PRICING AND ESTIMATION (CONTD.):MATERIALS/SUPPORT COSTS, PRICING OUT THE WORK

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LESSON 33

PRICING AND ESTIMATION (CONTD.)

BROAD CONTENTS

Materials/Support Costs

Pricing out the Work

System Pricing

Developing the Supporting/Backup Costs

The Low-Bidder Dilemma

Special Problems

Estimating Pitfalls

33.1

MATERIALS/SUPPORT COSTS:

Three of four major pricing input requirements are fulfilled by the salary structure, overhead

structure, and labor hours. The fourth major input is the cost for materials and support. Six

subtopics are included under materials/support: materials, purchased parts, subcontracts, freight,

travel, and other. Freight and travel can be handled in one of two ways, both normally

dependent on the size of the program. For small-dollar-volume programs, estimates are made

for travel and freight. For large dollar-volume programs, travel is normally expressed as

between 3 and 5 percent of the direct labor costs, and freight is likewise between 3 and 5

percent of all costs for material, purchased parts, and subcontracts. The category labeled "other

support costs" may include such topics as computer hours or special consultants.

Determination of the material costs is very time-consuming, more so than cost determination for

labor hours. Material costs are submitted via a bill of materials that includes all vendors from

whom purchases will be made, projected costs throughout the program, scrap factors, and shelf

lifetime for those products that may be perishable.

As depicted in the Figure 33.1 below, upon release of the work statement, work breakdown

structure, and subdivided work description, the end-item bill of materials and manufacturing

plans are prepared. End item materials are those items identified as an integral part of the

production end-item. Support materials consist of those materials required by engineering and

operations to support the manufacture of end-items, and are identified on the manufacturing

plan.

Figure 33.1: Material Planning Flow Chart

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Furthermore, a procurement plan/purchase requisition is prepared as soon as possible after

contract negotiations (using a methodology as shown in Figure 33.2 below). This plan is used to

monitor material acquisitions, forecast inventory levels, and identify material price variances.

Manufacturing plans prepared upon release of the subdivided work descriptions are used to

prepare tool lists for manufacturing, quality assurance, and engineering. From these plans a

special tooling breakdown is prepared by tool engineering, which defines those tools to be

procured and the material requirements of tools to be fabricated in-house. These items are

priced by cost element for input on the planning charts.

Figure 33.2: Procurement Activity

The materials/support costs are submitted by month for each month of the program. If long-lead

funding of materials is anticipated, then they should be as items must be applied to all

materials/support costs. Some vendors may provide fixed prices over time periods in excess of a

twelve-month period. As an example, vendor Z may quote a firm-fixed price of $130.50 per unit

for 650 units to be delivered over the next eighteen months if the order is placed within sixty

days. There are additional factors that influence the cost of materials.

33.2

PRICING OUT THE WORK:

Note that the logical pricing techniques are available in order to obtain detailed estimates. The

following thirteen steps provide a logical sequence in order to better control the company's

limited resources. These steps may vary from company to company.

Step 1: Provide a complete definition of the work

Step 2: Establish a logic network with checkpoints.

Step 3: Develop the work breakdown structure.

Step 4: Price out the work breakdown structure.

Step 5: Review WBS costs with each functional manager.

Step 6: Decide on the basic course of action.

Step 7: Establish reasonable costs for each WBS element.

Step 8: Review the base case costs with upper-level management.

Step 9: Negotiate with functional managers for qualified personnel.

Step 10: Develop the linear responsibility chart.

Step 11: Develop the final detailed and PERT/CPM schedules.

Step 12: Establish pricing cost summary reports.

Step 13: Document the result in a program plan.

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Although the pricing of a project is an iterative process, the project manager must still burden

himself at each iteration point by developing cost summary reports so that key project decisions

can be made during the planning. Detailed pricing summaries are needed at least twice: in

preparation for the pricing review meeting with management and at pricing termination. At all

other times it is possible that ''simple cosmetic surgery" can be performed on previous cost

summaries, such as perturbations in escalation factors and procurement cost of raw materials.

The list identified below shows the typical pricing reports:

A detailed cost breakdown for each Work Breakdown Structure (WBS) element. If the work

is priced out at the task level, then there should be a cost summary sheet for each task, as

well as rollup sheets for each project and the total program.

A total program manpower curve for each department. These manpower curves show how

each department has contracted with the project office to supply functional resources. If the

departmental manpower curves contain several "peaks and valleys," then the project

manager may have to alter some of his schedules to obtain some degree of manpower

smoothing. Functional managers always prefer manpower-smoothed resource allocations.

A monthly equivalent manpower cost summary. This table normally shows the fully

burdened cost for the average departmental employee carried out over the entire period of

project performance. If project costs have to be reduced, the project manager performs a

parametric study between this table and the manpower curve tables.

A yearly cost distribution table. This table is broken down by WBS element and shows the

yearly (or quarterly) costs that will be required. This table, in essence, is a project cash-flow

summary per activity.

A functional cost and hour summary. This table provides top management with an overall

description of how many hours and dollars will be spent by each major functional unit, such

as a division. Top management would use this as part of the forward planning process to

make sure that there are sufficient resources available for all projects. This also includes

indirect hours and dollars.

Monthly labor hour and dollar expenditure forecast. This table can be combined with the

yearly cost distribution, except that it is broken down by month, not activity or department.

In addition, this table normally includes manpower termination liability information for

premature cancellation of the project by outside customers.

A raw material and expenditure forecast. This shows the cash flow for raw materials based

on vendor lead times, payment schedules, commitments, and termination liability.

Total program termination liability per month. This table shows the customer the monthly

costs for the entire program. This is the customer's cash flow, not the contractor's. The

difference is that each monthly cost contains the termination liability for man-hours and

dollars, on labor and raw materials. This table is actually the monthly costs attributed to

premature project termination.

It is important to note that these tables are used by both project managers and upper-level

executives. The project managers utilize these tables as the basis for project cost control. Top-

level management utilizes them for selecting, approving, and prioritizing projects.

33.3

SYSTEMS PRICING:

The basis of successful program management is the establishment of an accurate cost package

from which all members of the organization can both project and track costs. The cost data must

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be represented in such a manner that maximum allocation of the corporate resources of people,

money, and facilities can be achieved.

In addition, the systems approach to pricing out the activity schedules and the work breakdown

structure provides a means for obtaining unity within the company. The flow of information

readily admits the participation of all members of the organization in the program, even if on a

part-time basis.

Functional managers obtain a better understanding of how their labor fits into the total program

and how their activities interface with those of other departments. For the first time, functional

managers can accurately foresee how their activity can lead to corporate profits.

Figure 33.3: System Approach to Resource Control

As shown in Figure 33.3 above the project pricing model (sometimes called a strategic project

planning model) acts as a management information system, forming the basis for the systems

approach to resource control. The summary sheets from the computer output of the strategic

pricing model provide management with the necessary data from which the selection of possible

programs can be made so that maximum utilization of resources will follow.

The strategic pricing model also provides management with an invaluable tool for performing

perturbation analysis on the base case costs. This perturbation analysis provides management

with sufficient opportunity for design and evaluation of contingency plans, should a deviation

from the original plan be required.

33.4

DEVELOPING THE SUPPORTING/BACKUP COSTS:

Remember that not all cost proposals require backup support, but for those that do, the backup

support should be developed along with the pricing. Extreme caution must be exercised to make

sure that the itemized prices are compatible with the supporting data. Government pricing

requirements are a special case.

Most supporting data come from external (subcontractor or outside vendor) quotes. Internal data

must be based on historical data, and these historical data must be updated continually as each

new project is completed. The supporting data should be traceable by itemized charge numbers.

It must be kept in mind that customers may wish to audit the cost proposal. In this case, the

starting point might be with the supporting data. It is not uncommon on sole-source proposals to

have the supporting data audited before the final cost proposal is submitted to the customer.

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Not all cost proposals require supporting data; the determining factor is usually the type of

contract. On a fixed-price effort, the customer may not have the right to audit your books.

However, for a cost-reimbursable package, your costs are an open book, and the customer

usually compares your exact costs to those of the backup support.

Commonly, most companies usually have a choice of more than one estimate to be used for

backup support. In deciding which estimate to use, consideration must be given to the

possibility of follow-on work:

If your actual costs grossly exceed your backup support estimates, you may lose credibility

for follow-on work.

If your actual costs are less than the backup costs, you must use the new actual costs on

follow-on efforts.

We see that the moral here is that backup support costs provide future credibility. If you have

well-documented, "livable" cost estimates, then you may wish to include them in the cost

proposal even if they are not required.

Since both direct and indirect costs may be negotiated separately as part of a contract,

supporting data such as those in the following four Tables (33.1, 33.2, 33.3 and 33.4

respectively) and Figure 33.4 following them may be necessary to justify any costs that may

differ from company (or customer-approved) standards.

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Tables 33.1 and 33.2

Table 33.3: Staff Turnover Data

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Table 33.4: Staff Experience Profile

Figure 33.4: Total Reimbursable Manpower

33.5

THE LOW-BIDDER DILEMMA:

There is little argument about the importance of the price tag to the proposal. The question is

what price will win the job? Everyone has an answer to this question. The decision process that

leads to the final price of your proposal is highly complex with many uncertainties. Yet

proposal managers, driven by the desire to win the job, may think that a very low-priced

proposal will help. But, hopefully, winning is only the beginning. Companies have short- and

long-range objectives on profit, market penetration, new product development, and so on. These

objectives may be incompatible with or irrelevant to a low-price strategy per se; for example:

A suspiciously low price, particularly on cost-plus type proposals, might be perceived by

the customer as unrealistic, thus affecting the bidder's cost credibility or even the technical

ability to perform.

The bid price may be unnecessarily low, relative to the competition and customer budget,

thus eroding profits.

The price may be irrelevant to the bid objective, such as entering a new market. Therefore,

the contractor has to sell the proposal in a credible way, e.g., using cost sharing.

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Low pricing without market information is meaningless. The price level is always relative

to (1) the competitive prices, (2) the customer budget and (3) the bidder's cost estimate.

The bid proposal and its price may cover only part of the total program. The ability to win

phase II or follow-on business depends on phase I performance and phase II price.

The financial objectives of the customer may be more complex than just finding the lowest

bidder.

They may include cost objectives for total system life-cycle cost (LCC), for design to unit

production cost (DTUPC), or for specific logistic support items. Presenting sound approaches

for attaining these system costperformance parameters and targets may be just as important as,

if not more important than, a low bid for the system's development.

In addition to this, it is refreshing to note that in spite of customer pressures toward low cost and

fixed price, the lowest bidder is certainly not an automatic winner. Both commercial and

governmental customers are increasingly concerned about cost realism and the ability to

perform under contract. A compliant, sound, technical and management proposal, based on past

experience with realistic, well documented cost figures, is often chosen over the lowest bidder,

who may project a risky image regarding technical performance, cost, or schedule.

33.6

SPECIAL PROBLEMS:

It is essential to note that there are always special problems that, although often overlooked,

have a severe impact on the pricing effort. As an example, pricing must include an

understanding of cost control-- specifically, how costs are billed back to the project. There are

three possible situations:

1. Work is priced out at the department average, and all work performed is charged to the

project at the department average salary, regardless of who accomplished the work. This

technique is obviously the easiest, but encourages project managers to fight for the highest

salary resources, since only average wages are billed to the project.

2. Work is priced out at the department average, but all work performed is billed back to the

project at the actual salary of those employees who perform the work. This method can

create a severe headache for the project manager if he tries to use only the best employees

on his project. If these employees are earning substantially more money than the department

average, then a cost overrun will occur unless the employees can perform the work in less

time. Some companies are forced to use this method by government agencies and have

estimating problems when the project that has to be priced out is of a short duration where

only the higher-salaried employees can be used. In such a situation it is common to ''inflate"

the direct labor hours to compensate for the added costs.

3. The work is priced out at the actual salary of those employees who will perform the work,

and the cost is billed back the same way. This method is the ideal situation as long as the

people can be identified during the pricing effort.

In this regard, some companies use a combination of all three methods. In this case, the project

office is priced out using the third method (because these people are identified early), whereas

the functional employees are priced out using the first or second method.

33.7

ESTIMATING PITFALLS:

There are several pitfalls that can impede the pricing function. Probably the most serious pitfall,

and the one that is usually beyond the control of the project manager, is the "buy-in" decision,

which is based on the assumption that there will be "bail-out" changes or follow-on contracts

later. These changes and/or contracts may be for spares, spare parts, maintenance, maintenance

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manuals, equipment surveillance, optional equipment, optional services, and scrap factors.

Other types of estimating pitfalls include:

Misinterpretation of the statement of work

Omissions or improperly defined scope

Poorly defined or overly optimistic schedule

Inaccurate work breakdown structure

Applying improper skill levels to tasks

Failure to account for risks

Failure to understand or account for cost escalation and inflation

Failure to use the correct estimating technique

Failure to use forward pricing rates for overhead, general and administrative, and indirect

costs.

Unfortunately, many of these pitfalls do not become evident until detected by the cost control

system, well into the project.

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