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More on Cost and Budgets

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Under Generally Accepted Accounting Principles (GAAP), R&D costs must be expensed in the year in which they are incurred.  There is a very good reason for this.  Booking an asset that has no market value puts something on the books that must be written off if the going concern assumption becomes problematic.  Thus, if there are unexpensed R&D costs on the books when things go bad, one can say with confidence that things are actually much worse than the financials indicate.  


Never-the-less, the Boeing non-GAAP approach called "program accounting" which is used for commercial airplane programs may be justified, if there is a high probability that a early sales of the plane being developed will generate enough revenue over and above unit production costs to cover the up front R&D investment.  Even then, carrying R&D costs as an asset beyond five years is, at best, a dubious practice and arguably highly misleading.  

The program accounting used by the commercial airplane part of Boeing books the development cost of a program that start to be incurred once a program proposal has been authorized to go forward and the sales organization has permission to start taking orders.  This is called the Full Scale Engineering Development (FSED) phase.  All R&D work, including concept development that is done prior to the board go-ahead is expensed as incurred, per GAAP.

On a new program, the FSED program costs are nominally expensed at a uniform rate as a part of the unit cost of the first 400 production airplanes that are delivered to customers.  This is called the program accounting block, or just the accounting block.  There have been instances in which the accounting block was increased by a couple hundred planes, but this was only done in instances when it was clear we had a runaway success.  That of course changed with the 787 program, which does not appear to ever be able to recover any of its FSED program costs, even though the accounting block was extended to 1600 planes.  An attempt at a GAAP equivalency disclosure shows the costs being written off more quickly, but even this is, at best, disingenuous since there is not demonstrable link between delivered planes and the costs of the overruns  How does one distribute the impact of watermelon charts over unit costs?  I must have missed that lecture back in school, or later in the Becker CPA Exam Review classes.  

When R&D costs are booked and carried for a lengthy period of time, the capitalized valuation of the company runs a serious risk of becoming a creature of image rather than one of substance.  The brand's history combined with investing behaviors commonly associated with the "greater fool" theory as applied to assets that have no intrinsic value of their own can end up driving stock valuations.  Non-fungible tokens and crypto currencies come to mind as examples of things that are similar in nature to badly aged R&D costs that continue to be carried on the books as assets.  For some reason, booked and badly aged R&D costs remind me of two other products.  One is "pet rocks" and the other was called "canned dark" that sold quite well during an eclipse in 1979.

There is another departure from standard accounting practices that is common in the aerospace industry.  For this part, we are dipping into the world of cost accounting, and not GAAP, which is all about the things that lead to financial reporting for the benefit of others. The departure from normal cost accounting methods is in the way cost estimates are used to create budgets.  

Cost accounting is not a part of GAAP because it does not flow its products into the financial reporting process.  Rather, it is a part of the system of internal controls.  Budgets and cost controls work quite differently in aerospace complex systems integration programs.  This difference is not so much in what they are, but rather in their function.  Normally a budget is a spending plan that guides much management decision making.  But in a complex systems integration environment at the scale of the development of a commercial airplane or its equivalent, budgets take a backseat to the schedule as the primary cost management tool.  The single biggest management performance risk factor on an FSED aerospace program is the schedule.  Revenue begins flowing in, and the accounting block start burning down the accumulated R&D spend, once satisfactory deliveries begin.  And on day 1 of the FSED effort, one thing that is known for certain is that a whole bunch of unknowns are going to require the invention of new solutions in order to get to IOC (initial operating capability, as it is commonly referred to on defense programs).  I like this term as it is very generic and can be applied to any aerospace product.  Also, it nicely encompasses the customers' point of view, which is the thing that really matters far more that delivery and receipt of payment for the first production unit.  However, the term most frequently used on commercial airplane programs is "first revenue flight."  In either case, the FSED burn does not end until the customer is happily executing their mission and not requiring fixes to make the product usable.

Once the FSED phase of development is complete, any continuing development costs must be expensed as incurred, unless they can properly be charged to the development of a derivative of the same basic air vehicle, such as a stretched version of a commercial airplane.

As I have said before, the development of a new air vehicle can quite accurately be described as "inventing on a schedule."  The most critical tool the program management team will have for managing costs will be schedule and monitoring progress against it.  The schedule is everything.  If the schedule is well managed, costs will be contained.  If not, they will not.  It's just that simple.

Now let's review a bit from the section on transparency, and apply it to costs and budgets.

Fortunately for the people working in the finance part of the company, over 80% of the work product of the engineering and technical teams is composed of drawings and documentation.  Their lab work can be hugely expensive, but much of their budget requirements are for the costs of labor and normal overhead such as buildings, support staff, and the usual things that go with maintaining an office.  So projecting the burn rate and thus generating a notional budget early on are not going to produce numbers that are too far off the mark.  This is all provided that the lab work doesn't force too many engineering process loops, especially late in the program.

This points to another reason why watermelon charts are so devastating.  The later in the program a test failure occurs that requires revisiting the design, the more costly it is going to be to go back and fix it or start over.  And, if there was a huge mistake in the form of chasing a bad concept, and the resulting process loop goes all the way back to the alternatives analysis and selection phase, then the cost to get things back on schedule are going to be huge.  At the very least, long days, and canceled vacations and holidays for the engineering and technical support teams can be expected.  Again, this also points to the necessity of transparency and humility within the engineering process.  If a concept is bad, and the pride of the individuals involved with it cause a protracted failure to admit that, nothing but failure will result.  Engineers need to be very cautious with their self-certainty.  Again, the engineering and technical community should lead by example in terms of keeping their pride in check.  Hubris has no place in an air vehicle development process, or any other human endeavor for that matter.

Let me cite three examples of how inadequate engineering work combined with watermelon charts contributed to the financial disaster known as the 787 program.  One deals with the wing, another with the vertical stabilizer, and a third with the lithium batteries.  In each of these three cases, significant redesign and modification of already produced planes had to be done because of the lapses.


The issue with the wing became known as the "side of body" problem.  The bulkhead that forms the end of the wing that is bolted to the plane is a complex part.  It has a number of openings or passages for things like fuel and hydraulic lines, and other equipment.  It is part of the wing fuel tank.  And, it provides the fastener attachment areas for joining it to the center wing box.  We almost got those fastener areas right.  Alas, those parts had to be redesigned and replaced.  Imagine replacing the frame of a truck and you can get a picture of how much stuff has to come apart to replace those.

Then there was a similar problem with the vertical stabilizer.  The one on the static test plane failed.  The last think one wants to get from the static and fatigue test planes is interesting data, and unfortunately we got a bunch of it, especially on the static test plane.


The third item was the failure of one of the lithium ion batteries that caused a fire on one of the early ANA flights.  The risk of internal membrane defects not being detected, or even being caused during battery assembly was something that GM had discovered early on during its hybrid and electric vehicle R&D efforts.  GM's experience came late in the 787 program, but well before ANA had one catch fire on one of their 787s.  We should have been proactive on that one, and headed off the issue before a customer had a problem with it.

I include these late program engineering reworks in this section on costs and budgets because it helps to make the point that unlike the role normal cost accounting plays in many businesses, on aerospace FSED programs, the primary tools for controlling costs are the schedule, and the culture of integrity and transparency in the conduct of the business.  It is attention to detail that controls cost, not check marks next to burn rate figures.  Management's job is not to keep the program on budget, but rather to apply resources where needed as quickly as possible, so the projected budget can end up being close to what is actually experienced.

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