Why do corporations like Boeing and Volkswagen prematurely launch Killing Machines?

Janek Ratnatunga CEO, CMA Australia
Prof Janek Ratnatunga
CEO, CMA Australia

It’s for profit and market share, stupid.

The cost-benefit analyses that management accountants perform, that compares quality-cost relationships, profits and market share vis-à-vis the risks associated with failure, can be traced to why corporations prematurely launch products that they know to be faulty to the unsuspecting customer market. This article looks at the management accounting implications when the faults of some of these products are so great, that the company is actually launching glorified killing machines.

Take for example Boeing. It has not been a good time for the company in the aftermath of the second crash of the company’s almost brand-new aircraft, the 737 Max jetliner. There is evidence that Boeing was well aware of the design faults that led to the Ethiopian Airlines plane crashing minutes after it took off in March 2019, killing all 157 people on board; and the October 2018 crash of a Max 8 operated by Indonesia’s Lion Air that killed 189 people. Still, despite knowing of these faults, Boeing went ahead with the production and marketing of these veritable killing machines.

The latest accident prompted most of the world to ground Boeing’s 737 Max 8 aircraft on safety concerns. Much of the attention has been focused on a flight-control system that Boeing now admits can automatically push a plane into a catastrophic nose dive if it malfunctions and pilots don’t react properly.

As a result, regulators and prosecutors have heightened scrutiny over whether the plane’s design certification and approval process were flawed. These appear to have had significantly flaws. A Seattle Times investigation has found that U.S. regulators delegated (outsourced) much of the plane’s safety assessment to Boeing itself; and that the company in turn delivered analyses with crucial flaws. Transportation Department auditors have confirmed the agency hadn’t done enough job to “hold Boeing accountable [1]

We are now learning that U.S. Federal Aviation Administration (FAA) employees who approve new and modified aircraft designs warned as early as seven years ago that Boeing had too much sway over safety approvals of new aircraft; but they had faced retaliation for speaking up (whistle-blowing). Their concerns pre-dated the 737 Max development. All this was to do with cost-cutting at the FAA.

In recent years, the FAA, which is probably underfunded for the important work they have to do, appears to have outsourced more and more of the authority over the approval of new aircraft to the manufacturer itself, even allowing Boeing to choose many of the personnel who oversee tests and vouch for safety. At least a portion of the flight-control software suspected in the 737 Max crashes was supposedly certified by one or more Boeing employees who worked in the outsourcing arrangement.

The FAA has let technical experts at aircraft makers act as its representatives to perform certain tests and approve some parts for decades. The FAA expanded the scope of that program in 2005 to address concerns about adequately keeping pace with its workload (which is an oblique way of saying that they were underfunded). In a process known as Organization Designation Authorization, or ODA, it let Boeing and other manufacturers choose the employees who approve design work on the agency’s behalf. The logic of the ODA process was simple: manufacturers have heavy incentives to build a safe airplane, not least because accidents can significantly harm their bottom line and perhaps even put them out of business. That argument carried the day in the US Congress, and the program was fully implemented in 2009, and by 2018 Congress had mandated the FAA to “delegate fully” safety functions to industry.

Although the 737 has been continually updated, plans for another update were shelved more than a decade ago when Airbus announced an upgraded version of its direct competitor to the 737, the A320 neo, with significant fuel-efficient engines. At the time, the market share of single-aisle planes like the 737 was nearly 70% of new aircraft deliveries. Boeing estimated that market would be worth some $2.5 trillion over the next 20 years, and decided it was not going to cede it to Airbus. Boeing needed a single-aisle plane with 20% better fuel efficiency and lower operating costs, that could be brought-to-market fast.

Enter the 737 Max.  However, there were challenges in both design requirements and cost management. In terms of cost management, Boeing decided to use an earlier version of the 737, rather than design the aircraft from scratch. But as the new LEAP-1B engines were 60 cm larger than the original engines, Boeing redesigned the 737’s pylons, which hold the engines to the wing, and moved them further forward.[2] But the more powerful engines in a different location could pitch the jet’s nose upward, creating the conditions for a mid-air stall.

To prevent the stall, Boeing created an automated-flight-control feature called the Maneuvering Characteristics Augmentation System (MCAS). When MCAS sensors detected the nose of the plane pitching up, the software controlling the tail’s horizontal stabilizer would automatically push the nose back down. It was a cost minimizing way to fix this nagging design problem; but as per a report in the Seattle Times, Boeing took a number of steps in its ODA process that blunted the scrutiny the MCAS feature could draw from safety regulators at the FAA.[3]

First, it understated the extent to which MCAS might take automated control of the plane. Next, with the support of regulators, it decided against extensive training for pilots on the 737 Max, including in how to disable the software. This was again a cost minimization feature that was good for both Boeing and the potential airline customers. Boeing said additional flight-simulator training for pilots–which costs airlines time and money, and therefore could have dampened 737 Max sales–weren’t necessary. Boeing has now acknowledged that training guidelines for the 737 Max did not mention MCAS.

These moves got the 737 Max to market faster, allowing Boeing to offer it just nine months after Airbus introduced its single-aisle, fuel-efficient competitor, the A320 neo. Due to the cost savings it gave airlines in terms of fuel efficiency and pilot training cost savings, the Max was an immediate hit, garnering more than 5,000 orders from more than 100 customers worldwide. It received FAA certification in March 2017, and regulators around the world followed suit.[4] Two months later, Boeing began deliveries of its 737 Max place, fully aware that they were potential killing machines.

It is worth noting that the ODA program was also at issue in the FAA’s 2013 grounding of Boeing’s 787 Dreamliner after two fires of battery packs. It was Boeing’s designated engineering representatives who oversaw tests of the battery packs.

Where do management accountants come into this picture? Cost savings is the obvious area. As organisations become ‘leaner’, management accountants look for ways that costs could be reduced. However, there is a quality-cost trade-off. The underlying requirement for any product or service that has the possibility of human life being lost in its use is, however, more onerous than a mere trade-off between quality and cost. For example, NASA erroneously used the quality-cost trade-off in its tendering process to acquire “O-Ring joints”, which resulted in the explosion of the Challenger Space Shuttle when the they failed. As we move from space, to air and then to land use, companies use statistical tools estimates the probability of failure of any component, and how its product or service can “fail-safe”. This requirement, obviously is far greater for aircrafts, than motor vehicles.

Boeing has previously launched aircraft into service before they were fully ready, but with the absolute 100% probability that it will “fail-safe”.  The Boeing 747 Jumbo, which turned 50 years last year, had major issues with its first engines, which were plagued with reliability issues. However, although the 747 had 4 engines, it could fly safely with just one. The statistical probability of all 4 engines failing on a single flight was calculated as being minuscule.[5] In fact, Boeing did not compromise on quality for cost reasons, but instead it borrowed heavily from banks the needed development money. On its September 30, 1968 rollout, the first 747 prototype looked ready to fly but was in fact only 80 percent complete. This deliberately premature unveiling served to reassure concerned bankers that their large loans had resulted in a real airplane.[6] Despite being only 80 percent complete, they were still designed to fail-safe, and prevent loss of human life.

As of January 2017, a total of 61 Boeing 747 aircraft, or just under 4% of the total number of 747s built, first flown commercially in 1970, have been involved in hijackings, terrorist activity, accidents and incidents resulting in a hull loss, meaning that the aircraft has either been destroyed or has been damaged beyond economical repair. However, the roots of causation in these incidents involved a confluence of multiple factors which rarely could be ascribed to flaws with the 747’s design or its flying characteristics.[7]

With the 747, Boeing had bet its future on creating a market that had not previously existed, a ‘Blue-ocean’ strategy. Design engineers and management accountants worked together to meet Boeing’s target of drastically reducing the number on which the whole project was based, i.e. the cost per available seat mile (calculated by multiplying the number of available seats on a flight by the miles flown, and then dividing the operating costs by that number). Pan Am told Boeing that its 747s were achieving a cost of 6.6 cents per seat mile—one third of the earlier Boeing 707’s cost.

To create this cost-efficient long-haul market, Boeing went to the brink of bankruptcy. At the peak of the program, Boeing was spending $5 million a day. Yet it did not compromise on quality, especially in terms of human safety. Boeing came out of the crisis a leaner and smarter company. It had the jumbo jet market to itself until the arrival of the Airbus A380 in 2005. When the latest model, the 747-8, comes to the end of its production run, Boeing will have produced more than 1,550 747s, way beyond what its creators imagined possible.

The Boeing 747 development and marketing case clearly shows that the pursuit of higher profits and shareholder value, need not be at the expense of breaking the law or the loss of human life. Unfortunately, companies today undertake unsafe and/or unethical actions in order to earn higher profits, as the cost of these actions are often easily absorbed by the sheer volume of revenue generated by such unsafe or unethical actions. In other words, companies assess the profitability of law breaking or the loss of life by weighing the benefit to be gained against the cost of being caught (or people being killed) multiplied by the probability of being caught (or settling negligence lawsuits).

Volkswagen (VW) is a classic example of a company that has got away by doing practices that have not only broken the law, but also developed killing machines. VW installed software in diesel engines on nearly 600,000 VW, Porsche and Audi vehicles in the US that activated pollution controls during Government tests and switched them off in real-world driving. The software allowed the cars to spew harmful nitrogen oxide at up to 40 times above the legal limit. There are some estimations that the health of up to 200,000 people around the would have been negatively impacted by these actions alone, with many deaths attributed to the deadly air pollution. In all, some 11 million vehicles worldwide were equipped with the software (ABC News, 2017) [8].

US regulators confronted VW about the software after university researchers discovered differences in testing and real-world emissions. Volkswagen at first denied the use of the so-called defeat device but finally admitted it in September of 2015. Volkswagen reached a $US15 billion civil settlement with environmental authorities and car owners in the US under which it agreed to repair or buy back up to a half-million of the affected vehicles.

Such negative publicity, massive criminal charges, huge civil settlements and potential investor lawsuits and criminal probes should surely have affected its share price in the long-run?

Not so. After a massive 20% fall when the diesel-emissions scandal broke in October 2015, just two-years later in November 2017, Volkswagen AG’s share price was back above where it was. Since its nadir in October 2015, the company has clawed back more than 35 billion euros (US$40 billion) in market value (Bloomberg, 2017) [9] . In fact, in April 2018, Volkswagen AG’s share price rose despite a drop in earnings (McGee 2018)! [10]

Whilst management accountants undertake cost-benefit analyses on a regular basis, a higher moral and ethical standard must be applied when these numbers are used as ammunition pertaining to conflicting objectives. This is especially the case when there is a conflict between the objective of maximising a company’s shareholder value vs. the social responsibility objective of keeping its customers safe.

The famous (infamous?) case of this profit vs. social responsibility conflict is the Ford Pinto Case. The Ford Pinto was a small car designed to compete with foreign cars of the company’s competitors in the 1970s. It had a target selling price of US$ 2,000. It was a rushed project, led by Lee Iacocca, in which the planning took just 25 months compared to the industry norm (of that time) of 43 months.

Ford’s testing found several defects: (a) at 25 mph and over, the gas tank would rupture in an accident; (b)  at 30 mph and over the rear endings would cause the gas tank to leak and the  rear of the car to be folded into the back seats and (c) at 40 mph and over the car doors would jam. Still, much to the disgust of the production engineers, Ford’s top management rushed the Pinto to the market. It was a veritable killing machine and consequently, there were several serious burn injuries and deaths when these low-speed accidents inevitably happened.

In 1973, under instructions from top management, Ford’s engineers and management accountants developed a cost-benefit analysis entitled Fatalities Associated with Crash Induced Fuel Leakage and Fires for submission to the NHTSA in support of Ford’s objection to proposed stronger fuel system regulation. The document became known as the “Pinto Memo”.

In this memo, the cost-benefit analysis appeared to compare the cost of recalling and repairing the faulty product vis-à-vis the societal costs for injuries and deaths related to expected future fires of the Ford Pinto. If Ford recalled the car, it would cost them be $11 per car for the safety alterations for a total of US$137 million. However, if Ford ignored the fact that they will be killing their customers, and accepted the legal costs of settling claims, it would cost them considerably less. The actuaries estimated that, based on the faulty cars sold, there would be a maximum of 180 future burn deaths, 180 serious burns and 2100 burnt Pintos that would need to be replaced. By using a settlement value of US$200,000 per death; US$ 67000 per serious injury[11], and US$ 700 per car 700, it would only cost Ford US$49.5 million; i.e. a saving of US$ 87.5 million, if they did not do a safety recall of the Pinto.

The reality was that the “Pinto Memo” was a well-researched, but poorly communicated document. The cost-benefit analysis actually compared the cost of repairs to the societal costs for injuries and deaths related to fires in cases of vehicle rollovers for all cars sold in the US by all manufacturers (not just Ford). In the memo Ford also estimated the cost of fuel system modifications to reduce fire risks in rollover events to be $11 per car across 12.5 million cars and light trucks (i.e. of all manufacturers), for a total of $137 million.

The public misunderstanding of the cost-benefit analysis has contributed to the mythology of the Ford Pinto case. The Time magazine said the memo was one of the automotive industry’s “most notorious paper trails”.[12] A common misconception is that the document considered Ford’s tort liability costs rather than the generalized cost to society and applied to the annual sales of all passenger cars, not just Ford vehicles. However, the bottom-line is that Ford did not recall the Pinto, and thus when the Pinto Memo surfaced, it was a public relations disaster for Ford as it implied Ford was callously trading lives for profits.

This shows the importance clearly communicating the management accounting numbers on which critical decisions are made, especially where a company’s products and services may endanger human lives. It also shows that human life cannot be equated to a monetary value in settling a legal liability.

 

Professor Janek Ratnatunga, CMA, CGBA

CEO, ICMA Australia

 

The opinions in this article reflect those of the author and not necessarily that of the organisation or its executive

[1] Bloomberg (2019), “The Grounded 737 Max is Turning into a Major Debacle for Boeing”, March 18.

[2] The A320 original design could house the larger engine under its wings.

[3] Dominic Gates (2019), “Flawed analysis, failed oversight: How Boeing, FAA certified the suspect 737 MAX flight control system, Seattle Times, March 21.

[4] W.J. Hennigan (2019), Second Hand Safety, Time Magazine, April 1. pp.43-45.

[5] All 4 engines did stop when a British airways flight flew into volcanic ash, and the 747 became a glider, but all recovered when the plane got out of the ash.

[6] Bruce Dorminey, (2019), “5 Things You Likely Never Knew About Boeing’s 747” Forbes, Feb 16, https://www.forbes.com/sites/brucedorminey/2019/02/16/5-things-you-likely-never-knew-about-boeings-747/#21f427b62422

[7] Wikipedia (2019) “Boeing 747 hull losses”, 6 April. https://en.wikipedia.org/wiki/Boeing_747_hull_losses

[8] ABC News (2017) “Volkswagen pleads guilty in emissions scandal, agrees to $5.7 billion settlement, ABC News, Updated 12 Jan 2017 http://www.abc.net.au/news/2016-10-26/us-judge-approves-record-deal-in-volkswagen-diesel-scandal/7965280

[9] Bloomberg (2017), Scandal? What VW Scandal? Bloomberg, Nov 2017. https://www.bloomberg.com/gadfly/articles/2017-11-02/vw-s-40-billion-recovery-is-nothing-to-celebrate

[10] Patrick McGee (2018) “VW shares rise despite drop in earnings”, Financial Times, April 26, 2018. https://www.ft.com/content/e334fcc0-492e-11e8-8ee8-cae73aab7ccb

[11] The values assigned to serious burn injuries and loss of life were based on values calculated by NHTSA in 1972.

[12] Time Staff and Dan Neil (2017), “The 50 Worst Cars of All Time”, Time magazine, April 25. http://time.com/4723114/50-worst-cars-of-all-time/