Monday, 1 December 2014

How to Overcome Limitations of Traditional Costing Practices

A decades-old system for cost classification and reporting inherited from industrial era still dominates management practices across the airline industry. Airlines continue to use this system partly driven by collective inertia and partly by the lack of alternative solutions that would empower decision makers with understanding of true origins of operating costs, essential for making informed cross-functional decisions of strategic and operational nature.

Traditionally, costs derived from financial reports are statistically distributed to segmented business units in order to be calculable at functional levels and easy to control. This practice ignores the fact that costs are more than just sums of numbers - they are nonlinear, interrelated, and consequently cannot be measured in a conventional way. This is why answers to questions related to true effectiveness of cost saving measures, route network, aircraft and hub operation, outsourced services, or investment in additional resources, remain stumbling blocks for improvement in cost efficiency and operational performance.

Answering these questions by using cost apportioned to operational units without knowing their true origins turns the decision making into a pretty risky process. This is not only because this information is simplistic, but also because it is just a historic snapshot of data collected mainly at the time of budget drafting. As soon as the ‘budget schedule’ starts to change (normally months before the start of a new scheduling season), it triggers changes in cost matrix, making the planned costs even less suitable for decision making.

This may, at least partly, answer the question why airlines with long established practices make so many changes in planned operations once the season starts. We have seen traditional and even some low cost carriers incurring significant losses in cost, revenue, and reputation by reducing the planned operation in the middle of scheduling season due to planning and strategic errors described as ‘overexpansion’, ‘overstretched capacities’ or ‘to avoid more operational problems'. What were the causes of such serious misjudgements resulted in change of decisions made just several months ago? How many of these changes and related losses were associated with wrong evaluation of disruption risks, or poor understanding of system limitations. How much does the cost planning process contribute to this situation?

Let's see how the typical process of cost planning looks like.
'The typical process of cost planning starts with projected traffic, cost, and revenue for the coming year. The company’s finance director then sets a target figure for net results including the necessary return to shareholders. This is further broken down into management units and transmitted to senior directors, responsible for squeezing the savings out of their respective departments. The initial figure may be adjusted several times during the year. There are reviews after the IATA slot coordination meetings and regular refinements in the light of information received on forward bookings, interim revenues, and yields. These adjustments can result in even tighter cost controls. The intense cycle of setting targets and searching for further departmental cuts is giving an early warning if a director is going to exceed the budget. If this happens, there are generally negotiations between the director and the CFO’s office to reach a satisfactory result. The process could be tightened further if necessary using various management techniques.' (Described by a senior manager of a major network carrier)

There are the two major setbacks in this process. The first one relates to the sources of information used for cost projection for the coming year based on too many assumptions. The second is the management aspect of cost control. Led by the nature of traditional cost information, managers put too much emphasis on cost control of departmental performance rather than on interrelated problem areas. As unforeseen problems start to emerge, senior directors have no other choice but to put even more pressure on middle managers and, through them on other staff to save more. The next round of ‘unexpected’ events includes the reset of targets, and continual search for new cuts from already well squeezed departmental cost - good for justifying efforts, but not good enough for improving business performance.

How can we overcome limitation of these costing practices?

Take the fuel saving measures as an example. The process is usually assigned to the Flight Operations department. There is a whole set of principles used to minimise fuel consumption on the day of operation. They include things like flying at optimum speeds and flight levels, fuel tankering policies, careful weight and balance control or flying the ‘cost efficient’ air routes (not necessarily the shortest ones). In reality, however, most of these principles cannot be applied. Fuel consumption will be increased every time when flight cannot operate at optimum flight level, ATC diverts the aircraft to a longer route or put it on hold over a busy airport, and in many other situations. According to industry research, about 10% of fuel consumption is attributable to changes in operational performance. Reducing it at busy airports is becoming more and more challenging. Still, the fuel-saving programs circulate mostly around these traditional measures.

Much bigger potential for reduction of fuel costs, however, comes from inside the airline. It comes from people who decide which airports and routes to fly to, which aircraft can best serve these routes, how many hours it should fly, when to replace old aircraft or introduce new aircraft type. Then, there are schedule creators that have to make all these ideas workable by balancing requirements coming from many different sides inside and outside of an airline, people who negotiate fuel prices, repair and maintain the aircraft, provide service to passengers, and many other specialists and generalists – the cost architects. The impact of this process of creation and preparation for service delivery remains invisible to senior decision makers focused primarily on cost output expressed in numbers. Reinstating the connection between numbers and their origins requires a refined, selective approach based on identifying the cost critical operational problems, bringing them to the attention of cost architects that have knowledge and power to fix them, and finally pass it on to senior decision makers who can balance their acts to achieve what is best for the organisation.

The same principle can be applied to every area of business management. Costs allocated to departmental units shouldn't be an obstacle if we don't stop there. Departments are integral parts of the company's organism. When problem arises in one part of the body and its root causes are not identified, the treatment applied to the wrong part will harm other parts of the body and weaken the organism. This reminded me of the case of a European Airline where crew shortages were being reported as a cause of costly disruptions for about four months, starting at the beginning of the new season. The C-Officers decided that saving company's reputation surpasses the investment in additional crew, and some time later 24 new crew members joined the company. To cut the story short, as there were no signs of improvement, the top team required a more thorough analysis of the root causes of problems. The analysis showed that crew shortages were only the last in the chain of disruption causes triggered by problems with aircraft maintenance, which was related to tight schedules, which appeared to be the consequence of strategic requirements for increased aircraft utilisation (a bit over tolerable level). The sunk investment could have been avoided if the magnitude of disruption costs and associated causes of problems were diagnosed at early stage.

To inject more life into the planning processes, upset by limitations of traditional costing system, senior executives need to be regularly informed about the cost critical but avoidable changes in planned operations and their root causes. This will bring profound changes in the way airlines plan and control their business resulting in measurable improvement in operational and cost efficiency.