Budgeting: A Focus on the Airline Industry - Case Study Example

Budgeting: A Focus on the Airline Industry Introduction Over the past few years, the significant increase of crude oil has had a tremendous change in the airline industry. The price of crude oil has increased from $38.27 a barrel in 2004 to $70-85 a barrel in August 2005. In December 2005, the price fell slightly, but it still regained its upward trend in the early months of 2006, particularly in the month of April when it exceeded $70 a barrel. The rise continued to be the order of the day, and reached $100 a barrel and $140 a barrel in the months of December 2007 and July 2008 respectively. Such fluctuations in crude oil have caused macro-economic distortions, especially in the oil-importing countries. The every-day rising of the fuel prices has brought about both negative and positive impact to the airline industry in the USA. The US Airways incurred a loss that was never expected. American West earnings dropped compared with the previous year; while on the other hand, American Airlines recorded a higher profit compared to the previous year, courtesy of increased fares and higher demand at the same oil prices. Airlines have been keen not to raise their fares due to increase in fuel prices, but they cannot do this for long. In some parts of the country, jet fuel prices rose up to about 18% from the second quarter, and 45% from the early-year period. Therefore, the impact of this is felt now more than ever. From the above, it can be understood that the high jet fuel prices will constantly affect revenue, expenditure (also the fiscal position of the government) and cause inflation. This paper attempts to analyze the impact of oil price fluctuations in the airline industry, as well as point out possible ways that decisions makers can use to deal with deviations in budget due to oil price shocks. In addition, a part of this paper will identify the major issues in budgeting, the past reforms that led to today’s way of budgeting, and another part will present a new concept that can be drawn from the airline industry when dealing with budget deviations. Budgeting and its major issues Budgeting is the process of financial planning that sets forth the resources to meet a set of goals for a certain period of time. It is an essential element of financial planning, control and evaluation processes of an organization. Donald (1995) argues that every company should always prepare a comprehensive budget that records staffing, operations, and realistic goals for programs in monetary terms. It is also thought of as an action plan, which helps an organization allocate resources, evaluate performance and formulate future plan in line with the available monetary resources. Functions of budgeting One major function of budgeting is facilitating financial control. Schick (1996) puts it as a control over the inputs of budgeting to make sure that they are certain, accurate, valid, appropriate, legal and honest at the same time. He adds that inputs, which include the amount of money to be spent, are the central point that decision makers base their information on. The second objective is to allow smooth running of managerial activities. Administrators use available information or results, costs, as well as daily operations to evaluate how well the programs are working. It gives the management an easier opportunity to address questions such as how best they can accomplish a given task or which proposed projects and grants should be approved first (Schick, 1996, p. 243-58). Budgeting is also relevant in planning for the future, with the help of agencies or even governments to predict how much a program will cost and relate those costs to activity levels for the numbers of years that it is expected to operate. In addition, budgeting requires entities to employ strategic planning, which means that budget proposals and appropriation as well as implementation should be in line with the chosen plans (Schick, 1996, p. 243-58) Another relevance of budgeting is its nature of setting priorities in an organization, though they differ to the extent to which they facilitate prioritizing. Entities are advised to provide multiple proposals to assist in facilitating prioritizing and grouping proposals from different entities with common goals. This could provide useful information to the management for allocation of scarce resources. Finally, budgeting allows accountability to prevail, whether it is to whom or for what purpose, for example, decision makers will hold administrators accountable of how money was spent if a budget system focuses only on inputs. Budgetary reforms As widely known, budgeting is used to gain superior control over how money is spent. It helps guard money against misuse such as fraud. Over the years, budget reformers have argued that a budget system should also address other functions such as management and planning. This comes amid evident sophistication in accounting and auditing systems that protect agencies against misuse of funds. Whenever a new budget system that is meant to serve a particular function of budgeting is proposed, some of the agencies will adopt and keep it, while others will adopt it, but they will still revert to their previous systems. Change in the budgetary system has been ongoing according to the needs of financial planners. The past budgetary systems did not live up to the financial planners’ expectations, and that gave rise to changes to fit both the past and the current system of financial planning. The budget reformers focused their attention on two major problems; the major one being lack of financial control, while the other one was financial co-ordination. The first problem complicated determination of how funds are spent, therefore, resulting in uncontrolled corruption. The solution to this was the adoption of the line-item budget whereby items were categorized with a lot of details of many government’s units, such as agency as a whole, departments within an agency, and subunits of departments. Therefore, legislators were not in a better position to allocate specified amount of money for specified inputs for a specific period of time and eventually verify that the amount was actually spent. The second problem made different agencies or departments submit their fund request independently and there were usually not enough efforts within legislature to consolidate them into a logical package for submission. But later on, the state moved to executive budget and budget centralization, which increased co-ordination as well and eventually, brought about the influence of government in the budgetary process (Mikesell, 1999, p. 186). Lessons to be drawn from the airline industry and its applicability A great deal of attention has been given to the relationship between oil price fluctuations and the economic activity since the early 1970s. Nowadays, every airline executive knows that it is not a good idea to pass the issue of higher prices on to passengers by raising the ticket fares, and this is due to the extreme competitive nature of the industry. The competition between large airlines on the most routes that they serve means that they cannot raise ticket prices in response to higher fuel costs. A good example is Continental Airlines, which pulled out from a fare hike after a couple of times to boost overall fares. They increased airfares due to high fuel costs, but the extreme competition left the firm incapable of passing the pinch of fuel costs to its clients (Carter, Rogers, & Simkins, 2004). Therefore, this has posed a lot of questions on the best solutions to this oil price shocks that keep haunting the ever-growing industry. In regard to this, the following are strategies that have been applied by some airlines, which can be integrated by other airlines to ensure that oil prices do not mess up their budgets. Spin-offs and outsourcing Jay Sorensen, the president of airline marketing consultancy IdeaWorks Co., in Shorewood, Wis, favors the spin-off idea, which is building teams across the industry that is marred by soaring oil prices and reduction in stock values. Analysts, consultants, and investors have come to believe that frequent-flier programs, which sell miles to its partners, can bring in more money than the airlines they support. Therefore, splitting off a subsidiary can lead to a better decision making at both units, as this makes it unavailable to subsidize a subsidiary (Trottman & Carey, 2007). Another strong evidence for successful outsourcing in the airline industry is Air Canada, which gained billions of dollars after it rose from bankruptcy in 2004 by spinning off its maintenance division and frequent-flier program into different businesses. The aftermath after September 11 was increased costs of technology, labor, maintenance of infrastructure and many high-profile airlines went into receivership. All these stirred a contraction of airline MRO activities, shedding of assets and a reshuffling that continues to date. Examples of airlines that have drawn down their MRO and outsourced more include Alaska Airlines, US Airways, and Northwest Airlines. They joined Southwest Airlines, Fedex and a few new entrants relying on outside MROs (Shifrin, 2007). Hedging of fuel costs In 2000, fuel prices rose by about 18% from the second to the third quarter, and 45% from the early-year period and the impact was immense. Despite this, American Airlines was able to save $158 million in the quarter, which is equivalent to 19 cents a gallon on the cost of jet fuel. This airline, which is a unit of AMR Corp., of Forth Texas made the best use out of the woes that their competitor United Airlines, a unit of UAL corp., was drowning in. These woes made American Airlines fill 76.3% of its seat capacity, which was an increase from 71.8% a year earlier. In addition, American Airlines recorded a withdrawal estimate of between $80 million and $100 million in revenue, thanks to Chicago carrier’s labor dispute that caused thousands of flight delays, as well as flight cancellations. This eventually led to an increase in profits share by 22 cents. American Airlines used the idea of hedging of fuel costs, which they did successfully (Trottman & Carey, 2006). US Airways Group Inc. did not hedge its fuel in the quarter as American Airlines did; hence, they suffered a big blow when they posted a wider-than-expected net loss of $30 million, which equates 45 cents a share. Furthermore, the airline was to post a loss of 19 cents a share as surveyed by First Call/Thompson Financial (Trotmann & Carey, 2000). Mergers and acquisition Due to the US Air’s year earlier loss of $85 million, which equates $1.19 a share, more problems emerged. It experienced extreme operational difficulties and labor strife, including threats of workers strike, but an agreement was reached with only seven days remaining before the International Association of Mechanists members walked off the job in late September 1999. Even though US Air’s revenue rose afterwards by 13% to $2.38 billion, up from $2.1 billion in the previous year, it led to an operating profit of $5 million, down from an operating loss of $110 million a year earlier. This later led to its rapid expansion in the next quarter. It did not deter them from approving a merger proposal from United Airlines to acquire US Air for $4.3 billion, and an assumption of $7.3 million in debt and lease obligations (Trotmann & Carey, 2000). Capacity cutting Capacity cutting has also been a budgeting concept in the wake of high oil prices. The moment carriers reduce capacity; it results in loss of jobs. Fluctuation of oil prices is virtually uncontrollable, and this messes up budgets of airlines, especially when there is an acute shortage. Due to this, it is difficult to forecast how much will be spent on it. In many areas of the operations, cost reduction has already been largely realized, and it has now narrowed down to be a labor problem. At the same time, employees rightfully want their share, and they would like to make up for the dispensation of the past. But the problem is the pre-structuring high water mark, when oil was around $30. That is what labor wants to return to, which is not possible and it is not definitely sustainable. That is why capacity cutting is being used to correct cases of fuel shortages, which leads to increase in fuel prices (Swelbar, 2011). Even as some airlines incorporated these methods to contain the oil situation, some are still on the cross-roads. Trottman and Carey (2006) point out that despite some hedging and 89% “inordinately high” tax rate, America West’s net fell by 94% to $1.3 million, which is equivalent to four cents per share, although First Call/Thompson Financial expects the airline to earn 15 cents per share. The Phoenix carrier was characterized by flight delays and cancellations due to continued operational problems. In particular, the month of July posted a 6% cancellation of its flight and on-time performance of 64%. Douglas Parker, the president of the company confirmed the poor run of operations and that they are doing all they can to win back lost customers, which they have not done so far (Shick, 1996). Other applications that work hand in hand with the above concepts It is always good to know your current and future capacity needs. There is no need for a surprise request for additional supplies during a fiscal year. Nick Johnson, director of marketing at Uptime Software advises companies, especially in the IT industry, to properly estimate physical resources, virtual, cloud compute, and storage capacity and understand growth rates. He adds that managers should not forget to talk to their clients to know if they are undertaking any project that may shoot the demand on services or products. He continues to say that the management will better understand why and when the business will need the additional capacity by using graphs and reports as well as capacity tools for physical, virtual and cloud capacity trending and planning. This will clearly make them understand the capacity trend and how it communicates expenses that need to be made on a quarter-to-quarter basis in order to set expectations (MacKinnon, 2011). Always be on the lookout for downtime as it is costly. Making sure that all the company’s systems are reliable will not only protect the company’s reputation, but also save a lot of money by preventing customer loss. Todd Finders, director of global data center services at Emerson said that as part of the budgeting process, IT and data managers should take into consideration the cost and overall impact of downtime. He added that a good number of companies have experienced unplanned downtime in the recent past, but most of them do nothing about it due to lack of enough resources and investments in place to respond accordingly (MacKinnon, 2011). It is advisable to approach budgeting process with wisdom just like Stahl of Info-Tech points out the struggle that leaders in midsized organizations have with budgeting process. He argues that most of these companies treat budget as an event rather than an ongoing process of enhancements, reporting and negotiations. Nonetheless, a majority of the leaders or managers are very much interested in learning about budgeting metrics like proposals, calculations, estimation and projection as well as negotiations. According to Stahl, many IT managers focus on the near-term CAPEX and the 12-month OPEX. This usually creates a budget environment that business initiatives are thoroughly vetted, but are not revisited through a needs’ analysis when it is past business strategies. Finally, Stahl says that IT managers should be held accountable for the long-term costs linked with those past business strategies that have become a ‘legacy’ (MacKinnon, 2011). Conclusion This paper attempts to analyze the impact of oil price fluctuations in the airline industry, as well as pointing out possible ways of dealing with deviations in budget due to oil price shocks. From the above discussion, it is clear that budgeting is inevitable in every organization. As oil prices keep rising every year frustrating the airline industry, it is certain that airlines cannot stop it, but they can manage it by use of applications like spin-offs and outsourcing, hedging of fuel prices and capacity cutting. They can also borrow a leaf from other industries, to compliment or supplement this problem that keeps messing their budget. Apparently, as increase in oil prices improve fiscal deficit of oil producing countries, oil importing countries have their fiscal deficit positions worsened (Carter, Rogers, & Simkins, 2004). References Carter, D. A., Rogers, D., & Simkins, B.J. (2004). Does fuel hedging make economic sense? The Case of the U.S. Airline Industry. Oklahoma: State University working paper. Donald, A. (1995). Budgeting for modern government. New York: St. Martins. Retrieved from http://www.aviationnow.com/aw/generic/story.jsp?id=new MacKinnon, A.C. (2008). The budget process: Balancing the budget is a question of planning and streamlining. Processor Articles, 33(3), 28-29. Mikesell, J. (1999). Fiscal administration. Forth Worth, TX: Harcort Brace. Shick, A. (1996). The road to PPB: The stages of budget reform. Public administration Review, 26, 243-58. Shifrin, C. (2007). The changing structure of MRO: Overhaul & maintenance. Retrieved from Swelbar, W (2008). Is oil a cancer or a cure? Retrieved from http://www.swelblog.com/articles/oil-and-water-jet-fuel-and-labor.htm Trottman, M., & Carey, S. (2006). American's net soars, but high oil prices sting US air – America west's profit disappoints amid 18% rise in fuel costs from 2nd to 3rd period. Retrieved from http://search.proquest.com/docview/ Trottman, M., & Carey, S. (2007). Airlines mull spinning off mileage plans. Wall Street Paper, B1. Read More