Monday, March 4, 2013

Budgeting 101 in the airline industry

A few years back, when trying to pitch my first aviation company to the people with the deep pockets, I passed my financial projections to my dad for a quick inspection. The quick scrutiny prolonged somewhat – to state it mildly – and when my dad, who has no aviation experience whatsoever, handed my pride back to me he passed me a fairly long list of comments as well. The most grave certainly being: “Your profit/loss and cash-flow statements are in a completely wrong format! How on earth do you expect financial analysts with little time on their hands and probably dozens of business plans in their in-trays to adjust to non-common financial projection layouts? You just have killed your project!”

And he was right, of course. Once an entrepreneur, with his headlines of the business plan, has finally managed to catch the attention of a potential investor, he needs to follow-up with streamlined, and easy to understand facts. And that includes an accepted set of financial projections in an understandable form.
Fortunately, ICAO can serve here as the cavalry that gallops-in to the rescue. In all their wisdom, ICAO has established a set of accounting rules for airlines that, if nothing else, establishes a set of conformities. For the budding aviation entrepreneur, but also for seasoned airline managers as a brief fresh-up, I present them here for you with a short discussion. As we will see, even ICAO has made some questionable rules that are hardly practical for an airline.

Generally, costs of any venture can be divided into

        I.            Non-operating items;
       II.            Operating items.

Non-operating items can be defined as costs that are incurred regardless the operating status of the organization.  In the case of an airline, these comprise mainly of:

·         Gains (or losses) from retiring property and equipment. Or, in another words, the difference between the depreciated book value and market value.

·         Interest and dividends paid and received on/from financial instruments.

·         Profits (or indeed losses) from affiliated companies, such as catering companies.

·         Forex gains and losses, and gains and losses from shares and securities.

·         Received government subsidies and payments.

Operating items then are items related to the operations of the company. In the case of an airline, they re associated with the aircraft operations. These are further divided into Direct Operating Costs (DOC) – costs that are directly affected by the operation of the aircraft - and Indirect Operating Costs (IOC) – operating costs that occur regardless the operation of the aircraft.

Direct Operating Costs consist, as per ICAO, of:

a)      Costs of flight operations, including

a.       Flight deck crew salaries and expenses;

b.      Fuel and oil;

c.       Insurance of flight equipment and crews;

d.      Rental of flight equipment and crews.

b)      Costs of maintenance and overhaul

c)       Costs associated with depreciation and amortization, including

a.       Flight equipment;

b.      Ground equipment and property;

c.       Amortization of route development costs and crew training;

d.      Other depreciation.

  Indirect Operating Costs then consist of (as per ICAO):

a)      Station and ground expenses, including

a.       Airport and en-route charges;

b)      Costs of passenger services, including

a.       Cabin crew salaries;

b.      Passenger liability insurance costs;

c)       Costs associated with ticketing, sales and promotion;

d)      General and administrative costs;

e)      Other costs.

Now, before we shout hooray and praise ICAO to the limit, let’s have a closer look at what ICAO actually recommends.

Costs associated with the depreciation of ground equipment and property do not rely on the aircraft operation. It is true that headquarters of airlines do seem to grow bigger when the airline’s aircraft types get bigger – probably to shelter the increased ego of the CEO - yet, this is hardly the aircraft’s fault. As such these costs should belong under IOC.

Similarly, airport and en-route charges and even cabin crew salaries do change with different aircraft types operated. A Saab340 with one cabin crew on-board shows a smaller cabin crew salary account than the one for an A380 that is manned (or mostly womanned) with the population of a small town. Thus, as per the definition, these costs should fall under DOC.

Clearly, the template provided by ICAO has its minor flaws but it does serve as a solid foundation for budgeting and accounting purposes in the airline industry. The recommendations also generate magnificent benchmarking figures for you to compare your airline’s financial viability with. What they do not do well, however, is to provide a viable platform for cost structure analysis - what the financial industry calls management accounting.

From the structure provided by ICAO, it is difficult to derive which costs are here for the short-term and can thus directly be influenced by managers – and find me a manager that does not like a quick fix -, and which costs the airline would need to live with, at least in the longer run. Or in other words, which DOC has the greatest change potential on the costs incurred?

To this end, DOC are often further divided into fixed and variable DOC. Fixed DOC do not vary in the short term while variable DOC could be avoided, at least to some extent, if a flight is cancelled. The so received structure allows for in-depth analysis and thus can very well prevent you from making very stupid decisions. Just don’t forget to factor-in a very high salary allowance for the so needed analyst. They do not come cheap!