Measuring EVA for Corporate Aviation
Capt. W. Patrick Gordon, M.Sc.
What's a flight department worth?
If you're a responsible aviation manager, EVA (Economic Value Added) is another acronym you'll be learning.
EVA and ABC (Activity Based Costing) have both been around for eight to 10 years. ABC has not caused much excitement since its exposure has been primarily in accounting journals, which are not exactly escapist reading material. EVA has been getting a lot of attention since the business press often ties it to corporate achievement and resulting stock performance. I became curious about the impact it would have on a typical corporate aviation department.
On a recent trip through Atlanta, I discussed EVA with Dr. James Owers, Professor of Finance at Georgia State University, and Peter V. Agur Jr., President of The VanAllen Group, an Atlanta-based aviation consulting company.
Dr. Owers described EVA as "a powerful measure and motivator of manager/employee performance." In a nutshell, here's the concept. Are you increasing or decreasing your corporation's wealth based on revenues generated compared with the amount of capital you're using? To determine the answer, calculate the amount of capital being used in your department, including aircraft, fuel, ground equipment, personnel, training, phone calls and coffee cups. Virtually all costs, fixed and variable are tallied.
With the capital totaled, compare the departmental revenue generated. If your revenue is larger than the amount used, congratulations. You have a positive EVA measurement and you're helping the company create wealth. Simple, right?
It's not so simple if your aviation department, like many corporate departments, does not generate revenue. EVA measuring is possible for a charter or even part-time charter department, because they generate real revenue. EVA measurement of a typical corporate flight department is not feasible unless your company's executives, marketers and accountants buy into the concept of imputed income, based on assisted sales generated. That means the flight department plays a key role in generating sales and is given direct credit for a portion of those sales revenues. Not very likely!
Since EVA requires cash dollar flows from outside sources, the concept of imputed income based on executive time value does not qualify either.
Some companies, in an attempt to make their flight departments fiscally acceptable, have used charge-back systems within departmental or divisional users. A problem often encountered in charge-back systems and in costing of corporate aircraft, is the cost of depreciation. Most companies apply GAAP (Generally Accepted Accounting Practices) to aircraft depreciation. This permits reduction of the book value of an airplane, like any other piece of industrial machinery, to a minimum salvage cost over a given period of years.
According to Agur, because of the durability of well-maintained aircraft and the resulting resale market demand, it is not unusual for a corporate aircraft to retain 75 to 120% of its purchase price in updated dollars if it's held over a number of years. Very rarely is an aviation department credited with the gain realized by the company on the difference between the sale or trade-in price and the depreciated value of an aircraft, when the deal is done. This results in a phantom or windfall profit for the corporation but at a very real cost to the aviation department. (My goodness! How the used aircraft market has changed since this article was written.)
One Fortune 500 company, well known for its application of EVA, uses a different approach of financial measurement for its cost centers. By using ABC, it makes a fiscal and practical justification for company aircraft. ABC finally gives executives ammunition to back up the gut feeling that corporate aviation is advantageous when their accountants say it isn't.
When ABC is accepted, a company can ignore GAAP and use an economic or market depreciation instead of a formulated, yearly schedule. ABC more fairly determines aircraft value and lowers depreciation costs substantially.
Another cost advantage of management buy-in to ABC would occur from the recognition that most corporate aircraft provide both strategic and operational services with a greater proportion of trips being strategic rather than operational. ABC rules recognize excess capacity and fixed aircraft costs can be assigned on a daily rate as opposed to a flat rate on flight hours over a given year.
Let's say that out of 365 days, an airplane is down for maintenance for 15 days, leaving a capacity of 350 days. It then flies 80 days on operational flights, another 140 on strategic flights and sits idle for the remaining 130 days. The idle days could be considered either excess capacity or strategic days available but not used. This is similar to the concept of a fire truck being idle at the fire house but creating value through its availability.
ABC allows the fixed costs of the aircraft, including depreciation, to be spread over the 350 aircraft work days (220 days flown plus 130 days available). Operational trips absorb only the fixed costs associated with the days flown for operational purposes. Strategic trips absorb the fixed costs associated with strategic trips plus the fixed costs on the days the aircraft was available but not flown (idle days).
This is justified because the aircraft was creating strategic value by being ready to respond. This loads the strategic trips with a larger portion of the fixed costs over the year but strategic flights are less cost-sensitive than operational flights and are far more able to carry these costs. To make the transition to ABC, Owers and Agur both agree that supporting background material is essential. After determining both fixed and variable costs, the next step would be to divide company flights into two major categories, strategic and operational.
Strategic and operational trips.
Strategic trips create income, prevent losses or address significant business threats or opportunities. An example would be an impromptu trip to sign a megadollar contract ahead of competition. Another example might be the swift movement of firefighters to an oil weIl fire.
Operational trips are strictly based on what's best for the company in the realm of cost effectiveness. One example would be a corporate, scheduled flight between different facilities. Another example would be the door-to-door employee time cost on a corporate aircraft, as opposed to another mode of travel.
Three basic applications to flight department activity might further clarify ABC:
A strictly operational, one-airplane flight department. No strategic flights at all. In this case ABC comes close to the normal total costing that we are familiar with. The difference would be in the depreciation to true market value instead of salvage.
One airplane used for both strategic and operational trips. 100% aircraft availability equals time used (strategic + operational days) + idle days. This does not include maintenance days since the aircraft isn't available. Therefore, 100% availability for ABC purposes is only 96% availability in our normal operational way of thinking.
• 04% maintenance downtime. (Not available, therefore no depreciation for this period of time.)
• 20% of time used for top management (strategic trips) 40% of time used for operational trips
• 36% of remaining time is idle capacity
• 96% total annual availability.
Strategic trips are allocated the fixed costs associated with strategic trip days. Since idle days are considered strategic trips-in-waiting, the fixed costs attributed to these idle days are also allocated to the strategic day costs. We are basically subsidizing operational trips with strategic trips, thereby increasing use of the aircraft.
Two airplanes, one used strategically and the other operationally. Each aircraft pays its own way in variable operating costs but the fixed costs for both airplanes are lumped together and allocated much as in the second example. The less cost-sensitive strategic flights pay the majority of the fixed costs.
ABC measures and allocates fixed or indirect costs on a more reasonable basis than total costing systems. Strategic costs per hour/mile go up and operational fights get the costing break they now lack.
Some forward thinking corporate flight departments are already working on ABC models with positive results and enthusiastic feedback from senior management. The only drawback to ABC is that it's not simple. It requires a comprehensive and complex model to allocate and evaluate costs. An effective ABC analysis of a flight department's activities is probably beyond the time restraints or capabilities of most aviation department managers.
Resistant to change and with other fires to put out, most accounting departments have little to gain from such an analysis. The key to implementing ABC is for senior management to decide that changing the costing system for company aircraft is worth the time and effort to ratify outside assistance.
Much of corporate aviation has long been a victim to another accounting acronym, LIFO (Last In/First Out). LIFO is usually applied to inventory control and pricing but certainly applies to many company aircraft. When times are good it's the last item purchased. When times are bad it's often the first thing sold. The acceptance of ABC standards of accounting can bolster the justification of valuable corporate assets, like aircraft, and break the reactive LIFO buy-sell cycle in corporate aviation.
Note: My goodness! How the fiscal times have changed since this was written. But this was a transition that we had to go through to survive. Used airplanes don't sell for anything like the levels stated in this article. They were accurate figures for the time though.