The airline industry is considered to be highly competitive and therefore airline company managers will need to determine the relevance of their current ERP systems with regards to the applicability of the financial information it generates. This is because the same quantitative and qualitative information is used for both financial and management accounting. However, the main goal of a company is to generate better profitability for its owners while remaining sustainable. This is done by controlling costs while improving revenues through the use of budgets and the standardization of costs and results to variances, which are primarily under management accounting. These management accounting theories are applied to an existing airline company, which is Virgin Atlantic.
ERP System Decisions
The increasing number of consolidations within the airline industry not only reduced competition (Koenig and Mayerowitz, 2015) but also increased its operating complexity (Supramaniam and Kuppusamy, 2010). This is because airline companies are competing both domestically and internationally, which means that it also needs to adapt to the changing global market (Kilic, Zaim, and Delen, 2014) in order to remain competitive (Han, Hu, and Liu, 2010). This is done by modifying or upgrading its enterprise resource planning (ERP) systems for the purpose of improving flight punctuality, safety, and operating efficiency (Han, Hu, and Liu, 2010).
The main problem on decisions with regards to ERP modification or upgrades is that it is both strategically important and difficult (Verville, 2003) especially with the wide range of ERP offerings and its high costs (Kilic, Zaim, and Delen, 2014). The reason for this is that the ERP system is considered by Sharma, Lavania, and Gupta (2011) to be an integral component of the company operations as well as its supply chain system, which is a core competency (Kashyap, 2011). Making an ERP mistake is considered to be financially significant especially due to limited resources (Kashyap, 2011). This is the reason why airline companies take their time to examine different ERP systems (Verville, 2003) before deciding on one ERP solution (Verville, 2003).
The problem is that some ERP systems may only consider financial accounting factors (Davenport, 2014) and ignore managerial accounting factors (Helmy, Marie, and Mosaad, 2012). The reason for this is that financial accounting information is primarily designed for external users (Horngren, Harrison, and Oliver, 2012) while management accounting information is designed for internal users, which are the company managers (Leung, 2011). This is despite the fact that both financial and management accounting uses the same qualitative and quantitative information (Warren, Reeve, and Fess, 2005).
Classification of Airline Costs
The success of the company operations is primarily based on the effectiveness of management accounting decisions (Gopal, 2009). This includes the correct classification of costs depending on their effect, behavior, function and relevance to the business operations. The reason for this is that costs are considered as the basis for management accounting decisions but it must be in a format relevant to the decision requirements of the managers (Coombs, Hobbs and Jenkins, 2005). This means that costs must be divided into relevant activities such as operations, administrative, selling and distribution expenses (Coombs, Hobbs, and Jenkins, 2005) especially in the airline industry (Virgin, 2016).
Figure 1. Virgin’s direct and indirect operating costs (Virgin, 2016)
Blocher, Stout and Cokins (2010) suggests assigning costs bases on their relevance, which is classified either under direct costs or indirect costs. Direct costs are defined as costs that are directly traced to a specific cost object (Blocher, Stout and Cokins, 2010), which is usually the main company operations. However, not all of the operating costs can be directly attributed to the company’s operations and are instead allocated to other activities such as administrative, selling, and distribution (Edmonds, Tsay and Olds, 2011). This is considered by Blocher, Stout and Cokins (2010) to be indirect costs since these cannot be specifically assigned to a single operation such as maintenance costs. Virgin Atlantic separates its operating costs into direct and indirect costs (Virgin, 2016). The direct costs in the comprehensive income statement are physical fuel, airline traffic direct operating costs, and aircraft costs (Virgin, 2016). The indirect costs are employee remuneration, other operating and overhead costs, other depreciation and amortization, and distribution, marketing and selling costs (Virgin, 2016).
Figure 2. Variable cost in total and as a unit (Warren, Reeve, and Fess, 2005)
Brealey, Myers and Allen (2014) separated costs into fixed and variable costs depending on the volume of production. The reason for this is that costs are dependent on the marginal productivity of the company (Brealey, Myers, and Allen, 2014), which in the case of Virgin Atlantic is the number of passengers flying on each available flight. The cost segregation is due to the fact that not all of the available flights will generate a 100% flying occupancy but the company will still incur the same fixed costs such as wages, physical fuel, and airport costs (Virgin, 2016). The variable costs (Maxon, 2008) in this case are passenger food costs, ticketing costs, baggage handling costs. This means that the fixed costs remained constant while the variable costs fluctuated depending on the passenger occupancy.
Coombs, Hobbs, and Jenkins (2005) suggest the use of unit costs since it can be used for comparison and control purposes. Unfortunately, in the case of the airline industry the unit cost cannot be specifically determined due to the fluctuations in passenger occupancy of each available flight (Virgin, 2016). However, avoidable and unavoidable costs are applicable to the airline industry since there are cases where available flights can be delayed due to uncontrollable factors such as the weather. In this case the unavoidable costs are delay compensation and denied boarding, which are implemented in the EU Regulation (Virgin, 2016).
Operating Budgets
Nataraja and Al-Aali (2011) revealed that some airline companies are able to generate exceptional financial performance while others incurred losses. The primary reason for this is the highly competitive environment of the airline industry as well as being capital-intensive (Cederholm, 2014). The resulting effect is that airline companies will require significant controls on their costs, which were further worsened by the number of mergers and consolidations (Koenig and Mayerowitz, 2015). Due to the high fixed costs incurred by airline companies, most managers prefer to make use of budgets since these are primarily used to control costs as well as quantify the company’s tactical plans (Noreen, Brewer and Garrison, 2011).
The main advantage of using a budget is that it can assess the effectiveness of the company’s strategies by comparing the actual performance with the predetermined budget (Barfield, Raiborn and Kinney, 2001). The budget or the selected strategies can be modified until management can achieve the company’s primary objectives (Barfield, Raiborn and Kinney, 2001), which is to generate or improve profits. Barfield, Raiborn and Kinney (2001) revealed that the exclusive use of financial information without considering the qualitative information is not realistic in the long run especially with regards to innovation failure or the loss of market standing.
The company’s budgets are usually on a yearly basis since its main purpose is to track the operational costs on a daily basis (Coombs, Hobbs, and Jenkins, 2005). Unfortunately, in the case of the airline industry most of its operating investments in the form of aircrafts are used for a long term (Barfield, Raiborn and Kinney, 2001) due to the significant cash and operating investments (Coombs, Hobbs, and Jenkins, 2005). This means that budgets can also be expanded into a longer period of time, which is primarily dependent on the objective of the management (Coombs, Hobbs and Jenkins, 2005).
Budgets therefore are considered by Noreen, Brewer and Garrison (2011) as operating forecasts since it plans for cash inflows and outflows. But the budget is also a form of control especially when the company has limited resources while planning for the achievement of its operating goals (Noreen, Brewer and Garrison, 2011). The value of a budget is that it reveals potential problems or bottlenecks such as inadequate cash inflows, which will require additional borrowings (Noreen, Brewer and Garrison, 2011). The disadvantage of a budget is that some company managers consider this as an unbreakable rule and will strictly comply resulting to the use of substandard products or offered services (Crosson and Needles, 2011).
Crosson and Needles (2011) revealed that there are two kinds of budgets, which are the operating and financial budgets. The operating budgets are strategic plans for the company’s daily operations while the financial budgets are projections of future operating results (Crosson and Needles, 2011). Crosson and Needles (2011) include the cash, capital expenditures, balance sheet and income statement in its financial budgets. However in a service organization like the airline industry, the operating budgets are limited to service revenue, labour, services overhead, and selling and administrative budgets (Crosson and Needles, 2011) while manufacturing companies also include production, direct materials, and cost of goods manufactured, and cost of goods sold.
Figure 3. Virgin’s revenue passenger kilometers for three years (Virgin, 2016)
The sales budget is considered the most important budget since it is based on customer demand estimates (Crosson and Needles, 2011). The reason for its importance is that its components are used for other budgets such as the sales and marketing budget and its required resources (Crosson and Needles, 2011). However, the budget must also be reasonable and achievable, which is why Virgin management is trying to increase their passenger growth due to the steady decline of revenue passenger kilometers in the last three years (Virgin, 2016). The company must also control its costs through the labour budget by planning the number of employees and their working hours (Crosson and Needles, 2011) since Virgin’s fuel consumption has already steadily declined (Virgin, 2016).
Figure 4. Virgin’s airline costs for three years (Virgin, 2016)
Standard Costing and Variances
Manufacturing companies primarily makes use of standard costing in the determination of each unit cost of its products (Barfield, Raiborn and Kinney, 2001) but this is also applicable to service and merchandising businesses (Warren, Reeve and Fess, 2005). The reason for standard costing use is that it can be used to evaluate the effectiveness of the company operations as well as controlling costs (Warren, Reeve, and Fess, 2005). However, companies in the same industry do not have the same standard costs since they may make use of different equipment, materials, and have differing skilled labour as well as dissimilar markets (Barfield, Raiborn and Kinney, 2001).
In the case of the airline industry the objective is to reach an expected available flight occupancy, which may range from 50-100%. The minimum number of flight occupancy at 70% (Virgin, 2016) can be considered as the basis for the determination of the standard. Warren, Reeve and Fess (2005) revealed that there are three manufacturing costs that need to be determined, which are the direct labour, direct materials, and overhead. The purpose of setting the standard is to compare it with the actual costs incurred and to determine any variances (Warren, Reeve and Fess, 2005). The standards can be set as ideal, normal or loose but the most commonly used is normal standards since it can be attained with additional effort (Barfield, Raiborn and Kinney, 2001).
Cost variances can be either favourable or adverse depending on whether the standard cost is higher or lower than the actual cost (Warren, Reeve and Fess, 2005). A favourable variance occurs when the actual cost was lower than the standard but becomes adverse when the actual cost is higher than the standard (Warren, Reeve, and Fess, 2005). This means that there are also three types of manufacturing cost variances, which are direct materials, direct labour and overhead (Warren, Reeve, and Fess, 2005). Each of these manufacturing cost variances are further divided into price or quantity variance to further enhance the control objective (Barfield, Raiborn and Kinney, 2001).
Figure 5. Cost variances (Warren, Reeve, and Fess, 2005)
Price variances are the cost differences between the developed standard and the actual price while the usage variance is the difference in terms of quantity used or hours worked (Barfield, Raiborn and Kinney, 2001). Since the airline industry is primarily a service organization then its management’s main focus is their labour and services overhead (Crosson and Needles, 2011), which means that direct material variances are ignored. The main focus of service organizations is the amount of productive work its employees are generating, which is perceived to be at 67% as implied by Barfield, Raiborn and Kinney (2001).
Figure 6. Productive day of a manufacturing worker (Barfield, Raiborn and Kinney, 2001)
If we apply the theory of standard costing and variances on Virgin Atlantic, one way to explain this is by assuming that the standard value is the 2014 figure while the actual value is the 2015 figures. In the case of the revenue passenger kilometres at figure 3, the declining number of passengers in 2015 at 37,157 was lower than the 38,643 in 2014 (Virgin, 2016), which means that actual is lower than the standard. Therefore capacity usage declined resulting to an adverse variance, which means that Virgin will need to improve their marketing strategies to increase the number of passengers so that the actual performance of 2015 will improve over its standard at 2014.
Conclusion and Recommendation
The ERP system uses the same information needed by both financial and management accounting users. However, management accounting users requires not only quantitative but also qualitative information for their decision making and thus requires a more flexible ERP system. This is because the company’s profitability and sustainability is dependent on the decision of the company management. This is seen in the development of budgets, which are further used as a comparison with the actual costs incurred. The resulting output are cost and usage variances, which will help the company management to improve their operations by changing their management strategies in order to align with the corporate goals. Virgin Atlantic is operating in a highly competitive industry due to an increasing number of mergers and consolidations. This means that the company will need to remain relevant and competitive, which can be done primarily through a carefully chosen ERP system upgrade or modification specifically on management accounting elements.
References
Barfield, J. T., Raiborn, C. A. & Kinney, M. R. (2001). Cost Accounting: Traditions and Innovations, 4th ed. United Kingdom: Thomson Learning.
Blocher, E. J., Stout, D. E., & Cokins, G. (2010). Cost Management: A Strategic Emphasis, 5th ed. New York, NY: McGraw Hill Irwin.
Brealey, R. A., Myers, S. C. and Allen, F. (2014). Principles of corporate finance (11th ed.). New York, NY: McGraw-Hill Irwin.
Cederholm, T. (2014). Low-entry barriers intensify competition in airline industry. Market Realist. Available at: http://marketrealist.com/2014/12/low-entry-barriers-intensify-competition-airline-industry/
Coombs, H., Hobbs, D., & Jenkins, E. (2005). Management Accounting: Principles and Applications. London: Sage Publications.
Crosson, S. V., & Needles, B. E. (2011). Managerial Accounting, 9th ed. United Kingdom: South-Western Cengage Learning.
Davenport, T. H. (2014). Is the US Airline Industry Over-Optimized? The Wall Street Journal. Available at: http://blogs.wsj.com/cio/2014/01/15/is-the-us-airline-industry-over-optimized/
Edmonds, T. P., Tsay, B., & Olds, P. R. (2011). Fundamental Managerial Accounting Concepts, 6th ed. New York, NY: McGraw-Hill Irwin.
Gopal, C. R. (2009). Accounting for Managers. New Delhi: New Age International Publishers.
Han, H. R., Hu, L. Y., and Liu, F. (2010). Research on Application of ERP System in Airlines. Applied Mechanics and Materials, 37-38, pp.976-979.
Helmy, Y. M., Marie, M. I., and Mosaad, S. M. (2012). An Integrated ERP with Web Portal. Advanced Computing: An International Journal, 3(5), pp.1-8. Available at: http://airccse.org/journal/acij/papers/3512acij01.pdf
Horngren, C. T., Harrison, W. T. and Oliver, M. S. (2012). Financial & Managerial Accounting, 3rd ed. Boston: Prentice Hall.
Kashyap, A. (2011). Impact of ERP Implementation on Supply Chain Management. International Journal of Computer Applications in Engineering Sciences, 1(4), pp.474-479.
Kilic, H. S., Zaim, S., and Delen, D. (2014). Development of a hybrid methodology for ERP system selection: The case of Turkish Airlines. Decision Support Systems, 66, pp.82-92.
Koenig, D., and Mayerowitz, S. (2015). Analysis: Consolidation of U.S. Airline Industry Radically Reducing Competition. Skift. Available at: https://skift.com/2015/07/14/analysis-consolidation-of-u-s-airline-industry-radically-reducing-competition/
Leung, D. (2011). Inside Accounting: The Sociology of Financial Reporting and Auditing. Surrey, England: Gower Publishing.
Maxon, T. (2008). Airlines – from fixed costs to variable costs. The Dallas Morning News. Available at: http://aviationblog.dallasnews.com/2008/05/airlines-from-fixed-costs-to-v.html/
Nataraja, S., and Al-aali, A. (2011). The exceptional performance strategies of Emirate Airlines. Competitiveness Review: An International Business Journal, 21(5), pp.471-486.
Noreen, E. W., Brewer, P. C., & Garrison, R. H. (2011). Managerial Accounting for Managers, 2nd ed. New York: McGraw Hill.
Sharma, H., Lavania, D. and Gupta, N. (2011). ERP + E-Business = An emerging relationship. International Journal of Managing Value and Supply Chains, 2(2), pp.1-9.
Supramaniam, M., and Kuppusamy, M. (2010). ERP System Implementation: A Malaysian Perspective. Journal of Information Technology Management, 21(1), pp.35-48.
Verville, J. (2003). A Process Approach for Selecting ERP Software: The Case of Omega Airlines. Journal of Cases on Information Technology, 5(1), pp.1-44.
Virgin Atlantic. (2016). 2015 Annual Report. Virgin Atlantic. Available at: http://www.virgin-atlantic.com/us/en/footer/media-centre.html
Warren, C. S., Reeve, J. M., Fess, P. E. (2005). Accounting, 21st ed. United States: South-Western.
