Direct Operating Cost.

This is in response to one of my pages I unknowingly removed - Calculating Direct Operating Cost.

Please keep in mind that these figures are "highly debatable" AND are mere assumptions.

What is Direct Operating Cost and how do you compute DOC?

In one of my previous post, I stated earlier that DOC is the operational expense directly associated with a flight. This cost is allocated towards the flight planning process (positive or negative outcomes).  DOC is summed up with both fixed and variable costing. For obvious accounting reasons, different airlines and their fleet manufacturers (Airframe and Power Plant) use different definitions on what their DOC is. In addition, airlines, charter companies, air taxis etc use different methods and approach to calculating DOC though some of the variables are constant. For instance Fuel, Crew, etc

In my previous post, I explained that these are the likely contributing variables to DOC

•       Depreciation, Insurance and Interest

•       Fuel; the biggest, single line item in the cost 

•       Station and Ground Services; varies upon weight, class and size of fleet

•       Flight and Cabin crew; varies upon weight, class and size of aircraft

•       Airframe and Power-plant Maintenance – varies on what class and size airliner belongs to

Depreciation, Insurance and Interest

Depreciation

Financially, there are different depreciation methods; however, it's important to note that when deciding on which depreciation method to use, you have to consider the aircraft utilization, as well as the tax advantages/disadvantages.

For instance, assuming that Southwest Airlines(SWA) purchased a Boeing 737-800 for their New York to Washington DC route, assuming the contractual cost of their airplane for $78million, ($71million (base price)+ $7million which includes taxes, operations engineering examination, flight testing, delivery charge, and the list goes on... etc ).

Depending on how the aircraft will be used (regular or heavy ops), they might decide to use Straight-Line, Declining balance (or Double Declining Balance), or activity based (based on number of hours or miles flown). 

To keep this “very simple”, SWA may decide its utilization is for medium ops and use the Straight-Line Depreciation method.

At $78million, assuming we decide to use the declining method, since this aircraft is "brand new", SWA is more likely to use the best out of it (heavy use) for the first 4year, average use for another years and standard use over the rest of its life. The double-declining method is the best approach because the airplane is more than likely to be thoroughly stretched during its first four years.

However, we've decided to keep this “very simple, and non-complex” and straight to the point. To keep this “easy and going”, SWA may decide its utilization is for medium ops and use the Straight-Line Depreciation method.

Here are the basic assumptions, again, nothing complex

•       Aircraft Purchase Price = $78 million

•       Residual Value = $3million

•       Useful Life = 20 Years

•       Depreciation years = 10 years (I purposely left it like this so that the next 10 years of light use will be depreciation expense free).

•       Interest Financing = 7.00%

•       Number of Periods Financing = 10years (120 periods) or 3,650 days (365 days x 10 years)

Monthly Depreciation Expense is $625,000 (its 120 periods or moths)

Daily Depreciation Expense is $20,548 (365days/year x 10 years = 3,650 days)

Now that the Depreciation expense is known, $20,548 daily, it's a lot easier to allot daily depreciation expense to daily ASM. Taking this assumptions, it flies daily,14 trips on a 161nm short haul, seating 140 passengers, total ASM's will be (14 x 161 x 140 = 315,560). With this calculation, if we're to allot every depreciation expense to every ASM, it will be $20,548 / 315,560 = $0.065cents / ASM. For every fulfilled ASM, there's a $0.65 cent allotted to depreciation expense.

Keep in mind that I said 14 trips based on a 65mins (Turn around including flight) because an average new aircraft flies about 15 to18hours daily, some even more. In addition, it doesn't really matter whether you fly a 500-nm trip that will increase the flight time as well. In addition to this, the airplane is highly unlikely to fly 7-days/wk

Insurance

To be honest, I am so not familiar with Aircraft Insurance Underwriting, thus, I can't speculate further on it, although I've read through some very interesting articles that explains how it's written. No single insurer can underwrite a commercial airliner due to high risk factors. Insurance can come in different forms --- most insurance underwriters may form a group and sell to any particular airliner.

There are different types of insurance coverage for different classes of aircraft and operators; there's the type where a)carriers pool their resources together and provide coverage for themselves b). Where Insurance companies provide their own coverage per their own policies. For instance, General Aviation are less riskier  unlike Commercial Airliners that carry greater risk. General Aviation aircraft obviously are not expensive and do not cost up to Airliners, so the class is very important in the writing process.

In addition, the types of pilots who fly these aircraft (number of hours, medical records, etc) play an important role as well. Another important factor to consider is the types of business involved (cargo or passenger), Geographical Location - flight route etc. For instance, airplanes that cross international routes tend to have higher premiums than domestic planes. Also, Airplanes that cross into “high risk airspace” for instance in the middle-east where there are tensions at the moment will often carry higher premiums.

In all, there are several mitigating factors that commercial airline insurance underwriters consider. According to what I've deducted from a few resourceful articles online, the rule of thumb is that annual insurance is between 4-8% of the assessed face value of the airplane. Given this assumption, it's fair to say that and avg annual rate of 6%, or 0.005% monthly rate, that's a 355,000 monthly.

With this calculation, from the calculation above, daily ASM is 315,560 and if the airplane flies for 6-days a week, 25-days a month, that’s 7,889,000 ASM monthly. If we divide 355,000/7,889,000, that’s a $0.044/ASM.

Financing Interest Rates

Like I said previously, DOC depends on what different airlines compute themselves; there is no direct approach in calculating DOC, however, Revenue Managers are responsible for accounting all possible “direct cost”. Although Interest Rates are not “directly” involved in the flight, they are “indirect cost”, however, I know of an airline that used this model.

On a $78million financing loan, if you use the “IPMT Function” in Excel, you will see that the interest charge for Day 1 $14,959. This interest will gradually reduce as the days go by, therefore, with a daily interest of almost 15,000 at 315,560 ASM, that’s a $0.047/ASM.

Now that we have 

·         Depreciation ---$0.065

·         Insurance ------$0.044

·         Interest Rate ---$0.047

Total ------------$0.156

That’s a total of 15.60cents

Assumptions

·         Depreciation was taken for 10years which in certain cases it’s a lot longer

·         Insurance Rates and premiums are “unknown” and calculation is based on “theory”.

·         Interest Rate could be higher or lower depending on Financial Market rates

·         I used 365 days x 10 years = 3,650 days. Calculation could be off due to leap year(s). 

 In all, assuming you scale down the by 20%, thus extend Depreciation by 20% (from 10 to 12 years), decrease insurance rates (from 6% to 4.8%, and Interest, (5.6%), this will surely reduce it from $0.156 to $0.124; that's a difference of $0.03 savings.

Coming up next is fuel