Cost Estimating and Contract Pricing,

Transcription

1 Cost Estimating and Contract Pricing, Part 3: Strategies, Methods, and Best Practices BY gregory a. garrett and john williams 24 Contract Management January 2009

2 As the final article in this series, this article expands on the concepts outlined in Parts 1 and 2 to discuss strategies, methods, and best practices of contract pricing. Contract Management January

3 So, what is price? What constitutes a fair and reasonable price? How do you develop the right price? The answer to all three questions is: it depends. No, we re not trying to be difficult; rather, price is a flexible item, depending on numerous factors. Price should be a derivative of your people, processes, performance, risk, and competition. Price should be adjusted by your business strategy, given the marketplace your organization is operating in as either a buyer or a seller. Price is an essential element for both buyers and sellers. Buyer s care about price because they have a limited budget and they want to ensure their selected seller is sufficiently motivated to achieve excellence. Likewise, sellers care about price because they want to ensure they are able to cover their actual costs, achieve a reasonable profit, and ensure customer satisfaction. So, let us now discuss how organizations develop the right price. Common Pricing Strategies In both the public and private sectors, the two most common pricing strategies are the Lowest Price Technically Acceptable (LPTA) strategy and the Best Value strategy. LPTA Pricing Strategy Simply stated, the LPTA strategy is typically used by buyers when there are multiple sellers, usually providing commerciallyavailable-off-the-shelf (COTS) products and services. LPTA is the right pricing strategy if there is no real differentiator other than price. In other words, if all the products and/or services being considered for purchase are basically the same in terms of quality, schedule, reputation, and technical capability/features, then price should be the key attribute for the purposes of source selection and contract award. From a seller s perspective, LPTA is the appropriate pricing strategy in most markets when its products and/or services offer no real value differentiator from its competitors products and/or services. LPTA is based on a simple strategy lowest price wins the deal. However, LPTA does not necessarily guarantee either party a fair and reasonable price. In reality, sometimes all of the sellers in the marketplace have overly high prices. This is based on supply and demand. Even the lowest price can still be perceived by the buyer as too expensive (e.g., gas prices). Likewise, sellers may feel that, in order to get the deal, they are being squeezed by their competitors and customers to drive their prices so low that they are forced to lose money (e.g., sport utility vehicle prices). Both buyers and sellers must properly evaluate the market to ensure when it is truly appropriate to use the LPTA pricing strategy. For both buyers and sellers, it is important to remember that the lowest price is not always the best deal or the right price. Best-Value Pricing Strategy The term best value can have several meanings, depending on one s particular perspective. The federal government defines best value as the expected outcome of an acquisition that, in the government s estimation, provides the greatest overall benefit in response to the requirement. Best value is usually associated with the source selection process. However, the concept can also be applied to other situations. In all situations, best value is intended to serve as a tool for the buyer and seller to establish a proper balance between factors such as price, quality, technical, and past performance. Best value applies to products and services already developed, as opposed to value analysis, which examines tradeoffs during the design and/or production process. Specifically, best value is a disciplined, balanced approach; an assessment of tradeoffs between price and performance; a team effort; an evaluation of qualitative and quantitative factors; and an integrated risk assessment. Best value is not price cutting, uncompensated overtime, accounting gimmicks, specials, one-time discounts, the shifting of all price and performance risk to the supplier, or an excuse not to properly define requirements. 1 For our purposes, best value is a determination of which offer presents the best tradeoff between price and performance; where quality is considered an integral performance factor. The best-value decision can be made using a variety of qualitative and quantitative management tools. Bestvalue contracting is intrinsically tied to the process of contract negotiations for several reasons. First of all, to be successful, negotiations must focus on a specific quantifiable objective. Best value offers a meaningful objective to each negotiation party. In addition, contract negotiation typically requires tradeoffs among a variety of interrelated factors. Using best-value techniques helps contract management professionals assess 26 Contract Management January 2009

4 the impact of these tradeoffs to ensure a successful negotiation session. These techniques also help determine the range of values (e.g., cost, production, quality requirements, life-cycle cost, etc.) where tradeoffs can be made while preserving the optimal balance between price, performance, risk, and quality. Lastly, best value establishes realistic negotiation objectives up front. For example, best-value contracting techniques can discourage the use of unrealistic initial negotiation positions by suppliers seeking to win a contract with practices such as uncompensated overtime or unrealistically low initial prices. To be successful, best-value contracting must be an integral part of the acquisition strategy planning process. This means early planning must occur. Best-value pricing also requires a team effort among various disciplines such as engineering, accounting, legal, manufacturing, and contracts to clearly identify all acquisition requirements and determine the optimum tradeoffs among various factors. Tradeoffs Decision-Making Tradeoffs in making a best-value pricing decision should always consider the objectives of both the buyer and seller. Tradeoffs may have to be revisited as negotiations progress, since the needs of the buyer and seller will be revealed (usually incrementally) during the course of negotiations. The level of analysis in best-value tradeoff decisions depends on the complexity of the particular procurement. Low-technology procurements usually require a simple, straightforward tradeoff approach, since price is normally the primary factor. However, high-technology procurements normally require more sophisticated tradeoff analysis tools because price is usually secondary to technical solution and quality concerns. 2 Due to the many types of contracting situations, there is no single preferred way to determine best value. Rather, a combination of techniques should be used, preferably integrating quantitative and qualitative factors. The use of a team approach helps with rationally making the necessary tradeoffs rationally (see FIGURE 1 on page 28). The Evolution of Best-Value Pricing Over the past decade, the practice of best-value pricing has continued to grow in importance in both the public and private sectors. First of all, the federal regulatory environment has continually evolved, gradually allowing for increased best-value pricing techniques. Government contractors have responded to these changes by offering bestvalue pricing as a part of an overall valuebased cost and technical approach. This has helped make government contractors more efficient and competitive. In addition, the items and services to be purchased have continued to become more technical and complex, e.g., sophisticated consulting, advanced hardware, software, and professional services. This has often made quality and past performance factors more important than price-related factors. Also, the emphasis on making best-value purchasing decisions will increase as the government refines Contract Management January

5 Figure 1. Sample: Best Value Proposal Evaluation Process A prop => B prop => RFP RFP => => Red x Blue = A s Tech Conclusion Red x Blue = B s Tech Conclusion T (Technical Differences) Compare Conclusions A s $ => B s $ => Govt. Request for Proposal (RFP) Proposal Preparation Instruction (PPI) Cost Tech A s $$ Conclusion B s $$ Conclusion Compare =======> Compare Development Determine what to evaluate Determine how much weight/importance each criteria has Weight (Example) Technical Approach 40, PPI 40: 40 PPI - Customer Satisfaction Cost Control ======> Schedule Past Performance Key Personnel 20% Evaluation: Red Rating x Blue Weighting Technical Conclusion Price Difference $ Excellent 9-10 Very Good 7-8 Good 5-6 Poor 3-4 Unacceptable 0-2 Adapted from a Best Value Source Selection Seminar, by Phil Salmeri, its attempts to obtain more value for its money. Finally, the continual improvement in increasing the professional qualifications and credentials of both government and industry acquisition workforce personnel has fostered the use of best value on both sides. The commercial sector has long used bestvalue contracting techniques as a means to remain competitive and profitable. The federal government has not had the same degree of flexibility to employ best value techniques because it must comply with various requirements that have no material bearing on the business aspects of the contract, but which are mandated by law to be included in all federal acquisitions as a matter of public policy. As a result, best-value pricing implementation has not achieved its full potential in the government contracting arena. 3 Too often, best-value pricing becomes a modified version of LPTA, where the buyer will agree to pay just slightly more than the LPTA for higher overall value. (See the checklists of best value do s and don ts on page 30). Major Methods for Determining Price There are three major methods for determining price: cost-based pricing, value-based pricing, and activity-based pricing. Cost-Based Pricing Cost-based pricing (CBP) is a relatively straightforward method of pricing. Using CBP, a seller must have an accurate and acceptable cost estimating and accounting system, whereby it can estimate its future costs and apply a desired margin, profit, or fee to yield a fair and reasonable price. The two most common challenges faced by sellers when using CBP are (1) creating an adequate cost estimating and accounting system and (2) applying an appropriate profit or fee structure that properly balances opportunity versus risk. In the private sector, there are generally accepted accounting practices (GAAPs) that are followed and audited to ensure companies have adequate cost estimating and accounting systems. However, there are no real stringent rules for commercial companies on applying an appropriate profit or fee structure. When dealing in the public sector, the government has numerous rules and regulations to ensure companies doing business with the government have adequate cost estimating and accounting systems, especially when using cost-type contracts, applying appropriate profit/fee structures, and practicing truth in negotiations. The primary goal of a cost estimating and accounting system is to ensure that costs are appropriately, equitably, and consistently estimated and allocated to all final cost objectives (i.e., individual contracts, jobs, or products). Essentially, the government requires a company to maintain and consistently apply any GAAP that is adequate, efficient, reliable, and equitable, but not necessarily exact and specific, and not biased against the government. Also, the government does not require companies to adopt separate or necessarily complex accounting systems. Consequently, contractors are free to develop and use 28 Contract Management January 2009

6 the type of cost estimating and accounting system most appropriate for their businesses. However, consistent application of this approach is vital. Although the use and design of certain specific cost estimating accounting records and practices may vary from company to company, the record-keeping system for all companies doing business with the government must include, at a minimum, a general ledger, a job-cost ledger, labor distribution records, time records, subsidiary journals, a chart of accounts, and financial statements. 4 To determine whether a company s accounting system is acceptable, a government auditor will generally go through a checklist, asking questions similar to those found in an accounting system questionnaire (see Figure 2 on page 32). Accounting information can, and should, be used in more ways than merely to produce financial statements and job-cost reports. Only after identifying activities that are important to your business and beginning to measure them can you encourage the rest of your team to support your goals. A business that provides clear expectations and real-time performance feedback can be managed on a real-time basis and, therefore, has greater control over its destiny. 5 Adequate Cost Estimating In the federal government marketplace, developing a sound cost estimate requires a coordinated effort by a team of qualified seller personnel who understand how to extract and price requirements presented in the buyer s request for proposal (RFP). Typically, the team consists of a program manager, technical manager, contract manager, accounting/finance manager, and a senior executive responsible for final review and approval of the proposal for submission to the buyer. Depending on the company s size, the magnitude of the proposal, and the types of costs being estimated, the estimating team also may include representatives of the purchasing, legal, human resources, and operations teams, among others. All personnel with any responsibility for preparing a proposal to the government should be well versed in the guidelines contained in the Federal Acquisition Regulation (FAR) especially FAR 15.4, Contract Pricing. All team members should have adequate experience and knowledge of how the particular requirements of pricing function to which they have been assigned. Responsible personnel should know where to obtain the most relevant and current data and be aware of the turnaround time allowed for submission of the proposal. 6 A proposal preparation system that entrusts one person with the sole authority for translating the RFP into requirements, pricing those requirements, and reviewing and submitting the final proposal is an accident waiting to happen. Omission of key personnel in the estimating process can result in cost and delivery projections that do not consider current and future business decisions and company plans. In other words, the proposal may not realistically represent the company s ability to deliver the product Contract Management January

7 Best Value Do s Do: Develop or obtain proven best value pricing tools; Select best-value measurement tools that are easy to understand and use; Ensure quality factors do not become secondary to cost issues, except for non-complex acquisitions; Consider using automation tools for best-value decision-making; Tailor best-value measurement tools to specific procurement situations, realizing that complexity increases with the size and scope of the acquisition; Use a contract type that fairly allocates risks; Provide contract incentives for superior (quality) performance; Implement guidance throughout the agency or company; Continue to improve techniques; Make each best-value decision a team effort between contracts, finance, engineering, production, quality assurance, and other related offices; Ensure a best-value approach supports the overall negotiation strategy; Realize the best-value approach works only if you know what you re buying; Document the rationale for best-value decisions; and Allow flexibility for tradeoffs. Source: NCMA National Education Seminar, Negotiating a Quality Contract, NCMA, or service within the estimated cost or required delivery timelines. Including personnel who are familiar with various components of the business operations will reduce the risk that a proposal will be overstated or understated. Even in small companies with few employees, in which people wear several hats of responsibility, it is just as important that the estimating system involve at least two or three qualified persons to better ensure an accuratelypriced final product. Finally, a forward-pricing proposal should minimize the use of judgmental estimates and maximize the use of factual data when such data is available and relevant. Developing extensive priced requirements with judgmental estimates does not provide the visibility required by the government to evaluate the reasonableness of a proposal. Judgmental estimates add time to the government audit and cost analysis and sometimes result in adverse audit opinions because of a lack of verifiable data. The typical cost elements in Figure 3 (on page 33) are examples of verifiable cost proposal supporting data. In selecting the proposal resources for developing and pricing RFP requirements, the supplier must be careful to use the most current, accurate, and complete information, especially if the government requires submission of cost or pricing data. This means selecting the data most relevant to the proposal being prepared and ensuring that the source information is as current as possible. Even if the proposal is not specifically subject to the Truth in Negotiations Act (TINA), 7 companies have an obligation to prepare reasonable estimates and, in that pursuit, should rely on up-todate, relevant, and factual data when possible. It goes without saying that cost estimating techniques must be relevant to the specific RFP requirements. Supplier techniques should be consistent among all bids and proposals, except in cases in which those techniques clearly will not produce the most accurate cost estimate for the RFP s scope of work. 7 Understand the TINA The TINA, enacted by Congress in December 1962, has been viewed as one of the most significant pieces of procurement legislation. The original act covered only contracts entered into by the Department of Defense (DOD) and the National Aeronautics and Space Administration (NASA). Civilian agencies subsequently adopted the same statutory provisions under their own regulations. The statutory disparity between the various government agencies was addressed by the 1984 Competition in Contracting Act (CICA), which required the TINA to apply to all government contracts. This remedy has significantly decreased the number of disputes brought before the various boards of contract appeals. 9 The TINA requires federal government prime contractors and subcontractors Best Value Don ts Don t: Use the low bid or the LCTA offer as a substitute for best value when best value is applicable; Expect to make a good best-value decision without clearly defining your approach up front; Attempt to implement best-value contracting without properly training acquisition personnel; Forget to research all relevant issues, especially technical factors; Make best-value decision tools unnecessarily complex; Allow for such practices as a buy-in or uncompensated overtime; Use auctioning, technical leveling, or technical transfusion techniques as a substitute for best-value contracting; Forget to formalize the elements of the best-value agreement as soon as possible after contract negotiations; Allow an offeror s low initial price to overshadow life-cycle cost considerations; or Expect to obtain the maximum level of economy when buying non-cots items. Source: NCMA National Education Seminar, Negotiating a Quality Contract, NCMA, Contract Management January 2009

8 to submit and certify to the government the data related to the basis of estimated contract costs. The objective is to provide the government with all necessary and relevant information to be able to negotiate a fair and reasonable price for a contract. The TINA requires that such information be current, accurate, and complete at the time such an agreement is reached by the negotiating parties. 10 In addition, the TINA requires contractors to disclose factual data that prudent buyers and sellers would reasonably expect to significantly affect the contract price negotiation. Some typical data that is disclosed under TINA includes the following: Historical costs, including material costs, labor hours expanded, labor rates paid, or labor union settlements; Make or buy program decisions; Subcontractor and vendor quotations; Learning curve projections; and Other business base projections. Although the TINA requires disclosure of these types of information to the government, the contractor is not required to rely on this data in developing its proposal. A contractor is not constrained in exercising its best judgment in developing the estimated cost of a contract. The key to compliance with TINA is disclosure of relevant factual data. If current, accurate, and complete cost or pricing data has been disclosed, then it is assumed that the government or prime contractor negotiators have the necessary information to reach an informed agreement and a fair and reasonable contract price. 10 In order to ensure that government contractors are providing data in compliance with TINA, contractors are required to certify that such disclosures are accurate (i.e., current, accurate, and complete) for contracts or Contract Management January

9 Figure 2. Government Auditor Accounting System Questionnaire Yes No 1. Is the system in accord with GAAPs? 2. Will the system be able to identify and segregate direct costs from indirect costs and allocate these costs equitably to specific contracts on a consis tent basis? 3. Is the system that accumulates costs integrated with, and reconcilable to, the general ledger? 4. Do the timekeeping and labor distribution systems appropriately identify direct and indirect labor charges to intermediate and final cost objectives? 5. Will the system be able to determine the cost of work performed at interim points (at least monthly) because of routine posting of costs to the books of account? 6. Will the system be able to identify and segregate unallowable costs as required by Federal Acquisition Regulation (FAR) Part 31 and any contract terms? 7. If required by the contract, will the system be able to identify costs by contract line item or by unit? 8. Will the system be able to segregate preproduction costs from production costs? 9. Is the system capable of providing the necessary information required by FAR , Limitation of Cost (also -21 and -22), or FAR , Incentive Price Revision-Firm Target? 10. Is the system able to provide the necessary data for recovery of costs using progress payments? 11. Is the accounting system designed? Are the records maintained in such a manner that adequate, reliable data is developed for use in pricing follow-on contracts? 12. Is the accounting system currently in full operation? Source: Lubeck, Jeffrey A., Beyond an Adequate Accounting System, Contract Management magazine, May Contract Management January 2009

10 Examples of Verifiable Proposal Supporting Data Direct Labor Hours Labor-hour history of the same or similar projects. Company or industry standards. Bill of Direct Materials Material planning documents. Engineering blueprints. Direct Labor Rates Labor cost history for the same or similar project. Average labor rates from payroll data. Market wage or salary survey information. Direct Materials Purchase history of same or similar items. Vendor quotations. Vendor catalogs. Indirect Rate Historical annual indirect rates. Budgetary/provisional rates. Source: Walker, Darryl L., Is Your Estimating System Asking for Trouble?, Contract Management magazine, May Figure 3. modifications to existing contracts with a value greater than certain dollar thresholds. Exceptions to disclosure and certification are provided in the following cases: When the contract price is based on adequate price competition, When an established catalog or market price exists and the item is sold in substantial quantities to the general public, When the prices are set by law or regulation, or If it is an exceptional case (such cases must be approved after agency head determinations). Of course, the government negotiator must likewise spend considerable time analyzing and using such information in negotiating the best deal for the government. Accordingly, after the final handshake, but before signing the certification, the contractor generally performs a final review to be sure that all of the cost and pricing data that may affect the final, agreed-to price has been disclosed. If the certified cost or pricing data is not current, accurate, or complete on the effective date of the certificate, the government is entitled to a downward adjustment to the contract price. Such a situation is known as defective pricing under the TINA. In addition to an adjustment to the contract price (if warranted), the contractor may be subject to further investigation for fraud, and, in cases where fraud is determined, criminal penalties may be imposed. Value-Based Pricing The opposite of CBP, value-based pricing (VBP) is all about determining the value of a product or service from the customer s or buyer s perspective. Clearly, the determination of value varies dramatically in certain products or services. For example, the pricing of works of art is certainly not based on the cost of clay, paint, and/or canvass, plus a reasonable profit or fee structure. From a seller s perspective, VBP allows the supplier to research the marketplace and assess the intrinsic and extrinsic value that a product or service may be deemed to possess by one or more buyers. Thus, VBP is a blend of art and science, where traditional buying and selling using cost-based methods do not apply. VBP is like the best-value pricing strategy on steroids; it provides the seller with the maximum potential opportunity for the highest possible profit and maximum price paid by a buyer. If you are a seller, then VBP is a beautiful thing! Activity-Based Pricing Activity-based pricing (ABP) seeks to determine a fair and reasonable price based on the costs estimated and/or actuals for the accomplishment of activities or processes, plus an appropriate profit/fee. ABP is basically a modified version of CBP; it seeks to continuously improve business activities and processes via internal and external benchmarking, thus reducing costs and increasing profit/fee margins for sellers. Likewise, the ABP method can benefit buyers, as sellers may be able to accelerate price reductions as a result of their continual focus on business activity and process improvement. ABP has evolved over the past decade as a result of research into activity-based cost and performance (ABC&P), which is a methodology to identify and measure the costs and evaluate the performance of an organization s business processes. ABC&P provides insights into areas and causes for poor performance, and helps target efforts on improvement opportunities. Understanding the cost of activities and products helps organizations focus on high payback areas and target investments for improvement of performance. The real key of ABC&P is to develop performance measures for each activity, then evaluate the actual performance results versus the plan. Figure 4 (on page 34) contains the typical ABC&P model and principal components. Summary So, in retrospect, contract pricing can range from simple to highly complex. The contract Contract Management January

11 Figure 4. ABC&P Component Definition ABC&P Principal Components Examples Resources Resource Driver Activity Activity Driver Products Cost Driver Performance Measure The elements (e.g. labor, materials, and facilities) used to perform work. A measure of the consumption of a resource used to determine the portion of the total resource cost assigned to each activity that uses the resource. One step within a process that uses resources to perform work. It occurs over time and has recognizable results. A measure of the frequency of activity performance and the effort required to achieve the end result. Any object that you wish to gain financial and non-financial information about through cost and performance measurement. An indicator of why an activity is performed and what causes the cost of performing the activity to change. An indicator of the work performed and the results achieved in an activity; a measure of how well an activity meets the needs of its customers. Facilities, Supplies, or Hardware and software. Number of hours to perform the activity, Number of square feet occupied, or Percentage of time spent. Test equipment, Teaching training classes, or Entering data. Number of classes required, Number of forms processed, or Number of lines of data. Repaired ship, Trained soldier, Processed travel voucher, or U.S. Army base. Proposed work package for a ship, Yield rate of the activity, or Characteristic of a product. Cycle time, Number of errors, Customer satisfaction, or Inventory fill rates. Source: Burk, Karen B. and Douglas W. Webster, Activity-Based Casting & Performance (ABC&P), American Management Systems, Fairfax, Virginia, pricing arrangement should appropriately reflect risk versus reward, given the marketplace, quantity, technology maturity, delivery schedule, geographic location(s), and other related terms and conditions of the deal. Remember, nearly everything a buyer does or does not do affects the price! CM About the Author GREGORY A. GARRETT, CPCM, Fellow, C.P.M., PMP, is a managing director of Navigant Consulting, Inc. He is an international educator, best-selling author, highly respected consultant, and is the recipient of numerous national and international business awards. He has authored 12 books and more than 70 published articles. Mr. Garrett is also a member of the NCMA Executive Advisory Council. JOHN WILLIAMS, CPA, PMP, is a director of Navigant Consulting, Inc. He leads the consulting engagements for numerous government contractors, providing expertise in cost estimating, contract pricing, cost accounting, contract administration, and project management. He is a graduate of the School of Business Administration at James Madison University. This article is a modified extract from the book, Cost Estimating and Contract Pricing, by Gregory A. Garrett, CCH-Wolters Kluwer, Law & Business, Chicago, Illinois, Send comments about this article to cm@ncmahq.org. Discuss this article with your peers online! Just go to Garrett and click on Join Discussion. Endnotes 1. Garrett, Gregory A., World Class Contracting, fourth edition, CCH, Inc.: Chicago, Illinois, Walker, Darryl L., Is Your Estimating System Asking for Trouble?, Contract Management magazine, May Ibid. 4. Lubeck, Jeffrey A., Beyond an Adequate Accounting System, Contract Management magazine, May Ibid. 6. Walker, see note Public Law (10 U.S.C. 2306). 8. Garret, see note Walker, see note Walker, see note Contract Management January 2009