In all forms of business you have annual budgeting processes that predict or restrict the amount of money the firm is willing or able to invest or spend in a given year. The budget processes start by analyzing the amount spent and earned from the previous year. You can then use market rates, factors or predictions to make an estimation of earnings for the upcoming year. Once you have your predicted earning you can reduce the cost of overhead, labor, etc to get the expected profit. Once profit is determined you can then make a decision on the amount you are willing to reinvest back into the company for things such as new factories, stores, etc. This type of annual budgeting is considered short-run since it looks at a single year’s production. You could also make an analysis which would attempt to project budgets five to ten years down the line. This would be considered long-run budgeting and is a key feature of a company’s strategic planning process.
Different forms of business prefer different budgeting strategies and their preferences can shift depending on how the market is doing. The companies budgeting can also be focused on short-run for some aspects of the business and long-run for other aspects at the same time. In this example I will show how the renewable energy market, particularly wind energy, has shifted their budgeting strategies over the recession.
In the early 2000’s wind energy was an up and coming market. Other markets were doing really well so there were lots of investors that were interested in developing renewable energies to take advantage of the tax credits that came from selling the green power. The mentality of wind energy companies was to increase construction because they wanted to build as many megawatts as possible. They didn’t focus on locking down power purchase agreements that would affect the long-run production of the wind farms and were willing to go merchant, which meant selling the power back to the grid at a variable rate. The rates were constantly rising so the companies figured they were better off with merchant power because locking in a fixed rate wasn’t as profitable. This was a very short-run budgeting decision as it focused on increasing production for the given year and not the affects of variable prices of the power being sold. However, the amount of companies that produced wind turbines to sell to the wind energy companies was few and far between. This meant the demand of wind turbines was much higher than the supply. Wind turbine manufacturing companies such as GE and Gamesa did not have the production capabilities to supply the demand so they needed to produce new facilities. However, the manufacturing companies did not run the same short-run budgeting as the energy companies so they weren’t willing to build new facilities without turbine supply agreements. This forced wind energy companies to look into long-run budgeting for this aspect and sign long term agreements. That is the first example of how the wind energy companies used both long and short-run budgeting for different areas of the company.
As the recession started the amount of investors began to decline. In order to keep the costs of electricity low the power companies began lowering the rates they were willing to pay for renewable energies. This effected companies that were selling merchant power because now the earnings they were expecting based on last year’s numbers were decreasing since they didn’t have stable rates. This completely changed the mentality of wind energy companies and drove them to focus on long-run budgeting. They did this by only constructing projects that had power purchase agreements with high enough rates to clear the internal rate of return. This meant that most wind energy companies began to reduce new construction in half compared to previous years. This had an opposite effect on wind turbine supply companies. As the wind energy companies reduced construction they were now over producing wind turbines so that now the supply was higher than demand. Wind energy companies no longer had to sign long term supply agreements which in turn drove down the price of wind turbines. This also meant that this aspect of wind energy companies switched to short-run budgeting as they began to focus on only purchasing turbines required for this year and not committing to building anything in future years. This shows again that wind energy companies will use both short and long-run budgeting and how the market can change the importance of each style of budgeting for different aspects of the company.