There is a lot of discussion about zero-based budgeting, where a budget is built from nothing into a detailed spending plan. This process can help many businesses and organizations.
For example, let’s say you have a nonprofit organization. Your previous year’s budget included several projects that can either be kept or cut. Normally, as you prepare for the next year, you ask yourself which of these projects do we want to do again and which of these projects need to be cut because they either don’t deliver enough benefits or cost too much. However, with zero-based budgeting, you start from scratch and instead ask: If we were to build our organization from the ground up, what projects would we consider doing irrespective of any previous projects that we have done? Then, the projects can be ranked so that only the best, most optimal projects are funded based on your budget.
Unfortunately, when we move to for-profit businesses, there is a substantive complication involved because now you have buildings, machines or, in general, capital equipment — all of which took considerable time and effort to build and put together. These are sunk costs, but are eminently available to use — i.e. as sunk values. You have to maintain equipment, but the value is there. Nonprofits might also face these constraints, but it is certainly a factor that the for-profits must consider.
When putting your budget together, look at the kinds of services and products you can offer. But you must also think about your existing capital equipment and what it can give you. It’s no longer zero-based budgeting in the sense that you can do anything you want, but at least you can objectively look at all your capital equipment to see any alternative businesses or services that are possible to offer. Then you rank them for potential profitability and consider objectively which will work best given your constraints.
A business can go further and change its capital equipment entirely; however, not only will you give up a sunk value of your existing capital equipment, but you may also incur a transition or decommissioning cost to get rid of the old equipment. For some businesses, these costs may simply be too high.
In the 1920s, diesel and electric train locomotives were available and created less smoke than coal-powered steam locomotives. However, the railroads already had the coal-fired locomotives in place, with trained engineers, coal supplies and water towers for refueling. If an electric or diesel locomotive replaced steam, then the old towers and locomotives would have to be destroyed or stored. Plus, the diesel and electric locomotives would require new infrastructure such as overhead wires and diesel engine repair shops in order to be used. Furthermore, it was unclear which technology would be cheaper and work best at various locations: diesel or electric. Therefore, with so much uncertainty about the best way to proceed, and with so much sunk value already in place, steam locomotives continued to be used until the 1950s and 1960s.
One of the most interesting case studies of zero-based budgeting, though, might be the Nokia Corporation based in Finland. Nokia started out as a paper mill in 19th century Finland and then, through mergers, acquisitions, divestments, research and development, started making and selling cell phones by the 21st century. And indeed according to Interbrand, Nokia had reached the fifth highest brand value in the world in 2009 before a series of failures and changes lowered it to the middle of the pack.
Still, Nokia had success throughout its history by using the concept of zero-based budgeting and leveraging it with long range planning, deliberate transitions and patient strategic moves that required years and even decades to carry out, rather than just quick jumps into new strategies.
Change, though, is never easy, but zero-based budgeting, as long as it can be leveraged with long-range planning, can successfully make your business dynamic and profitable. The question often comes down to who your customer or potential customer is. And, in the case of nonprofit organizations, who are your stakeholders or potential stakeholders?
The decision to continue using coal-fired railroad locomotives between the 1920s and the 1950s ended up working quite well for the United States, especially during World War II. Those coal locomotives freed up electric power capacity for military factories, and refined fuel supplies for tanks, supply trucks and aircraft carriers, all while still transporting cargo clear across America and in the process giving the U.S. a decisive edge in the war.
Douglas B. Reynolds is a professor of Economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at firstname.lastname@example.org. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.