Costs come in many flavors: Variable vs. fixed

Feb. 1, 2003

Costs come in many flavors: Variable vs. fixed

By Brandon Battles

Brandon Battles
For the organization that operates aircraft to generate a profit, it is very important that the revenue per flight is enough to cover your costs per flight hour. Therefore the organization must understand its cost structure.

As the manager of your maintenance organization you can probably handle, with a certain amount of ease, just about any question that deals with the technical aspect of fixing an aircraft. And if you don't have an immediate answer, you certainly have the knowledge to search for the information that will lead to the answer. Generally, a technical maintenance question seems easy for you because it involves your area of expertise. An important aspect of your expertise is that you understand the language and terms of the technical issue. As a result, when you either hear or answer the question, the communication process is improved because a common basis exists.

Unfortunately that common basis or level of knowledge does not always exist as you perform other management tasks. For example, how easy is it when answering questions about personnel issues or costs? Probably not very, but then, that's not your primary area of expertise.

I imagine that you were somewhat uncomfortable the first time you presented the maintenance department's budget to the executives at your organization. You were probably uncomfortable just attending the meeting much less presenting the subject matter. Did uncertainty erode your confidence? Were the following questions going through your mind?

o Was the format you chose to present the budget exactly what the others wanted or needed?
o Were the assumptions you made to develop the budget reasonable?
o Did you calculate the numbers correctly?

And if you felt uncomfortable going into the meeting, the level of discomfort probably increased when the discussion began. One possible reason for the discomfort may have been that you weren't familiar with the language or terms the others were using. The reason, perhaps is a common communication basis didn't exist.

Maintenance managers have expressed frustration to me when they hear or discuss various terms involving different types of costs such as variable, fixed, direct, discretionary, period, among others. The following offers a brief explanation about these types of costs. The intent is not to make you an expert but to make you feel more comfortable when exposed to these terms.

Variable vs. fixed costs
The difference between variable and fixed costs is the difference in their behavior when expressing them in a unit of measure. (For this article and to keep me from getting confused, I will use only one unit of measure, flight hours, in my examples.) Comparing the total cost for a variable category of cost to a fixed one at the end of a period of time, say a year, does not reveal much about the behavior of the cost during the year. However, comparing how a cost behaves or accumulates during the yearlong period, when expressing it in flight hours, reveals a difference.

An example should help explain the difference between fixed and variable costs. Let's take two costs that are common to most aviation organizations, fuel costs and hangar rental. At the end of the year, when we examine the total cost for each category, we may be able to draw certain conclusions and make comparisons with previous periods; however, we don't know much about how the costs accumulated.

The first cost, fuel cost, is a variable cost. The total amount of the cost at the end of a year will fluctuate depending upon the level of activity, flight hours, during the same period. If your operation does not fly at all during the year, then the total fuel cost will be zero. As the flight hours increase, the total fuel cost will increase.

Variable costs have another interesting characteristic. As the level of activity increases, the total cost is increasing at a constant rate. As your operation flies more hours, the aircraft consumes fuel at a somewhat constant rate and the cost of fuel per gallon is also somewhat constant. If your aircraft consumes 100 gallons per hour and fuel costs $2.00 per gallon, then for each hour flown your cost will be $200 per hour. If you fly 100 hours during the year, then your total fuel costs will be $20,000. If you fly 200 hours in a year, then your total costs increase to $40,000. As stated earlier, your total cost varies based upon the level of activity while the rate remains constant.

Chart 1 illustrates this relationship for variable costs between the rate and level of activity, while Chart 2 illustrates the behavior of the rate when expressed as cost per hour.

Chart 1
How do fixed costs differ from variable? Whereas the level of activity is one factor when determining the total costs of a variable cost, it does not have an effect when determining the total costs for a fixed cost. What type of cost is your hangar rental fee? That's right it's a fixed cost.

If you have hangar rental fees, then each year your organization probably negotiates a contract. For our purposes, let's say you pay $100,000 to rent your hangar for a 12-month period. Therefore the total cost for the year is $100,000. Again refer to Chart 1. The number of flight hours does not have an effect on the total costs.

But now let's express the hangar fee in our unit of measure, flight hours. If you express this cost based upon flight hours, unlike a variable cost, the cost per flight hour will vary. If you do not have any flight hours during the year then your cost per flight is $100,000. If you fly 500 hours, then your cost per hour is $200. If you fly 1,000 hours, then the cost per hour drops to $100.

Chart 2
Chart 2 illustrates the effect of increasing fight hours on the cost per hour of a fixed cost.

Behavior of costs - why it's important
Fixed and variable costs behave differently, so why is that important to you and the maintenance department?

For the organization that operates aircraft to generate a profit, it is very important that the revenue per flight is enough to cover your costs per flight hour. Therefore the organization must understand its cost structure and the related assumptions that will support an adequate revenue rate.

The easier part of the equation involves the variable costs. Regardless of the level of flight hour activity, the rate per hour remains constant. Again, using our example, we determined that fuel costs would be at a rate of $200 per hour. So we know that the organization must charge at least this much to cover its variable costs.

The fixed cost is a different situation. While the total fixed cost, hangar fees, from our example was $100,000 per year, how much per hour should the organization charge to ensure that it at least breaks even? If the organization believes it's going to be a good year and will fly 500 flight hours, then it will need to charge $200 per hour to cover the fixed costs. Therefore to cover its fixed and variable costs, the organization would need to charge $400. Based upon that it establishes a rate of $600 per hour.

However, if it's a difficult year and the organization misjudged its level of activity, then the situation can change. If the organization only flew 100 hours, then the actual cost per hour for the hangar fees was $1,000. Add that to the variable cost per hour and the organization would need to have charged $1,200 per flight hour to break even. Unfortunately, while fixed costs may be easier to determine than variable costs in total, they are more difficult to predict when associated with a unit of measure.

While this scenario may not seem to involve you directly, appearing to be the executive team's issue, it really does. If the overall organization is not doing well, then by default, the maintenance department will not do well. It behooves you to be a more informed participant when you are engaged in budget meetings. You will understand better the importance of comments that deal with fixed and variable costs.

A final example of the importance of understanding the behavior of costs involves a situation that I observed. The financial-type person in an organization approached the maintenance manager near the end of a year and commented that if it cost this much per hour to operate the aircraft, then they would sell the aircraft.

The maintenance manager was caught by surprise. Everyone had known that the aircraft was coming out of a heavy maintenance year and as a result, the aircraft did not fly as many hours as in prior years. And he was right, but what was missing from the conversation was that common basis of communication. The financial person viewed the costs from a certain perspective and because the maintenance manager didn't understand that perspective, it took a while for the two to communicate effectively. It would have helped if the maintenance manager had a general understanding of the behavior of fixed and variable costs.

Brandon Battles is a partner with Conklin & de Decker. He has spent more than 15 years in aviation working with maintenance organizations in the areas of cost collection and analysis, systems review, inventory analysis, and management training.