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Unit 2 Finance and Funding in Travel Tourism Sample Assignment
This assignment has used British Airways as the case study subject to bring out the various aspects of tourism financing, both conceptually and application-wise, so that we can get a clear view regarding the various modes and other matters which are essential for funding of tourism industry.
Concepts of Cost, Volume and Profit:
Analysing the nature of costs and its behaviour, how it relates to the volumes generated in a business and impact on the profits and profitability in an industry and more specifically in a business, aides the owners as well as the managers, assess risks involved and make conscious business decisions.
A cost is the monetary value incurred in order to produce goods and services and usually includes various components such as raw materials, labour, services. The travel and tourism industry which is a group of service providers, would consider cost of transport, fuel and labour in the nature of a cost.
Volume refers to the output of goods or service, quantified by the number of base units produced, during a particular period, usually annual. In Travel and Tourism, these could be measured in customer-tourist numbers or total revenues through sale of packages etc.
Profits represent the revenue gained from the business activity, in excess of the costs and taxes and is considered as a return on the activity and used by the owners either within the business or elsewhere.
Nature of cost
Costs are classified in many ways:
- Based on the nature of cost, they could be direct costs (e.g. Food and drinks) which can be identified with a specific cost centre (i.e. Entertainment) or Indirect costs (e.g. Indirect expenses like Tips)
- Based on the function they perform, they could be Production costs (e.g.ATC charges) or Non-Production costs (e.g. Selling costs like Commission)
- Based on the elements of production such as Materials, Labour and Overheads (e.g. Brochures, Salaries and advertising expenses respectively)
- Based on the behaviour as
- Fixed cost which does not vary with level of activity, within a defined set of output or activity limit(e.g. Rent and salary of crew)
- Variable cost which varies with the level of activity (e.g. Visitor entrance fees)
- Stepped fixed costs which are fixed within a level of production and goes up/down on breaching such levels (e.g. graduated costs of occupancy)
- Semi-variable costs, which comprise of a fixed and a variable element (e.g. rental + talk time in telephony, repair and maintenance etc.).
- Based on needs of decision making process, as opportunity cost, sunk cost, controllable or non-controllable costs, differential cost, joint cost, common cost and out of pocket costs (Puxty and Lyall, 1989).
One other concept that needs defining is the Marginal cost, which is the cost of production of one additional unit or in other words, it is the Variable cost per unit. The significance of such classification, is their utility in cost control or reduction, allocation and absorption of overheads, ensuring correct pricing, ease of production decisions such as to make or buy, to diversify, discontinue or not, etc.
In order to arrive at the total cost of production or sales or even the unit cost, differing methods of costing are adopted depending upon the nature of output or the production mechanism. Some of them are:
- Single or output costing which is used when a simple product manufacture is undertaken with a few gradations in quality such as cement or coal. Here unit cost is arrived at by dividing total cost of production by the number of units produced. (Harington, 1992)
- Contract or terminal costing for order based manufacture depending on client specifications, such as in large public works
- Job order costing in which individual or batch production is undertaken, where there in uniqueness in each for e.g., unique range of furniture or custom equipment
- Process costing where similar products are manufactured in large numbers and costing is aggregated at departmental or process level e.g. textiles, shoes etc.
- Operating or Service costing which is mostly used in service industries including the airlines and applicable to most of tourism segment. Herein, standardised services are undertaken and costing reckoned at service cost centre level. e.g. transport services, hospitals etc. (Woolf and Tanna et al., 1985)
- Multiple costingmethods use a combination of the above to be best suited to the industry segment it serves
Out of the above, we would confine ourselves to Operating costing as this would be applicable to British Airways, as recommended by the ICAO’s regulations and recommended practices for the airline industry.
Under this method, costs are segregated into operating and non-operating costs. Operating costs are those that are directly related to the key operations of business and are bifurcated into (a) Direct costs which change with the type of aircraft (i.e. flight operations, maintenance and depreciation) and (b) Indirect costs which remain unaffected in spite of any change in type of aircraft (i.e. user charges, passengers services, ticketing and sales, general/administrative and others) (Appendix 1 – ICAO Structure of Airline costs). Thus total costing is arrived at for the airline, as a whole.
Discuss how the pricing strategies are adopted in the travel and tourism sectorusing the case study example.
In the Travel and Tourism industry, business strategy would always take into account Porter’s (1985) broad targets of Cost leadership, differentiation and focus.
Cost leadership strategy is the ability to offer good, competitive products at lower costs. Companies can achieve such leadership through economies of scale, accessing factors of production (e.g. raw materials) at lower costs and by use of cutting-edge technology to name a few. In case of British Airways (BA), it has striven to achieve economies of scale mostly through acquisitions, mergers and strategic alliances e.g. British Caledonian (1987), Dan-Air (1992) Iberia Airlines merger (2010), BMI acquisition (2012) to name a few. These alliances has given BA economies through shared facilities, reduced outsourcing and technological edge, globally. (Britishairways, 2014)
BA which is our Case Study today has a range of product offerings, in its service, to list a few, Booking flights for passengers, Freight transportation, Hospitality management (Hotels, Car rentals), Aircraft control system, catering services etc. However, its main product contributor is the Passenger Transport, which made up 87% of revenues in 2009/10.
Within this service, BA offers 4 differing price plans for its passengers namely, Economy class, Premium economy, Business class and the First Class, in that order of value added services. Appendix II gives the break-up of the service commitments under each of these heads. BA thus uses a simple process of service differentiation on its flights, allowing travellers/clients the option to choose the level they would enjoy, according to their capacity to pay. For e.g. it is found that for the price of a return flight from London ?New York, a comparison of an economy class fare to that of a first class fare on the same flight, could be as high as 7.25 : 1.(Britishairways, 2014)
Along with service differentiation, BA also sets its pricing at a higher level showing a clear message that they cater to a different league of clients, who do not mind paying a premium for better hospitality, thus inviting a higher customer valuation. This phenomenon has been discussed by Brassington and Petitt, (2003:1106) whoopine that the price in such cases ‘’is set higher than others, to reflect better product quality and exclusivity’’.
For the airline industry, if we drill down the pricing numbers, Marginal cost of 1 additional passenger is said to be very small relative to the fixed costs of operating the airline (such as capital cost of the fleet, fuel and taxes). One study by a Commerzbank Securities transport analyst in 2002 showed that selling cost per passenger amounted to only 10.9%of the average ticket price. This is how many airlines, including BA are able to sell tickets during non-peak times at very low rates and still not be loss making, in the final analysis. (Geense, 2014)
In recent times, the competitive environment created by low cost airlines has caught the attention of the people especially due to the recessionary climate. Due to this, in spite of pitching to a more moneyed clientele, BA has had to reduce prices of its higher class tickets, to attract clients and increase occupancy rates, compromising profitability.
AirAsia is one of the largest economical airlines in the world. The organization has expanded rapidly since 2001. It currently owns approximately 72 airlines. The organization believes in hassle free travel at the lowest possible cost. This strategy has sparked a revolution in the airlines industry and as a consequence drawn a lot of consumers to the organization. Though the organization has flourished in the recent years the airline industry continues to be very competitive. The organization in order to thrive has to come up with the right set of strategy. The airline industry is very complex and if AirAsia does not have the right strategy it might not be able to compete. Through this paper a humble effort has been made to analyse the most appropriate strategy for the organization and the rationale behind choosing that strategy.
A differential pricing strategy is used by Airasia. This implies that the same ticket is sold to different customers at different prices. The price discrimination is done keeping the market segments in mind. In a competitive market lower prices are used whereas higher prices are used in a relatively less competitive market. Cost efficiency id the biggest advantage enjoyed by Airasia.
Role of Management accounting information in decision making
Business information which helps the managementwithin the business, who make vital decisions, is a key success factor in any commercial institution. Management accounting information covers areas like costing of products and services, budget analysis, performance reports and other resource and supply related information, all of which help in the planning and control functions. This is different from financial accounting information which is of value to all stakeholders, outside the business. (Atkinson, 1997)
The airline industry more than any other(due to its global reach and real time nature), depends on the exchange of information such as through computerised reservations, self-service platforms, luggage and cargo management systems, GPS, security systems and back end Billing and Ledger systems.
All data captured by and for the use of the above, are seamlessly connected to the various software modules listed below, which provide valuable management information, when aggregated:
- Passenger billing
- ATC billing
- Credit invoicing in multicurrency
- Sales and purchase ledgers
- Purchase order processing
- Stock control
- Fixed assets register
In terms of the BA corporate website, a comprehensive management accounting system is said to provide operational and financial performance measure indicators for the management andBA prepares detailed management accounts monthly in all areas of the business. ‘Budgets and Variances from plan and previous forecasts are analysed, explained and acted on in a timely manner. As well as regular Board discussions, monthly meetings are held by the Management Team to discuss performance with specific projects being discussed when required’.
BA further has constituted a Capital Investment Committee, chaired by the Chief Financial Officer, whose key function is to maintain tight control of capital and major contract expenditure and headcount. All major corporate projects are audited regularly by this Committee.
Objectives of Budgets
Budgeting is the exercise of recording likely income and expenditure for a future period, with a view to prioritise spending among the avenues available to a business, for it to achieve its financial goals.
When a company’s financial goals and objectives are documented in monetary terms, they can be used throughout the year and the periodicals performance reports generated can be compared with the actual results to arrive an variances which could be positive or negative, giving management a timely review point to take the necessary corrective action, if warranted. (Wiseman, 2010)
Thus budgeting is not forecasting. Forecasting needs to predict events and their outcome, while budgeting involves making plans to achieve a future result by controlling the variable factors, with a view to maximise achievement.
Budgeting benefits the business by ensuring that vital functions such as (i) planning, (ii) coordination, (iii) communication, and (iv) control and performance evaluation are planned and carried outs meticulously.
Every budget has an identified key factor (otherwise called the limiting factor or the principal budget factor), which requires careful consideration as a constraint, in the budgeting exercise. In the case of BA’s Sales budget one may consider customer demand as the limiting factor which in turn may be influenced by factors such as price, competition, purchasing power of clients or even advertising.
In the same manner, other micro budgets such as Production budget, materials budget, labour budget and cash flow budgets can be prepared, with careful consideration.
Given the multitude of factors which need to be monitored and their vagaries, BA would benefit by opting forflexible budgets rather than fixed budgets or even opting for a zero-based budgeting approach.
Importance of Budgets in Travel and Tourism (TAT) industry
There are very many reasons for focus on budgeting in this industry:
- TAT suffers from 2 key constrains namely, a high percentage of capital expense and slim margins due to competition. The utility of budgeting in such a scenario is that resources can be allocated efficiently and cost effective methods of operation can be arrived at. Further wasteful operations can be highlighted and done away with and alternative courses of action opted for. (Wiseman, 2010)
- Each cost centre is able to zero in on its specific mission and stick to its achievement
- Since budgeting can be trickled down to the level of each profit making unit and its attendant costing, even daily monitoring of corporate goal achievement, can be made possible. Such microscopic watch over growth trends can ensure that year end goals are no surprises or shocks and time is available throughout the year to fine-tune operations.
The advantages of the management information system of British Airways are:
- The baggage handling can be closely monitored and reviewed.
- Helps the clients to plan and controls their travel costs.
- It helps to track the baggage of the faster.
The disadvantages are as follows:
- The management information system cannot be built keeping every possible situation in mind. Hence, there are times when the managers have to rely on their experience and intuition.
- It created a lot of job losses.
- A lot of privacy issues have occurred because of this system.
Optimising use of financial statement using appropriate ratios
Financial planning and management are crucial roles of the Finance Manager and among the key tools which help carry out this function are, budgetary control, ratio analysis and cost volume profit analysis.
Financial statement analysis, involves the attempt to understand the performance outcomes and risk of a firm, sub-unit or a project, through the study of financial reports (Brealey and Myers, 1996).
In our case study, an analysis of BA’s financial statement, presents the following picture. The details of the derivations and base data are presented in Appendix III.
Interpretation of the financial analysis:
- A comparison of the P&L between the years 2011 and 2012 shows that while total revenues grew by over £800 Mn during the period, key expense areas which are vital to the airline business grew sharply as well, having a negative impact on profits and outpacing it. For e.g.
Growth of expenses:
Fuel increased by 466 Mn – a jump of 14.3%
Engineering costs by 82 M –an increase of 15.1%
Landing fees etc. 35 M – an increase of 5%
Handling charges by 161 Mn – a rise of 25.3 %
While some may argue that all of the above rises cannot be controlled by the airline, its incapacity to pass on the hike to its ultimate customers through airfare, speaks of the intense competition in the industry.
- The liquidity ratios have deteriorated slowly. Current ratio which has remained below 1, has further fallen from 0.71 to 0.60, pointing to difficulties BA would be facing in meeting its short term commitments, using its short term resources. Ideally this ratio should be around 2: 1. Further the quick ratio, which stood at 0.57 in 2012, is way below the level when creditors can be paid comfortably and potentially could lead to severe short-term obligation failures.
- Among the profitability ratios, Gross profit margin has performed below par in 2012, from 2011 levels which appears to have been a better year for BA. This ratio shows the relationship between sales and profits and measures the business’s ability to generate earnings.
- Net profit margin has turned negative in 2012, as net profits have stayed negative.
- A good measure of profitability is also the return on investment indicator. This shows the efficiency of operations and capacity to generate adequate returns to the shareholders. A 23% positive return in 2011 has turned into a 4% negative return, indicating erosion of accumulated profits and a grim picture for the owners. (Palmer, 1983)
- The leverage or solvency ratios which indicate how long-term funds are being used in the business, has not been affected drastically as BA does not appear to have opted for capital acquisitions in 2012. While this may be good, it would also be worthwhile to go over the serviceability of the aircrafts, which would be a safety concern in the airline industry.
Identification of sources of finance for the company
Given the state of dwindling profits and efficiency, even though the top line growth has been in keeping with the industry trends, a quick strategy would be issuance of shares or direct injection of capital. Additional share issue would require being times correctly, taking into account market sentiments, in order to make the best out of investment climate. (Atkinson, 2005)
Raising share capital or using retained earnings serve as an effective means of funding the business. Further, there may be tax advantages for the owners.
Short term internal funding may be effected through delayed payment to creditors, tighter credit controls over debtors etc.
External funding implies availing finance from:
- Commercial or development banks
- Leasing companies for the aircrafts
- Government grants and tax concessions if possible
The various sources of finance are:
Equity shares can be issued to raise capital for the organization. Equity shares are regarded as the most popular source of finance for an organization. The main merit of equity shares can be regarded as the non refundability of the amount of funds raised through the issuance, the capital contributed through purchase of equity shares are non refundable as the equity shares are irredeemable.
However there is a disadvantage of issuing equity shares, they carry ownership rights and as a result of that the equity shares dilutes the control of an organization.
Debentures are debt instruments. Debentures help in raising debt funds and the debenture holders are regarded as the creditors of the company. Issuance of debentures has got some merits, the debentures holders are fetched with interest at a certain rate and the same is tax deductible, debentures are regarded as a cheaper source of finance. However, issuing debentures can be disadvantageous as it will increase the debt obligations of the company.
Leasing is an indirect source of finance. Leasing is a process where the owner of an asset, provides another person the opportunity to avail the same on payment of lease rentals. The merit of availing assets on lease is that the assets can be availed without paying the whole value of the same. However on failure to pay the lease rentals in a timely manner the property given on lease can be forfeited by the leaser.
Commercial banks provide loans to different organizations. The advantage of availing bank loan is that long term loans taken from different banks are charged with a lower rate of interest, the interest for loan paid to the bank is tax deductible. However, availing excessive bank loans can create the chance of bankruptcy.
Retained earnings is regarded as one of the best source of finance for an organization retained earnings is the portion of earning that is ploughed back by the organization. The advantage of retained earnings is that it can provide huge amount of earnings to the organization as the organization can retain a huge portion of its earnings and it does not create any debt obligation for the company. But on the other hand retaining the earnings of the company would deprive the shareholders from their cut, and this causes a fall in the share price.
Impact of source of finance on financial statement
- External borrowings by way of term loans, debentures and leases could result in the dilution of ownership of existing holders
- The gearing ratio (i.e. Debt/Equity) may be compromised in case of heavy borrowing, which itself may jeopardise further loans.
- Companies ideally aim for a judicious mix of equity with capital, in order not to upset the balance, by way of high interest burden or an illiquid problem.
- Generally, cost of external debt is always higher than cost of equity financing.
- Existing shareholders normally look for not only capital appreciation on their investment, but also higher profits, controlled expenses and good level of competitive dividend. (Atkinson, 2005)
The above analysis conducted on BA , where the financial statements and other financial aspects of BA are analysed through which we get a clear view regarding the identification of the sources of financing and their impact upon the financial statements of the company and also various other matters that are discussed in the assignment like the role of financial management in decision making , different costing methods that are required to gauge the cost of a business, budgeting and the role of budgets etc.
Atkinson, A. A. 1997. Management accounting. Upper Saddle River, N.J.: Prentice Hall.
Atkinson, A. B. 2005. New sources of development finance. Oxford: Oxford University Press.
Brealey, R. A. and Myers, S. C. 1996. Principles of corporate finance. New York: McGraw-Hill.
Britishairways. 2014. British Airways 2009/10 Annual Report and Accounts. [Online] Available at: http://www.britishairways.com/cms/global/microsites/ba_reports0910/corpgov/cg_statement3.html [Accessed: 15 Apr 2014].
Geense, I. 2014. Managerial Accounting and Managerial Accounting Practices. [Online] Available at: http://www.managerialaccounting.org/ [Accessed: 15 Apr 2014].
Harington, D. 1992. Costing. Open College.
Palmer, J. E. 1983. Financial ratio analysis. New York, N.Y.: American Institute of Certified Public Accountants.