CS-04-011

Depreciation Policy: British Airways Versus Lufthansa

Synopsis
This case analyzes the depreciation polices used by British Airways and Lufthansa
Airlines. Although both airlines are substantially similar in the economic functioning
and strategic positioning, vast differences are observed in their choice of depreciation
estimates for their aircraft fleet. The case examines the reasons for these differences
and suggests methods to adjust financial statements for purposes of financial
statement analysis.

This note was prepared by Lakshmanan Shivakumar, London Business School, for the
sole purpose of aiding classroom instruction on depreciation policies rather than to
illustrate effective or ineffective handling of an administrative situation. Excellent
research assistance was provided by Bhupal Vepa and Li Zhang. I am grateful for
comments received from Gilad Livne, Arthur Kraft and Uli Schlosser.
Copyright 2008 London Business School. All rights reserved. No part
Of this case study may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise without written permission of
London Business School.

London Business
School reference
CS-04-011.

CS-04-011

The Airline Industry

The airline industry has come a long way since Ferdinand Graf von Zeppelin set up the first
commercial airline in 1912. Today air transport is one of the worlds largest industries, having
generated $395 billion in revenues in 2005 and having carried over two billion passengers on
international and domestic services in 2006. However, the actual economic impact of the
aviation industry is far more than that suggested by revenues, since it facilitates tourism,
world trade, international investment and economic growth. Air travel is therefore a vital
artery for the process of globalization, which is taking place in many other industries. Exhibit
1 presents a list of the leading international and world (i.e., international and domestic
services combined) airlines.
The global airline industry, after exhibiting strong growth during the late 1990s, saw a sharp
reversal of its fortunes in 2001 and 2002 as a result of the severe world economic slowdown,
combined with the impact of terrorist attacks in the US on September 11 2001 and the
subsequent uncertain geo-political environment. Between 2001 and 2004 the industry
reported cumulative losses exceeding $36billion, which posed enormous challenges to the
global airline industry on a scale not seen for at least a decade. In many ways, 2002 was a
year of transition, with airlines forced into a period of severe cost-cutting, fleet rationalization
and restructuring, as traditional network carriers in particular, struggled to survive in adverse
conditions.
The industry currently faces challenges from sharply rising infrastructure and fuel costs,
global economic slowdown, changes in regulation and significant environmental challenges.
Economic growth in developed economies, which traditionally has been an important
determinant of airline revenue growth, has slowed substantially during the latter half of 2007
and 2008. Falling house prices, higher fuel and food prices and reduced credit availability
have squeezed real disposable incomes, resulting in greater downside risks for global
economic growth. The sharp increases in price of crude oil, has caused fuel costs to account
for over a third of airlines overall cost now, compared to a little over 10% just five years ago.
This dramatic change in the cost structure has raised concerns about the sustainability of the
of the airline industry in its present form.
In March 2007, the EU and the US signed a new multilateral agreement, which removes
restrictions on transatlantic flights by EU and US airlines. This is anticipated to increase the
competition in this already competitive landscape and to bring down the profitability of flying
these routes.
British Airways
British Airways is the world's second biggest international airline, carrying more than 28
million passengers internationally in 2005. It was privatised in 1989 and has become a model
of successful privatisation of a national airline. As of March 2008, it served over 300
destinations. The airlines two main operating bases are Londons Heathrow and Gatwick
airports.
Over the last few years, British Airways has made significant changes in its business strategy
to better focus on reducing costs and improving efficiency. The changes are a response to
developments in the market environment, which overturned some of the assumptions under
which the company was developing its business in the mid-1990s. Opening up of the

European market has seen increased competition as established airlines have expanded
their networks and new low-cost competitors have arrived on the short haul scene. This has
been particularly true in the UK, which has experienced the most rapid growth in no-frillsoperators in Europe.
British Airways has long enjoyed the benefits of having Heathrow airport as its main hub.
However, recently competitor hubs to Heathrow have been developing, which has exposed
the limitations of Heathrows infrastructure in Terminals 1 to 4 and its lack of competitiveness
in the market for transferring passengers. Attempts to develop Gatwick as a complementary
hub have not proved commercially successful. The resulting deterioration in financial results
for British Airways made it even more urgent to address the structural weaknesses in the
airports, which it hopes to achieve through Heathrows Terminal 5. In spite of the delays and
problems with its opening, Terminal 5 is anticipated to provide significant revenue and costsavings opportunities for British Airways by reducing transfer times, eliminating duplicate
activities and increasing overall efficiency.
BAs Fleet
As of December 31, 2006 BA had a total of 282 aircrafts, including 76 aircrafts on operating
leases. Boeing 747-400s, the worlds 2nd largest and one of the most successful commercial
airliner, comprise the single largest type of aircraft and account for just over 1/5th of BAs
fleet. Although most of its present fleet consists of Boeing aircrafts, BA has currently an
option to purchase up to 28 Airbus aircrafts.
BAs Performance
For the year ended March 31, 2008, BA reported a pre-tax group profit of 883m versus
611m in the previous year. Revenues have increased in 2008 by 261m to 8.7b.
Passenger volumes and freight volume are also higher by about 3% in 2008.
BAs depreciation policy: BA depreciated its fleets on a straight-line basis over a period of 20
years after making allowance for residual values at 10% of cost. The information relating to
BAs aircrafts is provided in Exhibit 2.
Lufthansa
Overview
Lufthansa was the state owned German national airline until it was privatised in October
1997. It is one of the largest airlines in the world in terms of international scheduled
passengers carried with close to 400 subsidiaries around the world.
Lufthansas strategy for the passenger business segment is to rely on partnerships and
alliances to position it as a leading network airline. Its Star Alliance network has proven to be
a very successful development and Lufthansa has been able to exploit potential synergies for
mutual commercial benefit.
Lufthansa has also been growing through acquisitions. In March 2005 Lufthansa merged
with SWISS Airlines, although the two airlines continue to operate separately. In early 2008,
Lufthansa acquired a 19% ownership stake in the American low-cost airline, Jetblue.
Lufthansa is looking into further consolidation of the European aviation sector by acquiring a
majority stake in Polish flag carrier LOT and the Spanish flag carrier Iberia.

Lufthansas fleet
As of 2007, Lufthansa has about 494 passenger aircrafts and 19 cargo aircrafts in its fleet.
Airbus aircrafts account for about 47% of its fleet, while Boeing aircrafts account for about
21.8% of its fleet. Lufthansa relies heavily on both Airbus A340s and Boeing 747s for longhaul flights.
Lufthansas Performance
Lufthansa had revenues of 22.4b in 2007, compared to 19.8b in 2006. Stringent cost
management has led to a significant improvement in fortunes, with the group posting a profit
of 1,655m, compared to 803m for 2006. The number of employees went up from 93,541 in
2006 to 100,779.
Lufthansas depreciation policy: Lufthansas depreciates its aircrafts on a straight-line basis
over a 12-year period to an estimated residual value of 15% of cost. Exhibit 3 presents the
information relating to Lufthansas fleet.
Required:
(1) Estimate the average age of the fleets for both airlines at the end of their respective
accounting years (Dec 2007/ Mar 2008).
(2) What possible reasons explain the differences in depreciation policies between British
Airways and Lufthansa?
(3) Compare the aircraft turnover ratio (= sales/net book value of aircraft) for the two
companies? What might explain the difference?
(4) Make the adjustments needed in Lufthansas 2007 financial statements to control for the
differences in depreciation policy. Assume a marginal tax rate of 35% for these
adjustments. Do the differences in depreciation policies have a significant impact on the
financial statements?
(5) Compare the following ratios across the two airlines both before and after making the
adjustments to the financial statements. What effect do the adjustments for depreciation
estimates have on the ratio analysis?
(a) Return on equity
(b) Return on assets
(c) Profit margin
(d) Fixed asset turnover
(e) Aircraft turnover
(f) Debt to equity

Exhibit 1
Leading Airlines1

International Services
Rank

Airline

1
2
3
4
5
6
7
8
9

Lufthansa
British Airways
Air France
KLM
American Airlines
Singapore Airlines
Cathay Pacific
Emirates
SAS

10

Alitalia

International & domestic services

Passengers
carried in
2005 (000)
35,700
28,900
28,800
21,400
20,700
16,600
15,400
13,900
13,400

1
2
3
4
5
6
7
8
9

12,800

10

Rank

Source: ba.com, Fact Book, 2007

Airline
American Airlines
Delta Air Lines
United Airlines
Northwest Airlines
Japan Airlines
Lufthansa
All Nippon Airways
Air France
China Southern
Airlines
Continental Airlines

Passengers
carried in
2005 (000)
98,000
86,000
66,700
57,500
50,900
48,900
48,300
47,800
43,200
42,700

Exhibit 2

BRITISH AIRWAYS
Statement of fixed assets (aircraft fleet) for year ended March 31, 2008
(In millions of )
As of
Additions Depn for Disposals
April 1, 2007
2007-2008
Cost
Accum
depn
NBV

11,223
5,070

428

6,153

428

As of
Mar 31,
2008

542

(262)
(199)

11,389
5,413

(542)

(63)

5,976

Exhibit 3
LUFTHANSA
Statement of fixed assets (aircraft fleet) for year ended Dec. 31, 2007
(In millions of Euros)
Misc. items (e.g., Additions
As of
Jan 1, 2007
Exchange
movement)**
Cost
Accum
depn
NBV

15,742
9,119

915
(105)

455

6,623

1,020

455

* Estimate provided by Lufthansa staff

** Balancing figure.

Depn
2007

Disposals*

As of
Dec 31,
2007

902

(46)
(23)

17,066
9,893

(902)

(23)

7,173

Exhibit 4

British Airways Plc

Profit and Loss Account
For year ended 31st March
( Millions)
Revenue
Depreciation
Other expenditure on operations
Operating Profit
Other Income
Profit on sale of assets
Profit (Loss) before Interest
Interest Paid
Profit (Loss) before Tax
Taxation
Loss from discontinued operations
Profit (Loss) after Tax
Equity holders of the parent
Minority interest

2008
8753
(692)
(7186)
875
169
14
1058
(175)
883
(187)
(2)
694
680
14

Exhibit 4 (contd.)

Balance Sheet BA
As of March 31:
( Millions)
Non-Current Assets
Intangible assets
Tangible Assets
Land & Building
Equipment
Fleet
Investments
Other

2008

2007

221

212

977
310
5976
227
264
7975

932
272
6153
125
259
7953

112
586
1181
1269
3148

76
654
1642
1059
3431

Net Current Assets (Liab.)

Total Assets
Total Assets less Cur. Liab.

(2590)
(4)
(423)
(57)
(170)
(3244)
(96)
11123
7879

(2726)
(54)
(417)
(18)
(410)
(3625)
(194)
11384
7759

Long Term Liabilities

Long Term Debt
Total Other Long Term Liab.

(2751)
(1895)

(2929)
(2419)

3233

2411

288
937
(10)
1818
200
3233

288
933
(10)
1000
200
2411

Current Assets
Stocks
Trade Debtors
Bank & Deposits
Other Current Assets
Current Liabilities
Trade Creditors
Corporation Tax
Current portion of long-term borrowings
Derivative financial instruments
Short-term provisions

Net assets
Shareholders Funds
Issued Capital
Share Premium Account
Investment in own shares
Other reserves
Minority interest

Exhibit 5
Lufthansa
Profit and Loss
For year ended Dec 31:
Euro Millions
Turnover
Other income
Cost of materials
Staff expenses
Depreciation
Other operating expenses
Operating profit
Income from subsidiaries
Net interest payable
Other financial items
Profit on ordinary activities before taxation
Taxes
Profit from discontinued segment
Net profit for the year
Profit attributable to minorities
Transfer to retained earnings

2007
22420
1571
(11434)
(5498)
(1204)
(4269)
1586
131
(194)
90
1613
(356)
503
1760
(105)
1655

Balance Sheet Lufthansa

As of December 31st (Euro Millions)
2007
Fixed assets
Intangible assets
1049
Aircraft
7173
Aircraft under construction
1207
Aircraft spares
586
Other tangible assets
1776
Investments
1100
Other financial items
1185
Total fixed assets
14076
Current assets
Stocks
511
Accounts receivables
3448
Other current assets
678
Marketable securities
1528
Cash and Bank balance
2079
Current assets
8244
Total assets
Shareholders equity
Issued capital
Reserves:
Capital Reserve
Other neutral reserves
Retained earnings
Profit or loss for the period
Minority interests
Shareholders equity including minority
interest
Provisions and accruals
Liabilities
Long term borrowing
Trade payables
Other Liabilities
Deferred income
Total liabilities
Total Liabilities and Shareholders equity

10

Exhibit 5 (contd.)
2006
761
6623
782
540
1525
1558
1180
12969
457
2917
580
2083
455
6492

22320

19461

1172

1172

1366
589
2063
1655
55

1366
-299
1591
803
280

6900

4903

4863

5905

3098
3959
3500
0
10557
22320

2730
3223
2700
0
8653
19461