Parametric Cost Estimating Techniques

There are many ways to estimate costs. The most common method is the discrete estimate method where, for example, a bill of material is created and vendor quotations are obtained to determine costs. Another method used - especially by large firms with ample historical data and a significant volume of proposals - is "parametrics".

"Parametric cost estimating" (or, parametrics), are techniques employing one or more cost estimating relationships (CERs) to estimate costs associated with the development, manufacture, or modification of an end item. You have no doubt seen or heard the national average cost for new housing construction expressed as an amount per square foot, e.g. $125 per square foot. That is an example of parametric cost estimating - it factors in labor and materials, plumbing, electrical, etc into a single rate.

A CER expresses a quantifiable correlation between certain system costs and other system variables either of a cost or technical nature. CERs represent the use of one or more independent variable to predict or estimate a dependent variable (e.g. a cost).

Parametrics can be simple or complex. For example, a simple arithmetic relationship using historical data to estimate scrap costs is a parametric cost estimating technique. Simple ratios are easy to compute and explain to the Government's satisfaction. However, the use of parametrics are often based on more advanced or complex applications.

Advanced applications included cost-to-noncost CERs, multiple independent variables related to a single cost effect or independent variables defined in terms of weapon system performance or design characteristics.

Parametric estimating techniques may be used in conjunction with any of the following estimating methods:

• Detailed --- also known as the bottom-up approach. This method divides proposals into their smallest component tasks and are normally supported by detailed bills of material. 
• Comparative --- develops proposed costs using like items produced in the past as a baseline. Allowances are made for product dissimilarities and changes in such things as complexity, scale, design, and materials. 
• Judgmental --- subjective method of estimating costs using estimates of prior 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. 

Judicious use of parametric estimating can save a lot of time and effort over traditional methods. Just remember though that CERs invite a higher level of Government scrutiny as they become more complex.

 

Estimating - Use of Percentages and Conversion Factors

When preparing price proposals, many - perhaps most - contractors attempt to develop discrete estimates for each direct cost element and for required activities or purchases within those cost elements. These methodologies, while sometimes unavoidable, require a great deal of judgmental estimates or engineering estimates that have no basis other than someone's imagination. It also leads to inefficiencies during the negotiating process if the Government requires additional support or specificity.

There might be a better way to estimate certain direct costs however - especially when historical cost data is available. That would be through the use of percentages and conversion factors.

Take, for example, the category of sustaining engineering. Sustaining engineers is loosely defined as the continuing engineering and technical support that follows release of requirements, specifications and drawings for fabrication, assembly, testing, and delivery of an end product. Everyone would acknowledge that some level of sustaining effort is required. But how much? Trying to discretely estimate the number of sustaining engineering hours requires a great deal of judgment. However, you might be able to develop a relationship between engineering hours and sustaining engineering hours; or between manufacturing hours and sustaining engineering hours, assuming your timekeeping system is adequate and these is sufficient historical experience. Now instead of wild judgmental estimates, you have tangible support for your estimate.

Other areas where application of percentages and conversion factors are commonly used are in packaging, field services, tooling, desktop IT support, and reproduction.

When using percentages and conversion factors, the Government will undoubtedly request support. In fact, for the contract auditor, guidance on auditing percentages and conversion factors is found in the DCAA Contract Audit Manual at 9-604.1. The auditor's focus in reviewing percentages and conversion factors is to evaluate the propriety of the percentage and conversion factors for applicability in the current proposal.

Contractors should consider how the use of percentages and conversion factors can improve their own estimating practices and procedures.

What are Cost Estimating Relationships (CERs)?

A cost estimating relationship (CER) is a technique used to estimate a particular cost or price by using an established relationship with an independent variable. If you can identify an independent variable (driver) that demonstrates a measurable relationship with contract cost or price, you can develop a CER.

Many contractors develop and use CERs in their cost estimates to avoid the time consuming necessity to prepare discrete estimates for every cost. Most CERs used in pricing Government contracts are cost-to-cost relationships. By establishing a relationship between different elements of costs, contractors can use a CER to reduce its estimating or analysis effort and at the same time, increase accuracy. For example, if a contractor can establish a relationship between senior engineering hours and engineering technician hours, it doesn't need to discretely estimate the number of engineering technician hours - it simply applies a rate.

The Government generally likes and often encourages the use of CERs because it makes everyone's tasks easier. During negotiations, the parties are less likely to get bogged down in minutia - arguing over a few hours here and a few hours there.

While widely accepted as estimating techniques, the Government will still evaluate the propriety of CERs. The Government will probably test the correlation between independent and dependent variables by running regression analysis techniques against the data.

Once a CER is established, contractors must use them consistently in their pricings. Since CERs are basically averages, it wouldn't be equitable to use CERs in one case and discrete estimates in another. Some jobs would be expected to cost more and others less.

There have been situations where a Government contract negotiator objected to contractors' use of CERs when others have accepted them. If that happens, contractors need to ensure that various components of the Government are talking to each other. In that regard, its useful to include CERs as part of negotiated Forward Pricing Rate Agreements.

You can read more about CERs by clicking here.

Estimates of Future Costs and Government's Use of Global Insights

Here's something to consider when using historical costs to estimate and negotiate future contracts.

When contractors use historical costs as a basis for estimating future costs, they must add an escalation factor.Contractors, starting out with historical costs, must estimate what those costs will be during the contract performance period. For example, if wages were increasing at five percent a year, contractors might take their 2013 actual labor rates and increase them by five percent for work performed in 2014 and by five percent again for work performed in 2015.

What many contractors have found is that it doesn't really matter what rate they use for escalation, DCAA (Defense Contract Audit Agency) and DCMA (Defense Contract Management Agency) will use rates published by Global Insights in lieu of accepting (or even analyzing) contractor escalation estimates.

The Government is a major customer of Global Insights' economic forecasts. For most contractors, the cost of a subscription to Global Insights is cost-prohibitive. Since most contractors do not have the time or resources to purchase or to develop their own economic forecasting model, the end result is that the Global Insight projections become the negotiated projections. In doesn't matter how good your negotiating skills - this is one area of Government intransigence.

However, as we reported last January following the President's State of the Union Speech, minimum wages for Government contractors is about to rise to $10.10 per hour. That means, for example, if you're paying grass cutters $8.50 per hour, you're going to need a 19 percent increase to your historical wages in order to comply with the mandate. Right now, labor rate escalation, depending on skill, geographic area, and the particular index, is hovering in the two percent range. Obviously, the Global Insights forecasts are not going to apply in these situations.

Not only would Global Insights not apply to minimum wage situations, but there is also the likelihood that the new minimum wage for Government contractors will impact wages for other non-minimum wage labor categories. A supervisor earning $10 an hour isn't going to be satisfied with $10 per hour when his/her subordinates are making $10.10 per hour.

When negotiating contracts where the performance period extends into 2015, the economic forecasts of Global Insights might not be reasonable. Contractors need to make a careful assessment of their environment before succumbing to the Global Insights juggernaut.

How Many Working Hours in a Year?

What is the standard man-year (woman-year, person-year, whatever) in number of hours? Most of you will probably guess 2,080 (40 hours per week times 52 weeks in a year). That might be close enough for a lot of purposes but not nearly precise enough for Government purposes. Wait! What about that old adage "Its close enough for Government work"? Well, that old adage doesn't apply when it comes to Excel equipped Government contracting officers and their auditors.

More than a few Government solicitations call out a CME (Contractor Manyear Equivalent) of 2,087 hours. How do they get 2,087 hours?

There are more than 52 weeks in a year. There are actually 52.14286 weeks per year (365 days divided by 7 days). Multiplying that by 40 hours gives you 2,085.6 hours per year - not quite to the 2,087 hours yet.

To get to the 2,087 CME, we have to factor in leap years. Every 4th year we get an extra day and that raises the average number of weeks per year (over a four year period) from 52.14286 weeks to 52.17857 weeks per year. Multiplying 52.17857 by 40 hours gives us the 2,087 Contractor Manyear Equivalent (CME).

So, now you know.

Conditions That May Indicate Significant Estimating System Deficiencies

The Government loves to devise lists of things that might be indicative of other things. The Inspector Generals of the Executive Agencies (Defense, Energy, Interior, Commerce, Homeland Security, etc), for example, have "fraud" indicators meaning that if one or more of the indicators are present, there could be a chance of fraud occurring somewhere in the contractor's organization. The Government has financial capability risk indicators meaning that if one or more of these indicators are present, the contractor may be in dire financial straights and at risk of going bankrupt.

We found another list the other day. This one pertains to contractors' estimating system. As you know from previous postings, the estimating system is one of the six business systems that if found deficient, will result in payment withholds.

Here's the list. The following have been identified by the DoD as conditions that may indicate potentially significant estimating deficiencies and excessive costs to the Government.

• Failure to ensure that historical data on the same or similar work are available to and utilized by cost estimators where appropriate.
• Continuing failure to analyze material costs or failure to perform subcontractor cost reviews as required.
• Consistent absence of analytical support for significant proposed costs.
• Excessive reliance on individual personal judgment where historical experience or commonly used standards are available.
• Recurring significant defective pricing findings within the same cost element(s).
• Failure to integrate relevant parts of other management systems (e.g., production or cost accounting) with the estimating system so that the ability to generate reliable cost estimates is impaired.
• Failure to provide established policies, procedures, and practices to persons responsible for preparing and supporting estimates.
• Management information that does not match the data in proposals.
• Standards for labor and material costs that are not current.
• Changes in make-or-buy decisions not disclosed.
• Inappropriate or misleading sampling techniques.

Contractors might want to use this listing to perform their own self-assessments.

Decrement Factors

The term "decrement" as used in Government contracting refers to the amount of a reduction or price reduction. It is most commonly used as an estimating technique for subcontract costs. For example, a decrement factor may represent a percentage by which a subcontractor has agreed to past quoted prices. When estimating subcontract costs, contractors apply the decrement factor to subcontractor quotations or proposals because they know, based on historical experience, that the final subcontract price is always lower than the proposed price.

While decrement factors are common in estimating procedures, it is not the preferable method of evaluating subcontract costs. Prime contractors are required to perform cost or price analysis of subcontract costs included in their proposals. Sometimes situations arise that make it difficult or impossible for contractors to complete their cost or price analysis by the time it is needed to negotiate the prime contract. In those cases, decrement factors might be a viable option.

DCAA (Defense Contract Audit Agency) guidance directs auditors to review the methodologies used by contractors in arriving at subcontractor price reductions, to ensure that the data used for decrements were reasonably accurate, current, and representative. The guidance explains that information concerning patterns of reductions from quotes to actual prices paid may be useful in evaluating a cost estimate.

When developing decrement factors, some contractors calculate decrements for each subcontractor. Others pool their subcontractor history and calculate a factor to be used across the board. If you plan to use decrement factors in your estimating system, be prepared to justify your methodology.

Subcontract Price/Cost Analysis

When Government contractors (or prospective Government contractors) include subcontracts as part of their proposal, they have an affirmative duty to ensure that the proposed subcontract prices are fair and reasonable. This usually means that the contractor will perform some kind of cost or price analysis of the subcontractor proposal. The Government has a pretty good idea of what it takes to perform adequate subcontractor cost/price analyses - they perform them all the time at the prime contract level. There is a general expectation that prime contractors will apply the same procedures in evaluating subcontract prices as the Government does when evaluating prime contract prices.

An adequate estimating system will include policies and procedures related to subcontract cost/price analyses. In assessing adequacy of those policies and procedures, the Government will look for requirements to

• conduct appropriate cost or price analyses to establish the reasonableness of proposed subcontract prices
• include the results of these analyses in its own price proposal
• when required in accordance with FAR 15-404-3(c), submit subcontractor cost or pricing data to the Government as part of its own cost or pricing data.

Adequate and timely subcontract cost/price analysis is critical to the negotiation of fair and reasonable prime contract prices. For this reason, the contractor should have policies and procedures in place to accomplish such analyses prior to the submission of its own cost or pricing data.

Due to time and other constraints, the contractor may be unable to perform a detailed price/cost analysis prior to submission of its own cost or pricing data. In these instances, the contractor's policies and procedures should require that a plan be in place to complete the required analysis and provide it to the Government negotiator prior to negotiation of the prime contract price.

In some exceptional cases, the contractor may be unable to obtain adequate cost or pricing data and/or perform the required analysis prior to negotiation of the prime contract price. Regardless of the circumstances, the prime contract still has the responsibility for demonstrating fair and reasonable subcontract pricing. The contractor's policies and procedures should provide for the timely identification f such circumstances and submission of a request, to the contracting officer, to be excused from the submission of subcontractor cost or pricing data and related analysis. This request should be supported by

• the explanation as to why the data and analysis cannot be submitted in a timely manner, and
• an alternate analysis such as application of a negotiation reduction factor based on the historical difference between the initial subcontractor proposed amount and the ultimate negotiated amount.

Estimating Labor Productivity

A common technique for estimating labor hours is to use historical experience from similar work and from prior production runs. Whenever history is used however, it must be adjusted to account for such things as differing conditions, quantities, and improvement curves. When the government evaluates labor hour estimates, it nearly always asserts that contractors show improvement to historical data and patterns. Contractors would do well to also consider improvements to productivity in preparing estimates.

Productivity improvements result from any number of factors. They may be due to the adoption of improved methods and tools or the increased efficiency of the individual worker performing repetitive tasks (e.g. learning curve theory). The amount of improvement per unit of product is generally high during the early part of the production cycle and decreases as production is stabilized, processes are refined and additional experience is gained.

After awhile, the rate of improvement may not be measurable except over a substantial period of time. Where automation is used, the rate of improvement is usually zero. As production nears its end, productivity often decreases. Tooling wears out or the most skilled workers are transferred to other projects. Sometimes, production runs are less than optimal and fixed costs are spread to fewer units.

The government's primary interest in labor productivity is in measuring current productivity and past trends, and determining the causes of past trends so that the likelihood of continuance during the contemplated production period may be assessed. It is important that contractors (or potential contractors) ensure that the government understands all relevant factors in assessing productivity. The government's propensity is to conjure up reasons why contractors should or could be more productive. Sometimes these positions do not consider all relevant facts. Contractors without all the facts, might find themselves agreeing to something during negotiations that could imperil contract performance.

Business System Requirements - Estimating

The DoD has proposed regulations that will allow it to withhold 10 percent of each billing for each business system found to be inadequate. We have been discussing the Government's fundamental expectations of these systems. Previously, we looked at the Purchasing and Accounting Systems. Today we continue our coverage with the Estimating System. After the accounting system, we believe the estimating system is the most important business system for Government contractors. A good system will facilitate contract negotiation and award and will decrease the risk of defective pricing.


For DoD purposes, an adequate estimating system must:

1. Establish clear responsibility for preparation, review, and approval of cost estimates;
2. Provide a written description of the organization and duties of the personnel responsible for preparing, reviewing, and approving cost estimates;
3. Assure that relevant personnel have sufficient training, experience, and guidance to perform estimating tasks in accordance with the Contractor's established procedures;
4. Identify the sources of data and the estimating methods and rationale used in developing cost estimates;
5. Provide for appropriate supervision throughout the estimating process;
6. Provide for consistent application of estimating techniques;
7. Provide for detection and timely correction of errors;
8. Protect against cost duplication and omissions;
9. Provide for the use of historical experience, including historical vendor pricing information, where appropriate;
10. Require use of appropriate analytical methods;
11. Integrate information available from other management systems, where appropriate;
12. Require management review including verification that the company's estimating policies, procedures, and practices comply with this regulation;
13. Provide for internal review of and accountability for the acceptability of the estimating system, including the comparison of projected results to actual results and an analysis of any differences;
14. Provide procedures to update cost estimates in a timely manner throughout the negotiation process; and
15. Address responsibility for review and analysis of the reasonableness of subcontract prices.

How does your estimating system measure up?