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Project Management

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Lesson#32

PRICING AND ESTIMATION-1

PRICING AND ESTIMATION (CONTD.)

BROAD CONTENTS

Organizational Input Requirements

Labor Distributions

Overhead Costs


32.1 ORGANIZATIONAL INPUT REQUIREMENTS:

Note that once the work breakdown structure and activity schedules are established, the

program manager calls a meeting for all organizations that will be required to submit pricing

information. It is imperative that all pricing or labor-costing representatives be present for the

first meeting. During this ''kickoff" meeting, the work breakdown structure is described in depth

so that each pricing unit manager will know exactly what his responsibilities are during the

program. The kickoff meeting also resolves the struggle-for-power positions of several

functional managers whose responsibilities may be similar to overlap on certain activities. An

example of this would be quality control activities. During the research and development phase

of a program, research personnel may be permitted to perform their own quality control efforts,

whereas during production activities the quality control department or division would have

overall responsibility. Unfortunately, one meeting is not always sufficient to clarify all

problems. Follow-up or status meetings are held, normally with only those parties concerned

with the problems that have arisen. Some companies prefer to have all members attend the

status meetings so that all personnel will be familiar with the total effort and the associated

problems. The advantage of not having all program-related personnel attend is that time is of the

essence when pricing out activities. Many functional divisions carry this policy one step further

by having a divisional representative together with possibly key department managers or section

supervisors as the only attendees at the kickoff meeting. The divisional representative then

assumes all responsibility for assuring that all costing data are submitted on time. This

arrangement may be beneficial in that the program office need contact only one individual in

the division to learn of the activity status, but it may become a bottleneck if the representative

fails to maintain proper communication between the functional units and the program office, or

if the individual simply is unfamiliar with the pricing requirements of the work breakdown

structure.

Time may be extremely important, during proposal activities. There are many situations in

which a Request for Proposal (RFP) requires that all responders submit their bids no later than a

specific date, say within thirty days. Under a proposal environment, the activities of the

program office, as well as those of the functional units, are under a schedule set forth by the

proposal manager. The proposal manager's schedule has very little, if any, flexibility and is

normally under tight time constraints so that the proposal may be typed, edited, and published

prior to the date of submittal. In this case, the Request for Proposal (RFP) will indirectly define

how much time the pricing units have to identify and justify labor costs.

The justification of the labor costs may take longer than the original cost estimates, especially if

historical standards are not available. Many proposals often require that comprehensive labor

justification be submitted. Other proposals, especially those that request an almost immediate

response, may permit vendors to submit labor justification at a later date.

Remember that in the final analysis, it is the responsibility of the lowest pricing unit supervisors

to maintain adequate standards, if possible, so that an almost immediate response can be given

to a pricing request from a program office.

32.2 LABOR DISTRIBUTIONS:

The functional units supply their input to the program office in the form of man-hours as shown

in below.


Functional Pricing Flow

The input may be accompanied by labor justification, if required. The man-hours are submitted

for each task, assuming that the task is the lowest pricing element, and are time-phased per

month. The man-hours per month per task are converted to dollars after multiplication by the

appropriate labor rates. The labor rates are generally known with certainty over a twelve-month

period, but from then on are only estimates. How can a company predict salary structures five

years hence? If the company underestimates the salary structure, increased costs and decreased

profits will occur. If the salary structure is overestimated, the company may not be competitive;

if the project is government funded, then the salary structure becomes an item under contract

negotiations.

In this regard, the development of the labor rates to be used in the projection is based on

historical costs in business base hours and dollars for the most recent month or quarter. Average

hourly rates are determined for each labor unit by direct effort within the operations at the

department level. The rates are only averages, and include both the highest-paid employees and

lowest-paid employees, together with the department manager and the clerical support. These

base rates are then escalated as a percentage factor based on past experience, budget as

approved by management, and the local outlook and similar industries. If the company has a

predominant aerospace or defense industry business base, then these salaries are negotiated with

local government agencies prior to submittal for proposals.

The labor hours submitted by the functional units are quite often overestimated for fear that

management will "massage" and reduce the labor hours while attempting to maintain the same

scope of effort. Many times management is forced to reduce man-hours either because of

insufficient funding or just to remain competitive in the environment. The reduction of manhours

often causes heated discussions between the functional and program managers. Program

managers tend to think in terms of the best interests of the program, whereas functional

managers lean toward maintaining their present staff.

To cater to this, the most common solution to this conflict rests with the program manager. If

the program manager selects members for the program team who are knowledgeable in manhour

standards for each of the departments, then an atmosphere of trust can develop between the

program office and the functional department so that man-hours can be reduced in a manner that

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represents the best interests of the company. This is one of the reasons why program team

members are often promoted from within the functional ranks.

The man-hours submitted by the functional units provide the basis for total program cost

analysis and program cost control. To illustrate this process, consider the following Example

32.1:

Example 32.1:

On May 15, Apex Manufacturing decided to enter into competitive bidding for the modification

and updating of an assembly line program. A work breakdown structure was developed as

shown below:

On June 1, each pricing unit was given the work breakdown structure together with the schedule

as shown in Figure 32.2 below. According to the schedule developed by the proposal manager

for this project, all labor data must be submitted to the program office for review no later than

June 15. It should be noted here that, in many companies, labor hours are submitted directly to

the pricing department for submittal into the base case computer run. In this case, the program

office would “massage” the labor hours only after the base case figures are available. This

procedure assumes that sufficient time exists for analysis and modification of the base case. If

the program office has sufficient personnel capable of critiquing the labor input prior to

submittal to the base case, then valuable time can be saved, especially if two or three days are

required to obtain computer output for the base case.


Activity Schedule for Assembly Line Updating

Note that during proposal activities, the proposal manager, pricing manager, and program

manager must all work together, although the program manager has the final say. The primary

responsibility of the proposal manager is to integrate the proposal activities into the operational

system so that the proposal will be submitted to the requestor on time. A typical schedule

developed by the proposal manager is shown in Figure 32.3 below. The schedule includes all

activities necessary to "get the proposal out of the house," with the first major step being the

submittal of man-hours by the pricing organizations. It also indicates the tracking of proposal

costs. The proposal activity schedule is usually accompanied by a time schedule with a detailed

estimates checklist if the complexity of the proposal warrants one.

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Proposal Activity Schedule

The checklist generally provides detailed explanations for the proposal activity schedule.

After the planning and pricing charts are approved by program team members and program

managers, they are entered into an Electronic Data Processing (EDP) system as shown in Figure

32.4 below. The computer then prices the hours on the planning charts using the applicable

department rates for preparation of the direct budget time plan and estimate-at-completion

reports. The direct budget time plan reports, once established, remain the same for the life of the

contract except for customer directed or approved changes or when contractor management

determines that a reduction in budget is advisable. However, if a budget is reduced by

management, it cannot be increased without customer approval.

Labor Planning Flow Chart

In addition, the time plan is normally a monthly mechanical printout of all planned effort by

work package and organizational element over the life of the contract, and serves as the data

bank for preparing the status completion reports.

Initially, the estimate-at-completion report is identical to the budget report, but it changes

throughout the life of a program to reflect degradation, or improvement in performance, or any

other events that will change the program cost or schedule.

32.3 OVERHEAD RATES:

We should know that the ability to control program costs involves more than tracking labor

dollars and labor hours. Overhead dollars can be one of the biggest headaches in controlling

program costs and must be tracked along with labor hours and dollars. Although most programs

have an assistant program manager for cost whose responsibilities include monthly overhead

rate analysis, the program manager can drastically increase the success of his program by

insisting that each program team member understand overhead rates. For example, if overhead

rates apply only to the first forty hours of work, then, depending on the overhead rate, program

dollars can be saved by performing work on overtime where the increased salary is at a lower

burden. This can be seen in Example 32.2 below.

Example 32.2:

Assume that Apex Manufacturing must write an interim report for task 1 of project 1 during

regular shift or on overtime. The project will require 500 man-hours at $15.00 per hour. The

overhead burden is 75 percent on regular shift but only 5 percent on overtime. Overtime,

however, is paid at a rate of time and a half.

Assuming that the report can be written on either time, which is cost-effective— regular time or

overtime?

On regular time the total cost is:

(500 hours) ($15.00/hour) (100% + 75% burden) = $13,125

On overtime, the total cost is:

(500 hours) ($15.00/hour 1.5 overtime) (100% + 5% burden) = $11,812.50

Therefore, the company can save $1,312.50 by performing the work on overtime. Scheduling

overtime can produce increased profits if the overtime overhead rate burden is much less than

the regular time burden. This difference can be very large in manufacturing divisions, where

overhead rates between 300 and 450 percent are common.

Regardless of whether one analyzes a project or a system, all costs must have associated

overhead rates. Unfortunately, many program managers and systems managers consider

overhead rates as a magic number pulled out of the air. The preparation and assignment of

overheads to each of the functional divisions is a science. Although the total dollar pool for

overhead rates is relatively constant, management retains the option of deciding how to

distribute the overhead among the functional divisions. A company that supports its Research

and Development staff through competitive bidding projects may wish to keep the Research and

Development overhead rate as low as possible. Care must be taken, however, that other

divisions do not absorb additional costs so that the company no longer remains competitive on

those manufactured products that may be its bread and butter.

Furthermore, the development of the overhead rates is a function of three separate elements:

direct labor rates, direct business base projections, and projection of overhead expenses. Direct

labor rates have already been discussed. The direct business base projection involves the

determination of the anticipated direct labor hours and dollars along with the necessary direct

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materials and other direct costs required to perform and complete the program efforts included

in the business base. Those items utilized in the business base projection include all contracted

programs as well as the proposed or anticipated efforts. The foundation for determination of the


business base required for each program can be one or more of the following:

  • Actual costs to date and estimates to completion
  • Proposal data
  • Marketing intelligence
  • Management goals
  • Past performance and trends

Additionally, the projection of the overhead expenses is made by an analysis of each of the

elements that constitute the overhead expense. A partial listing of those items that constitute

overhead expenses is shown in Table 32.1 below. Projection of expenses within the individual

elements is then made based on one or more of the following:

  • Historical direct/indirect labor ratios
  • Regression and correlation analysis
  • Manpower requirements and turnover rates
  • Changes in public laws
  • Anticipated changes in company benefits
  • Fixed costs in relation to capital asset requirements
  • Changes in business base
  • Bid and proposal (B&P) tri-service agreements
  • IR&D tri-service agreements

In case of many industries, such as aerospace and defense, the federal government funds a large

percentage of the Bid and proposal (B&P) and IR&D activities. This federal funding is a

necessity since many companies could not otherwise be competitive within the industry. The

federal government employs this technique to stimulate research and competition. Therefore,

Bid and proposal (B&P) and IR&D are included in the above list.

The annual budget is the prime factor in the control of overhead costs. This budget, which is the

result of goals and objectives established by the chief executive officer, is reviewed and

approved at all levels of management. It is established at department level, and the department

manager has direct responsibility for identifying and controlling costs against the approved

plan.

The departmental budgets are summarized, in detail, for higher levels of management. This

summarization permits management, at these higher organizational levels, to be aware of the

authorized indirect budget in their area of responsibility.

Elements of Overhead Rates

Monthly reports are published indicating current month and year-to-date budget, actuals, and

variances. These reports are published for each level of management, and an analysis is made

by the budget department through coordination and review with management. Each directorate's

total organization is then reviewed with the budget analyst who is assigned the overhead cost

responsibility. A joint meeting is held with the directors and the vice president and general

manager, at which time overhead performance is reviewed.

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