11 September 2015, © Leeham Co: In connection with our articles, there a numerous reader discussions around the development and production costs of new aircraft families. It’s not easy to understand how these costs arise, how they are booked in the OEM’s accounting and how they can be compared. Time for a primer.
I will not duplicate a course in company accounting, but it can be worth the read to understand how costs are created, accounted for and what we as externals can observe via aircraft industry economic reports .
I will focus on Airbus and Boeing. These are good examples of the different ways of collecting and showing costs in the global aircraft industry.
Development costs are handled in two ways in the aircraft industry. The first and simplest, is where development costs are booked as costs when they occur (costs are expensed in the quarter). This means development costs that have been accrued in the quarter are shown as development costs in the financial report for the quarter and finally in the annual report. The alternative way is to defer development costs to inventory as e.g. “tooling cost”. The capitalized cost will later be amortized over, fof example, the first 400 aircraft. This is allowed under International IFRS accounting rules but not under US GAAP.
Development costs are predominantly costs for engineers working on the design of the aircraft, i.e., man-hour costs. It is not too difficult to estimate these costs. An engineer working for a year in Airbus or Boeing costs roughly $0.1m, so 10,000 engineers working on the design of an A350 or 787, cost the company ~$1bn per year. There are other costs like material, equipment and tooling, but man-hour costs are dominant in today’s design of aircraft. One gets a good understanding of a project’s “burn-rate” by looking at how many people are engaged in the project and assuming $0.1m per person and year.
It is now clear why project delays are so feared. A delay means the allocated man-hours, say five years into the project, have been consumed but the work result is not where it should be. Some key certification points have not been earned or design problems remain to be solved that should have been solved. Reaching the needed work result means more man-hours and therefore cost.
So to summarize; for the development of an aircraft “time is money” to the tune of roughly $0.1m per person and year. The costs are taken and shown in the time-period when they occur under US GAAP. Under IFRS it’s up to the company to decide if the costs are expensed (taken in the quarter) or capitalized to inventory, where they are amortized over a production run.
Production and preparation for production (like creation of production tooling, etc) is handled in two ways, with a mixed alternative possible.
The first is to expense costs when they occur. This is called Unit Accounting. The actual accrued costs are then shown in the quarterly and yearly financial reports as Cost of Goods Sold (COGS). This is the way that Airbus handled production costs until the A380 and A350 projects. For these two projects, select early customer orders are handled like Boeing’s program accounting (see below), but only for the aircraft inside the customer order. For all other orders, the actual production cost is expensed in the quarter. With the exception for these initial customer deliveries, the quarterly and yearly results are in close fidelity with how money has flown in the company during the time period. From an external viewpoint, it means that the quarterly and yearly bottom line includes all the revenues and costs that have been accrued during the time period. There is little or no overhang to the future.
From an observer’s point of view, it is difficult to know how much the different aircraft programs have cost the company. Airbus shows its revenues and costs on a division level but not on a program level. It is therefore not possible to know how much the first A350s cost Airbus to produce; it is hidden together with the margins that Airbus makes on other programs like the A320 and A330.
Boeing handles tooling and production costs differently. It packages every major aircraft program into its own accounting system called “Program Accounting.” Based on experience and knowledge of the production “learning curve” for similar aircraft programs, Boeing estimates the average production cost for an “accounting block” (for the 787 right now, the first 1,300 aircraft). When Boeing sells an aircraft like the 787, it takes the aircraft sales revenue and deduct the Program Accounting’s average production cost for the first 1,300 units as COGS (Cost Of Goods Sold). The result is the revenue, cost and profit which is show in the quarterly and yearly reports.
The method shows a higher profit per aircraft for the initial production run than if Unit Accounting was used. For late production units the pendulum swings the other way. Unit accounting shows a higher profit per aircraft, as program accounting is now adding the amortizing of the deferred costs to the current production costs to form COGS.
The difference between the real production cost and the Program Accounting’s average cost, is called deferred costs. These are booked on deferred costs accounts and are shown in the balance sheet of the OEM’s reporting under Inventory. By following the movements of costs for this account (actually two accounts, one for production and one for tooling, right now at about $30bn combined) and Boeing’s comments on deferred cost development, it is possible to understand the real production cost curve of the 787.
Real production costs
The real production costs of an aircraft like the 787 or A350 are very high for the first units. The financial data which is presented in connection with Program Accounting makes it possible to understand the real production costs of the 787 with good precision. I will give examples of figures that can be deduced from such data. The key take-away is not the figures but that fact that Program Accounting gives the external person a chance to understand the true production costs of an aircraft whereas unit accounting doesn’t.
Now to the example and how one can understand the production cost of the 787. To reach a production cost estimate, one has to assume a learning curve (Wikipedia link for those interested). The learning curve describes how different costs decline when production volumes increase.
The average production cost for the first 50 787 units can be estimated from Boeing’s accounting as $450m a copy (the first units cost over $1bn). The production cost of unit 50 can be estimated to $200m. With a learning curve of 85%, which is the normal in the industry (and which seems to be followed by the 787 after the initial troubled aircraft), the cost for aircraft 100 shall be 15% lower, or about $170m per aircraft. Double that again to unit 200 and we are at $145m. Right now, unit 330 goes out the door, which should have a production cost of around $125m. These values can be a bit off but not by much; the accounting around Boeing’s deferred production costs makes the figures pretty predictable.
As can be seen, Program Accounting gives the external observer a good idea of the real production costs in the aircraft industry. The market’s appraisers publicize the present market values for newly produced aircraft. This gives a good idea of the net prices for the aircraft. Right now a new 787-8 is valued at $120m, so Boeing would make a loss of about $15m per copy and go to cost/revenue break even next year. This is in line with Boeing’s financial guidance.
Airbus and Boeing represent the two different ways of how the costs of production aircraft can be presented. Of the two, the more involved method, Program Accounting, contains a number of assumptions over future costs and the learning curve effect. At first glance this makes the understanding of the true costs of the aircraft program less transparent.
As the practice leads to the company presenting the deferred costs each quarter, combined with statements of how fast the cost break even point will be reached, Program Accounting enables an analysis of the production costs that Unit Accounting doesn’t.