American Airlines is foremost a service company, simplistically offering two basic kinds of services. Measured by its fleet, a number of passengers, and revenue, it is the world’s biggest airline company. Despite its size and influence in air travel, the company experienced significant financial struggles. It filed for bankruptcy in 2011, stating decreasing demand for travel and increasing fuel costs (Le, 2019). Another issue is the inflated indirect costs and costing system. The company is still in the most amount of debt compared to other airline organizations in the US. With the COVID-19 pandemic affecting all kinds of travel, the company is predicted to continue to struggle. To achieve that, American Airlines first needs to restructure its costing system, as the current arrangement is not optimal.
For the sake of simplifying the complex analysis, the service offers of American Airlines can be divided into two categories: standard and custom. In the first category, there are standard air travel offerings; in the second – any other special services. Job order costing or job costing is a method for appointing and accumulating manufacturing costs of an individual unit of output. If one method is chosen over the other, namely the activity-based one, the costs would be lower, as the system would be optimized.
In the traditional approach, American Airlines lumps all overhead and indirect costs in one big sum, but activity-based approach can help to segment them to each activity, helping to reduce them. Often overlooked part of the costs for American Airlines is the indirect costs and costs from the differentiation of the products. Despite the simplified two-product approach in this analysis, American Airlines offers many more different services, bearing a significant portion of indirect costs. Indirect costs include the salary of the crew, flight attendants, technical inspection, licenses, loans, and staff training, while overhead costs involve sales, marketing, settlements, and administrative expenses. The types of costing for the abovementioned aspects would imply Job, Contract, and Operating costings.
Therefore, it can benefit from switching to an activity-based costing system. However, one downside of this system is the complexity of accounting calculations. In the past, it was the reason for adhering to the traditional costing method. The traditional approach is often called absorption method, as it lumps all the overhead and indirect costs into one inflated number, compared to differentiated small portions in activity-based one. For example, using the traditional method, American Airlines now absorbs the indirect costs, assigning it a huge chunk of finances, resulting in higher costs.
Using the activity-based method, American Airlines can charge the overhead and indirect costs to jobs, reducing the overall costs. In other words, overhead costs are calculated using the Overhead Recovery Rate Calculation, generally assigning indirect costs to each of two service offering. In this case, indirect costs are associated with jobs for these two products rather than any other segment. For example, in case of fuel and resources category, there are only direct costs, and, thus, overhead or indirect costs are useless for this segment.
Instead of paying for a large sum of indirect costs as in the traditional costing method, they can now be reduced by this segmentation using activity-based one. Moreover, it helps to establish activity cost drivers, which can be further used to reduce costs in the future, especially using AI technology prediction capabilities. Thus, the recommendation lies in applying Activity-Based Costing, which will optimize the financial procedures for the company. In other words, American Airlines should apportion salaries according to the use of certain processes within the company. It will help not to violate the financial balance in terms of the company’s performance and efficiency.
Overall, American Airlines can derive a greater profit margin by using an activity-based costing approach compared to the traditional one. It can be achieved by reducing the indirect costs by segmenting them. The downside of the activity-based approach can be mitigated by using improved AI technology. Moreover, this technology can further serve the company in reducing costs further using its prediction algorithms based on activity cost drivers.
Reference
Le, H. B. (2019). An ex post analysis of the US Airways/American Airlines Merger. Review of Economic Analysis, 11(3), 383-398.