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Cost-Based Pricing by Darrell J. Oyer CPA - Read Online
by Darrell J. Oyer CPA
• Develop more realistic estimates
• Enhance your support of those estimates in negotiations
• Avoid violations of the Truth in Negotiations Act
• Increase your chances of securing a fair and reasonable price
Publisher: Berrett-Koehler Publishers, Inc.Released: Oct 1, 2012ISBN: 9781567263718Format: book
Cost-Based Pricing - Darrell J. Oyer CPA
Phone: 703.790.9595
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.
2012939565
978-1-56726-369-5
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.
Chapter 1: Pricing Concepts
Chapter 2: Direct-Labor Dollars
Direct-Labor Hours
Direct-Labor Rates
Chapter 3: Direct Material and Subcontract Costs
Subcontract Prices
Indirect Cost Structure
FAR Subpart 31.2 Cost Limitations
Chapter 5: Other Direct Costs
Establishing Other Direct Costs
Estimating Other Direct Costs
Chapter 6: Facilities Capital Cost of Money
Chapter 7: Profit or Fee
Department of Defense Profit Guidelines
Other Agencies’ Guidelines
Chapter 8: Federal Acquisition Regulation Requirements
Field Pricing Support
Consistency in Estimating and Recording Costs
Price and Cost Realism
Estimating Systems—FAR
Estimating Systems—Defense FAR Supplement
Defense Contract Audit Agency Proposal Reviews
Chapter 9: Contract Modifications
Direct Materials and Subcontracts
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
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
Chapter 12: Defense Contract Audit Agency Proposal Reviews
Chapter 13: The Truth-in-Negotiations Act (Public Law 87-653)
Special Subcontracting Considerations
Proving Defective Pricing
Preventing Defective Pricing
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
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
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
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
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
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.
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.
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.
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.
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.
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.
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
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.
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