Cost-Based Pricing: A Guide for Government Contractors

Cost-Based Pricing

A Guide for Government Contractors

Darrell J. Oyer

8230 Leesburg Pike, Suite 800

Tysons Corner, Virginia 22182

Phone: 703.790.9595

Fax: 703.790.1371

www.managementconcepts.com

Copyright © 2012 by Management Concepts Press, Inc.

All rights reserved. No part of this book may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by an information storage and retrieval system, without permission in writing from the author and the publisher, except for brief quotations in review articles.

Printed in the United States of America

Library of Congress Control Number

2012939565

978-1-56726-369-5

10 9 8 7 6 5 4 3 2 1

About the Author

Darrell J. Oyer, CPA, is president of Darrell J. Oyer Co., a consulting firm that provides accounting services and training to government contractors and federal government employees. He is highly experienced in developing and reviewing contractor estimating systems, cost accounting structures, and other business systems to ensure compliance with federal procurement requirements. Prior to forming his own firm in 1991, Mr. Oyer was a partner in the Deloitte & Touche government contracts advisory practice. Previously, he worked for the Defense Contract Audit Agency and the U.S. Air Force Auditor General’s office.

To Irving J. Sandler, my long-time mentor, in gratitude for his contributions to my knowledge of estimating.

Contents

Preface

Chapter 1: Pricing Concepts

Cost-Based Pricing

Parametric Estimating

Should-Cost Pricing

Other Pricing and Estimating Methods

Chapter 2: Direct-Labor Dollars

Direct-Labor Hours

Direct-Labor Rates

Basis of Estimate

Chapter 3: Direct Material and Subcontract Costs

Material Quantities

Material Prices

Subcontract Prices

Intercompany Transfers

Basis of Estimate

Chapter 4: Indirect Costs

Indirect Cost Structure

FAR Subpart 31.2 Cost Limitations

Estimating Principles

Estimating Worksheets

Chapter 5: Other Direct Costs

Establishing Other Direct Costs

Estimating Other Direct Costs

Currency Exchange

Basis of Estimate

Chapter 6: Facilities Capital Cost of Money

Chapter 7: Profit or Fee

The Federal Acquisition Regulation

Department of Defense Profit Guidelines

NASA Guidelines

Other Agencies’ Guidelines

Chapter 8: Federal Acquisition Regulation Requirements

FAR Table 15-2

Field Pricing Support

Consistency in Estimating and Recording Costs

Price and Cost Realism

Estimating Systems—FAR

Estimating Systems—Defense FAR Supplement

Forward Pricing Rate Agreements

Defense Contract Audit Agency Proposal Reviews

Proposal Presentation

Chapter 9: Contract Modifications

Direct-Labor Hours

Direct-Labor Rates

Direct Materials and Subcontracts

Other Direct Costs

Estimating Techniques

Profit

Chapter 10: Improvement Curves

Application of the Improvement Curve Concept

Description of the Improvement Curve

Fitting the Improvement Curve to Data

Characteristics of the Improvement Curve

Improvement Curve Types

Fitting the Improvement Curve to Lot Data

Improvement Curve Techniques

Coefficient of Determination

Selection of the Curve

Engineering and Other Changes

Variations in the Theory

Chapter 11: Commercial and Market-Based Pricing

Commercial and Market Pricing

Commercial Pricing Additives

Price Analysis

Value-Based Pricing

Incremental Pricing

Activity-Based Costing and Pricing

Design-to-Cost

Chapter 12: Defense Contract Audit Agency Proposal Reviews

Direct Labor

Direct Materials

Other Direct Costs

Indirect Costs

Chapter 13: The Truth-in-Negotiations Act (Public Law 87-653)

Covered Contracts

Special Subcontracting Considerations

Proving Defective Pricing

Letter Contracts

Preventing Defective Pricing

Appendices

Appendix A: Audit Program for Evaluation of Cost Realism in Price Proposals

Appendix B: Audit Program for Estimating System Controls

Appendix C: Audit Program for Audit of Forward Pricing Rate Agreement

Appendix D: Audit Program for Price Proposal

Appendix E: Audit Program for Cost Element Review

Appendix F: Internal Control Matrix for Audit of Estimating System Controls

Index

Illustrations

2-1: Basis of Estimate for Direct Labor

3-1: Basis of Estimate for Subcontract, Material, Consultants, or Contract Labor

4-1: Employee Worksheet

4-2: Fringe Benefit Calculation Worksheet

4-3: Overhead Calculation Worksheet

4-4: General and Administrative Calculation Worksheet

4-5: Pricing Factors

4-6: Fringe Benefits

4-7: Overhead

4-8: General and Administrative

5-1: Basis of Estimate for Other Direct Costs

6-1: Facilities Capital Cost of Money Factors Computation

6-2: Contract Facilities Capital Cost of Money

7-1: Record of Weighted Guidelines Application

7-2: Structured Approach Profit/Fee Objective

7-3: Example of Application of Department of Energy Guidelines

8-1: FAR 15.408 Solicitation Provisions and Contract Clauses

8-2: Standard Form 1411, Contract Pricing Proposal Cover Sheet

8-3: DFARS Proposal Adequacy Checklist

8-4: Price Proposal, Acme Manufacturing Company

8-5: Price Proposal, Acme Services Company

9-1: Impact of Delayed Work—Costs for Accounting Period

9-2: Impact of Delayed Work—Unabsorbed Overhead Cost Allocation

9-3: Facts for Unabsorbed Overhead Calculations

9-4: Eichleay Method

9-5: Eichleay Variation Method

9-6: Allegheny Method

9-7: Carteret Method

9-8: Burden Fluctuation

9-9: Hudson or Canadian Method

9-10: Simulation Method

9-11: Enstrom Method

9-12: Manshul Method

9-13: Emden Method

9-14: Impact of Delayed Work—Extended Overhead

10-1: Learning Curve on Regular Chart Paper

10-2: Learning Curve on Log-Log Paper

10-3: Learning Curve Slopes of 70%, 80%, and 90%

10-4: Data Point Around Trend Line

10-5: Theoretical Unit #1

10-6: Multiple Learning Curve Projections

10-7: Significant Cost Reduction

10-8: Unit Curve Theory Versus Cumulative Average Theory

10-9: Cumulative Average Theory Versus Unit Curve Theory

10-10: Unit Curve Theory and Cumulative Average Theory

10-11: Impact of Engineering Change

10-12: Engineering Change—Component A

10-13: Engineering Change—All Other Components

10-14: Impact of Retained Learning

10-15: Impact of Break in Production

10-16: Lost Learning Calculation

13-1: Truth-in-Negotiations Act Data Sweep Checklist

13-2: Certificate of Current Cost or Pricing Data

Tables

10-1: Unit Theory Data

10-2: Cumulative Average Theory Applied to Unit Theory Data

10-3: Unit Theory Applied to Cumulative Average Theory Data

10-4: Calculation of Average Hours Based on Equivalent Units

10-5: Status of Production

10-6: Calculation of Equivalent Units

10-7: Learning Curve Data with Change at Lot 6

10-8: Data on Unchanged Portion of Work

10-9: Data on All Work

Exhibits

1-1: Market-Based Pricing and Cost-Based Pricing

7-1: Profit Weighting for Technical and Management Risk

7-2: Profit Guidelines for Standard and Technology Incentives

7-3: Annotated Extract from DD Form 1547

7-4: Profit Objectives (Normal Values and Designated Ranges) by Contract Type Risk

7-5: Contract Length Factors

7-6: Calculation of Working Capital Adjustment

7-7: Calculation of Facilities Capital Employed

7-8: Normal Values and Designated Ranges by Asset Type

9-1: Examples of Potential Claim Scenarios

10-1: Lost Learning Factors

10-2: Sample Application of Lost Learning Calculation

Preface

Cost-based pricing refers to the practice of estimating prices based on estimated cost plus a reasonable profit, as opposed to estimating a price based on the value received and other market circumstances. In government contracting, this distinction is significant, in that most government personnel and most regulations greatly favor using cost-based pricing. Cost-based pricing is necessitated by the government’s inability to purchase all needed goods and services in a commercial market. Until World War I, the government could purchase everything it needed in a commercial pricing environment; the advent of complex weapon systems not for sale in a commercial market required a cost-based pricing approach.

This book is intended to be used primarily by price estimators but also by pricing managers, business development personnel, accountants, subcontract administrators, and contract negotiators—in summary, anyone involved in the process of estimating and negotiating contract prices. Mastery of each topic is necessary to develop a complete pricing proposal.

Price estimating is not a common topic in college curricula, which train accountants to be auditors and accountants but not to be price estimators or pricing specialists. Yet in the government contracting environment, accountants are often required to do as much estimating as they do cost accounting. Most cost-estimating techniques are learned through on-the-job training and specialty courses designed strictly for government contract-estimating situations. This book is a response to the resulting need for a general description of the entire pricing process that will directly assist personnel in preparing or reviewing cost-based proposals. Its purpose is to review the practical techniques involved in estimating costs and prices for federal government contracts, with a heavy focus on cost-based pricing. In addition to the practical aspects of cost estimating, this book deals with requirements in the Federal Acquisition Regulation (FAR) Part 15 and issues arising from proposal reviews by government auditors and other reviewers. Use of this book will save time for contractors and will result in better-prepared and more defensible cost proposals.

Although cost-based prices dominate in the pricing of government contracts, estimating prices for government contracts involves both cost-based and market-based prices. Cost-based pricing pertains to cost reimbursement contracts and fixed price contracts that do not result from competition, because federal funds may be used by the state or local government in awarding a contract. Market-based pricing is less common in government contracts but is appropriate for commercial items purchased by the government. Because market-based pricing techniques are well established for commercial purposes, they are a secondary focus of this book.

This preface provides an introduction to the general topic of cost-based pricing. Chapter 1 explains basic pricing concepts and details the differences between cost-based pricing and other types of pricing. Chapters 2 through 6 address the cost elements that make up a cost-based price: (1) direct labor, (2) direct materials and subcontracts, (3) indirect costs, (4) other direct costs, and (5) facilities capital cost of money. Indirect costs consist of overhead and general and administrative expenses. Contractors may, of course, have more than one overhead pool, but each business unit may have only one general and administrative cost pool. This book does not address in detail the concepts of establishing direct costs versus indirect costs or establishing an indirect cost structure. An indirect cost structure is established in the types and number of indirect-cost pools needed to properly allocate indirect costs. For the purposes of this book, it is assumed that a company preparing a proposal already has these policies and procedures in place. If the reader needs further instruction regarding these policies and procedures, textbooks discussing how to distinguish between direct and indirect costs and how to establish an indirect cost structure are available.¹

Chapter 7 addresses the concept of markup, also known as profit or fee—specifically, the amount of profit or fee generally accepted by the government for the various contracting circumstances. Chapter 8 reviews requirements imposed by the FAR regarding the submission of price proposals, with Table 15-2 of the FAR (Instructions for Submitting Cost/Price Proposals When Certified Cost or Pricing Data Are Required) covered in detail. Other concepts addressed in this chapter are consistency of accounting practices as established by the FAR, the Cost Accounting Standards (CAS), and the CAS Board disclosure statement; government concerns regarding cost; and price realism (e.g., pricing too low). The fundamental FAR and CAS principles require consistency between estimating and recording costs; thus, the topics of estimating and cost accounting are intertwined.

Pricing contract modifications are discussed in detail in Chapter 9. Contract modifications are important in assuring maintenance of appropriate profit levels; a contractor who accepts changes in the form of increased work without compensation reduces profits unreasonably. Chapter 10 provides an extensive discussion of improvement curves. A basic principle of estimating labor hours is the concept that labor hours decrease as additional quantities are produced. Chapter 11 describes market- or value-based pricing; the FAR is clearly deficient in describing these methods. Chapter 12 describes Defense Contract Audit Agency (DCAA) audit guidance on review of proposals. This guidance is contained in the DCAA Contract Audit Manual and has been modified frequently in recent years as a result of pressures on DCAA to be more aggressive during proposal reviews. Chapter 13 addresses the requirements of the Truth-in-Negotiations Act and techniques for avoiding allegations of defective pricing. This legislation establishes a basis for price adjustments if a contractor does not disclose all current, accurate, and complete cost or pricing data. This topic is most important to those personnel negotiating prices with the government.

Darrell J. Oyer, CPA

January 2012

____________

¹ For example, Chapter 3 of Oyer, Darrell. Pricing and Cost Accounting: A Handbook for Government Contractors. 3rd ed. Vienna, VA: Management Concepts Press, 2011.

CHAPTER 1

Pricing Concepts

The pricing method preferred by the Federal Acquisition Regulation (FAR) is cost-based—in other words, the detailed, grassroots , or bottom-up approach. This method segregates activities with costs into their smallest component tasks, which are then supported with details such as bills of materials, hours (based on history), or work-measurement standards and rates based on historical rates. Price proposals based on cost estimates require an evaluation by the government customer—in the Department of Defense (DoD), by either the Defense Contract Audit Agency (DCAA) or the Defense Contract Management Agency (DCMA). Government evaluations of price proposals are frequently referred to as audits and are based on the FAR—Part 15 for pricing, Part 30 for cost, Part 30 for Cost Accounting Standards, and Part 31 for cost allowability.

Pricing encompasses all of a contractor’s activities in offering a price to the government customer. Pricing considerations include market research, cost estimates, market conditions, market objectives, long-range contractor plans, and contractor workload. The focus of this book is on the cost-estimating aspect.

Cost-based pricing is used in all cost-reimbursement contracts, where the price is based on an after-the-fact audit of actual cost. Variations of cost-type contracts include cost-plus-fixed-fee, cost-plus-incentive-fee, cost-plus-award-fee, cost sharing, cost (only), and the materials portion of a time-and-materials contract. Cost-based pricing also is used in negotiated fixed-price contracts, where the price is determined not by competition but by negotiation based on estimated cost (or on actual cost if the work has already been performed). Variations of fixed-price-type contracts include firm-fixed-price, fixed-price-incentive-fixed, fixed-price-award-fee, fixed-price with successive targets, fixed-price redeterminable, labor-hour contract, and the labor portion of time-and-materials contracts.

COST-BASED PRICING

Cost-based pricing differs from other pricing techniques in several ways. Cost-based pricing uses actual or estimated costs to determine the price of a government contract. Price is established by adding a profit or fee to these actual or estimated costs. Compared with market-based pricing, cost-based pricing is much more difficult to perform and subject to many more regulations. For example, the cost principles in FAR Part 31 apply when using cost-based pricing. Profit or fee is not significantly subject to regulation but is more prominently influenced by federal agency guidelines on negotiating profit or fee. Some legislated fee limits exist for cost-plus-fixed-fee contracts and for architect-and-engineering contracts; existing regulations do not address what fee a contractor may request but do provide guidelines to the government contracting officers. In market-based pricing, cost allowability and profit levels are irrelevant in that the price is assessed by the potential customer in terms of value received by purchasing the goods or services rather than by the cost (or estimated cost) to the seller.

By contrast, market-based pricing consists of a single figure for the price, which the buyer evaluates based on the perceived benefit or value received. The estimated cost and the amount of profit are irrelevant to the buyer’s decision; the value of the goods is simply assessed and compared to the price by the buyer. Prices of competitors’ products and services might be also compared in this decision process. In addition, completely different alternative solutions can be compared to one another.

Exhibit 1-1 shows the distinction between market-based and cost-based pricing.

EXHIBIT 1-1:

Market-Based Pricing and Cost-Based Pricing

In accordance with FAR Part 15, cost-based pricing is a structured pricing approach that is based on FAR-determined cost elements. Cost elements are the components of an estimated cost and consist of direct labor (Chapter 2), materials and subcontracts (Chapter 3), indirect costs (Chapter 4), other direct costs (Chapter 5), and facilities capital cost of money (Chapter 5). Chapter 7 addresses the topic of profit or fee.

Need for Cost-Based Pricing

Cost-based government contract pricing has its origins in World War I. Before that time, the federal government purchased goods and services mostly available to the general public—horses, guns, wagons, foodstuffs, and so on. The need to design and build advanced, technological, and highly specialized war machinery—such as tanks and airplanes—not sold to the general public caused a shift to cost-based pricing, for good reason. If a company had had to accept a firm-fixed-price contract to design and build the first United States government–purchased tank, the price would have been exceptionally high due to the uncertainties of production cost, technological feasibility, production quantity, and price stability of materials. Sellers would have had to include substantial contingencies to be assured of a profitable contract. Setting the price at allowable cost plus a fixed fee removed enough risk from the seller that the total price was much less than that for a fixed-price contract.

Note the use of the word allowable to describe reimbursed costs in the previous paragraph. Clearly, the government did not want to give any contractor a blank check. Certain costs were considered to be not reimbursable due to public policy. Thus, FAR Part 31 now provides detailed guidance on what costs are unallowable. For example, entertainment costs are unallowable because entertaining government officials is not allowed; thus, taxpayer money should not be paid to contractors to cover costs of entertainment.

Often cost-reimbursement contracts are rightly criticized as not providing an incentive for a contractor to reduce costs, because cost reductions result in a lower price for the next sale and less profit. This is a valid criticism, but this contract type still has value for certain procurements where the risk under a fixed-price contract is so great that the resulting prices would be extremely high.

Work Breakdown Structure

When cost-based pricing is used, the work breakdown structure concept is often needed to adequately apply cost-based pricing techniques. This concept was developed in 1957 by DoD as part of the program evaluation and review technique (PERT). PERT did not use the term work breakdown structure. However, PERT was the forerunner of the work breakdown structure; PERT-Cost was the forerunner of earned value management systems, and PERT-Time was the forerunner of the critical path method. The term work breakdown structure was first used in 1968 in a DoD document, Work Breakdown Structures for Defense Materiel Items (MIL-STD-881). The general purpose of these various techniques was to allow accurate and timely estimating of the cost of a program at completion. DoD in particular has been plagued by programs experiencing surprise cost overruns. The DCMA Web site (www.dcma.mil) contains useful information on the government review of earned value management systems.

A work breakdown structure is developed by starting with the end objective and successively subdividing it into manageable components (i.e., in terms of size, duration, and responsibility) that include all steps necessary to achieve the objective. The work breakdown structure provides a common framework for the natural development of the overall planning and control of a contract and is the basis for dividing work into definable increments from which the statement of work or statement of objectives can be developed and technical, schedule, cost, and labor-hour reporting can be established. A work breakdown structure permits summing of subordinate costs for tasks, materials, and so on into their successively higher-level parent tasks and materials. For each element of the work breakdown structure, a description of the task to be performed is generated.

A work breakdown structure is organized around the primary products (or planned outcomes) of the project instead of the work needed (or planned actions) to produce the products. Since the planned outcomes are the desired ends of the project, they form a relatively stable set of categories in which to collect the costs of the planned actions needed to achieve them. A well-designed work breakdown structure makes it easy to assign each project activity to one—and only one—terminal element. In addition to its function in cost accounting, the work breakdown structure also helps map requirements from one level of system specification to another.

PARAMETRIC ESTIMATING

Parametric estimating techniques use a statistical relationship between historical data and other variables (e.g., square footage in construction or lines of code in software development) to calculate an estimate. Parametric estimates of cost-to-cost relationships have been used for many years. Some examples are scrap costs to a priced bill of materials, non-touch labor to touch labor, sustaining engineering to initial engineering, and even other direct costs to direct labor costs.

In the mid-1950s, Rand Corporation in Santa Monica, California, developed the most basic tool of the cost-estimating discipline, the cost-estimating relationship, and merged this concept with the learning curve (discussed in Chapter 10) to form the foundation of aerospace parametric estimating. Rand derived cost-estimating relationships for aircraft cost as a function of such variables as speed, range, and altitude (known as AMPER Weights).

In the late 1970s, parametric models were expanded into two additional aspects. First, models were developed based on relationships of cost to noncost variables, such as feet of wiring in an aircraft. The mathematics and logic are basically the same as for cost-to-cost relationships. Second, models were developed to estimate the cost of an entire product rather than individual elements of cost for that product. For example, the speed of an aircraft, the weight of the aircraft, expected labor escalation, complexity compared to previous aircraft, and so on would be entered into the black box of a parametric model and the resulting answer would be a bottom-line estimate for the product. Proponents of this technique believe this approach can produce higher levels of accuracy, depending on the sophistication of the model and the underlying data built into the model, than the traditional grassroots buildup approach.

A popular initial software package called RCA Price was developed in the late 1960s by PRICE Systems, a cost-analysis unit of RCA. Through mergers and acquisitions, PRICE Systems successively became part of GE Aerospace, Martin Marietta, and Lockheed Martin. A management buyout from Lockheed Martin in 1998 formed the independent company known today as PRICE Systems, LLC. Other parametric software is available from several companies: SLM-Estimate; WinEstimator, Inc.; CostWorks RSMeans; SmartBidNet; PlanSwift; SEER; and d-tools.

The DCAA believes that parametric estimating techniques based on cost-estimating relationships are acceptable in the appropriate circumstances for proposing costs on government contracts and issued audit guidance on parametric systems as early as 1978. The DCAA criteria for a valid parametric estimate are:

Logical relationships. Contractors are expected to demonstrate that cost-to-noncost estimating relationships are logical. DCAA’s primary concern in this area is that contractors consider all reasonable estimating alternatives and do not use only the first apparent set of variables. Contractor analysis may disclose multiple alternatives that appear logical; statistical testing should be used to help identify the best choice.

Significant statistical relationships. Contractors are also expected to demonstrate that a significant statistical relationship exists among the variables used in a parametric cost-estimating relationship. Several statistical methods, such as regression analysis, graphic analysis, statistical sampling, and learning curves, can be used to validate a cost-estimating relationship; however, no single uniform test can be specified. Statistical testing may vary depending on an overall risk assessment and the unique nature of both a contractor’s parametric database and the related estimating system. Proposal documentation should describe the statistical analysis performed, including the contractor’s explanation of why the cost-estimating relationship is statistically valid.

Verifiable data. There must be a system in place for verifying data used for parametric cost-estimating relationships. In many instances, the reviewer will not have previously evaluated the accuracy of noncost data used in parametric estimates. To monitor and document noncost variables, contractors may need to modify existing information systems or develop new ones. Information that is adequate for day-to-day management needs may not be reliable enough for contract pricing. Data used in parametric estimates must be accurately and consistently available over a period of time and easily traced to or reconciled with source documentation.

Reasonably accurate predictions. The contractor’s demonstration that the parametric cost-estimating relationships it used predict costs with a reasonable degree of accuracy is important. If the contractor’s analysis of historical estimating and cost-performance data shows that the parametric estimating system is as accurate as a discrete estimating system, then the government has increased assurance of receiving a fair and reasonable price. As with any estimating relationship derived from previous history, it is essential for the contractor to document that the work being estimated with parametric cost-estimating relationships is comparable to the previous work from which the parametric database was developed.

Proper system monitoring. A contractor should also ensure that cost-to-noncost parametric rates and factors will be monitored periodically in the same manner as is expected for cost-to-cost rates and factors. Because of improved technology, production changes, or better pricing alternatives, cost-estimating relationships can and do change. The contractor should be prepared to revalidate a parametric cost-estimating relationship whenever system monitoring discloses that the relationship has changed.

DCAA believes parametric estimating approaches are acceptable when they are properly implemented. The reviewer encounters it most often as a technique used in conjunction with other estimating methods; the majority of audited proposals are not developed solely on the basis of parametric estimating techniques. For example, parametric techniques are often used for estimating costs of scrap and other such factors. The use of parametric estimating is most appropriate in such circumstances where historical data are not available, as when the program is at the engineering concept stage or when no bill of materials exists and the program definition is unclear. Contractors with good parametric cost-estimating systems analyze their draft or tentative proposal to determine the appropriate estimating technique for each part of the work breakdown structure.

Contractors should be satisfied that implementation and monitoring costs required to apply a parametric model do not outweigh the benefit of reduced administrative estimating costs due to use of parametric estimating techniques. Moreover, it is critical that the environment is appropriate for the use of parametric techniques; it would not be prudent to rely exclusively on parametric techniques to estimate costs when directly applicable historical cost data are available. Such is the case in follow-on production for the same or similar hardware. Contractors manufacturing mature weapon systems already have a record of the actual costs. The use of parametric estimating may be appropriate for certain aspects of follow-on production; however, the contractor should disclose any data that may have a significant impact on cost. The exclusive use of parametric models is generally not appropriate for economic forecasting of such elements as labor and indirect-cost rates. For parametric estimates, the contractor must ensure that any changes in accounting practices are accounted for in the estimate and that labor and indirect-cost rates are appropriately applied.

SHOULD-COST PRICING

Should-cost reviews are a specialized form of cost analysis. Although described in FAR Part 15, should-cost reviews are no longer common. Should-cost reviews differ from traditional evaluation methods in that they do not assume that a contractor’s historical costs reflect efficient and economical operation. Instead, these reviews evaluate the economy and efficiency of the contractor’s existing workforce, methods, materials, equipment, real property, operating systems, and management. These reviews are accomplished by a multifunctional team of government contracting, contract administration, pricing, audit, and engineering representatives. The objective of should-cost reviews is to promote both short- and long-range improvements in the contractor’s economy and efficiency to reduce the cost of performance of government contracts. In addition, by providing a rationale for any recommendations and quantifying their impact on cost, the government will be better able to develop realistic objectives for negotiation.

The two types of should-cost reviews are program should-cost review and overhead should-cost review. A program should-cost review is used to evaluate significant elements of direct costs such as materials and labor as well as the indirect costs usually associated with the production of major systems. When a program should-cost review is conducted relative to a contractor proposal, a separate audit report on the proposal is required.

An overhead should-cost review is used to evaluate indirect costs, such as fringe benefits, shipping and receiving, real property and equipment, depreciation, plant maintenance and security, taxes, and general and administrative activities. It is normally used to evaluate and negotiate a forward pricing rate agreement with the contractor. When an overhead should-cost review is conducted, a separate audit report is required.¹

OTHER PRICING AND ESTIMATING METHODS

Another estimating method is the comparative technique, which develops proposed costs using the costs for like items produced in the past as a baseline. Allowances are made for product dissimilarities as well as changes in such variables as complexity, scale, design, and materials by use of complexity factors, introduced in Chapter 2. A second technique is the judgmental method, which is a subjective estimation of costs using estimates of previous experience, judgment, memory, informal notes, and other data. It is typically used during the research and development phase when drawings have not yet been developed. A third technique is roundtable or estimating by consensus, whereby personnel from various disciplines discuss pricing, exchange views, and reach a consensus. Other commercial techniques focus on market pricing and may also include the above techniques, as addressed in Chapter 11.

Notes

1. A seldom-used DoD overhead analysis technique is probability of incurring estimated costs (PIECOST), developed by Otto Martinson in the late 1960s, the same time that should-cost pricing was developed.

CHAPTER 2

Direct-Labor Dollars

This chapter provides guidance on the estimating and pricing of direct-labor costs. ¹ This guidance addresses: (1) direct-labor hours, (2) direct-labor rates, and (3) other considerations in estimating direct-labor costs.

DIRECT-LABOR HOURS

The first step in estimating direct-labor costs is to estimate direct-labor hours. The source of information for the estimated hours varies according to the nature of the solicitation or request for proposal. For manufacturing and services, a solicitation might provide a statement of work that must be analyzed to estimate the number of direct-labor hours required. A statement of work is more common for the purchase of products, whereas the purchase of services might use the term statement of objectives. Regardless of the name, the concept is to develop direct-labor hour estimates based on the categories of labor required and the number of hours necessary for those labor categories. Sometimes product solicitations provide product specifications, which may require a contractor to design and build a product that meets a particular specification and to estimate the hours required to do so.

A solicitation might specify a level of effort for various labor categories; therefore, the number of direct-labor hours are a given. Another situation where estimating direct-labor hours is not important is for certain time-and-material or labor-hour contracts that may request only direct-labor rates (not hours). Direct-labor hours are provided in the solicitation; proposed rates are applied to these hours to estimate direct-labor dollars, to be used only for proposal evaluation purposes.

The government generally expects a detailed or grassroots buildup of cost estimates. This requires attention to detail to ensure that no cost is omitted from the estimate. One technique to assist in developing direct-labor hours involves the use of a work breakdown structure applied to the statement of work and is discussed in Chapter 1. This technique is also useful for cost elements other than direct labor and is described in Chapter 8.

Cost-estimating relationship techniques use a statistical relationship between historical cost data and other cost or noncost variables. Estimating techniques of cost-to-cost relationships have been used since many years before the development of CERs by Rand. Some examples of this are scrap costs to a priced bill of materials, non-touch direct-labor hours or dollars to touch direct-labor hours or dollars, sustaining engineering direct-labor hours or costs to initial engineering direct-labor hours or costs, and even other direct costs to direct-labor costs.

Previous production history is a good basis for developing an estimate of direct-labor hours but cannot be used blindly. Since the previous production, changes may have occurred in manufacturing processes, engineering, design, physical location of the work, or other significant attributes that would render the history unusable or limit its use. If such history is to be used, it should be reviewed for anomalies and to ensure that it corresponds to the conditions under which the product whose cost is being estimated will be manufactured.

A common problem contractors encounter is when a reviewer only considers historical data in evaluating a price proposal for work to be done in the future. Sometimes a reviewer is reluctant to complete a proposal evaluation unless historical data are made available. Some reviewers are not comfortable with contractor estimates and insist that estimates be based only on actual, historical cost information. The problem with this approach is that the results do not reflect the expected conditions during the future period where the work will be done but rather the historical data, which may or may not be pertinent. A reviewer may also look for the audit trail for a price proposal to support estimates with actual, historical cost data. This audit trail would be relevant only for work that has been completed. The term audit trail refers to a review or audit of costs that have been incurred and recorded in the books and records. When a proposal for work that has not been completed is being evaluated, the proper term is the basis of estimate, which is not found in the books and records but in documentation prepared to support a proposed price.

The basis of estimate may use historical data if they are relevant. For example, efficiency factors could be applied to historical data, or standard hours based on work measurement standards and time and motion studies could be adjusted for downtime due to personal fatigue. When labor hours are developed from a grassroots buildup, allowances must be made for legitimate downtime; employees require restroom breaks, walks to the coffee machine, and so on. These must be considered in estimating direct-labor hours. This factor, often termed personal time, fatigue, and delay, can be as great as 18 percent, depending on the work circumstances. The DCAA Contract Audit Manual (DCAM), Appendix I, Work Sampling, contains a discussion of this topic, but much of the meaningful discussion of appropriate percentages has been removed from the original guidance in a DCAA pamphlet. (The vital missing documents relate to support for the concept of personal time, fatigue, and delay.)

In a product environment, improvement curves are an excellent tool