Once Again, Cost Reasonableness and Cost Realism

In the context of the Federal Acquisition Regulations (FAR), the terms "cost reasonableness" and "cost realism" have very different meanings and purposes. It is easy to confuse the two similar sounding terms and some bidders have even appealed contract awards before the Comptroller General based on a lack of understanding between cost reasonableness and cost realism (or price reasonableness and price realism).

First, understand the following relationships:

• Cost reasonableness - fixed price contracts
• Cost realism - cost type contracts

The purpose of a cost reasonableness review in a competition for the award of a fixed-price contract is to determine whether the prices offered are too high, as opposed to too low.

The purpose of a cost realism review in a competition for the award of a cost-type contract is to determine whether the prices offered are too low. In a cost-type environment, estimated costs are not dispositive, because regardless of the costs proposed, the Government is bound to pay the contractor its actual and allowable costs (see FAR 15.605(d)). A price realism analysis determines the extent to which an offeror's proposed costs represent what the contract should cost, assuming reasonable economy and efficiency.

Cost Realism Reviews

When the Government evaluates proposals for the award of a cost-reimbursement contract (e.g. CPFF, CPIF, and CPAF), a prospective contractor's proposed estimated cost of contract performance is not considered controlling since, regardless of the costs proposed by the contractor, the Government is bound to pay the contractor its actual costs (as long as those costs are allowable, allocable, and reasonable). Consequently, a cost realism analysis must be performed by the agency awarding the contract to determine the extent to which an offeror's proposed costs represent what the contract costs are likely to be under the offeror's technical approach, assuming reasonable economy and efficiency (see FAR 15.305(a)(1), and (2).

A cost realism analysis is the process of independently reviewing and evaluating specific elements of each offeror's cost estimate to determine whether the estimated proposed cost elements are realistic for the work to be performed, reflect a clear understanding of the requirements, and are consistent with the unique methods of performance and materials described in the offeror's proposal (see FAR 15.404-1(d)(1)).

The Government will adjust an offeror's proposed costs when appropriate based on the results of the cost realism analysis (see FAR 15.404-1(d)(2)(ii)). Herein lies the basis for many bid protests. Sometimes, the Government will increase the estimated cost of an offeror's bid, sending it out of the competitive range. Appeals to the GAO (Government Accountability Office) usually question the propriety of the Government's adjustments by maintaining they were inappropriate, undocumented, or fundamentally changed the proposed technical approach. Most of the time, these appeals are unsuccessful. Because, FAR requires the Government to conduct cost realism reviews and adjust proposed prices if necessary, the GAO limits is review to determining whether the cost analysis was reasonably based and not arbitrary.

For more information on cost realism reviews, see our previous posts on the subject.

• Cost Realism Analysis - Part I
• Cost Realism Analysis - Part II

Cost Realism Analysis - Part II

Last Wednesday, we began a series on Cost Realism Analyses. Cost realism analyses are not audits - they are typically much less in scope than a full audit or even audits of parts of a proposal. They usually happen when the Government is evaluating competitive bids. Sometimes they happen without the bidders' knowledge. They usually occur when the Government is concerned that one or more of the bids submitted are unrealistically low. Unrealistically low bids occur for a variety of reasons; failure to understand contract requirements, failure to properly coordinate proposal preparation, and consciously understating the proposed cost/price with the hopes of "getting healthy" later on through contract modifications. Bids that are found to be unrealistically low based on cost realism analyses, are usually excluded from futher consideration.

There have been many protests to the Comptroller General (GAO) challenging Government cost realism analyses. GAO generally sustains the contracting officer's judgment on cost realism as long as that judgment is informed, accurate, sufficiently thorough for the acquisition situation, reasonable - not arbitrary, and performed in accordance with the evaluation criteria stated in the solicitation.

The cost realism process generally goes something like this:

1. The Government must assure that the solicitation states how cost realism analysis will be used in the contract award decision.
2. The Government compares bids with its own in-house estimate of the likely cost of the project (the IGE or Independent Government Estimate).
3. The contracting officer obtains information other than cost or pricing data needed to support cost realism analysis
4. If necessary, the contracting officer obtains other information to support his/her analysis
5. If necessary, the contracting officer obtains analysis support from other members of the acquisition team. This could be in-house personnel, audit support, and field support.
6. The contracting officer identifies costs/prices that are understated for the required contract effort.

When performing cost realism reviews, the Government will focus on those areas that appear to have significant variances from the "probable costs" - however "probable costs" were determined. It could be labor hours, labor dollars, material quantities, material prices, indirect rates or a combination of these, or all of these.

So be forewarned, just becuase you submit a bid on a competitive procurement, does not mean that someone from the Government won't come poking around your records. You need to be ready to support the reasonable of your bid.

Cost Realism Analysis

When negotiating a contract price, the Government's primary concern is the price that it will pay to obtain the required supplies or services from a responsible contractor. The Government's objective is to negotiate a contract type and price (or estimated fee and cost) that will result in reasonable contractor risk and provide the contractor with the greatest incentive for efficient and economical contract performance.

In a competitive bid situation, the Government is keenly sensitive to unrealistically low offers. Unrealistically low offers generally occur, because the offeror:

• Does Not Understand Contract Requirements. Government requirements may not be clearly stated or the offeror may be unfamiliar with common product terminology. If the offeror underestimates the magnitude or complexity of a proposed task, the estimated costs could be far below the probable cost of successful contract performance.
• Did Not Properly Coordinate Proposal Preparation. The cost proposal may not be consistent with the offeror's technical proposal. The inconsistency may occur as the result of inadequate coordination between the team preparing the technical proposal and the team preparing the cost proposal.
• Consciously Understated The Proposed Cost/Price. In the face of competitive pressure, an offeror may submit an unrealistically low price in order to win a contract (i.e., use a buy-in pricing strategy).
• On cost-reimbursement contracts, the contractor may expect to recoup all or most of the costs related to any cost overrun that may occur.
• On fixed-price contracts, the contractor may hope to:
• Increase the contract amount after award (e.g., through unnecessary or excessively priced contract modifications), or
• Receive follow-on contracts at unrealistically high prices to recover losses on the buy-in contract.

If there appears to be one or more unrealistically low bids for a given procurement, the Government will perform a cost realism analysis. Cost realism analysis is discussed in FAR 15.101, FAR 15.401 and FAR 15.404-1(d). Cost realism is the process of independently reviewing and evaluating specific elements of each offeror's proposed cost estimate to determine whether the estimated proposed cost elements:

• Are realistic for the work to be performed;
• Reflect a clear understanding of contract requirements; and
• Are consistent with the unique methods of performances and materials described in the offeror's technical proposal.

Sometimes cost realism analyses are performed in-house by the contracting officers' staff. Sometimes the work is farmed out to auditors or contract administrators. Tomorrow, we will look at some of the specific steps that are performed in a cost realism review.