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The production economics of a very large civil aircraft
Journal of Air Transport Management Vol 2, No 1. pp. 11-16, 1995
Elsevier Science Ltd Printed in Great Britain. OY69-6997/95 $10.00 + .OO
0969-6997(95)00020-S
The production economics very large civil aircraft
of a
David Starkie and Simon Ellis Putnam, Hayes & Bartlett Ltd, Lansdowne House, Berkeley Square, London
WlX 5DH,
UK
A number of studies are taking place to see if there is a viable market for a very large civil aircraft capable of carrying in excess of 600 passengers. The development and launch costs of such an aircraft are very high. Based on indicative costs reported in the press, estimates are derived of how unit costs might vary with the length of the production run. These estimates are then combined with an estimate of market size to judge to what extent dividing production between rival manufacturers would add to unit costs. The indications are that unit costs would increase significantly. Keywords:
economies
of scale, natural
monopoly,
competing
A number of studies are currently being undertaken into the marketability of various designs for what the popular press refer to as a ‘super-jumbo’ aircraft. Boeing has been working for some time with a number of the world’s major airlines to define key features of a design capable of carrying 600 or more passengers on intercontinental routes. In Europe, the four partners in Airbus are also studying the possibilities for launching a similar aircraft. In addition, in January 1993 Boeing and Airbus started looking at the market potential, technical issues and possible business arrangements for a joint launch programme for a very large aircraft (VLCA).’ This combination of competing and collaborative programmes reflects a dilemma faced by the world aerospace industry. The launch costs for new types of aircraft, particularly a large aircraft, are very high. For a VLCA, the development and launch costs could be three or four times those of other wide-bodied jets launched in recent years; the total size of the market for such an aircraft is uncertain, and therefore the risks involved are very considerable. The size of the market is primarily a function of the aircraft’s direct operating costs (DOCs) per
‘We use VLCA as a generic term. Boeing refers to its programme as the New Large Aircraft (NLA) study; Airbus refers to the A3XX. The collaborative programme is known as a Very Large Commercial Transport (VLCT) study.
production
available seat kilometre which, in turn, is a function of its sales price, its operating characteristics (fuel burn rate, range etc) and its size. There is therefore an interdependence between the development costs, which affect the aircraft’s price, and market size. At one extreme, it is possible that the VLCA project will not be viable at all. It is also possible, although most unlikely, that the market will be able to sustain the efficient production of two potentially competing types of aircraft. Alternatively, the production economies and size of the market may dictate that least-cost production is achieved by the manufacture of a single aircraft type; in which case the VLCA would be a natural monopoly product. In this paper our objective is to explore these conflicts and contradictions by providing an insight into the production economics of the VLCA. In the next section we set out more fully the implications of the substantial development cost for a viable VLCA programme and show how the average costs of production and the level of market demand interact. We then develop a simple model of VLCA production costs and, from it, derive unit cost estimates based on press reports of the costs of developing a VLCA. The unit cost estimates at different levels of output are then compared with forecasts of the size of the market for VLCAs. Following this analysis we consider whether and to what extent production of the VLCA is a natural monopoly. 11
The production
Economies
economics of a very large civil aircraft: D Starkie and S Ellis
of scale and market size
A feature of the development programme of the VLCA is the very substantial costs involved. The implications of this can be shown by reference to Figures 1-3, which show a (hypothetical) relationship between the average costs of producing a VLCA, total output, and the level of demand.* Consistent with the large fixed costs of developing VLCAs, the average cost/output relationships are shown to exhibit pronounced economies of scale, particularly over relatively small levels of output. On the basis of the relationships shown in Figure I (which combine pronounced scale economies with only a limited market demand), the VLCA programme would be uneconomic; the demand curve fails to cut the average costs curve at any point. In these circumstances, no VLCAs will be produced unless state aid is used to subsidize production. Figure 2 illustrates the same basic cost relationship as before but, on this occasion, the market demand for VLCAs is larger. Production is now commercially viable, although at a level of demand X, unit costs are above minimum levels: to achieve minimum unit costs, demand would have to be at the level X,. Figure 3 illustrates the same basic cost relationships as in Figures I and 2 but, on this occasion, the global market demand for VLCAs is much larger and is assumed to be twice the level X, shown in Figure 2. At this level of demand X4, in spite of the substantial initial development costs, it would be possible to divide total output between two (competing) manufacturing firms (or consortia) with negligible increase in units costs. However, for any level of demand less than X4, the VLCA is a natural monopoly. Although these relationships are hypothetical, there is a presumption that production of the VLCA is viable, but is a natural monopoly, and that the relationship shown in Figure 2 prevails. Tyson (1992), for example, is of the view that: ‘The production level required to exhaust the scale and scope economies associated with a single product family still exceeds total global demand’. If this is the case, the point at issue becomes the additional cost that arises from dividing the production of VLCAs between more than one manufacturer.
Production
Unit cost!4
lDemand is driven by DOCs per available seat kilometre; the aircraft unit cost (price) is a component in the DOC calculation. Figures l-3 show how demand changes with changes in unit costs while holding other factors constant.
economics with small market
AC
Output
(No.ot onraft)
Figure 2 Production
Unit costs
economics with medium-size
market
Ac
cost components
The fly-away price of a wide-bodied jet aircraft includes two principal components: the price of the airframe and the price of the engines. Airframe and engines are both chosen by the airline according to
12
Figure 1 Production
dutput (No.of
Figure 3 Production
OirCrOft)
economics with large market
factors such as the type of route on which aircraft is to be flown, the characteristics of existing fleet, maintenance contract terms price. Both airframes and engines have their associated production economics, and each
the the and own will
The production
have a significant impact on the final price of the completed aircraft. According to standard industry estimates, the airframe, including avionics, typically accounts for around 70% of the final price, with the engines accounting for the remainder, although this split can vary with the type of aircraft. Engines capable (with some further development) of powering a VLCA are already being developed for the Boeing 777 and the Airbus A330 aircraft. Assuming that the commercial viability of these basic engine types (General Electric’s GE 90, Pratt & Whitney’s PW4000 and the Rolls Royce Trent Series) is ensured through sales of smaller aircraft types, their unit costs are unlikely to be substantially affected by the size of the VLCA market. Consequently, the analysis of costs in this paper focuses on the airframe (fuselage, wings and avionics), because airframe costs will be the most important factor driving the overall viability of VLCAs. The airframe will require a fundamentally new design, as derivatives of existing aircraft would be unlikely to offer the required performance. The largest civil aircraft currently in production, the Boeing 747-400, is capable of carrying around 400 passengers in standard threeclass configuration,’ and even with a full-length upper deck would still carry less than 600. In addition, a stretch of the 747 could affect its range, effectively ruling out a number of non-stop longhaul flights such as London-Singapore, and hence reducing the attractiveness of the derivative to the airlines.
The cost model The cost model is based on estimates of the following cost elements: l
l
development cost - the cost of developing a prototype aircraft capable of meeting the criteria necessary to receive a certificate of air worthiness; and manufacturing cost - the cost of producing aircraft for sale in the market.
Each of these elements is considered Development
in turn.
costs
Development costs cover the cost of designing the airframe, including the avionics package, building the prototype, testing and certification, and tooling the production plant. They are largely fixed and sunk (ie irrecoverable in the event that the aircraft does not reach the market). They are also difficult to forecast, and can increase significantly in the event of unforeseen contingencies: for example, those arising during testing and certification. Press reports indicate total development costs for the VLCA at $10-15 billion. These estimates are
economics of a very large civil aircraft: D Starkie and S Ellis
highly speculative. For modelling purposes, $15 billion was taken as a baseline figure for developing and building an airframe and testing and certificating the complete aircraft. Clearly, given the uncertainty associated with the development of such a radically new aircraft, it is possible that this baseline figure substantially underestimates or overestimates development costs. To take into account this uncertainty, three model runs based on development cost estimates in the range $10-20 billion were carried out. Manufacturing
costs
Manufacturing costs are driven to a large extent by so-called learning economies of scale. These are cost reductions that arise as cumulative output increases and the workforce learns how to perform particular tasks more efficiently.3 Various studies of the extent of learning economies in aircraft production have been carried out, which taken together indicate that a learning elasticity of -0.2 is typical across a range of aircraft types (a learning elasticity of -0.2 means that the manufacturing cost of each additional aircraft falls by 0.2% with each 1% increase in cumulative output).4 In practice, manufacturing costs are also determined by other scale effects: for example, the more efficient use of production equipment and the realization of managerial economies as production levels increase. There may also be economies of scope associated with the production of other aircraft, especially where they share common production equipment, components or avionics with VLCAs. These scale and scope effects are extremely difficult to quantify but, given that the VLCA represents a fundamental departure from conventional wide-bodied aircraft design, economies of scope might be limited. In order to generate a series of manufacturing unit costs for the VLCA, it is necessary to combine the learning elasticity with an estimate of the cost of first the very airframe. manufacturing Unfortunately, there are no published estimates of this figure. However, it is possible to make some assessment of the cost involved by reference to information on other aircraft types. A report for the US Department of Commerce (1990) on Airbus Industries indicates that the cost of the first aircraft unit for a conventional wide-bodied jet can range from $500 million to a multiple of that amount.
‘Learning economies of scale are through cumulative increases in represent static scale economies scale of output at a point in time. economies are important in the aircraft. %ee for example US Department
a dynamic concept; they arise output over time. Figures Z-3 associated with increasing the Both dynamic and static scale manufacture of wide-bodied of Commerce
(1986).
13
The production
economics of a very Iarge civil aircraft: D Starkie and S Ellis
VLCA manufacturing costs are subject to the same degree of uncertainty as development costs. To reflect this, we have taken a range of estimates based on a simple proportional relationship between initial unit costs and development costs. The figure of $500 million from the US Department of Commerce report was taken to represent a lower bound for the initial production airframe and assumed to apply in the case of a $10 billion development programme. Programmes of $15 and $20 billion were assumed to imply initial unit costs of $750 million and $1 billion respectively.
Table 2 Unit cost of a VLCA Model run 300 A B C
Model run
Cost estimates The above estimates of development and manufacturing costs were combined using a simple cost equation in order to calculate total and average airframe costs for different lengths of the production run up to a maximum of 1000 aircraft.” Three model runs were carried out, using the estimates of development and initial manufacturing costs given in Table 1. The estimates of average unit costs for a VLCA airframe generated by the model are illustrated in Table 2. Unit costs differ significantly between
Table 1 Estimates of development manufacturing costs Model run
A B c
Development (Sbn)
10.0 15.0 20.0
and initial unit
cost
Initial unit manufacturing cost (airframe ($bn)
164 246 329
A B C
Unit cost at output of 500 ($m) 214 296 379
1000
156 234 312
136 203 271
with
Percentage increase with output reduction of: 10% 25% 50% 2.8 2.7 2.6
7.0 7.8 7.9
19.6 21.3 21.6
model runs, even for production runs in excess of 500 aircraft. For example, in case B - the baseline case - the average unit cost for a cumulative output of 500 airframes is $246 million. In case C, the corresponding figure is $329 million, an increase of 34%. The sensitivity of the different cost estimates to the length of the production run is better illustrated once we have taken into account the cost of the engines. We have noted above that the core engines that will power a VLCA have been developed a!ready for the Boeing 777 and Airbus 330 aircraft, and it is on this basis that we have allowed $50 million for a ship set of four up-rated versions. Taking these engine costs into account, Table 3 shows the percentage increase in unit costs associated with different reductions in the production run, beginning with a cumulative output of 500 aircraft. The estimates indicate that a relatively small reduction in output, of the order of 50 aircraft, would increase unit production costs by $6 to 10 million or around 2.&2.8%. A 50% reduction in output would increase unit costs by about 20% which, on the most favourable assumptions about development and manufacturing costs, would add $42 million to the fly-away price of the aircraft.
The market for VLCAs only)
0.5 0.75 1.0
5The cost equation is given by c = (F + nX(b + l)}/X, where c is the unit cost of the aircraft. F is the fixed development cost, X is the number of aircraft in the production run, a is the initial unit cost and b is the learning elasticity (assumed to be -0.2).
14
($ million) at output of 500 600
Table 3 Percentage increase in unit costs associated reductions in cumulative output
Other costs
In addition to these cost drivers, a manufacturer of VLCAs would also have to recover the costs of marketing and overheads, and allow for a rate of return on capital. These additional costs have not been modelled explicitly, as there are no reliable estimates of their size, even for aircraft already in production. Hence the cost estimates generated by the model will understate the total costs of bringing the VLCA to the market. However, we believe that they provide a reasonable indication of the likely order of magnitude of pure production costs. In addition, assuming that the inclusion of other costs would affect chiefly the level of the cost curve rather than its slope, the model is capable of demonstrating the sensitivity of costs to the length of the production run.
193 290 386
airframe
Having shown how the unit cost of producing a VLCA varies with the level of output, to set against this one needs to show how demand is likely to vary as the price of the aircraft changes. However, there is no information of this type publicly available. Although the manufacturers are likely to have undertaken some analysis of this nature, it remains proprietary information. What is available, are some forecasts of the potential size of the VLCA market. These are derived from an analysis of the likely future density of air traffic on routes suitable for
The production
economics of a very large civil aircraft: D Starkie and S Ellis
284
Figure 4
VLCA fleet forecast by region, 2017
operations such as those across the Pacific Ocean and between Europe and the Far East; they are estimates based on the structure of markets, and implicitly assume that the direct operating costs of VLCAs will be such that the potential demand is realized. One such forecast has been prepared by the UK Department of Trade and Industry (DTI) using a fleet forecasting model that is capable of providing forecasts of the composition of the world aircraft fleet by global region over the next 25 years. A breakdown of the forecast of the VLCA fleet by region based on our interpretation of output from the DTI model is given in Figure 4. As with all longterm forecasts, the data should be treated with caution. In particular, it is possible that VLCAs will face strong competition from smaller aircraft types, and that some airlines may choose lower capacity aircraft because, for example, traffic volumes are particularly responsive to flight frequency. Such competitive influences on the demand for VLCAs are not captured by the DTI model, and hence it is possible that the forecasts could over- or understate likely production levels. However, they are derived from a rigorous and systematic modelling process and, in the absence of information on the competitive options that might become available, we believe that they provide a reasonable estimate of the potential size of the VLCA market. The forecast global fleet size increases from 29 aircraft in 2006 (when VLCAs are assumed to enter service), to 470 aircraft in 2015, to 578 aircraft by 2017 at the end of the 25 year period. The European-domiciled fleet increases from 2 to 57 aircraft over the same period. Hence the European market is expected to account for some 10% of the VLCA
global market by 2017. The US-domiciled fleet accounts for only 47 aircraft in 2017. Asia and Japan represent a far more important market according to the forecast, accounting for 389 aircraft, well over half the global fleet, by 2017. These figures are in line with the view that VLCAs will be generally unsuitable for serving many European routes, given the relatively short distances or low traffic densities involved.6 By contrast, the relatively high traffic density on many Asian routes, coupled with the rapid growth of traffic in the region and congestion at key airports in the Far East, will probably ensure substantially higher sales to Asian-domiciled airlines. How costly is competing
production?
Although we have not been able to establish a true demand function for a VLCA aircraft, nevertheless we are able to use the global forecasts of the size of the potential market to judge whether it is economic to have the VLCA produced by more than one firm (or consortium). This we can do by comparing the global fleet forecasts with the output of the production cost model. By 2017 the prediction was that potential world demand for the VLCA would be close to 600 aircraft. Using the development cost assumption of $15 billion (Case B in Tables 1 and 2), this suggests
6They may, however, prove commercially attractive on selected long-haul routes from Europe, particularly the North Atlantic routes, and on some routes from congested airports (eg Heathrow), where slot constraints prevent the operation of smaller aircraft at higher frequencies.
15
The production
economics of a very large civil aircraft: D Starkie and S Ellis
a unit cost for the airframe plus engines (net of additional marketing costs and overheads) of $284 million. However, if we divide the production of 600 aircraft between two identical sources, each producing 300 aircraft, the unit cost would increase by almost 20%. On the most favourable assumptions about the development and manufacturing costs, this would add $56 million to the price of each aircraft. Moreover, in a competing environment, the market may divide less than equally, so that the manufacturer with the smaller market share is at a particular disadvantage by having to carry similar development costs to those of its competitor over a smaller production run. Of course, the market for VLCAs can be expected to extend beyond the year 2017, but even if we assume a requirement for 1000 aircraft by perhaps 2025, dividing production will still add 17% to unit costs. On the other hand, from the airline customer point of view, there is no assurance that the price at which the aircraft is sold will reflect the underlying efficient costs of production. A single manufacturer might be expected to seek monopoly profits rather than secure a reasonable return on capital employed7 and, in the absence of competitive pressures, inefficiencies might creep into the production process (the learning elasticity, for example, might be less than the -0.2 assumed in the above calculations). Duopoly production, therefore, may increase costs in theory but result in lower aircraft prices in practice. But it is also far from certain that a duopoly will result in cost-based pricing of the VLCA. Under certain assumptions it can be shown that even a non-cooperative relationship between two manufacturers could result in a price for the VLCA exceeding its average cost of production.x
‘Tyson (1992) quotes one estimate that ‘Boeing makes $45m on each 747 it sells for an estimated $150m a piece’. XOne would expect this if the two rival firms colluded, but to do so would be contrary to US and EU anti-trust laws. Significantly, the cooperative venture between Boeing and Airbus involves lawyers specializing in anti-trust law.
16
Although natural monopolies and oligopolies are frequently subject to economic regulation, in circumstances where the good is traded on the international markets and demand from the host manufacturing nation(s) is limited relative to total demand, the incentives to regulate supernormal profits are diminished. In the view of some international trade theorists, the desire to capture economic rent from the international market may even provide a motivation for government support for the aircraft industry.9 The VLCA, however, may not be worthy of such concerns. Unless its DOCs give it a significant advantage over existing wide-bodied aircraft, there will be little economic rent to regulate or to capture. At the present time it is arguable whether such a cost advantage will exist.
Acknowledgements We would like to thank Branch 3 of DTI Aerospace Division for making available output from their fleet forecasting model. Interpretation and comment on these data is entirely the responsibility of the authors, and does not necessarily represent the interpretation of DTI itself.
References Tyson, L (1992) Who’s Bashing Whom? Trade Confkt in High Technology Industries Institute for International Economics, Washington DC US Department of Commerce (1986) A Competitive Assessment of the US Civil Aircraft Industry Boulder, CO US Department of Commerce (1990) An Economic Financial Review of Airbus Industrie Report prepared by Gellman Research Associates Inc
‘Tyson (1992) comments that ‘the industry is widely regarded as the best example of an industry in which strategic, beggar-thyneighbour, rent-shifting policies may improve national economic welfare’.
Elsevier Science Ltd Printed in Great Britain. OY69-6997/95 $10.00 + .OO
0969-6997(95)00020-S
The production economics very large civil aircraft
of a
David Starkie and Simon Ellis Putnam, Hayes & Bartlett Ltd, Lansdowne House, Berkeley Square, London
WlX 5DH,
UK
A number of studies are taking place to see if there is a viable market for a very large civil aircraft capable of carrying in excess of 600 passengers. The development and launch costs of such an aircraft are very high. Based on indicative costs reported in the press, estimates are derived of how unit costs might vary with the length of the production run. These estimates are then combined with an estimate of market size to judge to what extent dividing production between rival manufacturers would add to unit costs. The indications are that unit costs would increase significantly. Keywords:
economies
of scale, natural
monopoly,
competing
A number of studies are currently being undertaken into the marketability of various designs for what the popular press refer to as a ‘super-jumbo’ aircraft. Boeing has been working for some time with a number of the world’s major airlines to define key features of a design capable of carrying 600 or more passengers on intercontinental routes. In Europe, the four partners in Airbus are also studying the possibilities for launching a similar aircraft. In addition, in January 1993 Boeing and Airbus started looking at the market potential, technical issues and possible business arrangements for a joint launch programme for a very large aircraft (VLCA).’ This combination of competing and collaborative programmes reflects a dilemma faced by the world aerospace industry. The launch costs for new types of aircraft, particularly a large aircraft, are very high. For a VLCA, the development and launch costs could be three or four times those of other wide-bodied jets launched in recent years; the total size of the market for such an aircraft is uncertain, and therefore the risks involved are very considerable. The size of the market is primarily a function of the aircraft’s direct operating costs (DOCs) per
‘We use VLCA as a generic term. Boeing refers to its programme as the New Large Aircraft (NLA) study; Airbus refers to the A3XX. The collaborative programme is known as a Very Large Commercial Transport (VLCT) study.
production
available seat kilometre which, in turn, is a function of its sales price, its operating characteristics (fuel burn rate, range etc) and its size. There is therefore an interdependence between the development costs, which affect the aircraft’s price, and market size. At one extreme, it is possible that the VLCA project will not be viable at all. It is also possible, although most unlikely, that the market will be able to sustain the efficient production of two potentially competing types of aircraft. Alternatively, the production economies and size of the market may dictate that least-cost production is achieved by the manufacture of a single aircraft type; in which case the VLCA would be a natural monopoly product. In this paper our objective is to explore these conflicts and contradictions by providing an insight into the production economics of the VLCA. In the next section we set out more fully the implications of the substantial development cost for a viable VLCA programme and show how the average costs of production and the level of market demand interact. We then develop a simple model of VLCA production costs and, from it, derive unit cost estimates based on press reports of the costs of developing a VLCA. The unit cost estimates at different levels of output are then compared with forecasts of the size of the market for VLCAs. Following this analysis we consider whether and to what extent production of the VLCA is a natural monopoly. 11
The production
Economies
economics of a very large civil aircraft: D Starkie and S Ellis
of scale and market size
A feature of the development programme of the VLCA is the very substantial costs involved. The implications of this can be shown by reference to Figures 1-3, which show a (hypothetical) relationship between the average costs of producing a VLCA, total output, and the level of demand.* Consistent with the large fixed costs of developing VLCAs, the average cost/output relationships are shown to exhibit pronounced economies of scale, particularly over relatively small levels of output. On the basis of the relationships shown in Figure I (which combine pronounced scale economies with only a limited market demand), the VLCA programme would be uneconomic; the demand curve fails to cut the average costs curve at any point. In these circumstances, no VLCAs will be produced unless state aid is used to subsidize production. Figure 2 illustrates the same basic cost relationship as before but, on this occasion, the market demand for VLCAs is larger. Production is now commercially viable, although at a level of demand X, unit costs are above minimum levels: to achieve minimum unit costs, demand would have to be at the level X,. Figure 3 illustrates the same basic cost relationships as in Figures I and 2 but, on this occasion, the global market demand for VLCAs is much larger and is assumed to be twice the level X, shown in Figure 2. At this level of demand X4, in spite of the substantial initial development costs, it would be possible to divide total output between two (competing) manufacturing firms (or consortia) with negligible increase in units costs. However, for any level of demand less than X4, the VLCA is a natural monopoly. Although these relationships are hypothetical, there is a presumption that production of the VLCA is viable, but is a natural monopoly, and that the relationship shown in Figure 2 prevails. Tyson (1992), for example, is of the view that: ‘The production level required to exhaust the scale and scope economies associated with a single product family still exceeds total global demand’. If this is the case, the point at issue becomes the additional cost that arises from dividing the production of VLCAs between more than one manufacturer.
Production
Unit cost!4
lDemand is driven by DOCs per available seat kilometre; the aircraft unit cost (price) is a component in the DOC calculation. Figures l-3 show how demand changes with changes in unit costs while holding other factors constant.
economics with small market
AC
Output
(No.ot onraft)
Figure 2 Production
Unit costs
economics with medium-size
market
Ac
cost components
The fly-away price of a wide-bodied jet aircraft includes two principal components: the price of the airframe and the price of the engines. Airframe and engines are both chosen by the airline according to
12
Figure 1 Production
dutput (No.of
Figure 3 Production
OirCrOft)
economics with large market
factors such as the type of route on which aircraft is to be flown, the characteristics of existing fleet, maintenance contract terms price. Both airframes and engines have their associated production economics, and each
the the and own will
The production
have a significant impact on the final price of the completed aircraft. According to standard industry estimates, the airframe, including avionics, typically accounts for around 70% of the final price, with the engines accounting for the remainder, although this split can vary with the type of aircraft. Engines capable (with some further development) of powering a VLCA are already being developed for the Boeing 777 and the Airbus A330 aircraft. Assuming that the commercial viability of these basic engine types (General Electric’s GE 90, Pratt & Whitney’s PW4000 and the Rolls Royce Trent Series) is ensured through sales of smaller aircraft types, their unit costs are unlikely to be substantially affected by the size of the VLCA market. Consequently, the analysis of costs in this paper focuses on the airframe (fuselage, wings and avionics), because airframe costs will be the most important factor driving the overall viability of VLCAs. The airframe will require a fundamentally new design, as derivatives of existing aircraft would be unlikely to offer the required performance. The largest civil aircraft currently in production, the Boeing 747-400, is capable of carrying around 400 passengers in standard threeclass configuration,’ and even with a full-length upper deck would still carry less than 600. In addition, a stretch of the 747 could affect its range, effectively ruling out a number of non-stop longhaul flights such as London-Singapore, and hence reducing the attractiveness of the derivative to the airlines.
The cost model The cost model is based on estimates of the following cost elements: l
l
development cost - the cost of developing a prototype aircraft capable of meeting the criteria necessary to receive a certificate of air worthiness; and manufacturing cost - the cost of producing aircraft for sale in the market.
Each of these elements is considered Development
in turn.
costs
Development costs cover the cost of designing the airframe, including the avionics package, building the prototype, testing and certification, and tooling the production plant. They are largely fixed and sunk (ie irrecoverable in the event that the aircraft does not reach the market). They are also difficult to forecast, and can increase significantly in the event of unforeseen contingencies: for example, those arising during testing and certification. Press reports indicate total development costs for the VLCA at $10-15 billion. These estimates are
economics of a very large civil aircraft: D Starkie and S Ellis
highly speculative. For modelling purposes, $15 billion was taken as a baseline figure for developing and building an airframe and testing and certificating the complete aircraft. Clearly, given the uncertainty associated with the development of such a radically new aircraft, it is possible that this baseline figure substantially underestimates or overestimates development costs. To take into account this uncertainty, three model runs based on development cost estimates in the range $10-20 billion were carried out. Manufacturing
costs
Manufacturing costs are driven to a large extent by so-called learning economies of scale. These are cost reductions that arise as cumulative output increases and the workforce learns how to perform particular tasks more efficiently.3 Various studies of the extent of learning economies in aircraft production have been carried out, which taken together indicate that a learning elasticity of -0.2 is typical across a range of aircraft types (a learning elasticity of -0.2 means that the manufacturing cost of each additional aircraft falls by 0.2% with each 1% increase in cumulative output).4 In practice, manufacturing costs are also determined by other scale effects: for example, the more efficient use of production equipment and the realization of managerial economies as production levels increase. There may also be economies of scope associated with the production of other aircraft, especially where they share common production equipment, components or avionics with VLCAs. These scale and scope effects are extremely difficult to quantify but, given that the VLCA represents a fundamental departure from conventional wide-bodied aircraft design, economies of scope might be limited. In order to generate a series of manufacturing unit costs for the VLCA, it is necessary to combine the learning elasticity with an estimate of the cost of first the very airframe. manufacturing Unfortunately, there are no published estimates of this figure. However, it is possible to make some assessment of the cost involved by reference to information on other aircraft types. A report for the US Department of Commerce (1990) on Airbus Industries indicates that the cost of the first aircraft unit for a conventional wide-bodied jet can range from $500 million to a multiple of that amount.
‘Learning economies of scale are through cumulative increases in represent static scale economies scale of output at a point in time. economies are important in the aircraft. %ee for example US Department
a dynamic concept; they arise output over time. Figures Z-3 associated with increasing the Both dynamic and static scale manufacture of wide-bodied of Commerce
(1986).
13
The production
economics of a very Iarge civil aircraft: D Starkie and S Ellis
VLCA manufacturing costs are subject to the same degree of uncertainty as development costs. To reflect this, we have taken a range of estimates based on a simple proportional relationship between initial unit costs and development costs. The figure of $500 million from the US Department of Commerce report was taken to represent a lower bound for the initial production airframe and assumed to apply in the case of a $10 billion development programme. Programmes of $15 and $20 billion were assumed to imply initial unit costs of $750 million and $1 billion respectively.
Table 2 Unit cost of a VLCA Model run 300 A B C
Model run
Cost estimates The above estimates of development and manufacturing costs were combined using a simple cost equation in order to calculate total and average airframe costs for different lengths of the production run up to a maximum of 1000 aircraft.” Three model runs were carried out, using the estimates of development and initial manufacturing costs given in Table 1. The estimates of average unit costs for a VLCA airframe generated by the model are illustrated in Table 2. Unit costs differ significantly between
Table 1 Estimates of development manufacturing costs Model run
A B c
Development (Sbn)
10.0 15.0 20.0
and initial unit
cost
Initial unit manufacturing cost (airframe ($bn)
164 246 329
A B C
Unit cost at output of 500 ($m) 214 296 379
1000
156 234 312
136 203 271
with
Percentage increase with output reduction of: 10% 25% 50% 2.8 2.7 2.6
7.0 7.8 7.9
19.6 21.3 21.6
model runs, even for production runs in excess of 500 aircraft. For example, in case B - the baseline case - the average unit cost for a cumulative output of 500 airframes is $246 million. In case C, the corresponding figure is $329 million, an increase of 34%. The sensitivity of the different cost estimates to the length of the production run is better illustrated once we have taken into account the cost of the engines. We have noted above that the core engines that will power a VLCA have been developed a!ready for the Boeing 777 and Airbus 330 aircraft, and it is on this basis that we have allowed $50 million for a ship set of four up-rated versions. Taking these engine costs into account, Table 3 shows the percentage increase in unit costs associated with different reductions in the production run, beginning with a cumulative output of 500 aircraft. The estimates indicate that a relatively small reduction in output, of the order of 50 aircraft, would increase unit production costs by $6 to 10 million or around 2.&2.8%. A 50% reduction in output would increase unit costs by about 20% which, on the most favourable assumptions about development and manufacturing costs, would add $42 million to the fly-away price of the aircraft.
The market for VLCAs only)
0.5 0.75 1.0
5The cost equation is given by c = (F + nX(b + l)}/X, where c is the unit cost of the aircraft. F is the fixed development cost, X is the number of aircraft in the production run, a is the initial unit cost and b is the learning elasticity (assumed to be -0.2).
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($ million) at output of 500 600
Table 3 Percentage increase in unit costs associated reductions in cumulative output
Other costs
In addition to these cost drivers, a manufacturer of VLCAs would also have to recover the costs of marketing and overheads, and allow for a rate of return on capital. These additional costs have not been modelled explicitly, as there are no reliable estimates of their size, even for aircraft already in production. Hence the cost estimates generated by the model will understate the total costs of bringing the VLCA to the market. However, we believe that they provide a reasonable indication of the likely order of magnitude of pure production costs. In addition, assuming that the inclusion of other costs would affect chiefly the level of the cost curve rather than its slope, the model is capable of demonstrating the sensitivity of costs to the length of the production run.
193 290 386
airframe
Having shown how the unit cost of producing a VLCA varies with the level of output, to set against this one needs to show how demand is likely to vary as the price of the aircraft changes. However, there is no information of this type publicly available. Although the manufacturers are likely to have undertaken some analysis of this nature, it remains proprietary information. What is available, are some forecasts of the potential size of the VLCA market. These are derived from an analysis of the likely future density of air traffic on routes suitable for
The production
economics of a very large civil aircraft: D Starkie and S Ellis
284
Figure 4
VLCA fleet forecast by region, 2017
operations such as those across the Pacific Ocean and between Europe and the Far East; they are estimates based on the structure of markets, and implicitly assume that the direct operating costs of VLCAs will be such that the potential demand is realized. One such forecast has been prepared by the UK Department of Trade and Industry (DTI) using a fleet forecasting model that is capable of providing forecasts of the composition of the world aircraft fleet by global region over the next 25 years. A breakdown of the forecast of the VLCA fleet by region based on our interpretation of output from the DTI model is given in Figure 4. As with all longterm forecasts, the data should be treated with caution. In particular, it is possible that VLCAs will face strong competition from smaller aircraft types, and that some airlines may choose lower capacity aircraft because, for example, traffic volumes are particularly responsive to flight frequency. Such competitive influences on the demand for VLCAs are not captured by the DTI model, and hence it is possible that the forecasts could over- or understate likely production levels. However, they are derived from a rigorous and systematic modelling process and, in the absence of information on the competitive options that might become available, we believe that they provide a reasonable estimate of the potential size of the VLCA market. The forecast global fleet size increases from 29 aircraft in 2006 (when VLCAs are assumed to enter service), to 470 aircraft in 2015, to 578 aircraft by 2017 at the end of the 25 year period. The European-domiciled fleet increases from 2 to 57 aircraft over the same period. Hence the European market is expected to account for some 10% of the VLCA
global market by 2017. The US-domiciled fleet accounts for only 47 aircraft in 2017. Asia and Japan represent a far more important market according to the forecast, accounting for 389 aircraft, well over half the global fleet, by 2017. These figures are in line with the view that VLCAs will be generally unsuitable for serving many European routes, given the relatively short distances or low traffic densities involved.6 By contrast, the relatively high traffic density on many Asian routes, coupled with the rapid growth of traffic in the region and congestion at key airports in the Far East, will probably ensure substantially higher sales to Asian-domiciled airlines. How costly is competing
production?
Although we have not been able to establish a true demand function for a VLCA aircraft, nevertheless we are able to use the global forecasts of the size of the potential market to judge whether it is economic to have the VLCA produced by more than one firm (or consortium). This we can do by comparing the global fleet forecasts with the output of the production cost model. By 2017 the prediction was that potential world demand for the VLCA would be close to 600 aircraft. Using the development cost assumption of $15 billion (Case B in Tables 1 and 2), this suggests
6They may, however, prove commercially attractive on selected long-haul routes from Europe, particularly the North Atlantic routes, and on some routes from congested airports (eg Heathrow), where slot constraints prevent the operation of smaller aircraft at higher frequencies.
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The production
economics of a very large civil aircraft: D Starkie and S Ellis
a unit cost for the airframe plus engines (net of additional marketing costs and overheads) of $284 million. However, if we divide the production of 600 aircraft between two identical sources, each producing 300 aircraft, the unit cost would increase by almost 20%. On the most favourable assumptions about the development and manufacturing costs, this would add $56 million to the price of each aircraft. Moreover, in a competing environment, the market may divide less than equally, so that the manufacturer with the smaller market share is at a particular disadvantage by having to carry similar development costs to those of its competitor over a smaller production run. Of course, the market for VLCAs can be expected to extend beyond the year 2017, but even if we assume a requirement for 1000 aircraft by perhaps 2025, dividing production will still add 17% to unit costs. On the other hand, from the airline customer point of view, there is no assurance that the price at which the aircraft is sold will reflect the underlying efficient costs of production. A single manufacturer might be expected to seek monopoly profits rather than secure a reasonable return on capital employed7 and, in the absence of competitive pressures, inefficiencies might creep into the production process (the learning elasticity, for example, might be less than the -0.2 assumed in the above calculations). Duopoly production, therefore, may increase costs in theory but result in lower aircraft prices in practice. But it is also far from certain that a duopoly will result in cost-based pricing of the VLCA. Under certain assumptions it can be shown that even a non-cooperative relationship between two manufacturers could result in a price for the VLCA exceeding its average cost of production.x
‘Tyson (1992) quotes one estimate that ‘Boeing makes $45m on each 747 it sells for an estimated $150m a piece’. XOne would expect this if the two rival firms colluded, but to do so would be contrary to US and EU anti-trust laws. Significantly, the cooperative venture between Boeing and Airbus involves lawyers specializing in anti-trust law.
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Although natural monopolies and oligopolies are frequently subject to economic regulation, in circumstances where the good is traded on the international markets and demand from the host manufacturing nation(s) is limited relative to total demand, the incentives to regulate supernormal profits are diminished. In the view of some international trade theorists, the desire to capture economic rent from the international market may even provide a motivation for government support for the aircraft industry.9 The VLCA, however, may not be worthy of such concerns. Unless its DOCs give it a significant advantage over existing wide-bodied aircraft, there will be little economic rent to regulate or to capture. At the present time it is arguable whether such a cost advantage will exist.
Acknowledgements We would like to thank Branch 3 of DTI Aerospace Division for making available output from their fleet forecasting model. Interpretation and comment on these data is entirely the responsibility of the authors, and does not necessarily represent the interpretation of DTI itself.
References Tyson, L (1992) Who’s Bashing Whom? Trade Confkt in High Technology Industries Institute for International Economics, Washington DC US Department of Commerce (1986) A Competitive Assessment of the US Civil Aircraft Industry Boulder, CO US Department of Commerce (1990) An Economic Financial Review of Airbus Industrie Report prepared by Gellman Research Associates Inc
‘Tyson (1992) comments that ‘the industry is widely regarded as the best example of an industry in which strategic, beggar-thyneighbour, rent-shifting policies may improve national economic welfare’.