What is a Life Cycle Cost analysis and why does it matter when buying a new business aircraft? David Wyndham explains the process…
A consulting client I worked with was evaluating Large Cabin business jets. Initially the client was more concerned with minimizing the operating expenses and less concerned with the capital costs. As long as the acquisition price fitted within their $25m budget, they would be satisfied.
Yet those evaluating business jet ownership should be concerned with more than just the acquisition costs. They should also factor operating costs (variable and fixed), amortization, interest, depreciation, taxes and the cost of capital. Items like depreciation, interest and taxes – for example - can add as much as 60% to the Aviation Department’s costs depending on the value of the aircraft.
Furthermore, you should also consider when the costs occur.
General Methodology for Life Cycle Costing
When analyzing the potential acquisition of a whole aircraft or a share of one, Life Cycle Costing ensures that all appropriate costs should be considered.
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.
The first step is to know what aircraft to evaluate. This is achieved with an understanding of the key missions and the technical analysis of all potential aircraft. You need to be sure you are not buying more (or less) aircraft than you need.
There should be no room for assumption in the process. The costs should cover a specific period and take into account the aircraft’s expected value at the end of the term of ownership.
Comparisons of two or more aircraft should cover the same period of time and utilization, ensuring an apples-to-apples comparison is provided.
On the subject of utilization, you are advised to use miles if the aircraft is flying point-to-point and convert each aircraft to hours based on their speed. To have an accurate comparison, you will need to measure performance using the same criteria. Different aircraft fly at different speeds. Using a mile-based measurement accounts for the speed differences between aircraft.
I also recommend that you have a baseline. If an existing aircraft is to be replaced, that aircraft becomes the baseline. If you charter or own a fractional share in an aircraft, then continuation of that charter or fractional share would be the baseline.
The baseline essentially forms a basis for the comparison, establishing whether the new option under consideration costs less than the current baseline or more. If the cost will be more, what is the value of the increased cost?
Net Present Value Analysis
A complete Life Cycle Cost accounts for the time-value of money in a Net Present Value (NPV) analysis. Using NPV enables the differing cash flows from two or more options to be compared and analyzed from a fair and complete perspective.
An NPV analysis takes into account the time value of money, as well as income and expense cash flows, type of depreciation, tax consequences and residual value of the various options under consideration.
When an expense (or revenue) occurs can be as important as the amount of that item. This is useful in the comparison of Cash Buy vs Lease vs Finance options for the same aircraft.
Business aircraft do not directly generate revenue except for the sale of the aircraft. Thus, the NPV results are typically negative.
When comparing negative NPVs, the "least negative NPV" is the more favorable. In other words, if Option A has an NPV of $5m and the NPV of Option B is $6m, Option A has a better NPV.
You may want to run several scenarios. For example, what if you owned the aircraft for five years? How about ten? What if utilization was increased? What is the break-even point to move from fractional ownership to whole ownership? There may be many possible best alternatives when you adjust the important criteria.
Regarding the client mentioned above, we evaluated new and used business aircraft and found several options that were at the top of the acquisition budget had lower total life cycle costs than aircraft with lower acquisition prices.
A Life Cycle Cost analysis is an important decision-making tool, but it is not the answer all by itself. I like to use the term "Best Value" in combining both the capabilities and the costs of the various options analyzed.
Run the numbers and use them in your decision - but remember: Never let a spreadsheet make the decision for you.