Maintenance accounting as a strategic tool January 2000
Cost reduction is not the only way in which engineering and maintenance (E&M) can save money. This article makes the case that appropriate measurement and attribution of maintenance costs can deliver money to the bottom line, because it leads to decision making that improves overall airline profitability.
Contrary to the view of many a harried maintenance manager on the hangar floor or ramp, airlines do not measure maintenance costs primarily to support annual exchanges of charges and recriminations at executive management meetings, nor to amuse the underlings in the finance department. In fact, airlines measure E&M costs in detail for four important reasons.
The first reason is to comply with regulatory and financial reporting requirements. Most airline maintenance costing capabilities have been built around this need, and are reasonably good in producing accurate, timely, and representative summaries of cost (e.g., US DoT Form 41).
The second reason is more interesting, as it affects the boundaries between the airline and its suppliers. Airlines measure costs to understand productivity trends internally, in economic terms, over time. Time series data of labour and materials costs can indicate the need for the introduction of additional cost controls, capital investment, or work process redesign.
The third reason relates to suppliers very directly: to identify and isolate operations for outsourcing, and conversely, to identify operations to be brought back in, as well as opportunities to profitably sell maintenance work to other airlines.
The final reason is because a full understanding of correctly attributed costs can affect strategic decisions. Consider, for instance, the addition of a distant destination to an international carrier’s route network. Served three times per week, it looks narrowly profitable with average allocations of maintenance costs. Its actual profitability, however, may hinge on the way that maintenance costs are incurred and reported. Is the line maintenance capability to be performed by another carrier, or will the airline put a skeleton staff in place, and then try to fill their time by selling their services to other carriers? Will the new station require pre-positioned rotables? What are the chances of an AOG, its likely passenger cost impact, and the maintenance cost of resolving it? A rational decision to add, or not to add, the new station will depend on the airline’s ability to provide clear answers to these questions.
From allocation to attribution
Costing maintenance work is difficult, and airlines have struggled for years to produce timely reports that represent costs in a meaningful way. The concept of cost representation is important since only a fraction of costs within any maintenance activity is directly attributable to any particular operation. Some cost categories (e.g., direct labour on the check line or in a repair shop) may be 80% attributable, with only minor allocations. Other categories (e.g., line maintenance labour, engineering support) may represent allocations almost entirely.
As a starting point in measuring maintenance costs, it is important to understand how costs are caused. The easy category includes the direct costs: the price of parts actually installed, the benefits-loaded cost of the time the mechanics expended in installing them, etc. Clearly, these costs are caused by the direct operations with which they are associated. At most airlines, everything else is handled through a system of overheads, which often are allocated based on the direct costs.
The recent trend to outsourcing more maintenance activity can be seen in this light, since it converts a combination of direct and indirect costs (of, for instance, overhauling an engine) into pure direct costs (removing and reinstalling an engine overhauled by a third party provider).
In reality, indirect costs are caused by some combination of three discrete factors:
- Existence of the maintenance function (function costs);
- Performing a particular capability internally (capability costs); or
- Making a particular service available (availability costs).
Let us turn now to a more complete definition of each of the cost categories that we propose.
Simply defined, direct costs are those costs (usually, direct labour and materials) which are immediately and exclusively attributable to a particular unit of output. This output is normally one of the core production responsibilities of the unit. Therefore, a mechanic’s labour in repairing a particular piece of avionics equipment is a direct cost, while a planner’s labour in scheduling such pieces of equipment through the shop normally is not.
The best way to categorise costs is to think about how you would eliminate them. Function costs remain as long as there is an E&M function. They include the head of E&M and his staff, some minimal engineering, planning and quality control capability, and a bit of infrastructure. Airlines that outsource engines, components, heavy checks, and line maintenance at outstations will find that most of their remaining costs are function costs.
Capability costs are those associated with providing a particular internal service that is part of the normal production of the E&M function. For example, handling landing gear in-house rather than outsourcing requires the existence of a shop, physical assets (tools, plating baths, etc.), and a management and planning capability in its own right. It also causes other costs to be incurred, including additional engineering capacity, additional materials support, chemical disposal costs, a portion of the total finance and administration capability, and so on. These costs go away (i.e., are transformed into direct costs) at the point when the airline outsources the function.
Capability costs are largely predictable on a tactical as well as a strategic basis. If an airline has an engine shop, it will produce engines. The number of engines it will produce, and the work scopes associated with them, are largely predictable.
Whereas capability costs are prominent in production settings, such as check lines and component shops, availability costs predominate in the functions that look and behave like fire departments: notably, the emergency response centre and line maintenance. Once everything possible has been done to match these staff with workload drivers (e.g., adjusting shifts to flight banks), airlines don’t care how busy they are, as long as they are available. If the line mechanics at Station A turned 20 flights and resolved 30 snags on a particular day, they were not more meaningfully productive than Station B mechanics, who turned 20 flights but resolved only 15 snags. Tomorrow, the numbers might reverse; if both stations have the right staff to turn 20 aircraft per day, and no more, both operations are optimally efficient. Organisations that function in this way show high proportions of availability costs.
Better than tradition
Expanding traditional direct/indirect cost thinking to four categories (function, capability, availability, and direct) requires some getting used to. Accounting systems aren’t set up along similar lines. Staff don’t think in these terms. Within the four categories, some level of arbitrary allocation still is required. However, the benefits in supporting decisions can be considerable, although this approach has mainly been used, up to this point, mostly in consulting assignments or one-off internal projects.
A simple example illustrates the difference in decision making that might result from a review of attributed, as opposed to allocated, costs. Say the overhaul of a particular component costs $1,800 in direct labour and materials. The airline’s current practice, based on overall financial performance, is to allocate indirect costs by applying a factor of 0.8 to direct costs. The result is an internal cost delivered cost of $3,240. If the airline knows of a third party provider that can turn the units for $2,800 each, outsourcing looks like a viable alternative.
It happens, however, that in this case the shop operates with a lot of fully depreciated equipment, and few chemicals and other indirect materials. It requires little management, no independent planning capability. The $1,800 in direct costs stand, but the real capability costs per unit attributable to the operation are $400. A general allocation technique masks the fact that other, more complicated shops contribute proportionally more to the department’s indirects. Function costs still are essentially an allocation, but at $150 per unit are a small proportion of total costs. The result of this more detailed review of costs indicates a more accurate internal cost of $2,350 per unit. On this basis, outsourcing this component turns from looking like a promising idea to looking like a bad one. Implicitly, the high overall indirect levels suggest that there are higher potential email: outsourcing targets elsewhere in the airline.