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Goodbye, Operating Margin. Hello, ROIC.

Jul 19, 2018 10 MIN. READ

Airline senior managers need to understand this key financial metric in order to set appropriate performance measures that help maximize value.

The airline industry is one of the most capital-intensive, tying up vast amounts of capital in aircraft, spare parts, and facilities. Despite that, airline senior managers tend to rely on operating margin to gauge profits—an approach that does not account for these extensive capital costs. This lack of focus on how assets are employed helps to explain why the airline industry has—with the exception of the last few years of record profits—consistently failed to cover its cost of capital.

Operating margin represents the percentage of each dollar in sales that the airline retains as profit. However, since it fails to capture the amount of capital required to run the business and how this capital is utilized, it does not provide airline senior managers with any sense of whether their decisions are actually creating value.

The lack of focus on how assets are employed helps to explain why the airline industry has—with the exception of the last few years of record profits—consistently failed to cover its cost of capital.

Consequently, airline senior managers who rely on operating margin are unable to gauge whether they are making smart decisions.

And that’s not uncommon. In over a decade of working with airlines around the world, I have rarely seen organization-wide applications of a much more powerful and complete metric: return on invested capital (ROIC).

ROIC is a profitability metric that captures both operating margin as well as the capital required to generate it. It tells us how much a company earns for each dollar invested in the business. When ROIC is greater than the firm’s weighted average cost of capital—that is, the return owed to shareholders and lenders for providing capital to run the business—the firm is said to be allocating its assets efficiently and creating value for its shareholders and lenders.

This makes ROIC a complete financial metric that is particularly well-suited for capital-intensive industries like airlines.

Using ROIC to make strategic decisions

Airline senior managers need to identify the components of ROIC in order to understand the airline’s key value drivers; it is by acting on these drivers that value can be created.

Despite these benefits, ROIC is generally confined to discussions in the airline C-suite or finance department. For ROIC to be useful in strategic decision-making, a single financial metric is not enough.

Airline senior managers need to identify the components of ROIC in order to understand the airline’s key value drivers; it is by acting on these drivers that value can be created. Once understood, managers can set appropriate strategies that are linked to employee performance measures and targets.

The key value drivers of airline ROIC

The basic formula for ROIC is as follows:

airline infographic

NOPAT is operating profits before interest payments, but after taxes. Invested capital, on the other hand, is the sum of fixed assets and net current assets. In the case of airlines, the main invested capital are aircraft, spare parts, facilities, and working capital.

However, this formula returns a ratio that, for all intents and purposes, is meaningless to airline senior managers because it doesn’t identify the airline’s value drivers or—critically—how to influence them. The important next step is to disaggregate ROIC into its key parts: return on sales (NOPAT divided by sales) and capital productivity (sales divided by invested capital) using a modified version of what is known as DuPont analysis:

airline infographic

This can be broken down further into the key value drivers that make up return on sales and capital productivity (1):

airline infographic

Each of the underlying airline value drivers above can be further deconstructed to understand their various components. For instance, labor as a proportion of sales can be broken down into the drivers of labor cost (e.g., staffing levels, pay rates, productivity, training, etc.) – these are the levers that senior airline managers act upon.

The link between ROIC and airline strategy

The above deconstruction of ROIC—combined with knowledge about an airline’s operating environment and business model—allows airline senior managers to identify the causes of differences in financial performance over time, or between their airline and competitors, and to set appropriate strategies that drive higher return on sales or capital productivity (and thus create value).

Operational managers and their reports then have performance measures and targets that are relevant to their specific areas, but that are linked to the overall strategy of maximizing value. This ensures that airlines are aligning employee activity with shareholder returns.

Breaking down ROIC reveals the direct interrelation across strategy, performance measures, and value creation. For example, strategies that achieve the following measures will, in most instances, improve return on sales:

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We regularly help airlines improve their return on sales and capital productivity, such as:


  • working with a major Asian hub carrier to increase aircraft productivity by reducing minimum ground times;
  • advising a European low-cost carrier (LCC) on boosting flight crew productivity through improved rostering;
  • helping a Middle Eastern carrier drive more third party customers to its MRO business, leveraging underutilized capacity; and
  • advising a North American major carrier on optimizing its spare parts inventory.


  • Increasing productivity of existing aircraft (provided the additional flying covers variable costs)
  • Increasing crew and staff productivity
  • Increasing ancillary revenue sales
  • Increasing the proportion of direct sales
  • Increasing frequent-flyer program mileage sales to airline and non-airline partners
  • Lowering transaction fees (e.g., GDS, payment commissions, etc.)
  • Lowering outsourced service costs (e.g., for ground handling, maintenance, IT, etc.)
  • Lowering airport charges
  • Lowering catering costs

Meanwhile, strategies that achieve the following measures will improve capital productivity:

  • Increasing productivity of existing aircraft (this action appears in both categories—if airlines can produce more revenue per available aircraft, capital productivity rises)
  • Reducing spare parts inventories
  • Increasing usage of other fixed assets, such as ground-handling equipment; maintenance, repair, and overhaul (MRO) facilities; and airport gates (when leased by the airline, as in the U.S.)
  • Driving a longer advanced booking window (arguably, this is not entirely within an airline’s control, but there are actions that can influence passenger behavior)

Ensuring a proper understanding of ROIC and its components is critical—and not just within the airline C-suite or finance department. Airlines need to consider both their operating margin and their cost of capital to align employee actions with shareholder returns.

Successful organizations are those where the culture of value creation is embraced from the C-suite down to front-line staff. By focusing on maximizing ROIC, strong performing airlines are better able to maintain their advantage and underperforming airlines have a better chance of turning around their business.

Airline ROIC Case Studies

ROIC deconstruction analysis provides us with a practical way to analyze airline financial performance and identify the sources of superior performance. For illustrative purposes, read on to see examples of ROIC deconstruction analysis for select competitor airlines in North America and Latin America. Note that these are single-year snapshots—ideally, ROIC analysis should be conducted over several years to identify trends. (2)

North American Full-Service Carriers

American Airlines (AA) and Delta Air Lines (DL) are the two largest U.S. full service carriers, with very similar total revenue in 2017: American had sales (revenue) of $42.2 billion while Delta sold $41.2 billion. However, the two differed greatly in terms of their ROIC; Delta’s ROIC (17.1%) was substantially higher than American’s (7.9%).

airline infographic

How do we explain this large gap? The difference is mainly due to Delta’s superior return on sales (50% higher than American’s).

Delta’s differentiation strategy, which targets higher yield customers by investing in a superior passenger experience and establishing strong positions—alone or with partners—in the main U.S. business markets, is paying off through much higher margins than its North American rival.

Greater asset productivity also plays a part in Delta’s higher ROIC. In terms of fixed assets, Delta’s higher turnover can be explained by the fact that it generates comparable revenue levels with a smaller fleet (Delta has 856 mainline aircraft to American’s 948). Delta’s fleet is also considerably older (16.6 years on average compared to American’s 10.5 years), and is thus more highly depreciated. Delta is also able to operate with much less net working capital (working capital turnover) than American. An obvious question is whether Delta’s capital productivity will fall as it renews its ageing fleet.

North American Low-Cost Carriers

Now let us compare ROIC for two U.S. low-cost carriers (LCC): Southwest (WN) and Spirit (NK).

In 2017, Southwest generated a ROIC of 13.7%, considerably higher than Spirit’s 9.4%.

airline infographic

Unlike the full-service carrier example, return on sales only partially explains Southwest’s stronger returns here. Interestingly, by looking at the disaggregation, we can see significant differences in each airline’s cost structure. For instance, Spirit relies heavily on outsourcing as a core part of its ultra-low cost (ULCC) business model, and, consequently, has very low labor costs as a proportion of sales.

Also, Spirit’s higher aircraft rent and depreciation expense relative to sales is driven by its greater reliance on operating leases (52% of Spirit’s fleet is on operating lease compared to less than 10% for Southwest), which is also common among ULCCs. (3)

However, the large gap in ROIC stems from Southwest’s superior capital productivity, and particularly the significant difference in working capital turnover. Southwest, like many airlines, is able to operate with large negative working capital (i.e., it collects cash from customers long before it has to pay suppliers or incur flight operating expenses). In other words, customers and suppliers fund Southwest’s day-to-day operations, whereas Spirit has a large positive working capital. For example, Southwest’s air traffic liability—cash collected from ticket sales for future travel—represents over 16% of total revenues compared to only 9% at Spirit.

This means that Southwest is able to sell tickets much further in advance of travel than Spirit, providing a valuable source of cash to run the business. For Spirit airlines’ senior managers, understanding the causes of their high working capital requirements relative to industry norms should be a high priority to improve value creation.

Latin American Full-Service Carriers

Finally, let us examine ROIC for two major Latin American full-service carriers: Copa Airlines (CM) and Avianca (AV). Note that these carriers operate in different jurisdictions, so they are subject to different corporate tax rates. (For this reason, and to allow for apples-to-apples comparisons of the underlying value drivers of ROIC, the following numbers are pre-tax. [4])

Copa’s pre-tax ROIC of 16.6% is far higher than Avianca’s (5.7%). The main explanation lies in Copa’s vastly superior return on sales, which is over twice as high as its competitor.

airline infographic

Despite operating a full-service hub-and-spoke business model, Copa pays very close attention to costs. At the same time, the airline operates in many origin-destination markets with limited or no nonstop competition, where it commands high yields. As a result, it combines a differentiation strategy—through a superior intra-Americas route network—with cost leadership among full-service peers, which results in sales margins that consistently rank among the highest in the industry.

The main difference between Copa and Avianca’s cost structure lies in the other costs category, which includes sales and marketing, airport-related expenses, and overheads. Copa’s other costs are substantially lower than Avianca’s—this is a red flag to Avianca senior managers to understand the causes of their underperformance in this area.

Meanwhile, capital productivity at both airlines is quite similar, and does not drive the differences in ROIC performance. It is worth noting that Copa and Avianca each own about 70% of their fleets (including capital leases).


  1. PPE is plant, property and equipment, net of depreciation; NWC is net working capital.
  2. Net working capital in the ROIC calculation is defined as non-cash working capital, as excess cash is not part of invested capital. Net working capital has been adjusted to reflect the lesser of current cash and marketable securities or cash equal to 10% of sales (i.e., security cash to fund day-to-day operations).
  3. Income statement or balance sheet have not been adjusted to capitalize operating leases, as this is a complex and time-consuming exercise that is not necessary for the illustrative purposes of this paper. However, it is important to understand each airline’s fleet ownership strategy when comparing ROICs, as airlines with a high proportion of aircraft on operating lease will tend to have overstated ROIC. We have included notes, as appropriate.
  4. Due to significant differences in corporate taxes applicable to Copa and Avianca, this paper shows pre-tax ROIC and sales margins. This is an appropriate approach to allow for comparisons of structural differences between carriers that operate in different markets. However, after-tax ROIC must be used to compare returns against each company’s cost of capital.


All financial and fleet data is from airline audited annual reports for FY2017.

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