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Misconceptions about Aircraft Costing

by David Wyndham 12. October 2018 09:01
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Over the years I have written a number of articles discussing aircraft operating costs and methodologies for analyzing them. This month, I’d like to review some common misconceptions about costs that I run into on a regular basis. Most of these result from connecting something that we are familiar with, like the cost of running an automobile or building a house, and using those as an analogy for the unfamiliar cost of owning and operating an aircraft. 

The biggest misconception is focusing on the acquisition cost to the detriment of operating costs and asset value over time. I have a client whose maximum acquisition budget is $20 million. This is a real limit and not one to exceed. Where the misconception arises is that if we are looking at Aircraft A with a selling price of $20 million and Aircraft B which sells for $17 million, the former aircraft is the less costly option. But is it?

Assume the both aircraft have similar capabilities in terms of range and cabin.

The only way to know which one costs “less” is to evaluate the total costs to acquire, operate and dispose of the aircraft. Two major costs are the operating costs, to include maintenance, and the estimated residual value after a set length of time. Looking at our current scenario, Aircraft A has a lower fuel consumption than Aircraft B. Aircraft A also has engine and airframe maintenance costs similar to Aircraft B. Looking at the costs per hour:

Variable cost.                        Aircraft A.                  Aircraft B. 

Fuel                                        $1,376                        $1,521

Engines                                  $ 580                          $560

Maintenance                         $ 784                          $677

Per Hour                                $2,740                        $2,758

There is more:

Aircraft A flies faster than Aircraft by 8%. Remembering the aircraft fly from origin to destination, the faster aircraft uses fewer hours to fly the same trips. If Aircraft A flies 400 annual hours, this requires Aircraft B to fly 432 hours. The annual variable cost is

Variable cost.                        Aircraft A.                  Aircraft B. 

Per Year                                $1,096,000                $1,191,456

Aircraft A costs almost 10% less in variable cost per year than Aircraft B. If both have about $650,000 per year in fixed costs, the annual operating budget favors Aircraft A slightly. While not enough to make up the $3 million price difference, it does account for about $1 million over 10 years. There is still more.

Aircraft A is a popular model and is currently selling better than Aircraft B. Current market values are being maintained better than for Aircraft B. After 10 years the estimated residual (resale)  value in dollars and percent is higher for Aircraft A. Now our 10-year life Cycle Cost is:

10 YEAR COST.                               Aircraft A                               Aircraft B

Acquisition                                        $20,000,000                         $17,000,000

Variable costs                                   $ 10,960,000                         $11,914,560

Fixed Costs                                       $ 6,500,000                           $ 6,500,000

Resale value                                     ($10,000,000)                       ($ 7,500,000)

10-Year TOTAL                                $27,460,000                          $27,914,560

Aircraft A costs about the same to own and operate as Aircraft B. Making the purchase decision just on acquisition price doesn’t tell the entire story. In the above example, we need to evaluate of parameters in addition to just costs to determine which aircraft is the best value. 

There could be other considerations like product support. Not only the perceived quality but where are the service centers located? If Aircraft A has a service center on your home field while Aircraft B’s nearest service center is 300 miles away, Aircraft A will be easier to maintain and, if AOG at home, might be repairable in less time.

Consider the equipment? What if Aircraft B has a more advanced SVS than Aircraft A? But what if you prefer the usability and displays in the avionics system on Aircraft A?

Never let a spreadsheet make a decision for you.  Never just look at a single cost item when evaluating aircraft costs. Aircraft are not commodities sharing essential the same characteristics. That is why I stress to my clients to look for a best value when making the aircraft decision. Costs are a very important part, but even the total costs do not tell the total story. 

(A version of this was previously published in AvBuyer magazine.)

 

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Quick Tips - Aviation Tax Planning

by David Wyndham 31. August 2018 14:36
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In my previous blog post, the financial analysis identified the aircraft that does the best job for the money. This month, I'll touch on some of the US aviation tax basics to be considered.

Ben Franklin supposedly said that in life, there are only two certainties - death and taxes. The former I'll leave to others. Taxes can be significant, and if not properly planned for, can lead to spending more money than is necessary. 

My partner, [Nel Stubbs], is business aviation’s best resource on aviation taxes for the United States. If you are buying or selling an aircraft that will be based in the US, she’s your contact. However, here are some general tips.

You may be FAA Part 91 and still face “commercial” taxes! What?

At the Federal level, the tax laws are managed by the Internal Revenue Service. The IRS separates aviation into two groups - commercial and non commercial. Do not make the mistake that the IRS definition is in any way required to match that of the FAA Federal Aviation Regulations (FAR's) for commercial and non commercial operations. The IRS and FAA use different standards to define commercial operations and they have "agreed to disagree."

The FAA uses regulatory definitions for a commercial operator. It involves the "intent" to hold one's aircraft out for hire. The IRS looks primarily at whether there is "transportation of persons or property for compensation or hire by air." Whether a profit is intended is not the IRS' concern. There may be times when an operator is FAA Part 91 private but can be subject to IRS "commercial" taxes. Many operators run afoul of the IRS in incorrectly figuring out how or whether to apply the Federal Excise Taxes. Add in an election year with carriage of elected officials, transporting guests on corporate aircraft and international operations, and it can get confusing fast. Business and Personal use is a complicated subject on its own.

Aircraft Are Not Real Estate. But, its still Location, Location, Loacation

Add to that the 50 US States Departments of Revenue and local county/city tax authorities. They are all slightly different. Some apply sales taxes. The seller of an aircraft may be required to collect and remit sales taxes on the sale of an aircraft. Many states offer some exemptions or exceptions. Property taxes can be applied to aircraft - some being based on the percentage of time the aircraft spends in the state and others flat rated for aircraft based in their state.

Where the aircraft is based matters. It can be in a Delaware LLC or in a Trust, but if the aircraft spends any significant amount of time in (Name a US state), then your aircraft may be subject to taxes. There may be sales taxes, use taxes, and property taxes. You may even face taxes from two different states if the aircraft spends a lot of time in a second location over than its home base. 

There are use taxes and fuel taxes applied at the state and county level. Some of those taxes get applied to the state's aviation fund and other just go into the general fund. Again, there may be exemptions for commercial operators.

The biggest thing to remember is to Plan Ahead. Before taking action, find out what the options are and their costs. Trying to do this after the fact often proves costly. Secondly, document, document, document. Paperwork can be your friend as a "paper trail" can provide proof of the taxable/non-taxable activity and or its intent.

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October 16-18, I'll be at the 2018 NBAA BACE. Stop by Booth 1134 to say hi. 

 

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David Wyndham

Financial Analysis Part 2 - Time Value of Money

by David Wyndham 29. June 2018 11:15
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Aircraft Financial Analysis

In the previous blog post I introduced the criteria for a financial analysis.  Recall that the goal of the financial analysis is to identify the aircraft that does the job for the least money.

The financial analysis should analyze all of the costs associated with the aircraft: acquisition cost, operating costs, depreciation and taxes, and the potential residual value after a set term. If the aircraft is to be used in a commercial operation, you will need to make assumptions regarding potential revenues as well. All of these considerations are important and needed to complete the analysis. Use the same set of assumptions for each aircraft to ensure that you get a true comparison.

The analysis tool to perform the financial analysis is the life cycle cost. In addition to showing the expenses, revenues, taxes as necessary, and a cash flow, there is one more thing remaining. The time-value of money.

The cash flow, or the monies in and out for pre and post tax, may be very different for the aircraft and the scenario. For instance, option A may be a cash purchase, option B, a loan, and option C, an operating lease. For the same aircraft, the cash flows will be dramatically different. Option A has a large cash outflow at the start in the form of the acquisition cost. Option B just has a down payment, but also has interest on the outstanding balance of the loan. Both of these purchase options do have the revenue in the form of the residual value estimate at the end of the term. The lease has no acquisition cost, but no revenue at lease end either. 

For a commercial operation, cash flow is king. At any given time if the money leaving in the form of expenses is not covered by the revenue coming in plus the money in the bank, you are not in business much longer. For a not-for-hire operation, the cash flow remains negative until you sell the aircraft where they may be a “profit.”

There is one more important consideration to consider, the timing of the expenses and revenues. Regardless of for hire or not, when the expenses occur as well as their magnitude is important. 

The time-value of money places importance on the timing of a revenue or expense occurs. Think of interest. If I invest $1,000 at 5% per year, I'll have $1,050 at the end of a year. Similarly, if I owe you a $1,000, and I pay you today, I need $1,000. But, if I can wait a year to pay you, I can invest $953 at 5% and end up with $1,000 after a year. Taking the time-value of money into account allows you to compare different streams of revenues and expenses  (i.e. cash flows) to see which one has the better time-value. Each future revenue and expense has a value in today’s dollars, or a Present value.

The Net Present Value is the sum of the present values of these future cash flows (revenues and expenses) less my initial investment. It takes into account my assigned value of money and inflation. An NPV greater than zero means I’ve made a profit. A zero NPV is break-even while a negative NPV is a loss. For a not-for-hire operation, minimizing the loss is the goal.

Terms used to describe the time-value "interest rate" include return on investment (commercial operations) and net present value (non-revenue operations like a corporate flight department or government). These are usually abbreviated as ROI and NPV respectively. 

What is a typical percent to use for the ROI/NPV analysis? You usually don't have to make one up. Government agencies usually look at the cost of borrowing money - Treasury Bill interest rates for example. Corporations have expected returns and use that for all major purchases. If you are in a large organization, just call the financial department, the CFO, comptroller, etc. and ask them for the relevant rate and your organization's marginal take rate. They will be impressed at your level of understanding!

Now that you have your costs, ROI/NPV rate, and marginal tax rate, how do you perform the analysis? Prior to spreadsheets, it was a time-consuming process. Today, there are spreadsheet applications that, given the proper data entry, will quickly calculate cash flows and ROI/NPV. Our company has a tool, Life Cycle Cost, that has a built in aircraft database that allows you to do all of the analysis mentioned here. I believe it is the only database plus software of its kind that does all these calculations specifically for aircraft.

The financial analysis with NPV takes into account all of the variables and calculates the net return for the option. This financial analysis allows you to rank order the capable aircraft to find the one that does the required job for the money.

One last warning, never let a spreadsheet make your decision for you. 

Aircraft A may be technically adequate for your mission and have the most favorable NPV. Aircraft B may exceed all your requirements but have a less attractive NPV. Since both Aircraft A and Aircraft B meet your technical needs, Aircraft A is the financial best alternative. But, the financial decision maker may feel that Aircraft B has a better value, or “more bang for the buck” and favor that option. As a consultant or analyst, my job stops at the technical and financial ranking. The decision maker, the person who signs the check, gets the final word.

 

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David Wyndham | Flight Department

Financial Analysis - Part 1

by David Wyndham 30. April 2018 12:11
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It seems that in aviation there are some who think finances are scary (read as job threatening) and those who think finances are just simply boring. Both groups try their best to avoid the subject. There is a middle way, those whose knowledge of finances gives them a powerful and convincing tool for making the right aircraft decision!

To do a proper financial analysis, you will need the initial investment required, the variable and fixed costs of operation, and the estimated residual value of the aircraft at the end of the term. Taxes and revenue potential can also play an important part in the analysis. The objective of a financial analysis is to determine which of the qualified aircraft provides the optimum combination of these elements.

Before doing a financial analysis, you will need to establish financial criteria and options. This process starts in the same manner as when you are selecting an aircraft. First you choose the criteria by which you will select an aircraft. With aircraft, we think in terms of things such as range, payload and cabin size. In aircraft financial analyses, we think of things like:

Amount of utilization. For point to point travel, do this in miles (or kilometers). Trips from Point A to Point B have a set distance. Add up those trips' distances. Then divide by the aircrafts' typical trip speeds to arrive at the utilization in hours. 160,000 nautical miles is 400 hours at 400 knots or 500 hours at 320 knots. This will have an impact on the fleet size as well. A large amount of utilization (in miles) can spell three slower aircraft or two faster ones.

Type of ownership. Full ownership, co-ownership, fractional ownership. Maybe not even owning at all. Utilization under 200 hours per year can suggest a form of charter or perhaps fractional ownership. Between 200 to 300 hours, fractional ownership and full ownership should be considered. Over 300 hours tends to favor full ownership. There may be extenuating circumstances to consider as well. 

New versus used. Do the lower maintenance costs, added tax depreciation benefits, and the ability to specify the exact configuration of the new aircraft outweigh the used aircraft's lower acquisition cost? There may be other considerations favoring the new aircraft such as updated avionics.

Lease or Purchase? A lease typically has a very low initial payment, and depending on the type of lease, may not be considered "long term debt" on the corporation's balance sheet. Purchase includes both finance and full payment up front. With a purchase, you do have ownership and after the payment(s), have an asset with a definite value.

Trade-in Value. If you currently own an aircraft, you need to get an idea of its current worth in the market. Price guides such as the Aircraft Bluebook Price Digest, Vref , and The Official Helicopter Bluebook offer a good starting point for determining the value of an aircraft. Nothing beats an appraisal by a qualified appraiser. The National Aircraft Appraisers Association is one place to start. An appraiser will give you the real-world value in today's market that will aid you in negotiations with buyers.

Acquisition Price. For used aircraft, see the references above. You can also look at aircraft-for-sale web sites to see what the "asking" prices are. Keep in mind that there can be a considerable margin between asking and final selling price. An appraiser can also give you some information on used aircraft prices as well. For new, start with the manufacturer's list price. In today's market, most sellers are willing to make a deal, so don't count out a new model that is "just a little bit" outside of the target acquisition price.

Length of ownership. When you analyze each aircraft, use an equal length of ownership. Looking at cash flows and costs over different lengths of time can give you a distorted picture. This is very important when considering the time value of money. When income or expenses occur can be as important as how much.

The methodology to do all the calculations is called Life Cycle Costing. The Life Cycle Costing includes acquisition, operating costs, depreciation, and the cost of capital. Amortization, interest, depreciation, and taxes also play a part in what it costs to own and operate an aircraft and can be included in the Life Cycle Costing as appropriate.

Once you have calculated the life cycle costs of the various options, you can compare the total costs. However, this may not be enough. While the magnitude of expenses and revenues is critical, their timing is important, too. In general, it is preferred to pay the bills as far into the future as we can without penalty. 

The next step is to use the concept of the time value of money. We all can agree that being paid today and paying our bills next week is the preferred way to manage our finances. This is the simple version of the time value of money. Next month, we will explain it in detail and complete the financial analysis.

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David Wyndham | Flight Department

Aircraft Technical Analysis

by David Wyndham 12. March 2018 10:15
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To continue our review of the components of a successful Aircraft Acquisition Plan, I will be discussing the technical analysis. The technical analysis is as varied as the types of missions. They keys are to adequately define the key missions and evaluation parameters. Use those to develop the objective criteria to judge candidate aircraft.

I just finished a fleet plan for a client. Before starting the report, the Chief Pilot was sure that the best aircraft for their mission was the "BelchFire Warp 2K." But to placate the boss, the Chief Pilot hired us to do an analysis. As it turned out, their preferred aircraft was number three on the list of best alternatives. The other two had similar speed and range capabilities and offered the bigger cabin the boss was looking for. While in many instances, your initial instinct is correct, the technical analysis can reveal other alternatives, some of which may be better suited for your mission than the initial pick.

Aircraft Technical Analysis

The focus of the technical analysis is on size, features, range, and performance. The acquisition cost, cost of operation, and other financial and ownership matters are for a second analysis.

Make sure the requirements are listed correctly. An eight passenger cabin and 2,500 NM range are different than a range of 2,500 NM with eight passengers. Perform the basic analysis with the objective of developing a short list of candidate aircraft that will be used in the detailed analysis. Then you are ready for the detailed analysis:

* Determine the most (likely) demanding payload, range, cabin size and/or passenger seating requirement as defined by your key mission.

* Compare those requirements against the capabilities of a range of aircraft from the sources of information you have gathered.

* Eliminate all those that do not meet the requirements.

* Eliminate those aircraft that are vastly more capable than required. The cost of acquisition and ownership does up dramatically as size, range and speed increase.

How many aircraft should you end up with the do a detailed analysis? An absolute minimum would be two aircraft but three to nine aircraft is the preferred goal. If you end up with only one aircraft to analyze, go back and review your key missions. It is rare than there would be only one aircraft that can perform your mission. If that is the case, it is likely that the aircraft seller may know that and thus, you will have little room to negotiate on price. More than nine aircraft and your analysis gets unwieldy - better to go back and come up with some more restrictive requirements.

The detailed analysis is designed to outline clearly the various capabilities of the candidate aircraft in relation to your key mission. Depending on your key mission, the following may be included:

* Weight buildup. This includes passenger payload, baggage capacity and even weight and balance considerations. Also include baggage size considerations. Four sets of skis may not weigh much, but will require a longer baggage compartment than will four overnight bags. Four fully-equipped SWAT Team members will weight a lot more than four medical personnel. Remember the mission drives your requirements.

* Range and reserves. Given your weight for the key mission, can the aircraft fly the required trip? Make sure the fuel reserve calculation is correct for your mission. Run specific scenarios to make sure the aircraft will perform as required. Do you need to lift two med-evac patients from a high altitude location on a hot day? What about navigation requirements such as FAMS-1, ADS-B,  minimum engine inoperative altitudes if operating over mountains, etc. can be important considerations.

* Airport restrictions. Do you fly into a short runway? Narrow taxiway? What is the weight limitation on your parking ramp? Where you operate will define things such as runway requirements, climb and obstacle clearance criteria, etc.

* Have a hangar with a twelve foot opening? Don't find out that your new aircraft is 12 feet 2 inches tall after the sale is completed! 

* Features and Equipment. This can be a short list or an extensive one. It can include things such as auxiliary power for ground and air use, a private lavatory, single point refueling capability, crew rest areas, a separate cargo door, and required ground support equipment. WiFi here in the US is a different requirement than WiFi with global capability. Again, the key mission defines the parameters.

* Reliability and Support. This can be hard to quantify as very little quantitative data exists. A good source of this type of information is to talk to other operators of the type of equipment that you are evaluating. In addition, magazines conduct and publish product support surveys. Locations of factory approved service centers can be important, as can spares support. If the manufacturer is still producing the same or similar aircraft that you are evaluating, support could be better than trying to find qualified support for old, out of production models for which there is no major spares supplier.

These are some of the major items. Your evaluation parameters may likely include others. Once you have performed the analysis, it is time to rank order the aircraft.

Determine how many criteria each aircraft meets, did not meet, or exceeded. The minimum Key Mission criteria is mandatory - failure to meet them will result in the aircraft being removed from consideration. Other criteria should be rated as desired in that it will enhance mission effectiveness or add extra capability. Not meeting desired criteria can still result in a mission capable aircraft. See which aircraft, having met all the required criteria, also meet some or all of the desired criteria. Adding the deficiencies and excesses can result in a numerical score. You may add your own multiplier to favor one criterion over another.

If no aircraft meets the required criteria, what do you do? Go back to your key mission and carefully evaluate each of the evaluation parameters and how, if changed or removed, would affect the key mission. In other words, find out what you can live without.

There still may be an occurrence where no one make/model will adequately perform your missions. In that case, maybe acquiring one aircraft to do 90% of the missions and chartering an aircraft to perform the remaining 10% may be the solution. I had one client with a lot of trips with four to six passengers of 150 NM and under. The next requirement was for three to four passengers to fly 2,000 NM. In their case, a turboprops served the short trips quite well and since the longer trips were infrequent, a fractional share was a good alternative for those trips.

The technical analysis is as varied as the types of missions. The keys are to adequately define the key missions and evaluation parameters. Use those to develop the objective criteria to judge candidate aircraft. It is better to explain to the boss why his favorite pick (1) can't perform the mission and to offer alternatives than to acquire a less than desirable aircraft and find that out after the fact.

Note (1): Yes, I’ve seen a thorough analysis identify a best-fit aircraft only to have the decision maker get a different, less capable aircraft because of personal reasons. My job is to provide the factual data to allow for a fully informed decision. 


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