The CFO as the Architect of Zero-Based Transformation
The best approach to zero-based transformation comes from treating all spending as investment and making the CFO a key strategist for generating value.
This article was first released in November 2019 and has been updated.
Recession or not, businesses are being squeezed from all sides: decades-high inflation, heightened geopolitical tensions, protracted supply chain disruptions and pandemic-related issues, labor shortages and salary pressures, and funding pressures for their digital and ESG agendas. Add to that mounting investor activism and the likely resurgence of M&A activity, and the result is a stew of epic challenges.
As companies contemplate ways to free up funds to save money and shore-up balance sheets, many are turning to a zero-based transformation (ZBT). Grounded in zero-based budgeting principles, ZBT goes beyond selling, general, and administrative (SG&A) costs to take a cross-business-unit, cross-functional view of the entire enterprise. With ZBT, leaders can shape initiatives from the bottom up while weighing strategic tradeoffs—and working collaboratively to instill a sustainable savings mentality.
ZBT can foster top-line benefits, reconfigure cost structures, and free up investment funds, unlocking tremendous value that can be a source of growth. But this strategic approach requires a profound shift in thinking—and in how a company and its people operate. And in that respect, it is more than just a discipline.
As with any transformation, it’s best to implement ZBT proactively—even during a downturn. History repeatedly shows that businesses that invest during economic slowdowns come out markedly stronger. Rather than ponder how to survive a downturn, successful companies set themselves up to thrive regardless of the economic environment. For those companies that never adopted zero-based budgeting—or aren’t using it to prime growth—now is the time to implement ZBT, before the economy puts their survival skills to the test.
Long-term total shareholder return (TSR) depends, above all, on growth. When companies respond to a slowdown with broad-brush cost-cutting measures, they often trigger a negative cycle of declining revenues and shrinking margins, leaving a smaller pool of capital available for investment.
By definition, zero-based budgeting has always rejected blanket cost-cutting. It entails meticulously scrutinizing expenditures and, in many cases, resetting budgets annually to ensure the most efficient and effective use of resources. ZBT goes a step further: it integrates tightly with a company’s business strategy and its growth levers. ZBT calls for distinguishing between high-value-adding costs and low-value-adding costs. The idea is to eliminate inefficient spending and redirect it to more strategic, growth-oriented uses.
When applying ZBT, companies start with three questions: What is our top-line aspiration? What investments are necessary to reach it? And how should we structure the cost base to enable those investments? This approach recognizes that it takes more than cost discipline to fund investments and opportunities that foster growth. Like its earlier incarnation, ZBT is not a one-time exercise; rather, it’s a way of doing business, infused in everything a company does.
Zero-based budgeting has long been commonplace among consumer products companies—its early adopters. But its appeal has spread across industries, and for good reason: it’s appropriate for any industry and offers essential benefits at a critical time. Growing uncertainties, competitive pressures, and global economic volatility, along with the ever-present threat of disruption, require companies to be as lean, flexible, and adaptive as possible. ZBT, a more evolved version of zero-based budgeting, could well be the most important way a company strengthens itself, both defensively and offensively.
ZBT supports the ability to strategically target cost reduction while freeing up funds for growth. Because expenditures are classified according to their type, rather than their point of origin, ZBT brings once-hidden costs to the surface. This added transparency, together with clear cost accountability and cost-management methods, facilitates and encourages the much-needed discipline that helps companies better identify high- and low-value costs and make conscious, strategic decisions.
For global companies, this transparency enables de-averaging, which is particularly important during downturns. Applying a universal cost-reduction policy or cookie-cutter approach to operations across markets and regions with different conditions and opportunities makes little sense.
Along with securing efficiency in the cost base, ZBT also simplifies and creates organizational efficiencies. Cost reduction is essentially the strategic enabler: you remove bloat to fund opportunity and nimbleness.
Proactive adoption is key, even with traditional zero-based budgeting. Consider how it paid off for two leading global companies. A consumer goods giant thoughtfully excised 25% of its SG&A budget, applying those funds to successfully fend off a takeover. During the pandemic, a premium-spirits maker culled 20% from its budget, savings that it plowed back into its brands. The result was record growth.
Research from the BCG Henderson Institute shows that preemptive transformation of any kind generally yields a greater payoff, because it boosts a company’s capacity to grow instead of merely survive. The Institute analyzed hundreds of corporate transformations that large, listed US companies undertook during the past decade. It found that companies that implement change preemptively generated significantly higher long-term value than those that responded reactively. In the three years after a transformation began, the preemptive transformers achieved an annualized TSR that was 3 percentage points higher than the annualized TSR of reactive transformers. Furthermore, the preemption premium has long-lasting effects: the earlier a company transforms, the better its future performance. In fact, that’s the most important observable success factor in corporate transformation.
Acting preemptively delivers other benefits as well: the transformation can be executed faster and for less cost. Those two benefits combine to produce a return on investment that is about 50% higher than the ROI of a reactive transformation.
The value of restructuring the cost base proactively is, as with other types of transformation, especially striking when we consider the fate of companies that wait to act. In the period leading up to the global financial crisis that began in 2007, companies continually absorbed higher costs as long as those costs helped deliver necessary volumes. When the financial crisis struck and volumes plummeted, those companies had to reduce their absolute cost base in order to preserve the bottom line as much as possible. Most companies were caught off guard; although the signs of a slowdown did not escape them, they had underestimated the severity of the prospective downturn and waited to act. For most, their actions amounted to too little, too late.
Additionally, an extensive BCG survey conducted during the initial months of the crisis found that even as events unfolded, some companies remained surprisingly complacent, neglecting to create contingency plans in the event of a deepening and prolonged slump. As the CEO of a large industrial company observed at the time, “Managers look at their balance sheet and cash reserves and think they are safe. But they are very surprised by how little time they have once demand drops like a rock.”
Consider the example of a major consumer goods company. Because the company wasn’t proactive, it had to take draconian measures after suffering a double-digit decline in profit in mid-2009. The company was forced to promote basic versions of its major brands, cut prices, and increase package sizes in order to compete with private labels. Analysts cautioned that these stopgap measures would do little to promote long-term profit growth or support innovation.
The delayed response of many companies cost them in another painful way: they had to use savings culled through their emergency austerity efforts to shore up their balance sheets in order to protect access to financing. Thus, their savings assisted only in the short term and could not be used to improve their long-term positions.
To stay primed for growth, companies must maintain strategic momentum regardless of market conditions. They must sustain marketing support, carry out internal improvements, seize M&A opportunities, and pursue innovation. An upside is that such activities are generally cheaper in downturns and out of the reach of cash-strapped competitors.
During the height of the Great Recession, a multinational consumer goods company took such steps. It not only carried out its advertising and marketing plan, taking advantage of the decline in media prices to secure more coverage for the same cost; the company also made an unprecedented double-digit increase in its marketing spending. While peers disappeared from consumers’ view and were forced to cut prices amid rising costs, the company ratcheted up investment in its brands, shrugging off widespread concerns about the encroachment of private-label sales. Despite anemic growth in household products, the company achieved organic top-line growth of 10% in one year.
Cutting R&D, an inevitable step for most companies in reactive mode, can also have debilitating long-term consequences on innovation. During the recession, as competitors pulled back on R&D spending, the consumer goods company continued investing in innovation—a critical decision, given that new products and line extensions typically sell better and command higher prices in that industry. Executives bet that consumers would gladly pay more for innovation regardless of economic conditions—and they were right. Amid the worst global recession in 70 years, the company achieved record results.
Outperformers in a recession remain market leaders (in revenue and stock price) for years afterward, and this company was no exception. From 2007 through 2012, a period that spanned the depth of the last recession and extended well into the recovery, the company significantly outperformed its peers in TSR; it also beat the S&P 500 and the S&P 500 Consumer Staples Index. More impressively, the company maintained its robust TSR performance for more than a decade.
Because ZBT is as much a mindset as it is a way of working, it can only take hold within the right organizational context. (See the sidebar “Shaping a ZBT Culture.”) Cultural change must start at the top. The CEO and CFO must be actively involved not only in determining why ZBT should be adopted but also in articulating how it will contribute to the company’s long-term growth.
The CEO and CFO must also design the most appropriate ZBT program. They, along with other leaders, will need to refocus their energies, recognizing that ZBT is a long-term journey and that everyone needs to embrace the new culture of cost ownership. Leaders must model the desired behaviors, demonstrating how to communicate, set priorities, and interact with others. Leaders can also agree up front on how to reinvest savings for growth and communicate that commitment to the larger organization.
Companies can shape the organizational context in many ways, such as by linking desired behaviors to performance management incentives, training and engaging people, communicating the what and the why, and putting in place the right tools. Efficiencies are the aim. The point is not only to eliminate waste but also to streamline processes and structures—and avoid adding new ones.
For all these reasons, change management is essential for sustaining a ZBT. At the macro level, companies need to establish the rationale and messaging, identify those most affected and create a plan for involving them, and support the development of all the levers that will help shape the right organizational context. At the micro level, companies need to help frame the messaging for each initiative in a positive, actionable light (“go paperless,” for example, instead of “no more printing”).
ZBT, when adopted in the right spirit, can do much more than inject cost discipline—it can help companies maintain their strategic momentum even amid difficult economic conditions. History shows that freeing up resources to invest for growth is particularly important during a downturn. It gives companies a significant edge over competitors, many of whom will find themselves struggling to survive. And that edge can have staying power: companies that perform well during a downturn enjoy a performance premium long after recovery sets in.
Because it is not a one-shot effort, ZBT adoption calls for a new mentality and a new culture—which takes time to instill. By taking action now, companies can make themselves nimble, strong, and ready for any challenges that may come.