Whenever cost or pricing data is required in connection with a Government contract or subcontract, whether certified or other than certified, contractors (or subcontractors) are called upon to provide a significant amount of detail to back up their estimates. Then it is up to the Government - could be the Defense Contract Management Agency, the Defense Contract Audit Agency, or cost/price analysts in the buying activity - or the prime contractor to decide the level of review necessary to validate the propriety of the estimates. Today we will discuss some of the considerations that auditors might use to evaluate labor costs, and more specifically, labor hours.
Labor costs are comprised of labor rates and labor hours. Estimates for labor rates are fairly straight-forward. Usually labor rates are based on existing pay rates with escalation thrown in. Estimates for labor hours however create a big challenge to estimate and represent a significant risk area for the Government. Contractors need to answer the questions of how many hours will it take to perform a particular task and how does it know? The Government will come along and asked them to "prove it".
Historical data is usually the preferred method of forecasting future hours. Without historical data, labor hour estimates are usually based on judgmental estimates, or engineering estimates. Estimates cannot be evaluated with empirical data. Negotiations usually come down to decisions about reasonableness or who can put up the most convincing arguments.
The Government however wants to know about a contractor's historical experience in building whatever the item being built or assembled. For this reason, the Government will always ascertain the suitability of historical data for making estimates. (i.e. accurate, reliable and representative). If a contractor has not identified relevant historical labor hours in its basis of estimate, the Government is going to ask for historical hours and make that comparison.
The Government will also take that history and adjust it for learning/improvements. The Government might apply improvement curve techniques or regression analysis, or other trend-line techniques to historical hours.
The Government will also look at a couple of other areas. They will make sure that proposed direct labor is classified consistent with FAR 31.202 and 31.203(a). In other words, they do not want contractors to propose as direct labor, activities that are and should be charged indirect. Second, the Government will want to ensure that the proposed labor mix is consistent with past performance and company demographics. For example, there should be consistency in the proposed mix of various skill levels with that supported by historical evidence.
Sometimes contractors get a little sloppy in estimating their direct labor hours and are left scrambling when the Government begins inquiries into the propriety of historical hours. Be prepared.