Main Issues in Budgeting - Case Study Example

Budgeting Heather Jenks BUS630 Managerial Accounting Moustafa Ahmed January 7, Budgeting Budgeting is the process of monitoring and controlling the allocation of corporate funds to activities that support day-to-day business operations, sustain the viability of the business in the long run, and aid the business in recovering control of financial resources. As such, a budget is tied to business goals and objectives, current and expected financial capability, and management strategies. In a business environment where there are uncertainties, budgeting is a means of managing risks. Issues in budgeting arise from the influence and confluence of internal and external factors that create anticipated and unanticipated risks. (Davis & Davis, 2012) Industry context determines the particular risks that affect the budgeting process and outcomes in certain businesses. In the airline industry, fuel price volatility constitutes an external risk that significantly affects the budget of airlines. Fuel hedging is a strategy practiced in the airline industry to stabilize the budget and offset risks involved in changing prices. Fuel hedging can result to benefits and/or downsides relative to the budget of airlines. Fuel hedging does not ensure absolute positive results for all firms and in all circumstances. Budgeting is a complex process influenced by various factors that could lead to different outcomes. There are lessons to be learned by considering budgeting in the context of fuel hedging in the airline industry. The succeeding discussion focuses on the issues involved in budgeting by taking the case of the airline industry. Lessons on budgeting are drawn and practical applications are identified. Main Issues in Budgeting Budgeting should be realistic and based on a thorough analysis of a firm’s financial needs, current and expected revenue generation, and business objectives (Davis & Davis, 2012). Several issues emerge in realistic budgeting and the analysis of the firm’s condition and targets. These issues are estimation; timescale prioritization; recording monitoring and managing income and expenses; and revision of the budget. These issues are experienced by firms in the airline industry. Estimation Estimation in budgeting is deriving a forecast of the extent of resources needed by the firm for particular expenditure areas (Robinson, 2007). An accurate estimate would result to a budget that is very close to the actual amount of resources used. Among airline companies, fuel cost constitutes a significant expense comprising around one-third of the overall budget for a certain period. Airlines need to estimate the expected fuel cost in a given period to be incorporated into the overall budget for that period. Estimation involves uncertainties because of unexpected factors. An unexpected factor is change in the cost of fuel. Airline companies do not have any control over the price of fuel since many factors, from both the demand and supply side can affect the price. The extent of change in fuel prices are also beyond the full control of airline companies. (Karp, 2008) In 2000, fuel prices increased by an average of 18 percent between the second and third quarter to represent a 45 percent increase in the same period of the past year. Estimates of many of the airline companies in the U.S. were not able to approximate the actual price increase. As a result of the wide gap between the estimated change in fuel prices and actual fuel prices, U.S. Airways incurred losses while America West achieved profit levels much lower that its projections. (Trottman & Carey, 2000) While estimation is wrought with uncertainties, managers and decision-makers lessen the gap between expected and actual expenses by learning from repeated experience of the estimation process given different price situations. Fuel hedging involves an estimation of the rate of change in fuel prices over a given period and entering into an agreement for the supply of fuel at a particular price within that period. The contract represents a price where the airline or the oil company both benefit from controlling the risk of incurring losses. (Karp, 2008) In 2000, American Airlines appeared to have achieved a closer estimation of the rate of increase in fuel prices for the second and third quarters so that it entered into a fuel hedging agreement for this period. Fuel hedging resulted to better earnings for American Airlines since actual fuel prices exceeded the hedge price. American Airlines reported significant earnings while other U.S. airlines incurred low earnings or experienced losses. (Trottman & Carey, 2000) Time Scale Prioritization Budgeting implies the scarcity of resources so that not all cost factors would receive a budget or available resources are spread throughout expenditure areas. The issue is in the prioritization of certain cost factors throughout the period of the budget or within different times along the budget period. With fuel prices comprising an uncertainty in the airline industry, prioritizing allocation for fuel with or without hedging is a consideration. If a firm engages in hedging, employing a hedged price for the entire budget period or a changing level of hedged price for different times during the budget period is a further consideration. (Karp, 2008) Between the second and third quarters of 2000, when fuel prices rose to unprecedented highs, some of the U.S. Airlines have not engaged in fuel hedging agreements. Presumably, these airlines anticipated an offsetting effect in the rise and fall of fuel prices for the average price to fall within estimates for the period. Unfortunately, the rise in fuel prices was upward. As a result, only American Airlines was able to achieve good performance during the period because it engaged in fuel hedging. For the third quarter, American Airlines was able to save $150 million from fuel hedging for the second and third quarters. (Trotter & Carey, 2000) The timing of hedging is important. In 2000, American Airlines gained much from fuel hedging while American West engaged in fuel hedging to some degree but this was not sufficient to prevent losses (Trotter & Carey, 2000). In 2008, during the peak of the economic crisis, airlines in the U.S. experienced two periods of fuel price highs that caught the airlines off guard. In 2009, there is pressure for the airlines to engage in fuel hedging. However, many airline companies were cautious about the timing of hedging since price could also work to their disadvantage, such as when prices in 2009 would become lower than the hedge price. (Peterson, 2009) While caution is warranted, decisiveness on the timing of hedging is important since this could usher in cost savings or result to losses. Recording, Monitoring and Managing Income and Expenditures Keeping track and controlling the flow of income and expenditures is important in determining progress towards the achievement of the parameters of the budget and the purpose intended for the budget. There may not always be readily available funds to meet the budget for a certain period. It is not uncommon for expected earnings to become the basis of resource allocation for a particular period. As such, analysis of the flow of income and expenditures should consider a range of factors that could affect expectations of income availability and extent of income generated as well as the range and necessity of certain expenditures. (Krause, 2012) In the airline industry, there are seasonal and unexpected variations in income and expenditures. There are peak periods for travel and oil prices often rise during the winter period. Peak periods and increases in fuel demand affect sales relative to expenditures. Sales lower than expenditures translate into losses. Airlines in the U.S. record and monitor income and expenditures based on their quarterly and annual financial reports. (Karp, 2008; Peterson, 2009) In 2000, there were comparable financial data from American Airlines, U.S. Airways and America West indicating income and expenditures (Trotter & Carey, 2000). The difference in the budgeting outcomes of the airlines is in the management of income and expenditures. The manner with which the airlines interprets their income and expenditures relative to unexpected conditions, such as fuel prices and the decision to hedge lead to varying outcomes. Revisions to the Budget Budgeting for a particular period is susceptible to alterations or changes in response to emerging conditions that warrant adjustments. Revisions to the budget could be higher or lower relative to the budget set for a given period. Typically, the revisions to the budget are higher because of unforeseen cost factors or lower than expected sales. The alterations in the budget could be a matter of estimation, time scale prioritization or control of income and expenditures. (Davis & Davis, 2012) In the U.S. airline industry, revisions in the budget are more commonly made by airlines that do not engage in fuel hedging. Jet fuel prices can change from one day to the next. If an increase is offset by a decrease, then the budget may not change. If there is an increasing trend in fuel prices, then airlines are likely to adjust their monthly and quarterly budgets. The important thing is for airlines to exercise vigilance over factors that could lead to changes in oil prices and adjust the budget accordingly and in a timely manner. (Karp, 2008) For airlines that engage in fuel hedging, fuel prices for a given period serves to stabilize the budget because of better control of the expenditure component (Peterson, 2009). New Learning on Budgeting and Application in the Workplace Consideration of the main issues in budgeting, specifically in relation to hedging and jet fuel price volatility in the airline industry, have given rise new learning that are applicable in the workplace. These lessons pertain to the contextualization of budgeting, joint effort in budget planning, and learning from repeated experience. These lessons are important not only in the academic field but also in the workplace. Contextualizing Budgeting Contextualizing budgeting involves relating the process to factors or situations that influence this activity and its outcomes. Contextualizing requires awareness of the conditions that affect the budgeting process as well as accurate appreciation or interpretation of the circumstances surrounding the budget. This coincides with budgeting as tied to purpose and firm situation. Placing budgeting in context is important because of the need to consider and control the effect of uncertainties, such as through hedging. In industries where uncertainties affecting the budgeting process are high, such as in the airline industry, keeping track of factors and situations as these progresses are ways of arriving at effective estimates, time scale prioritization, control of income and expenditures, and revision in the budget. (Robinson, 2007) In the workplace, contextualization applies to budget planning, with the factors and circumstances affecting budgeting outcomes varying across industries. Use of hedging together with other budgeting differs from industry to industry and even from one business to another in the same industry. Hedging, as a budget control strategy, may work in airlines but not for other fuel-dependent industries. Hedging could also work for some firms in certain situations but not in others. In budget planning, the context provides the pieces needed to achieve more or less accurate estimation, effective prioritization of items in the budget at given times, good management of income and expenditures, and timely revision in the budget as the need arises. Working on the budget planning of a particular company requires constant updates on changing conditions and effective grasp of all information relevant to budgeting. Budgeting as a Joint Effort Budget managers need to gain a full or thorough understanding of the context of the budgeting process to come up with an effective budget plan and ensure the expected outcomes. Consultation with other departments to collect necessary information, seeking second and alternative views on the importance and impact of key factors, and joint monitoring of components of the budget and the achievement of budget goals are important in the budgeting process. These facilitate the flexibility and responsiveness of budget managers to emerging conditions that could affect budgeting outcomes. Collaborative attitude and behavior supports effective foresight of budget managers in planning, monitoring and adjusting the budget. (Krause, 2012) Learning from Experience The learning curve describes the manner in which repeated experience enhances knowledge. Initial learning gains derived from experience is high but lessens with repetitive experience. (Davis & Davis, 2012)While learning gains may be decreasing with repetition, this could also imply the mastery of certain lessons. Learning from experience in firms affects budgeting in two ways. First, learning could influence forecasting, such as estimates of expenditure over time. In a manufacturing firm, expected cost could decrease in the future as production processes improve and workers gains expertise. Errors are minimized, quality of products is improved and retained, and delivery becomes timely. (Davis & Davis, 2012) In practice, initial entry to a budget manager position entails high learning gains from several repeated involvement in budgeting. As experiences are repeated new lessons decreases but mastery of certain areas increases. Every change in the budgeting context provides new lessons to the budget manager. Second, experiential learning could also influence the attitudes of budget managers towards activities and tools in the budgeting process, such as monitoring, budget revision, and strategy selection. Budget managers would learn to identify the critical factors for monitoring and direct/redirect the focus of monitoring as changes emerge. Budget managers would also be able to revise the budget accurately and in a timely manner to respond to changing conditions as they learn to recognize signs and timing from experience. The level of experience of managers also determines effectiveness in decisions over the use of certain budgeting strategies for particular circumstances. (Davis & Davis, 2012) In practice, use of the particular strategy of hedging to control the budget in given situations to achieve positive outcomes is learned by budget managers from experience. Conclusion Budgeting is a complex process influenced by various factors that could lead to different outcomes. There are lessons to be learned by considering budgeting in the context of hedging in the airline industry. The discussion identified four key issues involved in budgeting. Three lessons on budgeting are drawn and practical applications in the workplace were identified. By encompassing a wide range of areas for application, such as hedging in the airline industry, budgeting offers diverse situations that enrich the experience of budget managers. Insights on budgeting emerge from interactions with different members of the organization, listening and sharing input, making individual and collective decisions, analyzing information, implementing the budget, observing progress, making adjustments, and evaluating outcomes. Budgeting is a field for continuous learning. Each addition to the knowledge and experience of budget managers has a positive contribution to performance and outcomes. References Davis, C., & Davis, E. (2012). Managerial accounting. Hoboken, NJ: John Wiley & Sons, Inc. Karp, A. (2008). Losing bet on hedging. Air Transport World, 45(12), 61. Krause, P. (2012). M&E systems and the budget. In G. Lopez-Acevedo, P. Krause & K. Mackay (Eds.), The nuts and bolts of monitoring and evaluation systems (pp. 75-86). Washington, D.C.: The World Bank. Peterson, K. (2009, May 29). Hedging strategy key for airlines whipsawed by fuel. Reuters. Retrieved from http://www.reuters.com/ Robinson, M. (Ed.). (2007). Performance budgeting: Linking funding and results. New York, NY: Palgrave Macmillan. Trottman, M., & Carey, S. (2000, October 19). American 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. The Wall Street Journal, B.4. Retrieved from www.proquest.com Read More