Aviation Costing Methods Essay

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Management Accountin TERM PAPER Abstract: Competition today is one of the major threats to an airline industry. Competitive advantage therefore can be achieved by establishing cost leadership. The ultimate challenge faced by any company would be to leverage between the escalating operational costs and falling revenues so as to maximise the profits. Determine the costing procedure of an airline industry and the various possible efforts it takes to reduce the costs. The airline industry employs a trend and horizontal analysis to evaluate its performance and productivity.

This industry can be categorised into international, national, regional and cargo operations. The major costs incurred by the airline industry are weather costs, fuel cost and labour costs. Therefore this term paper intends to explain how an increase or decreases in these costs affect the services of the airline industry. COSTING ANALYSIS: AIRLINE INDUSTRY 1|Page Introduction Industry has incurred significant losses resulting in airline restructurings and bankruptcies, which could result in changes in the industry.

The airline industry has incurred significant losses resulting in airline restructurings and bankruptcies, which could result in changes in the industry. Since 2001, as a result of slower general economic conditions, the continuing impact of the September 11, 2001 terrorist attacks, attempted terrorist attacks, the high price of fuel, military action overseas and intense competition, the airline industry experienced a decline in demand which resulted in record financial losses.

In response to the adverse financial results the airline industry has experienced, most airlines have taken actions in an effort to reduce losses, such as reducing capacity, reducing employee headcount, limiting service offerings, renegotiating labor contracts and reconfiguring flight schedules, as well as other efficiency and cost-cutting measures.

Despite these actions, financial losses in the airline industry continued into 2006 and it is foreseeable that further airline reorganizations, bankruptcies or consolidations may occur, which could serve to reduce AirTran’s cost advantage. AirTran cannot assure you that the occurrence of these events or potential changes resulting from these events will not harm its business or the airline industry generally. Major airlines are reducing their cost structures through various methods and these changes could reduce AirTran’s cost advantage.

The airline industry has incurred significant losses resulting in airline restructurings and bankruptcies, which could result in changes in the industry. Since 2001, as a result of slower general economic conditions, the continuing impact of the September 11, 2001 terrorist attacks, attempted terrorist attacks, the high price of fuel, military action overseas and intense competition, the airline industry experienced a decline in demand which resulted in record financial losses.

In response to the adverse financial results the airline industry has experienced, most airlines have taken actions in an effort to reduce losses, such as reducing capacity, reducing employee headcount, limiting service offerings, renegotiating labor contracts and reconfiguring flight schedules, as well as other efficiency and cost-cutting measures. Despite these actions, financial losses in the airline industry continued into 2006 and it is foreseeable that further airline reorganizations, bankruptcies or consolidations may occur, 2|Page hich could serve to reduce AirTran’s cost advantage. AirTran cannot assure you that the occurrence of these events or potential changes resulting from these events will not harm its business or the airline industry generally. Major airlines are reducing their cost structures through various methods and these changes could reduce AirTran’s cost advantage. The airline industry has incurred significant losses resulting in airline restructurings and bankruptcies, which could result in changes in our industry.

As a result of slower general economic conditions, the continuing impact of the 2001 terrorist attacks, the high price of fuel and military action in Iraq, the airline industry has experienced a decline in demand which has resulted in record financial losses. In response to the adverse financial results the airline industry has experienced, most airlines have taken actions in an ffort to reduce losses, such as reducing capacity, reducing employee headcount, limiting service offerings, renegotiating labor contracts and reconfiguring flight schedules, as well as other efficiency and cost-cutting measures. Despite these actions, financial losses in the airline industry have continued through 2005 and it is foreseeable that further airline reorganizations, bankruptcies or consolidations may occur, which could serve to reduce our cost advantage.

We cannot assure you that the occurrence of these events or potential changes resulting from these events will not harm our business or the airline industry generally. Major airlines are reducing their cost structures through various methods, these changes could reduce our cost advantage. The airline industry has incurred significant losses resulting in airline restructurings and bankruptcies, which could result in changes in our industry.

As a result of slower general economic conditions, the continuing impact of the 2001 terrorist attacks, the high price of fuel and military action in Iraq, the airline industry has experienced a decline in demand which has resulted in record financial losses. In response to the adverse financial results the airline industry has experienced, most airlines have taken actions in an effort to reduce losses, such as reducing capacity, reducing employee headcount, limiting service offerings, renegotiating labor contracts and reconfiguring flight schedules, as well as other efficiency and cost-cutting measures.

Despite these actions, financial losses in the airline industry have continued through 2005 and 3|Page it is foreseeable that further airline reorganizations, bankruptcies or consolidations may occur, which could serve to reduce our cost advantage. We cannot assure you that the occurrence of these events or potential changes resulting from these events will not harm our business or the airline industry generally.

Major airlines are reducing their cost structures through various methods, these changes could reduce our cost advantage. Airline strategic combinations or industry consolidations could have an impact on our operations in ways yet to be determined. The strategic environment in the airline industry changes from time to time as carriers implement varying strategies in pursuit of profitability including consolidation to expand operations and increase market strength and entering into global alliance arrangements.

Similarly, the bankruptcy or reorganization of one or more of our competitors may result in rapid changes to the identity of our competitors in particular markets, a substantial reduction in the operating costs of our competitors or the entry of new competitors into some or all of the markets we serve. Additionally, we have sought to acquire gates and other assets from other carriers.

In the event we complete one or more acquisitions, we may be subject to a variety of risks including risks associated with an ability to integrate acquired assets or operations into our existing operations, higher costs or unexpected difficulties or problems with acquired assets or entities including different flight equipment, outdated or incompatible technologies, labor difficulties or an inability to realize anticipated synergies and efficiencies; whether within anticipated timeframes or at all, one or more of such risks, if realized, could have an adverse impact on our operations.

We are unable to predict exactly what effect, if any, changes in the strategic landscape might have on our business, financial condition and results of operations. 4|Page Labour Cost The specimen of what is the scenario in the airline industry across the globe with fuel and labour cost peaking the operational costs in various airlines as: The graph clearly shows the inverse relation between the fuel and the labour cost’s share of the total operating cost. In North American airline in the mid of 5|Page 005 the labour and the fuel cost’s share in operating cost matched but then with an increase in the Aviation Turbine Fuel’s price soaring year by year the labour cost’s share in the total operating cost is lowering down. Same is the case with the entire industry and all major airlines across the globe. The following matrix clearly points out the per cent share of each cost in the total operational cost across the sectors in the globe. Labour’s share of total operating costs for North American airlines has fallen sharply from 36. % in 2001 to 21. 5% in 2008. This reflects a sharp rise in the share of fuel costs over the same period, but also reflects much lower labour costs. And the same feature can be reflected in the matrix. In 2008, fuel continued to be the largest single cost item for the global airline industry. Based on a sample of 45 major global passenger airlines, fuel represented about 32. 3% of the total operating cost, up from 27. 4% in 2007. These numbers are consistent with global industry fuel share so this sample can be taken to be representative.

The share of labour (including pension) expenses fell from 22. 8% in 2007 to 20. 1% in 2008. 2009 was the worst year ever for aviation; global traffic declined 3. 1% year-onyear and yields slumped. With older airlines mostly heavily unionized, in many cases involving a dozen or more unions, this scale of cutback would normally have caused extensive 6|Page industrial disputes. Unexpectedly, the threat did not materialize in 2009, with many unions accepting the reality of a chronic downturn for their airline employer.

The restraint shown reflected an understanding that this was a potentially lifethreatening environment. So, in most cases, intelligent deals have been achieved, where the airline involved has both had the communication skills and a sufficiently obvious need to metamorphose. But as we enter the second decade of the new century, all the signs are of gradual recovery, both in traffic numbers and profitability, as some premium market recovery occurs. This will make it less palatable for union leaders to accept the need for frugality.

Global airline capacity for Feb-2010 shows a 5% increase in seat capacity compared to Feb-2009. OAG reports this marks the sixth consecutive month in which overall airline seating capacity has shown growth. Global frequencies are also showing growth, with an increase of 4%, with a total of 2. 2 million flights scheduled for Feb-2010. Global frequency and capacity in the low-cost sector are up by 11% compared to a year ago, with 40,704 more flights and 6. 1 million more seats.

The fruits of recovery will be accompanied by some gradual capacity expansion (as new aircraft orders are pushed into the market – like it or not) and, for some airlines, profitability. In these circumstances, the case for cost cutbacks – still in fact badly needed by all legacy airlines – will be much harder to plead. And the restraint shown by labour in 2009 is likely to be a thing of the past. Here lie the seeds of a difficult year for staff relations, especially in Europe and North America.

CAPA believes 2010 is shaping as the year for industrial confrontation – and may as a result see more fundamental change, including market exit of some famous brands, than in the past year. As a minimum, there will be major shifts in the shape of some of those well-known entities, even if economic recovery starts to soften the impact. 7|Page The specimen of the airline and its operating cost is given below: 8|Page From the above study we can conclude that fuel and the labour cost are the two prominent costs in the airline industry that constitutes more than half of the operational cost of an airline.

Though fuel cost is something that an airline cannot take control of but the labour cost can be controlled and restricted within the limits in the operational cost structure. This can be done by: ? Multi-Tasking: It means that if a staff is good at ticketing and does a regular work always each day in an uninterrupted manner then his/her specialization is that part but when one specialization is combined with another specialization then it becomes a multi specialized personnel. Example: Ticketing and boarding section can be handled by the staff in a routine manner. SOP: Standard Operating Procedure is one of the tool in an organization that clearly defines the rules of working and the set pattern which has to be used to carry out an activity. So following the SOPs is of utmost importance which helps an employee to know what he/she has to do and gain that knowledge in the particular field. ? Simplification: Keeping the task simplified so that it is understandable to all and that is really important. Complications or complexity in the work do not interests the employee to carry on the same task rather with simplifications the task can be conducted coupled with perfection. Training and Development: Constantly upgrading the skills and the knowledge of the current employees to mould them according to the new technology and processes is really important to keep them updated with would directly impact their productivity and organizations profitability and attrition could be controlled in that manner then. 9|Page ? Crew Planning: Inadequately planned crew resources could cause serious operational disruptions resulting in losses counted in millions. Problems with crew shortages are often a result of series of oversights and cannot be quickly resolved.

They could be quite damaging, often ending up with numerous flight cancellations or sub chartering. ? “ON 31 JULY 2003 ONE OF THE MAJOR US CARRIERS CANCELLED MORE THAN 80 FLIGHTS, WITH ADDITIONAL PRE-CANCELLED FLIGHTS IN AUGUST DUE TO AN “INCORRECT PILOT STAFFING MODEL. ” ? Proper Mix: A proper mix of Part/Full time employees coupled with proper policies and procedures when added with a compact shift time designing structure would definitely result in cost saving from the labour factor in the operations. 10 | P a g e There is obviously an enormous hidden potential for improvements in airline and air transport cost efficiency.

Most of the risks in the above mentioned areas are induced by the lack of knowledge and information which are the prerequisites for improvements. While sophisticated optimization tools necessary to help solve the information problem are still a remote option, airlines should adopt a more realistic approach towards a solution that will provide essential, less complex but more effective operation. This will help them build the so much needed cost awareness and ‘system’ thinking among decision makers, resulting in less risky and more profitable operations.

Weather Costs Hurricanes, blizzards, fog and floods are a few of the weather elements that can lead to your flight being cancelled. When flights cancel due to adverse weather, airlines usually have a policy set up for passengers Bad Weather + Low Fuel = Diversion How airline cost saving strategies may be contributing to increased aviation system costs 11 | P a g e Diverted Airline Flights 1995 – 2008 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 12 | P a g e

A diverted flight is one that left from the scheduled departure airport but flew to a destination point other than the scheduled destination point. Cost reduction strategies in the face of financial difficulties when subjected to weather factors ? ? ? ? Aircraft Mechanical Passenger / crew medical or other flight incompatibility Airport closure (poor weather conditions) Change in airline operating strategies. Airlines are claiming to reduce overall costs in two ways: ? ? ? ? ? Reduction of flights Consolidated schedules Larger aircraft Reducing fuel costs Lighter take-off weights 3 | P a g e ? Airlines are consolidating operations into largest hubs during peak hours ? And using larger aircraft which require greater spacing for departure and arrival. 14 | P a g e Fuel Costs Fuel cost can be simply defined as the cost incurred by the aero plane for the day to day operations in the airline industry. Brent crude oil prices have dropped 16. 1% from their highs in April to $104. 13 per barrel (Rs 5,165 today). But the hope that this will bring relief to aviation firms and boost their stock prices is likely to be pie in the sky.

Investors closely track crude prices, as fuel constitutes up to half the operating costs for airlines. But a fall in benchmark fuel prices doesn’t mean anything for these companies this time around. The price of the Indian crude basket has fallen only 10% since April compared with the steeper fall in Brent. Secondly, the sharp fall in the rupee versus the dollar has meant that import costs haven’t really declined by much. The local currency has fallen 10. 6% since August, which has pretty much wiped off any advantage from lower crude prices.

Indian aviation companies buy their domestic aviation turbine fuel requirements from local oil marketers, who revise prices on the 1st and 16th of every month in line with international crude prices. “Jet fuel prices have averaged $127 per barrel (quarter-to-date) against an average price of $131 (the April-June quarter). Domestic travel has increased by 18. 6%, which is pretty impressive considering growth in other sectors. 15 | P a g e Airline operators haven’t been able to increase prices or pass on increase in costs as they have increased capacity at a faster rate than demand.

On the global front the fuel cost faced by the airline industry is justified by the table given below. It gives a relationship between total revenue earned with increase in jet fuel price per year. Fuel is every airline’s highest expense item and covers more than 30% of an airline’s total revenue. Hence, the airlines must find ways to increase revenues and/or decrease costs to match these large fuel price increases. Fuel Conservation Strategies Cost Index Cost index Defined as the CI is the ratio of the time-related cost of an airplane operation and the cost of fuel.

The value of the CI reflects the relative effects of fuel cost on overall trip cost as compared to time-related direct operating costs. In equation form: CI = Time cost ~$/hr Fuel cost ~ cents/lb The cost of fuel is the denominator of the CI ratio. Although this seems straightforward, issues such as highly variable fuel prices among the operating locations, fuel tankering, and fuel hedging can make this calculation complicated. A recent evaluation at an airline yielded some very interesting results, some of which are summarized in A study was made of the optimal CI for the 737 and MD-80 fleets for this particular operator.

The optimal CI was determined to be 12 for all 737 models, and 22 for the MD-80. 16 | P a g e The table shows the impact on trip time and potential savings over the course of a year of changing the CI for a typical 1,000-mile trip. The potential annual savings to the airline of changing the CI is between US$4 million and $5 million a year with a negligible effect on schedule. Fleet Current ($000’s) 737-400 737-700 MD-80 Time Cost The numerator of the CI is often called time-related direct operating cost (minus the cost of fuel).

Items such as flight crew wages can have an hourly cost associated with them, or they may be a fixed cost and have no variation with flying time. Engines, auxiliary power units, and airplanes can be leased by the hour or owned, and maintenance costs can be accounted for on airplanes by the hour, by the calendar, or by cycles. As a result, each of these items may have a direct hourly cost or a fixed cost over a calendar period with limited or no correlation to flying time. In the case of high direct time costs, the airline may choose to use a larger CI to minimize time and thus cost.

In the case where most costs are fixed, the CI is potentially very low because the airline is primarily trying to minimize fuel cost. Pilots can easily understand minimizing fuel consumption, but it is more difficult to understand minimizing cost when something other than fuel dominates. 30 45 40 Optimum 12 12 22 +1 +3 +2 Time Impact minutes US $754-771 $ $1790-1971$ $319-431 $ Annual Cost Savings 17 | P a g e Fuel Hedging Fuel Hedging is a contractual tool some large fuel consuming companies, such as airlines, use to reduce their exposure to volatile and otentially rising fuel costs. A fuel hedge contract allows a large fuel consuming company to establish a fixed or capped cost, via a commodity swap or option. Large fuel consuming companies enter into hedging contracts to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes. References: ? http://www. airlinenewsindia. com/2011/09/lower-crude-prices. ? http://blogs. star-telegram. com/sky_talk/2011/03/higher-fuel-prices-couldcost-airline-industry-more-than-9-billion-in-extra-expenses. html. Article on fuel saving strategies by Bill Roberson, Senior Safety Pilot, Flight Operations. ? Paper on “THE HIDDEN COSTS OF AIRLINE OPERATIONS NEW INITIATIVE FOR IMPROVING AIRLINE OPERATIONAL AND COST EFFICIENCY” by Jasenka Rapajic. ? Airline Industry Revenue – Cost Analysis from AirlineFinancials. com ? ? ? ? ? ? IATA Economic Briefing February 2010. “Airport Manpower Planning Case Study”- Seabury Aviation Aerospace. This excerpt taken from the AAI 10-K filed Mar 1, 2007. Excerpt taken from the AAI 10-K filed Aug 9, 2007. Excerpt taken from the AAI 10-K filed Aug 9, 2006. Excerpt taken from the AAI 10-K filed Mar 9, 2006. 18 | P a g e

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