Tuesday, 16 July 2019

If You Think You Understand Airline Costs, Think Twice

Did you know that analysts claim that every year 2 trillion dollars is wasted globally due to poor implementation of strategy? The question is how big is the share of the airline industry, and what is it that drives the poor implementation of strategy, pretty visible through increased disruptiveness of air travel and unexplainable rise in costs?

There are many reasons for this, but let’s on this occasion focus on the strategic aspects of operating costs and their impact on operational underperformance. 

Traditional airline costing is among the biggest obstacles to alignment of strategies with operational reality. It is the by-product of the industrial approach to management and costing so firmly ingrained in the mindsets that even when a company decides to introduce the latest technology, no one even thinks about adjusting the approach to costing to improve the scope and quality of decision making.

So, what is it that stands so stubbornly in the way of understanding the true nature of costs essential for successful system management? At the very core, it is about departmentalisation of costs set as a standard many decades ago. It was meant to ease up the budgeting and control processes from the top without awareness of how much this mechanistic approach affects overall organisational results. It may have been understandable at the time when this short-sighted idea was conceived. Such costing standards have, however, completely ignored the intricate nature of costs based on the constantly changing interactions between data, people, and processes within and outside of an airline. This is why the gap between strategic assumptions and operational reality continues to widen, resulting in ‘unexplainable’ drop in operational efficiency and rise in costs. It deprives strategists from understanding the impact of their decisions not only on profit, shareholder value and lost revenue, but also on people, organisation, society and the environment.

Is it really so difficult to understand that costs apportioned to operational units without knowing their true origins can turn every decision into an undesired outcome? This is not only because this information is simplistic, but also because it is just a historic snapshot of data collected at the time of budget drafting and some years earlier. 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 is how decisions related to cost savings, network development, aircraft and hub operation, outsourced services, or investment in additional resources, become stumbling blocks for improvement in cost efficiency and operational performance.

Let's look more deeply at what the typical process of cost planning looks like. It 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.

There are two major setbacks in this process. The first one relates to the sources of information used for cost projections 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 the limitations of these functional 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 a flight cannot operate at optimum flight level, when ATC diverts the aircraft to a longer route or puts it on hold over a busy airport, and in many other situations. According to industry research, about 10% of fuel consumption is attributable to operational changes. Reducing it at busy airports is becoming more and more difficult. 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 and introduce more fuel-efficient ones. 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 getting the insight in their origins requires a refined, selective approach. This approach should be 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 passing them 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 a 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.

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 and quality-critical but avoidable changes in planned operations and their underlying causes that constantly stress the system. These insights bring profound changes in the way airlines plan and control their business, resulting in measurable improvement in operational and cost efficiency.

Being in a position to experience first-hand the strategic, operational, and information side of costing problems, I came up with a practical method and technique that support the creation of missing links between strategy and operations. It cuts through the complexities and brings new value to this still unexplored area of airline management, in particular when supported by emerging technologies. The basic principles are explained in my book ‘Beyond Airline Disruptions – Thinking and Managing Anew’ and webinar: Let's Disrupt Disruptions.