Budgetary Process of the British Airways Group - Coursework Example

Individual Project 2: Annotated Report Outline of British Airways Introduction British Airways (BA) is the biggest airline among the UK centered airlines by way of fleet size, number of international flights and international destinations. BA has its headquarters in waterside near its main hub at London Heathrow Airport. Its second hub is London Gatwick Airport. BA signed an agreement with Spanish carrier Iberia to form Europes second largest airline group. British Airways began discontinuing all direct overseas flights from UK airports other than Heathrow, Gatwick and London City Airport. The British Airways Group was created on 1 September 1974 with nationalization by the Labor Government of the time. BA was formed by merging two large London-based airlines, namely BOAC and BEA, and two very small regional airlines, Cambrian airways Cardiff and Northeast Airlines Newcastle upon Tyne. All four companies were dissolved on 31 March 1974 to form British Airways and almost thirteen years later, in February 1987, the company was privatized. Despite being a primarily Boeing customer, British Airways is the largest operator of the type in the world. 1. Budgetary process and procedures BA has adopted a competitor centered budgetary process. Its budgetary procedures are determined by the need to preserve its existing market share. Despite a recent financial shake up the company still largely remains what it was in its heyday of its operations in a purely guaranteed monopoly market. BA has been compelled to adopt a series of budgetary rules that were not in operation when it was in the hands of the British government. During the past three years the company has introduced some innovative budgeting techniques to face the twin challenges of global economic and financial crisis and the stiffer competition coming from low cost or budget airlines (www.britishairways.com). A Full Service Airline (FSA) like BA finds it difficult in budgeting for change, especially in respect of acquisition of new assets and the disposal of old assets. BA has adopted the following budgetary procedures against the above backdrop. There is a fully comprehensive follow up procedure in cash flow forecasting. Asset phase-out procedure is connected with selling old assets when they are still usable like aircraft and replacing them with new assets to overcome operational process related handicaps that many other airlines are faced with right now. Annual budgets are not necessarily discrete but rather conflated so that budgeting for continuity is the raison d’être behind its current budgeting procedure based on expenditure control (Moyer, 1996). Its subsidiaries/divisions are subject to the same process and procedures so that loss incurring subsidiaries are much less. When loss incurring subsidiaries struggle to match their income with expenditure, BA dispose of their assets to recoup losses in time rather than persist with them. Evaluation techniques involving performance of assets and their contribution to the company’s revenue are based on the most significant financial ratios such as earnings per share and net revenue (Gillen & Gados, 2008). Comparative performance of its divisions such as administration and engineering is evaluated on par with the same standards applied to BA. However, there is a fundamental difference between `the existing process and procedural techniques that have just been introduced at BA and most of its subdivisions, i.e. they don’t share a common platform for information dissemination and customer relations management. As such budgeting procedures aren’t the same. 2. Management Accounting System (MAS) at BA Accounting information is disseminated at BA with particular emphasis on the administrative sphere. BA manages its administrative structure with outsider networks of solely owned units that handle area-based administrative work like booking and handling customer inquiries. The MAS framework is based basically on this network of self-contained individual administrative units that are contracted as service providers. In other words the management functions of the company are outsourced to a certain extent and the management structure is diverse and diffused (Collison & Boberg, 1987). As against Cost Accounting System (CAS) MAS at BA is characterized by a degree of synchronization with subsidiaries. This is basically attributed to the fact that heads of divisions at BA are bound by a uniform rule-based structure as per administration. But nevertheless as per operations there is a greater degree of independence between divisions. BA’s management structure is characterized by a horizontal chain of command and a span of control. However, the top hierarchy is vertically structured while the middle level and bottom level staff are horizontally structured. As a result of this management structure MAS has become much less centralized at the top level. There is also administrative unit level independence for MAS activities. For example, accounting departments at all units exercise a degree of freedom in designing, developing and implementing MAS related concepts to a greater extent (Spiceland, Sepe & Nelson, 2010,). Therefore it must be noted that management structure at BA is helpful towards the formation of independent MAS based operations. Managers of sub divisions at BA are expected to practice both lean and throughput management accounting systems that are intended to empower managers to perform some critically important tasks in a highly competitive airline industry environment. Thus both functions and systems are sought to be integrated at the divisional level for increased resource mobility and utilization. Functions and systems cannot be integrated without different areas of MAS being adopted simultaneously within the organization and its sub divisions (???). MAS can be divided into Strategic Management Accounting (SMA), Performance Management Accounting (PMA) and Risk Management Accounting (RMA). SMA is considered to be of great significance to the unit manager because both the financial division and the management division of the same unit ought to rectify the recurrence of decision errors. For instance, at BA both engineering division and the ground handling staff at Heathrow Airport have been increasingly identified with trade union related activism and therefore the top management has sought to integrate these divisions in to a strategic conceptual management accounting framework consisting of SMA, PMA and RMA. Despite these efforts the organization has suffered a number of setbacks in day-to-day management accounting operations. BA has adopted an SMA framework of broader reference for divisional managers on the premise that both functional and task based operations of each division would be subject to a regulated regime of supervision and integration. While uniform standards of auditing practice and corporate social responsibility (CSR) initiatives have also been integrated in to MAS at BA there is still a lack of lean auditing and accounting practice as a whole at the divisional level (Evans, Campbell & Stonehouse, 2003). This shortcoming has been highlighted as one of the most critical in RMA related operations. PMA centric methodology at BA is basically concerned with strategies that are focused on achieving predefined managerial goals such as divisional level output, quality management and implementation of accounting and auditing standards. While HRM managers at BA and its subdivisions are expected to coordinate with each other and financial division staff, there is very little follow up work with respective MAS procedure. Despite this shortcoming the organization has created a highly independent operational environment for managers of sub divisions to interact freely, so that performance related accounting practices include value generation on par with standard industry practice. RMA practices at BA have also been characterized by a similar approach, though there is no tendency on the part of individual managers to share each piece of information on risk reduction and management strategy (Möller & Halinen, 1999). Unit managers are expected to initiate information sharing and retrieving systems that are interconnected at all levels. While access to information is on the basis of responsibility the top management has delegated a considerable amount of responsibility for information dissemination to all sub divisional managers. While accounting information is basically a privilege shared by only a few managers in the respective departments, there is a considerable amount of information dissemination from top down at BA on some important management accounting procedures. 3. Cost Accounting System (CAS) Cost Accounting System (CAS) at BA is highly characterized by the same level of sub divisional integration as MAS. However, there is a fundamental difference in the process of information dissemination and sharing. In the case of latter sub divisions operate with a greater degree of independence. However, in the case of CAS managerial staff are inter linked functionally to achieve a substantial amount of task based coordination. For example, BA’s sub divisions managed by independent contractors like IT service suppliers are constantly advised to keep a tab on cost operations, so that the organization as a whole would not be compelled to pass higher cost on to customers (Aksoy, Atilgan & Akinci, 2003). As a corollary of the above regional sub divisions or offices that are independently managed on contractual basis are compelled to adhere to costing methods adopted by the organization. For example, in the case of asset valuation, depreciation and investment appraisal Net Present Value (NPV) is often adopted but nevertheless it is not the sole technique. Recently BA was forced to re-examine its overall CAS with specific focus on the costing strategies adopted after the acquisition of some more slots at the Heathrow Airport. Unexpectedly the current global economic recession forced FSAs like BA to adopt far reaching changes to their CAS and as a result BA in turn forced regional operations managers to target cost related productivity schedules. But nonetheless there was very little positive response at the beginning. Sub divisional managers at BA are empowered to make decisions only in respect of day-to-day management functions. For instance, financial staffs are expected to carry out those duties strictly in keeping with day-to-day operations. Assuming that both managerial functions and departmental coordination on CAS take place in conformance with recent cost cutting measures introduced in the wake of global economic crisis, then it can be presumed that CAS related activity at BA is basically intended to overcome current operational cost related overheads such as material supplies procured from private contractors. Contractual obligations are subject to prearranged terms and conditions and therefore agreements are subject to renegotiation only after a stipulated time period. Critics of BA’s CAS policies and strategies have just criticized the inclusion of non – negotiable clauses which are rather unfavorable to BA. CAS measures including cash flow strategies at BA include the following. BA’s cash flow forecasts are strategically determined to include current cost reduction methods such as selling short life span assets and disposing of old stocks of material. Costs are calculated on the basis of market value of both mobile and immobile assets. For example, even old aircraft are subject to book value plus a margin costing method. CAS at BA is also influenced by modern market valuation of assets while losses are sought to be spread over a longer duration of time. Sub divisional managers at BA are advised to improve profitability of the organization by reducing costs. Especially managers are required to cut down on overheads, such as those costs that are directly related to CSR initiatives. Some CSR initiatives have been discontinued in an effort to reduce overheads. BA’s profit margins have been shrinking over the years and as a result managers at sub divisions have come under pressure to initiate cost control measures that go beyond the hitherto practiced norms in CAS. Finally BA’s financial and accounting departmental structures invariably support loss minimizing and revenue maximizing efforts at the divisional level. Standard cost accounting practices have been adopted with specific emphasis on lean cost management procedures. For example, BA has been influenced by recent EU regulations that compel multinational companies (MNCs) to restructure their financial management structures in conformance with common regulations that are intended to prevent bankruptcies. BA has adopted a strategic initiative on depreciation of aircraft and ground handling equipment and as a result there is a big change in calculating depreciation. In the first instance depreciation takes place much slower than otherwise it could be. This is intended to keep the existing stock of wholly owned and leased aircraft running as long as it is economically feasible. Secondly the organization is wary of competitors’ moves (Park, Park & Zhang, 2003). For example, North American airlines and some budget airlines in Europe have adopted strategies with far reaching consequences for FSAs like BA. These strategic measures of rivals have forced BA to identify possible weaknesses and remedy them immediately. Shrinking profit margins and rising operating costs are the most glaring weaknesses of the organization. 4. Capital Decision Making Capital decision making process at BA can be divided in to three segments. a. Equity share ownership by employees Equity share ownership was particularly encouraged at almost every denationalized or privatized former government businesses. BA is one of them. This tradition of equity ownership by employees was so popular during Thatcher’s regimes. However, subsequently employee equity share ownership concept declined in acceptance. The subsequent developments brought a new dimension to the BA’s capital structure. Employee share ownership of equity was considered to be a sacrosanct feature in the 1980’s, the period in which so many British government owned businesses were privatized. b. Debt capital is increasingly replacing equity capital During the late 1990’s BA’s capital structure received a big change in that debt capital began to replace equity capital at a rising rate. For example, when managers at BA began to be threatened by a powerful stakeholder community of ordinary shareholders, the former responded by exercising their discretion. As a result more debt was borrowed and managers’ power began to increase. For instance, trade-off theory was gaining ascendancy with managers who felt that the presence of bankruptcy costs was not harmful. Thus, managers became more assertive and independent in the decision making process. As per Miller-Modigliani Theorem capital structure determination at BA continued to favor ordinary shareholders when government protection by way of soft loans was prevalent (Modigliani & Miller, 1958). With the new emphasis on creating a competitive edge by making use of tax holidays granted by the government to private enterprise, BA restructured its capital and sought to achieve tax related synergies by relying on borrowing from commercial sources at very competitive interest rates. c. Capital structure at BA favors debt capital owners against equity owners Debt capital owners at BA are favored by managers because managers are able to manipulate the debt structure for their decision making freedom. In other words finance mangers at BA exercise a greater degree of discussion in financial decision making process. This freedom in turn leads to an excess amount of debt borrowed at commercial rates. In the absence of renegotiation clauses in the debt instrument BA might be affected by unfavorable long-term terms and conditions (Damodaran, 1997). Despite this handicap managers at BA have manipulated the debt restructuring programs in the wake of the current global financial crisis in a manner that much of the debt capital is secured against reinsurance policies. This in turn has enabled top level managers to implement decisions affecting most of the organization’s future debt restructuring plans. For example, the recent decisions to pay dividends to ordinary shareholders only when after-tax-revenue has reached a certain target are a clear indication that managers’ ability to manipulate the debt structure in keeping with future expansion strategy at BA is much more relevant in understanding how managers have made use of their powers. Decision making process at BA in the early 2000’s was subject to a greater change with managers realizing the need to meet debt obligations at regular intervals and the threat posed by the financial crisis (Jensen & Meckling, 1976). This dimensional shift has added to the curtailment of managers’ freedom though capital decision making freedom at BA is not synonymous with some market related outcomes. For instance when budget airlines began to threaten the open skies policy enjoyed by BA elsewhere in Europe, market reforms in the rest of Europe were favorable to budget airlines since they were operating in extremely low-cost environments. FSAs like BA were subject to tax related pressures such as those directly affecting the capital structure. While theoretically tax exemptions are made use of by organizations to increase after tax earnings, the manager is much less free to manipulate the government policy despite tax exemptions being substantial when volumes generated are substantial. 5. Capital Structure of BA Capital structure of the firm is defined as the manner in which a company would seek to finance its assets by using a combination of equity and debt or/and some hybrid securities. It’s a long term effort to keep the company going (www.investorwords.com). A company’s capital structure is determined by the manner in which it combines its assets such as between equity capital and debt capital. If the company issues 90% debt and 10% equity by way of ordinary shares then its capital structure is 90% financed by debt and 10% financed by equity. Weighted average cost of capital (WACC) is a measure used to calculate the amount of debt that a firm holds against the amount of equity. However it’s much better to put it this way it’s a measure of the amount of debt that a firm should hold against the amount of equity. Thus capital structure of the firm is basically determined by the WACC and the formula given below explains how it’s calculated. This is also the basic determinant of performance. [Rd x D/V x (1-5)] + [Re x E/V] Rd = Bonds yield up to maturity; D = Market Value of Bonds; (1 - t) = 1 - tax rate = Deductible tax shield of interest expenditure; Re = Shareholders return requirement; and V = Total value of (Debt + Equity). As Figure 1 below shows the levered firm stands to gain by way of tax deductions, i.e. it is entitled to compensation of interest related expenses. This means leveraging would help the firm to pay less taxes than those unlevered firms (Lightner, 2008). Thus it brings the argument to the very beginning again. M&M proves that as long as the capital market is efficient in preventing additional costs of borrowing, i.e. other variables remaining constant, then leveraging helps the firm to achieve a degree of efficiency but capital structure itself does not determine the value of the firm. BA’s capital structure is coming closer this position with ever increasing leveraging by the top management. Naturally debt issue gives out a positive message to the financial markets while an equity issue gives out a negative message. Further the cost involved in an equity issue is much higher in comparison to a debt issue. Pecking order theory does not necessarily comment on the value determination of the firm; neither does it discuss irrelevance of the capital structure to value determination (Damodaran, 1997). However it adequately explains the circumstances under which the firm raises debt so that the subsequent outcomes focus on the irrelevance of capital structure to the determination of value. The firm might borrow and invest, it can issue shares or/and it can reinvest money from its reserves. Whatever it does, its freedom to choose between choices is limited by the very structure of capital. In other words the leverage decisions might interfere with its freedom to have more of one and less of the other even if it were desirable. Despite this limitation according to M&M there is no need for the firm to have a dividend policy (Modigliani, & Miller, 1958). Above all M&M seeks to prove its validity through an example of two firms, one adopting a leverage policy in which the firm borrows money partially (debt) and finances its assets and another adopting an unlevered approach in which it finances its assets only through equity. M&M comes to the conclusion that the value of both the firms would remain the same. BA has been seeking to increase the value of the organization. Jensen and Meckling (1976) however question the credibility of M&M’s assumption that individual firms make their investment decisions with no regard to capital structure. They cite the asset substitution effect as the basis on which such conclusions cannot be warranted. In other words equity-holders of levered firms can benefit at the expense of debt-holders through manipulating risk when investments have been made. As for a particularly advantageous position of the firm vis-à-vis its competitors, there is very little to be mentioned by way of well-geared capital ratios Swift, A 2002 The theory does not necessarily mention about the relevance or irrelevance of capital structure except to support a very high content of debt or leverage. As for the dividend policy of the firm, the theory seems to identify the existence of a dividend policy depending on the degree of leverage. The higher the leverage the higher the after-tax profits for distribution or/and ploughing back into the business. This outcome has been cited as the most relevant for the current level of operations at BA. BA’s leveraging efforts are aimed at just increasing its top management’s ability to manipulate equity capital holders’ ability or inability to exert pressure on managers to comply with EU financial regulations that are too stringent by any point of view. 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