Monthly Archives: March 2014

Wells Fargo History Museum at San Francisco

While reading Warren Buffett’s 2013 letter to the Shareholders of Berkshire Hathaway a few days ago, I was reminded of the Wells Fargo bank and its History Museum at San Francisco, that we visited during our honeymoon last year.

As we could learn in the museum the history of the bank is very much linked to the expansion of the nation to the West in the XIX century, the discovery of gold in California, and mail and express services.

Both founders, Wells and Fargo, were prominent figures in the express services (what now would be UPS or FedEx). They had already formed American Express, and wanted to expand to the West, however most directors doubted about the idea, and Wells and Fargo decided to start that venture in 1852 independently, with the aim of providing express and banking services in California.

After a bank run in 1855, Wells Fargo emerged as a sound, dependable bank practically without competition in California. The fate of the West expansion was since linked to the bank, which provided not only banking and express services, all types of other services of transportation, communications, the iconic stagecoach service, the Pony Express, etc.

Thus, the visit of the bank’s museum becomes a discovery of some of the details and processes that helped and fueled the expansion to and development of the West coast.

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The museum is located besides the HQ of the bank at Montgomery Street, the entrance is free and I do recommend the visit.

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Boeing real prices (accounting for inflation) after discount

In a previous post I compared for some Boeing airplanes (737-800, 737-900ER, 777-300ER and 787-8) what had been the evolution from 2008 to 2013 of the published list prices against the estimated discounted prices. In that post, I arrived to the following conclusions:

[…] the pricing power of Boeing had remained barely constant during the last 5 years.

  • Through continuous increases, 2013 list prices were between 18% (737 and 777) and 27% (for the 787) higher than in 2008.
  • However, due to increasing discounts from 38% in 2008 to 47% in 2013, the increase in list prices is almost entirely offset.
  • 2013 discounted prices are below 2010 discounted prices for all models.
  • 2013 discounted prices are almost back at 2008 levels for the 737 and 777, only the 787 seems to have stayed at 2010 levels.

I, then, received one interesting comment from a reader, ikkeman, pointing at the fact that if the estimated discounted prices are expressed in then-year dollars (1), if real prices had not increased since 2010, that meant that they had indeed decreased.

See below the graphic I included in the a previous post updated adding the data of US inflation after 2008. [The series is: -0.4% (2009), 1.6% (2010), 3.2% (2011), 2.1% (2012) and 1.5% (2013)]

Boeing List & discount Prices evolution graphic vs. inflation in USA,

Boeing List & discount Prices evolution graphic vs. inflation in USA.

With the information of the inflation (purple line) the following 2 conclusions apply:

  • 787 real price (accounting for inflation) after discount has simply kept up with inflation rate since 2008.
  • 737 and 777 real prices after discounts, however, have lost ground with respect to inflation since 2008. On average they have lost about 8.5% in total or about 1.6% per year.

(1) That is the case as estimated discounted prices have been estimated year by year from the financial reports and list prices of the year, thus, using then-year US dollars.

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Implications of the independence of Kosovo in the case of Crimea

From the onset of the current crisis in Ukraine and the increased presence of Russian forces in Crimea I am having in mind the same word: Kosovo.

I was reading in today’s article from the Wall Street Journal, “A Defiant Putin Endorses Crimean Bid to Secede“, the following:

“The steps taken by the legitimate leadership of Crimea are based on the norms of international law and aim to ensure the legal interests of the population of the peninsula,” Mr. Putin said Sunday in the calls, according to a statement from the Kremlin.

I admit that when Kosovo unilaterally declared its independence in 2008 I did not follow in detail the case, other than knowing the basics and Spain’s opposition to it. It was only last year that I got to know a bit more the details of the case due to the fact that my sister Beatriz, pursuing a Masters programme on  International Security and Law at the University of Southern Denmark, wrote a paper about it and asked her brothers to review it.

I am sure that I miss many of the nuances of the case, but my feeling is that the way that case was handled is backfiring at the moment. When I read Putin’s declaration, “based on the norms of international law and aim to ensure the legal interests of the population of the peninsula“, I see some of the details I will try to summarize below.

A rather complete article about the case can be found here in the Wikipedia.

Let’s start from the beginning. In 1999 and in view of the crisis going on for already 2 years in Kosovo, “Determined to resolve the grave humanitarian situation in Kosovo, Federal Republic of Yugoslavia, and to provide for the safe and free return of all refugees and displaced persons to their homes […]”, the United Nations Security Council adopted the Resolution 1244 (1999) [PDF 24KB, 8 pages]. I invite you to go through it. Here I recall some passages to relate it to the current situation in Crimea:

Reaffirming the commitment of all Member States to the sovereignty and territorial integrity of the Federal Republic of Yugoslavia […]

Reaffirming the call in previous resolutions for substantial autonomy and meaningful self-administration for Kosovo […]

(e) Facilitating a political process designed to determine Kosovo’s future status, taking into account the Rambouillet accords (S/1999/648);

(f) In a final stage, overseeing the transfer of authority from Kosovo’s provisional institutions to institutions established under a political settlement; […]

[excerpts from United Nations Security Council Resolution 1244 (1999), PDF 24KB]

On the reference to the Rambouillet accords (S/1999/648):

3. The Federal Republic of Yugoslavia has competence in Kosovo over the following areas, except as specified elsewhere in this Agreement: (a) territorial integrity, […]

[from page 10. Rambouillet Accords (S/1999/648), PDF 3.4MB, 86 pages]

Fast forwarding 7 years (from the Wikipedia):

International negotiations began in 2006 to determine the final status of Kosovo, as envisaged under UN Security Council Resolution 1244 which ended the Kosovo conflict of 1999. Serbia’s continued sovereignty over Kosovo was recognised internationally. The vast majority of the province’s population sought independence.

Fast forwarding 2 more years (from the Wikipedia):

The 2008 Kosovo declaration of independence was adopted on 17 February 2008 by the Assembly of Kosovo

At that point Serbia requested the United Nations General Assembly to seek an opinion from the International Court of Justice (ICJ) on the case, obviously thinking that the ICJ would rule against the declaration of independence. The resolution was passed with 77 countries voting in favor (including Russia, Brazil, India, China, Norway, Spain, Indonesia, Mexico, South Africa…), 6 against (including United States, Albania and some islands from the Pacific ocean) and 74 countries abstaining (including most of Western Europe, Canada, Japan…).

The article of the Wikipedia on the case includes some of the points raised by each country. I find it interesting to bring forward the points from:

United States:

The United States invites the International Court of Justice to leave the declaration of independence intact as an expression of the will of the people of Kosovo, either by refusing to comment on its legality, or by determining that the international law does not prohibit declarations of independence. The declaration of independence did not violate any principle of territorial integrity because under international law, only states must comply with this principle, and not internal entities. […]

Russia:

  • General international law prevents Kosovo from declaring independence, bearing in mind that the people of Kosovo do not enjoy a right to self-determination.
  • Russia rejects claims coming from those countries who support the unilateral declaration that international law “does not regulate independence declarations”, and reminds that the UN Security Council declared Northern Cyprus and Rhodesia’s independence to be illegal, since secession is forbidden outside the colonial context. […]
  • Resolution 1244 cannot be overturned by a decision of UN secretary-general’s envoy Martti Ahtisaari to end the negotiations and recommend independence as the only solution. Quoting the words of Kosovo Albanian representative Skënder Hyseni, who said that the negotiations were led on “whether or not Serbia will accept Kosovo’s independence”, Gevorgian said that Ahtisaari’s failure does not mean that the process has been concluded.
  • We often hear that international law is no law, that it does not apply to precedents, and that power is the law. This case is a chance to demonstrate that international law is in effect.

As requested, the International Court of Justice gave its advisory opinion on the case [PDF 190 KB, 31 pages], and found that:

THE COURT,
(1) Unanimously,
Finds that it has jurisdiction to give the advisory opinion requested;
(2) By nine votes to five,
Decides to comply with the request for an advisory opinion;
(3) By ten votes to four,
Is of the opinion that the declaration of independence of Kosovo adopted on 17 February 2008 did not violate international law.

… to the dismal of Serbia, Russia and others (1). I strongly recommend reading, or skimming through, the summary of the advisory opinion.

While reading the article prepared by my sister, I must confess that the (dissenting) opinion that I sided the most with was from Judge Koroma (2).  You may find it here [PDF 139KB, 22 pages]. I especially enjoyed this paragraph:

19. In addition to resolution 1244 (1999), the Court has considered whether the unilateral declaration of independence has violated certain derivative law promulgated pursuant to it, notably the Constitutional Framework and other UNMIK regulations. It concludes that the declaration of independence did not violate the Constitutional Framework because its authors were not the Provisional Institutions of Self-Government of Kosovo and thus not bound by that Framework. The jurisprudence of the Court is clear that if an organ which has been attributed a limited number of competences transgresses those competences, its acts would be ultra vires […]. However, the majority opinion avoids this result by a kind of judicial sleight-of-hand, reaching a hasty conclusion that the “authors” of the unilateral declaration of independence were not acting as the Provisional Institutions of Self-Government of Kosovo but rather as the direct representatives of the Kosovo people and were thus not subject to the Constitutional Framework and UNMIK regulations. That conclusion simply cannot be correct, since the unilateral declaration of independence was adopted in the context of resolution 1244 (1999) and the Court has acknowledged that the question posed by the General Assembly is a legal question and that resolution 1244 (1999) is the lex specialis and applicable in this case.

I love that expression, “sleight-of-hand”.

I also fail to see how if the resolution 1244 (and the Rambouillet Accords), recognized the sovereignty of Serbia over Kosovo and called for an agreed future status, the unilateral declaration of independence taken by an Assembly created by the Provisional Institutions of Self-Government of Kosovo which was a result of resolution 1244 can suddenly be considered as not acting as the Provisional Institutions of Self-Government of Kosovo and not subject to the Constitutional Framework and UNMIK regulations.

We may call Putin whatever words, we may find him opportunistic, etc., but when Russia stated before the UN General Assembly in 2009 “We often hear that international law is no law, that it does not apply to precedents, and that power is the law. This case is a chance to demonstrate that international law is in effect”, and saw how the ICJ opined afterwards, it can only be taken as a logic conclusion that now Russia finds “The steps taken by the legitimate leadership of Crimea are based on the norms of international law and aim to ensure the legal interests of the population of the peninsula”.

Some times politics and international law can get really entertaining. 

You reap what you sow.

(1) Kosovo has been recognised to date by 108 out of 193 (56%) United Nations member states, though not including Brazil, India, China, Russia, Argentina, Iran, Israel, Mexico, South Africa, Spain, etc. 

(2) To make the riddle even more tricky: Judge Koroma, a natural from Sierra Leone, studied law at the Kiev State University… I would love to hear his opinion today on the case.

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Blagnac half marathon 2014

After 2 months without competing, I took part today in Blagnac’s half or semi marathon.

In this 2014, I am finding it hard to find the necessary consistency with the training. I go from fulfilling a week of training to just run 2 or 3 days the following week. It’s an issue of motivation, engagements and fatigue. That is why, today, I had not in mind pursuing any personal best time in the distance (1h37’29”). I rather checked beforehand the paces needed to achieve 1h40′ and 1h45′ and I targeted at the start line for 1h40′.

The day was sunny and windy. But it was way to sunny and hot, and a bit too windy for some of the long straight streets. Nevertheless, Blagnac’s half is completely flat. Thus, the main issue today was the lack of fitness.

I started with 2 kilometres at about 4’30” and then adapted the pace to try to continue at about 4’45” in order to be under 1h40′. However, in the second half of the race I felt that I wasn’t going to make it. It was hard for me to keep the pace.  Thus, I just tried to maintain a rhythm which was not painful and at the same time would permit to clock a time below 1h45′ and so I did. That is the good thing of having a plan B, or making it (making up the numbers in your head) on the fly (or rather run).

In the end, I finished in 1h44’19” net time as recorded by my Garmin. Definitely not the best half I have done (I haven’t done so many). I take it as a training and a test for Rotterdam Marathon, in about a month (April 13th). I will need to get more serious in the remaining weeks of training prior to that date if I don’t want that marathon to be a nightmare.

After finishing Blagnac's half marathon.

After finishing Blagnac’s half marathon.

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Boeing discounts detailed calculation, 2013 vs. 2012

Last years I have published in the blog  some posts (1) dedicated to show what was my estimate of the average discount Boeing applies to its commercial airplanes. I included in those posts the rationale used for the calculation. Find here the post related to the calculation of the discount based on 2013 data of Boeing Commercial Airplanes revenues, deliveries and list prices.

In this post, I wanted to show in detail a simplified table (2) with the calculation comparing 2013 simplified result versus 2012:

Boeing discount detailed simplified calculation: 2013 vs. 2012.

Boeing discount detailed simplified calculation: 2013 vs. 2012.

In the table above, you may find for both 2013 and 2012 Boeing reported deliveries per model and Boeing published list prices per model (3) and Boeing Commercial Airplanes reported revenues.

What is then estimated? Boeing Commercial Airplanes services revenues (deduced from financial reports reported information), Boeing Commercial Airplanes platforms revenues (derived from the previous figure) and the average discount; this is calculated from the difference between estimated BCA platforms revenues and what should have been that figure had the airplanes been sold at list prices.

Results: average discounts of above 46% in 2013 and above 45% in 2012.

(1) Find here what is becoming a “body of knowledge” on Boeing discounts: estimates calculated for 2013201220112010 and 2009; a review of the French portal Challenges.fr of aircraft discounts prior to Le Bourget airshow of 2013; aBombardier’s CEO statement on what is known in the market as the Boeing discount; Boeing Commercial Airplanes president Ray Conner speaking about the more aggressive pricing they are being forced to offer.

(2) I refer to this table as “simplified” as it excludes from the calculation the potential influence on yearly revenues (note, not cash flow) of down payments linked to orders received in then-year versus orders received in previous years for aircraft delivered in then-year.

(3) Two assumptions are needed: 737-800A transfer prices from BCA to Boeing Defense Space & Security for the P-8 (for simplicity assumed to be the same as the 737-800 price) and for the 737-based business jets (for simplicity assumed to be the same as the 737-900ER).

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Augustine’s Laws and the future long-range bomber

The US Air Force is moving ahead with its plan to develop a new long-range bomber aircraft to be operational by the mid of next decade. The program is not yet launched, but within this year it is expected that we will see the launch of a request for proposals (RFP).

I read about the latest moves about this program-to-be in an article from DefenseNews, “USAF To Shed Light on ‘Mystery’ Plane“. Apart from different declarations from officials and industry, the article provided some main general clues:

The Air Force intends to begin fielding the bomber in the mid 2020s, with penetrating capability in mind. The service will procure 80 to 100 planes, which will mostly be made with existing technologies. Those machines will also have both standoff and direct-attack munitions and room for a large payload.

The service also is exploring the idea of the aircraft being optionally manned.

Service officials have cited a cost of $550 million per plane as the ceiling for the program, but even that figure has some mystery to it. Observers have noted that the figure does not include research and development (R&D) costs, which could drive that amount up.

My first reaction on that figure of $550 million per aircraft was:

For those not acquainted with him, Norman Augustine served in many positions both in the Administration (Under Secretary of the Army) and in the Aerospace & Defense industry (CEO of Lockheed Martin). Lately he lead the Committee that was reviewing the US Human Space Flight Plans. He wrote a fantastic book, “Augustine’s Laws”, about the aerospace and defense industry, the problems that plague their programs, etc. I reviewed that book in this post.

However, after writing that tweet I decided to check it myself…

See below the original graphic from the book depicting the trend of increasing costs of bomber aircraft:

Trend of Increasing Cost of Bomber Aircraft (source: Augustine's Laws).

Trend of Increasing Cost of Bomber Aircraft (source: Augustine’s Laws).

I extrapolated the trend with the information provided in the article, that is, a $550 million unit cost with an entry into service by the mid 2020s, see below where that spot is in the enlarged graphic:

Updated Trend of Increasing Cost of Bomber Aircraft (source: Augustine's Laws + future long-range bomber information).

Updated Trend of Increasing Cost of Bomber Aircraft (source: Augustine’s Laws + future long-range bomber information).

You will see that I marked 2 different spots in red and blue. The blue one corresponds to the unit cost ceiling of 550M$ reported in the article. You will see that the spot is way off the 70-year old trend (from the end 1920s-1990s). Therefore, I decided to continue the trend line and see at what unit cost would a bomber aircraft with entry into service in the mid 2020s still follow the trend, and I marked that unit cost in red. The result is that the future bomber would have to cost about $500 billion apiece, or a cost roughly equal to the entire Department of Defense yearly budget.

That may seem impossible today, completely off reality. How could that happen? Start by imagining that the budget which will be earmarked for 80-100 airplanes along several years, in the end serves to procure many less units (40?, 10?… 1?). Then, add to that the information appearing in the article accompanying the 550M$ figure, “the figure does not include research and development (R&D) costs, which could drive that amount up”. Put all that together and we might end up seeing, 10 years from now, that Augustine’s was right on the spot.

In fact, the assertion that one single airplane would cost the US Air Force the entire DoD yearly budget was exactly predicted by Augustine in his Law number IX, though he applied it for tactical fighter aircraft, and the date in that case would be a bit later, 2054:

In the year 2054, the entire defense budget will purchase just one tactical aircraft. This aircraft will have to be shared by the Air Force and Navy 3 1/2 days each per week except for leap year, when it will be made available to the Marines for the extra day. (LAW NUMBER IX)

Update (2014-03-08): See in the article from Bloomberg, “Long-Range Bomber’s Development Would Get $12 Billion“, a declaration from Lt. General Charles Davis: “Is it going to be $550 million a copy? No, of course it’s not going to be $550 million a copy once you add in everything.“. The article includes further figures providing a new estimate of 810M$ apiece… The closing of the gap between 550M$ and ~ 500bn$ has started.

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Warren Buffett’s 2013 letter to the shareholders of Berkshire Hathaway

Last Friday (28/02/2014), Warren Buffett’s 2013 letter to the Shareholders of Berkshire Hathaway [PDF, 252 KB] was released. As always, I strongly encourage you to read it (23 pages).

From this year’s letter, I wanted to bring attention to the following passages, on value creation, insurance business, intangible assets amortization, simplicity of some transactions, fundamentals of investing and a sound investing strategy.

***

On what is the focus of Warren and Charlie to create value:

“Charlie and I hope to build Berkshire’s per-share intrinsic value by (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.”

On the keys of insurance business:

“[…] a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.

[…] That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.”

On the different views to be taken of certain intangible assets amortization no matter what accounting rules say about them:

“[…] serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others in no way lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real costs. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated – even though from an investor’s viewpoint they could not be more different.

[…] Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.”

On simplicity of some transactions and trust:

“I think back to August 30, 1983 – my birthday – when I went to see Mrs. B (Rose Blumkin), carrying a 1 1⁄4-page purchase proposal for NFM that I had drafted. (It’s reproduced on pages 114 – 115.) Mrs. B accepted my offer without changing a word, and we completed the deal without the involvement of investment bankers or lawyers (an experience that can only be described as heavenly). Though the company’s financial statements were unaudited, I had no worries. Mrs. B simply told me what was what, and her word was good enough for me.

[…] Aspiring business managers should look hard at the plain, but rare, attributes that produced Mrs. B’s incredible success. Students from 40 universities visit me every year, and I have them start the day with a visit to NFM. If they absorb Mrs. B’s lessons, they need none from me.”

Offer Letter for NFM (retrieved from BRK annual report [PDF, 6.5MB])

Offer Letter for NFM (retrieved from BRK 2013 annual report [PDF, 6.5MB])

On certain fundamentals of investing:

  • “You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
  • Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. […] omniscience isn’t necessary; you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating. […]
  • […] I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. […]
  • Forming macro opinions or listening to the macro or market predictions of others is a waste of time. […]”

A sound investing strategy:

“[…] The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

[…] My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) […]”

His best investment ever:

“[…] I learned most of the thoughts in this investment discussion from Ben’s book The Intelligent Investor, […]

[…] For me, the key points were laid out in what later editions labeled Chapters 8 and 20. […]

I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would
underscore the truth of Ben’s adage: Price is what you pay, value is what you get. Of all the investments I ever
made, buying Ben’s book was the best […]”

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Learning Curves: Boeing 787 case in 2013

In the previous two posts I introduced the concept of learning curve and provided a case in point (based on figures attributed to A350 FAL by Leeham News). In the first of those posts, I discussed that:

Boeing does not disclose outright what is the actual learning curve it is achieving in its program. Nevertheless, in its investor relations conferences it provides information here and there of cost savings achieved, etc. This can be interpreted as derived from learning curve effects, and would permit to build a model, even if based on scarce information.

Let me quote again one of those excerpts from Boeing executives:

“We continue to see progress in key operational performance indicators and unit costs, as we further implement production efficiencies and stabilize the overall production system on the 787 program. Unit cost has improved approximately 20% over the past year on the 787-8 […]“Greg Smith, Boeing EVP – CFO at Q4 2013 Earnings Conference.

To the avid reader, and knowledgeable and savvy analyst, this paragraph is enough to deduce the actual learning curve achieved by the 787 during 2013, provided that information reported by Boeing CFO, Greg Smith, was accurate.

During 2013 Boeing delivered 65  787s, from the 50th to the 114th units (in previous years it had delivered already 3 in 2011 and 46 in 2012).

Thus, the exercise to find out what learning curve Boeing achieved in 2013 is as simple as to see what learning curve yields an “approximately 20% unit cost improvement” from the unit 50th to the unit 114th. The beauty is that we do not even need to know the initial unit cost to perform the calculation, as the relative improvements in terms of percentages are independent of the starting point. All the information has indeed been provided by Boeing.

In the first graph below I just plotted some generic learning curves, from 95% to 75%. This form of representation provides a good view of how learning is intense at the beginning of the production process and it stabilizes later on. It also shows well how learning is more intense and cost reductions are bigger for a 75% curve than for a 95% curve.

Generic learning curves.

Generic learning curves.

However, in the previous curve it is difficult to distinguish the 50th and the 114th units which are needed for the calculation. Thus, I plotted the same curves in with a log scale for the numbers of units produced in the graphic below:

Boeing 787 learning curve in 2013 calculation, delta unit cost between 50th & 114th units.

Boeing 787 learning curve in 2013 calculation, delta unit cost between 50th & 114th units.

In this second graphic I added the information of what relative cost reduction is achieved between the 50th and the 114th units for each of the curves (1).

To make sure that readers are not lost, let’s take the 85% curve. Following that curve, the unit cost of the 50th unit produced is a 40.2% of the 1st unit cost, whereas the unit cost for the 114th unit produced is a 32.9% of the 1st unit cost. The difference is then 40.2% – 32.9% = 7.2%, which represents a 18.0% cost reduction from the 50th unit cost. If you follow the same calculation for each of the curves, you will obtain the following unit cost improvements between 50th and 114th units:

  • 95% curve: -6.1% unit cost improvement
  • 90% curve: -12.0% unit cost improvement
  • 85% curve: -18.0% unit cost improvement
  • 80% curve: -23.8% unit cost improvement
  • 75% curve: -29.6% unit cost improvement

Thus, from the information provided by Boeing of units delivered and unit cost improvement (“approximately 20”, Greg Smith) we can deduce that during 2013 the learning curve that the 787 program has achieved is between 85% and 80%. Thus, in line with aerospace average indicated by NASA (85%), or in line with the reported 84% achieved in the 777.

If we wanted to know what learning curve yields exactly that 20% unit cost improvement, it is now trivial to calculate it: the 83.3% learning curve.

Having made these numbers, and taking into account the words used by Boeing CFO, “unit cost has improved approximately 20% over the past year on the 787-8″, I take it as that the improvement has been close to 20% though probably not reaching it; thus, I understand that the learning curve was rather between 83.3-85% instead of down to 83.3%.

(1) Bear in mind what a relative cost reduction is in contrast to the fact of relative costs represented in the vertical axis as percentages of the initial cost (100%).

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Learning Curves (case in point)

In a previous post I made an introduction of the concept of learning curve and the gains that can be achieved through experience, with the focus on aerospace industry.

Case in point 1

Few days ago I found an interesting blog post at Leeham News, “Lessons learned from A380, 787 benefit A350“, which discusses lessons learned reportedly being applied into the A350 programme and includes two interesting tables. I will use one of those tables in order to show an exercise of learning curve calculation, without caring of whether the information included in the table is accurate or reflects actual lead times of A350 at Final Assembly Line (FAL). [I do not validate the information of the table despite of using it for an intellectual exercise.]

A350 days in FAL as reported by Leeham News (Reprinted with permission by Leeham Co).

If we take the lead times reported by Leeham News in the table above, we can calculate to what learning curve profile would those lead times correspond. See the result in the graphic below:

Learning Curves.

Learning Curves.

The information reported by Leeham News corresponds to a learning curve between 85% and 90%, about 88%. If figures resemble the reality, between the first and second units, the learning was closer to 95%, however, between the 2nd and 3rd it improved greatly. Since the 3rd unit, the learning is more stabilized at about 88%. [Again, having made this calculation as an exercise does not validate the information taken as an input]

It is important to bear in mind the units used in this calculation are days. Days of assembly are linked to unit production costs, but not necessarily in a linear fashion, as it will depend on the labor / automation being employed in the production of each unit, which may change as production evolves. It is also important to note, that the example of learning curve calculated would refer only to assembly at FAL and not to the overall production process, from material costs, production at earlier stages of the manufacturing process, etc. The value added at FAL is but a minor percentage of the value of an airplane.

I leave for a following post a case in point 2, with the learning curve of the 787 during 2013.

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Introduction to Learning Curves

Let me introduce the learning curve effect by quoting directly from the Wikipedia:

“The rule used for representing the learning curve effect states that the more times a task has been performed, the less time will be required on each subsequent iteration. This relationship was probably first quantified in 1936 at Wright-Patterson Air Force Base in the United States, where it was determined that every time total aircraft production doubled, the required labour time decreased by 10 to 15 percent.” […]

“Learning curve theory states that as the quantity of items produced doubles, costs decrease at a predictable rate.”

I used the concept of learning curve in a blog post in which I discussed whether and when the Boeing 787 would break even. In that post I referred to Boeing’s target of reaching a 75% learning curve on the 787 program, much more difficult to reach than the 84% that Boeing reportedly achieved in the 777 program.

Why is a curve of 75% more difficult to achieve than a 84% curve? The meaning of the figure “84%” attached to the learning curve is that each time that the number of units produced is doubled, the cost is reduced in 16%, or the 2*nth unit cost is 84% of the unit cost of the nth unit. Thus, a 75% curve would imply that the cost is reduced in 25%, which is a higher cost reduction than 16%, and, thus, more difficult to achieve.

On the other hand, NASA, in its Learning Curve Calculator, offers some guidance on learning curves for different industries and mixes of hand labor and machining work:

  1. Aerospace 85%
  2. Shipbuilding 80-85%
  3. Complex machine tools for new models 75-85%
  4. Repetitive electronics manufacturing 90-95%
  5. Repetitive machining or punch-press operations 90-95%
  6. repetitive electrical operations 75-85%
  7. Repetitive welding operations 90%
  8. Raw materials 93-96%
  9. Purchased Parts 85-88%

How is the concept of learning curve calculated? (from Wikipedia: )

 Now the equation for the unit curve is given by:

Y_x = K x^{\log_2 (b)}

where

  • K is the number of direct labour hours to produce the first unit
  • Yx is the number of direct labour hours to produce the xth unit
  • x is the unit number
  • b is the learning percentage (expressed as a decimal)

How does a learning curve look like? (from Wikipedia) Actual examples of curves in both linear and logarithmic scales would be:

Experience curve (from Wikimedia, by Apdevries).

The concept of learning curve is indeed used in aerospace, however, coming back to the 787 program, Boeing does not disclose outright what is the actual learning curve it is achieving in its program. Nevertheless, in its investor relations conferences it provides information here and there of cost savings achieved, etc. This can be interpreted as derived from learning curve effects, and would permit to build a model, even if based on scarce information.

See some of the hints that Boeing provides:

“We continue to see progress in key operational performance indicators and unit costs, as we further implement production efficiencies and stabilize the overall production system on the 787 program. Unit cost has improved approximately 20% over the past year on the 787-8 […]”, Greg Smith, Boeing EVP – CFO at Q4 2013 Earnings Conference.

“[…] as we continue to make improvements 787 unit cost […]”Greg Smith, Boeing EVP – CFO at Q4 2013 Earnings Conference.

“when you look at flow-time, you look at unit cost at Charleston whether it’s final, mid, or (aft) it made great progress there. And the team has been very focused on continuing that progress going forward. We have experienced a higher number of jobs behind schedule in the mid-body section, and that’s really due to, if you think about it, you are introducing the Dash-9 at the same time going to 10 a month. […], we’ve applied additional resources. We know how to do this and we’ll get those jobs back to what we view as a more acceptable level. So we got mitigation plans.” Greg Smith, Boeing EVP – CFO at Q4 2013 Earnings Conference.

“This morning we announced plans to increase 787 production beyond the 10 per month we’re on track to achieve this year to 12 per month in 2016 and then 14 per month, before the end of the decade. […], capture productivity and learning improved profitability […]” Jim McNerney, Boeing Chairman, President and CEO at Q3 2013 Earnings Conference.

“We’ve added another line or sorry, a position within the line, where we’re doing the wing, body joint earlier in the process and this is through experience after 134 airplanes, the teams are really coming up with better ideas or improvements on how to increase flow and that’s going to require some upfront investment. But obviously in the units to come after we’ll see that improvement again in flow and productivity.” Greg Smith, Boeing EVP – CFO at Q3 2013 Earnings Conference.

“[…] the flow time reductions, we’ve had in our factories, the hours per unit, the productivity per whatever are increasing significantly on all of our programs.” Jim McNerney, Boeing Chairman, President and CEO at Q3 2013 Earnings Conference.

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