Lesson 4
Business metrics
October 23, 2024
Structure
Definitions
Cost classification
Fixed and variable costs
Variables to measure company’s result
1. Definitions
Revenues
Revenue, often referred to as sales or the top line, is the money received from normal business operations
Accounting includes sales made on credit as revenue for goods or services delivered to the customer. Under certain rules, revenue is recognized even if payment has not yet been received.
Revenue = Quantity Sold x Unit Price
Expenditure
- Payment with either cash or credit to purchase goods or services
Expenses
- Cost of operations that a company incurs to generate revenue
Expenses are recognized when they are incurred, not necessarily when they are paid for
Expenses are reported on the income statement
Cost
Expenditure required to produce or sell a product or get an asset ready for normal use.
Amount paid to manufacture a product, purchase inventory, sell merchandise or get equipment ready to use in a business process
Cost and expense frequently intermingled
🎥 video on cost definition (just the first minute)
Profits
Difference between the revenue received from the sale of an output and the cost of all inputs
Economic profit vs Accounting profit
Accounting profit: revenue - expenses. Total earning of a company
Economic profit: revenues - expenses - opportunity costs
Accounting profit = net income
Structure
Definitions
Cost classification
Fixed and variable costs
Variables to measure company’s result
2. Cost classification by nature
C1. Material costs
C2. External services costs
C3. Depreciation costs
C4. Labour costs
C5. Opportunity costs
C1. Material costs
Cost of materials used to manufacture a product or provide a service
Prices paid for raw material components and purchased finished goods, including any packaging necessary for the shipment of products, which are purchased from outside vendors as well as any freight and duty where applicable
Raw materials, spare parts, sub-assemblies, packaging materials, commodities, etc
Boeing aircrafts raw materials
C1. Material costs II
Sub-assemblies: Aircraft construction begins with the assembling of detail parts into aircraft sub-assemblies. Positioned adjacent to one another these aircraft sub-assemblies make the final assembly of the aircraft. To prevent these aircraft sub-assemblies from a wrong location and position, tooling fixtures are used throughout the assembly process. Tooling fixtures locate the detail parts of aircraft sub-assemblies, and then these are attached to mating aircraft structure (definition from Lockheed Martin Corporation link)
Aerospace supplier chain tiers:
Tier 1: major components or systems who receive parts
or subassemblies from the Tier 2 supply chain. Engines, control systems, landing gear, braking systems, flight deck, avionics, aerostructures, electronic warfare systems and interior cabin productsTier 2: manufacture of parts or subsystem assemblies
used by Tier 1 companies. Airfoils and tires, missile nose cones and airframe structures, transmissions and flight controlsTier 3: component manufacturers that ship their products directly to Tier2. Hydraulic fittings and hose, instrumentation fittings and tubing, high strength fasteners and pins
- Reading on aerospace supplier chain tiers
C1. Material costs III
Products have extremely long life cycles of 30 years or more, during which they need to provide legacy-parts support.
But the internal components for those systems, including semiconductors, electronic boards, and mechanical parts, have much shorter life cycles, in some cases less than five years.
Because of this disparity—the “two speed” challenge—components can become harder to source over time and even grow obsolete as suppliers struggle to source the raw materials or stop manufacturing them altogether
As a result, manufacturers must design replacements for those obsolete components and face nonrecurring engineering costs as a result.
C1. Material costs IV
Shortly after becoming CEO of Ford Motor Co., the former head of Boeing Commercial Airplanes,
Alan Mulally, was asked if he was ready for the complexity of the automotive industry.
He replied;
“An automobile has about 10,000 moving parts, right? An airplane has 2 million, and it has to stay up in the air,”
C2. External services
Services provided by external providers to the contracting company such as:
Transport and logistics
Maintenance
Leasing
Insurance
Financial services: loans
Accounting
Backoffice
Legal
Tech support
Software development
and others
Outsourcing. Is it always good?
C3. Depreciations
Decline in value of assets
Allocation of the cost of tangible assets to periods in which the assets are used
Businesses need to account for the consumption of fixed assets over time in a way that reflects their reducing value, this is termed as ‘depreciation’
Working out depreciation presents problems and requires acknowledge about :
Taxation policy
Maturity (lifespan)
Residual value (scrap value, salvage value)
Amount to be depreciated
Depreciation method
C3. Depreciation II
Example:
Extracted from How to depreciate property. Publication 946. Department of Treasury:
You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You can also depreciate certain intangible property, such as patents, copyrights, and computer software.
To be depreciable, the property must meet all the following requirements.
It must be property of your own
It must be used in your business or income-producing activity
It must have a determinable useful life
It must be expected to last more than one year
C3. Depreciation III
The fixed assets are valued at the price of acquisition (market price) or at the production cost: purchase cost + expenses (all kind of expenses until the asset is running)
All fixed assets, with the exception of land, suffer physical depreciation and obsolescence
The depreciation is an expense (cost) that is accounted in the Income Statement
Types of depreciation:
Physical depreciation
Functional depreciation
Obsolescence
The useful economic life of an asset is the total time, measured in years, that the asset is in conditions to produce goods and services. The period in which the asset is expected to be used by the entity in its business
C3. Depreciations IV
The useful life of an asset will be the lower between:
Physical or mechanical: timespan without decreasing productivity. Most of the assets suffer from wear and tear: physical deterioration through usage
Technical life or obsolescence: physical conditions can be right but the asset can be replaced for technological reasons (new models ->higher productivity)
End of the product life cycle
Obsolescence in avionics: upgrade (retrofit) vs aftermarket (spare sets)
Straight-depreciation method
To estimate the annual depreciation expense (d), you need to know:
Useful life of the asset (t)
Cost of the fixed asset (V0)
Residual value (salvage or scrap value) of the asset (Vr)
Then you can estimate:
- Total depreciation and (book) value of the asset in the period n
Straight-depreciation method II
Being:
d: annual depreciation d=V0−Vrt
Vo: value of the asset at t=0
Vr: residual value
t: lifespan
Accumulated depreciation in the nth year: Da=V0−Vrt⋅n=(V0−Vr)⋅nt
Book value of the asset in n-year: Vn=V0−Da
Amount to depreciate: Vp=(V0−Vr)−Da
Depreciation tables
The Spanish official depreciation tables state (tax purposes):
The maximum annual rate, constantly applied, it estimates the minimum period for depreciating each asset according to tax regulations
And the maximum period for depreciating the asset completely
Depreciation tables II
Depreciation tables III
Depreciation in airlines
Aircraft are depreciated using the straight-line method
over their average estimated useful life of 20 years,
assuming no residual value for most of the aircraft of
the fleet. This useful life can, however, be extended to
25 years for some aircraft.
During the operating cycle, and when establishing fleet
replacement plans, the Group reviews whether the
amortizable base or the useful life should be adjusted
and, if necessary, determines whether a residual value
should be recognized.
Since 2013, new commercial aircraft and reserve
engines have been depreciated over a period of 20
years to a residual value of 5 per cent.
Assets acquired second-hand are depreciated over their
expected remaining useful life
Aircraft are depreciated using the straight-line method
over their average estimated useful life of 20 years,
assuming no residual value for most of the aircraft of
the fleet. This useful life can, however, be extended to
25 years for some aircraft.
Ryan Air depreciation policy
Extracted from Ryan Air Annual Report 2024
Ryan Air depreciation policy II
Extracted from Ryan Air Annual Report 2024
Rotable spare parts held by the Company are classified as property, plant and equipment if they are expected to be used over more than one period.
Ryan Air depreciation policy III
Intangibles Assets:
Extracted from Ryan Air Annual Report 2024
Typical depreciation rate information for different aircraft types
Factor affecting the depreciation rate in airlines
Effective depreciation rates for individual components are determined by the estimated useful life and residual value.
Determining an appropriate depreciation rate is dependent on a number of factors including:
• Intended life of the fleet type being operated by the airline
• Estimate of the economic life from the manufacturer
• Fleet deployment plans including timing of fleet replacements
• Changes in technology
• Repairs and maintenance policies
• Aircraft operating cycles (long-haul aircraft may have a different depreciation profile to high cycle short-haul aircraft)
• Prevailing market prices and the trend in price of second hand and replacement aircraft (which impact the estimate
of residual value)
• Aircraft-related fixed asset depreciation rates, for example, rotables and repairables may reflect the airline’s ability
to use common components across different aircraft types
• Treatment of idle assets
• Distinction between fleet types
Depreciation exercise 1
An airline company is buing a passanger aircraft, specifically a Boeing 737-800 for 82 million $
Build a depreciation table for the following cases:
Maximum period (Spanish law), no residual value
AirFrance-KLM: minimum period, 4% residual value
Exercise 2. Depreciation
AirChina is overhauling two engines for 6 million $ each. Assuming a 5-year useful life after the overhauling and a 7% residual value, work out the annual depreciation of both engines
C4. Labour expenses
The cost of labour is the sum of all wages paid to employees and the cost of employee benefits and payroll taxes paid by an employer
Salary
Social Security
Employee benefits: perks
C5. Opportunity costs
The value of the next-best alternative when a decision is made
Potential forgone profit from a missed opportunity
The value of what you lose when choosing between two or more options
What must be given up to obtain something that is desired
Structure
Definitions
Cost classification
Fixed and variable costs
Variables to measure company’s result
3. Fixed and variable costs
Variable costs
A variable cost is an expense that changes in proportion to production output or sales
When production or sales increase, variable costs increase
When production or sales decrease, variable costs decrease
Variable costs are a central part in determining a product’s contribution margin
Examples of variable costs include raw materials, labor, utilities, commission, or distribution costs
Fixed costs
A cost that does not change with an increase or decrease in the number of goods or services produced or sold
These costs are set over a specified period of time and do not change with production levels
They are usually established by contract agreements or schedules
Once established, fixed costs do not change over the life of an agreement or cost schedule
Depreciation is one common fixed cost
Structure
Definitions
Cost classification
Fixed and variable costss
Variables to measure company’s result
4. Variables to measure company’s results
EBITDA = Earnings before interest, taxes, depreciation and amortisation
EBIT = Earnings before interest and taxes
Both EBIT and EBITDA strip out the cost of debt financing and taxes
Both focus on the operation side
Companies with high fixed assets will have higher depreciation and so lower EBIT than companies with lower levels of fixed assets
Variables to measure company’s results II
Profits
Net income for a company or revenus minus expenses
Profit (loss) before income tax
Profit (loss) after income tax
Accounting profit shows the amount of money left over after deducting the explicit costs of running the business
Explicit costs include labour, inventory needed for production, and raw materials, together with transportation, production, and sales and marketing costs
Accounting profit differs from economic profit as it only represents the monetary expenses a firm pays and the monetary revenue it receives (remember opportunity cost)
Variables to measure company’s results III
Cash flows:
Revenue - C1 - C2 - C4 - Income tax = Operation cash flows
EBITDA (1-t) = Operation cash flows
Measure of the cash obtained, costs without payments are not considered (depreciations)
