you might plan a marketing budget that equates 10% of your category’s marketing spend. In this way you maintain a share of voice versus your competitors.

A variant of this is Excess Share of Voice (ESOV) where excess share of voice is the difference between share of voice and share of market. The 2009 IPA Effectiveness study ‘How share of voice wins share of market’ by Les Binet and Peter Field using Nielsen and IPA data found ESOV to be a significant factor in brand share growth. Brands spending at a share of voice that is higher than their share of market tended to grow, whereas brands underspending relative to their share of market tended to decline.

“How would you set budgets for a new brand launch or a start-up that wanted to grow to £10m in revenues within two years?”

SOV/SOM does bear some relation to what has to be achieved, and can be effective in larger scale markets where a small shift in share can generate significant increased revenues. But SOV/SOM still has critics: smaller brands can always punch above their weight and large brands can run large scale but commercially inefficient campaigns.

We can see from these examples that incremental budgeting has a number of weaknesses. It is backward looking, it’s not related to what has to be delivered by marketers, it can signal a deprioritisation of marketing activities, it keeps inefficient activities out of the spotlight and can even contribute to organisational stagnation – a dangerous place to be in today’s fast-moving world.

Only SOV/SOM relates to the delivery of an objective but it is only an indicator of required budget levels, rather than being a task-driven approach to budget setting.

Introducing Zero-Based Budgeting: Starting with a Blank Canvas

Zero-based budgeting is need-based. Budgets are set by starting with no preconceived idea of how much money will be required and then taking an objective look at what needs to be achieved and calculating how much that is going to cost.

The best analogy would be asking yourself how you would set budgets for a new brand launch or a start-up that wanted to grow to £10m in revenues within two years. With no history to look back on your only option it to base your budgeting on costing out the activities required to deliver your objectives. But how do marketing managers align budget requirements with the delivery of marketing objectives?

Let’s look at how you can do that.

Marketing budget per sales unit or customer

In its simplest form marketers can look at the size of their markets, the number of units they intend to sell or the number of new customers they intend to recruit over a given time period. They can then allocate a proportion of the revenue generated per unit sold or new customer acquired to invest in marketing activities. So if the marketing allocation is £10 per unit and the plan is to sell 100,000 units then £1m will be required.

Lifetime value can have an important role to play here. If you know that a customer has a value of £1,000 over two years you might choose to allocate a percentage of this future value to your acquisition marketing budget. This approach is favoured by direct marketers and is centred on calculating an ‘Allowable Cost per Order’. The allowable cost per order can include current and projected costs as well as projected lifetime value of customers. Direct marketers often think in terms of acquiring the lifetime value of a customer. The higher the lifetime value then the higher the initial investment to win the customers can be.

This can be a source of significant competitive advantage: if you understand your customers’ lifetime value you can potentially invest more than your competitors in winning customers. This in turn can expand your share of market. Allowable Cost per Order is popular with direct to consumer companies who are managing an addressable customer base such as software as a service (SaaS) businesses.

For those who are interested, Peter Rosenwald, a former CEO of both Saatchi & Saatchi Direct and Wunderman Worldwide details the calculation of allowable cost per order in his book ‘Accountable Marketing – The Economics of Data Driven Marketing’ (2004).

Task driven

Of course, not all marketers are running a direct to consumer business model. In businesses that are working through distribution networks other factors come in to play. Marketers have to create pull through demand in large customer segments. This pull-through is developed by identifying target segments and building consumer awareness and understanding of the brand offering in those segments.

In this case marketers have to manage the relationship between marketing inputs and sales or share outputs. At a basic level, this can be achieved identifying the budget required to reach a given segment of the population a number of times in a certain time period.

Regression modelling can be a powerful tool, especially when combined with competitor activity, pricing, distribution and other broad factors such as GDP, consumer confidence or even the weather. These “market mix” models can reveal the cost effectiveness of marketing budgets – both online and offline.

Once parameters have been established marketers can start at ‘time/base zero’ and look into the future by rolling the channel coefficients forward and exploring both different channel mix combinations and different levels of marketing investment.

Benefits of Zero-based Budgeting

The first benefit of ZBB is to persuade budget holders to think harder about what they need to do and how much it’s going to cost. This should encourage the development of new and innovative solutions to marketing challenges. Second, ZBB disrupts the inertia that maintains the marketing status quo.

Incremental budgets can shelter inefficient activities. There may be conferences, initiatives and even campaigns that don’t add any real value – either brand value or bottom line value. Without ZBB, thorny questions may never be asked and money may continue to be wasted.

“If marketers can make the right business case their marketing budgets could actually increase under zero-based budgeting”

Thirdly, ZBB is forward looking. Change will always come from the future, not from the past, so it always makes sense to look forward rather than backwards. And last, but not least, ZBB gives management the opportunity to take a greater stake in what the company is doing and how shareholder funds are invested.

All the current talk of zero-based budgeting sends shockwaves through the marketing community. Many observers interpret zero-based budgeting as corporate speak for huge budget cuts. You can see how they get there: the words ‘budget’ and ‘zero’ might appear to amount to ‘no budget’.

But, as we’ve seen, that’s not how zero-based budgeting works. Yes, it does have a cost-cutting heritage but ZBB is really about improving the way budgets are used. It’s about reallocating budgets within organisations to improve overall shareholder value.

Against this background we can see that if marketers can make the right business case their marketing budgets could actually increase under zero-based budgeting.

Simon Foster

Simon Foster is Managing Director of MUSE, a business modelling consultancy within the MC&C Group and was previously a Managing Partner at Oystercatchers

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