How to Screw-Up Ownership Cost Projections: The Seven Deadly Sins
Buying a plane involves spreadsheets.
Data. Justifications. Comparisons. Analysis … Math. We can be forgiven for romanticizing the past – when aircraft financial analysis consisted of two numbers: how much did it cost, and how much fuel did it burn? Life was simple. If the company could afford it, and the boss wanted it, the decision was made.
Competitive forces being what they are, those days are over. Well-run companies today strive to apply the same analytical rigor to aircraft decisions as they would their core business decisions. The idea is simple: analysis leads to optimization, which leads to savings.
This is all great in theory – as long as the analysis is done correctly. In reality, we see misleading ownership cost projections passed as gospel all the time. Rather than an attempt to convey insight, much analysis of this type is generated in an attempt to persuade. To sell.
The message here is simple: if you are writing a check for an airplane, be wary of slick spreadsheets and the recommendations they seem to provide. They can do more harm than good.
We’ve isolated seven areas to watch out for – the deadly sins of ownership cost projections:
Assumptions
The least important number on the spreadsheet is the final result.
Focus on the underlying assumptions; how those assumptions were derived, and what may be omitted. You can generate almost any result you want for an analysis merely by finagling the assumptions.
What do we mean by assumptions? Things like:
- Ownership Structure (cash/financing/lease)
- How long is the term of the analysis
- Utilization
- Residual Value
- Fixed Costs
- Direct Costs
- Acquisition/ Disposition Expenses and Fees
Spend time understanding where the underlying assumptions came from, how they were derived or established, and who derived or established them …
As an example, residual value assumptions will have a massive impact on the bottom line. But very few people ever ask what underlying data they were based on.
Discounting
Two assumptions deserve special mention. The first applies to a specific type of analysis known as a Discounted Cash Flow (DCF). DCF is a universally accepted method of accounting for Time Value of Money. The idea is that a dollar in the future is worth less than a dollar today. Why? Because a dollar in-hand is a dollar that can be used for something else – like making money. For those of you fortunate enough to spend your day on more enjoyable pursuits; a refresher:
A cash flow is just adding up all of the money spent and received for a particular project. It usually gets broken down year-by-year. A simple example for an aircraft investment could look like this:
5-Year Cash Flow ($M) | ||||||
Year | 0 | 1 | 2 | 3 | 4 | 5 |
Loan Payments | -2.0 | -1.9 | -1.9 | -1.9 | -1.9 | -13.4 |
Fixed Cost | -1.0 | -1.0 | -1.0 | -1.0 | -1.0 | -1.0 |
Direct Cost | -1.4 | -1.4 | -1.4 | -1.4 | -1.4 | -1.4 |
Resale Value | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 12.1 |
Cash Flow | -4.4 | -4.3 | -4.3 | -4.3 | -4.3 | -3.7 |
Total Cash Flow | -25.3 |
A Discounted Cash Flow is the same thing, with one important addition: it “discounts” the value of each year’s cash flow by the Discount Rate. Adding up the discounted yearly cash flow results in the Net Present Value (NPV) of the investment.
Here’s the same cash flow from above, this time with a 10% Discount Rate added:
5-Year Cash Flow ($M) | ||||||
Year | 0 | 1 | 2 | 3 | 4 | 5 |
Loan Payments | -2.0 | -1.9 | -1.9 | -1.9 | -1.9 | -13.4 |
Fixed Cost | -1.0 | -1.0 | -1.0 | -1.0 | -1.0 | -1.0 |
Direct Cost | -1.4 | -1.4 | -1.4 | -1.4 | -1.4 | -1.4 |
Resale Value | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 12.1 |
Cash Flow | -4.4 | -4.3 | -4.3 | -4.3 | -4.3 | -3.7 |
Discounted | -4.4 | -3.9 | -3.5 | -3.1 | -2.8 | -2.2 |
Total Cash Flow | -25.3 | |||||
Net Present Value | -19.9 |
Big difference: the NPV of the investment appears 20% less than the actual cash flow.
So, if universally accepted, what’s the problem with this discounting mumbo-jumbo? NPV can obscure the true cost of ownership. Discounted dollars are not real dollars. NPV is an effective cost, not an actual cost. It can be very useful for certain exercises, like deciding to pay cash vs. leasing or financing, where measuring time value of money is the essential question being evaluated. But don’t allow NPV to mask the actual number of dollars that will depart your wallet.
However, if you are using NPV to evaluate an aircraft investment, pay close attention to the Discount Rate. Many companies set a Discount Rate that is derived partly by math and partly by policy or corporate decree. The Discount Rate selected can singularly sway the analysis in favor of one decision or another. It may or may not be appropriate to apply the normal corporate Discount Rate to your aircraft analysis. Have the discussion.
NPV has its place. But never ignore the actual cash flow. Remember – when you go to sell your plane in 10 years, the loss you take won’t feel discounted. And neither will the price of a new one.
Taxation
Taxation is the second set of assumptions that deserve special mention. If you choose to include tax benefit in your projections – or if someone else does for you – please review the assumptions with an expert familiar with your situation. Please.
We commonly see maximum tax benefit automatically included. This will drastically reduce the result. But many folks cannot actually take full advantage for one reason or another. Don’t assume.
Also, we almost never see recapture included. That’s just wrong – and a great trick to make more expensive planes seem a lot cheaper. Even though your company will almost certainly do a 1031 Like Kind Exchange, the “cost” of doing so will come out of the next aircraft. In other words, it’s still there. 1031 just kicks the can down the road.
Should you even include tax benefit in your analysis? Most organizations do. One suggestion is to evaluate with and without. And, if the analysis is being conducted to answer a question of affordability – do it without. Don’t depend on tax breaks to afford a plane.
Sensitivity
Reducing a complex analysis, containing lots of variables, about the future, to a singular numeric output is presumptuous. Your plane will not cost $7,186,132 over 5 years.
Play around with different scenarios. Use sensitivity analysis to see how changing certain variables will impact the result. As an example, want to understand the importance of picking the right Discount Rate? Here’s a simple sensitivity analysis that clearly illustrates the point. This is the NPV exercise from above using 4 different Discount Rates:
Sensitivity to Discount Rate | ||
Rate | NPV | |
0% | -25.3 | |
5% | -22.4 | |
10% | -19.9 | |
15% | -17.7 | |
20% | -15.8 |
In this analysis, we can knock 10% off of the NPV for each 5% bump in Discount Rate.
Sensitivity analysis will help build understanding of how aircraft economics work. And that’s a lot more valuable than blindly accepting $7,186,132.
Determinism
The type of analysis we’ve been discussing so far is called “deterministic.” You determine the variables and assumptions and those variables and assumptions determine the result.
The problem with deterministic analysis is that it doesn’t capture risk or uncertainty. It mistakenly presents the future as a single outcome, or “best guess.” We all know that’s naïve. We need a better way to express how much the aircraft investment could cost. What do the upside and downside look like?
One method is to run the analysis through a Monte Carlo simulation that will examine different combinations of key variables and tabulate the results. This allows a decision maker to understand the range of probability surrounding an aircraft investment.
Result of a deterministic analysis: Your plane will cost $12.6M.
Result of a Monte Carlo analysis: Best guess – plane costs $12.6M. But, with 95% probability, it will cost less than $15.81M and more than $8.15M.
The range provides context, and it helps eliminate surprises down the road. Here are the tabulated results of a Monte Carlo simulation run 10,000 times:
Amnesia
We get asked to run a lot of ownership cost projections. Do you know what almost nobody ever asks? To take a look back at what their current or previous aircraft actually cost.
That’s a shame because it’s an insightful tool. Pretend you are running an ownership cost projection for your aircraft from the beginning. Best part – you already know all the inputs (if you can dig out the information!).
Better yet, keep them current every year. Fill in the lease/loan payments, tax deduction, and operating costs, etc. for that year. Mark the plane’s value to market as your terminal value and figure out what your all-in cost has been. Lastly, you also know your utilization, so you can precisely calculate how much your aircraft has cost per flight hour. Are you above or below plan (if you had one)?
Retro ownership cost projections. A great tool. You will look at future aircraft decisions 100% differently.
Bias
Ownership cost projections are equal parts art, math, and judgment. If you want to understand how projections may be massaged towards a particular answer, keep a careful eye out for bias. As a broad observation, these types of analysis often advocate the best interest of those directing or producing them. That may be a manufacturer, a consultant, or a flight department.
It may even be the boss. Happy calculating.