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NPS-54-87-004 



NAVAL POSTGRADUATE SCHOOL 

Monterey, Calilornia 




ON THE FEASIBILITY OF CREATING A COMPARABLE 

DATABASE FOR NONRECURRING COST ANALYSIS 

UNDER DUAL SOURCE COMPETITION 

Dan C . Boger 
// 

and 

Shu S. Liao 
May 1987 

Approved for public release; distribution unlimited. 

Prepared for: Naval Air Systems Command 

Cost Analysis Division 
Washington, D. C. 20361 



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NAVAL POSTGRADUATE SCHOOL 
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The research summarized herein was sponsored by the Naval Air 
Systems Command, Cost Analysis Division under work order 
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On the Feasibility of Creating a Comparable Database for Nonrecurring Cost Analysis 
Under Dual Source Competition 



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Dan C . Boqer and Shu 


S. Liao 






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Dual source commetition, nonrecurring costs, cost 








drivers, cost estimation relationships 











19 abstract {Continue on reverse if neceisary and identify by block number) 

This study examines the nature of nonrecurring cost items and develops systematic 
procedures for the government and contractors to follow in order to generate a 
database of nonrecurring costs which is both consistent and comparable. The objective 
was to develop a method for generating an analyzable set of data for parametric 
estimation of nonrecurring costs. Cost elements were analyzed and their cost 
drives were identified. 



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ON THE FEASIBILITY OF CREATING A COMPARABLE DATABASE 
FOR NONRECURRING COST ANALYSIS UNDER 
DUAL SOURCE COMPETITION 



by 

Dan C . Boger 
and 

Shu S. Liao 

Department of Administrative Sciences 
Naval Postgraduate School 
Monterey, California 93943 



May 1987 



EXECUTIVE SUMMARY 



In dual sourcing decisions, it is necessary that the nature and 
extent of nonrecurring costs be fully analyzed. Nonrecurring costs 
are important since they represent those investment costs which 
must be incurred before the second source produces any output. 
Therefore, good measurement and models of nonrecurring investment 
costs are required in order to determine whether dual sourcing can 
save costs . 

A major task in cost estimation is to determine the cost 
behavior of a cost element so that the amount of the cost element 
may be estimated when the factors driving the cost change. This 
report examines the cost behavior of major nonrecurring cost 
elements and explores the feasibility of creating a comparable data 
base for parametric analysis of nonrecurring costs when a second 
supplier is to be established for competitive procurement. 

To estimate nonrecurring costs associated with establishing a 
second source, both analogy and parametric CER methods have been 
used. However, our examination of contractors' cost estimation 
methods indicates that government cost analysts face several 
difficulties under current cost data reporting systems. These are 
discussed in detail in chapter 2. 

Since nonrecurring costs consist of several categories of cost 
items, a parametric cost estimating model with a small number of 
available observations and a large number of potential explanatory 
variables would be unreliable, even if possible. A feasible 
solution is to disaggregate the nonrecurring costs into relatively 



i 



homogeneous groups of cost items for data accumulation purposes. 
With a consistent data base and relatively homogeneous cost items, 
a parametric model for each group may be constructed with a 
relatively small number of observations, a typical constraint in 
major weapon system cost estimation. 

Our research effort focused on identifying the components of 
nonrecurring second source start-up costs, their cost behavior, and 
cost drivers. Our findings can be summarized below. 

First, it is necessary to separate nonrecurring material costs 
from labor and overhead costs for estimating purpose. The main 
reason is that the cost drivers for each are not always the same. 
Lumping material and labor costs together would require adding more 
explanatory variables to the CER model. 

Second, parametric CER models for labor cost must be based on 
labor hours, not on labor dollars as some cost analysts do now. 

Third, the most important explanatory variable that needs to 
be operationalized is the complexity of the weapon system. Most of 
the manpower needed is variable and is driven, according to 
contractors, by the amount of labor hours. In fact, some contractors 
have used certain surrogate measures for the level of complexity. 
Standardizing the measure of system complexity is necessary if a 
parametric CER is to be developed. 

Our recommendation is that material and labor costs should be 
separately reported for each category defined in the main body of 
the report and that defining the complexity level of a system holds 
the key to developing viable parametric CER models for nonrecurring 
costs . 



ii 



CHAPTER 1 



INTRODUCTION 

Competition has been hailed by virtually every corner of the public 
and private sectors as a vehicle for reducing the cost of acquiring 
weapon systems. However, in order to introduce competition in 
major weapon system procurement, a second source of supply must be 
created. The cost to establish a competitive second supply source 
can be high and difficult to estimate. This report examines the 
feasibility of creating a comparable data base for parametric 
analysis of nonrecurring costs when a second supplier is to be 
established for competitive procurement. 

BACKGROUND 

In dual sourcing decisions, it is necessary that the nature and 
extent of nonrecurring costs be fully analyzed. Nonrecurring costs 
are important since they represent those investment costs which 
must be incurred before the second source produces any output. It 
should be noted that the only way dual sourcing will produce 
overall cost savings for the Government is for the present value of 
the eventual recurring cost savings to offset the nonrecurring 
investment costs. Therefore, good measurement and models of 
nonrecurring investment costs are required in order to determine 
whether dual sourcing can save costs. 

A major task in cost estimation is to determine the cost 
behavior of a cost element so that the amount of the cost element 



1 



may be estimated when the factors driving the cost change. Our 
earlier research has identified several difficulties with the 
current state of the estimation of nonrecurring costs of dual 
sourcing. 1 First among these difficulties is that there is an 
inconsistent treatment of nonrecurring cost elements with their being 
predefined as either fixed or variable. The second difficulty is 
that different methods were used to aggregate costs into the cost 
elements used for analysis. These difficulties result in the data 
of nonrecurring costs compiled by specific sources being noncom- 
parable with data compiled by other sources, thus rendering the 
data unusable for analytical purposes. The lack of acceptable 
nonrecurring cost models can be partially attributed to these 
difficulties . 

To address this problem, it is necessary to develop systematic 
procedures for the government and contractors to follow in order to 
generate a database of nonrecurring costs which is both consistent 
and comparable. These procedures should provide specific and 
particular guidelines for all parties to a contract to follow in 
order to produce a consistent and comparable database of nonrecurr- 
ing costs for parametric analysis. 

OBJECTIVE OF THE PROJECT 

The objective of the project is to examine the nature of 

1 Dan C. Boger and Shu S. Liao, "An Analysis of Quantity- 
Split and Nonrecurring Costs Under a Competitive Procurement 
Environment (Vol. I)," Technical Report NPS54-85-08, Naval 
Postgraduate School, Monterey, CA, September 1985. 



2 



nonrecurring cost items and develop systematic procedures for the 
government and contractors to follow in order to generate a 
database of nonrecurring costs which is both consistent and 
comparable. Potential changes to RFP ' s and RFQ ' s will be analyzed 
with recommendations made as to how such changes could result in 
the provision of an analyzable set of data from each government 
contractor and how these sets may be aggregated to provide weapons- 
system peculiar databases for future analysis. The key element in 
such a system will be the provision of consistent and comparable 
databases . 



RESEARCH METHODOLOGY 

Due to the paucity of prior research on nonrecurring costs under 
dual source environments, the study relies heavily on first-hand 
data gathering. Five missile system contractors were visited by 
the research team jointly or separately. One of the five defense 
contractors is a prime contractor for a sole-source missile 
program. The intention was to see the differences and similarities 
between a sole sourced program and a dual sourced program. The 
remaining four are either the original source or the second source 
of dual-sourced missile programs. Individuals interviewed included 
cost-estimating specialists, financial managers, program managers, 
contract managers, and engineer ing/technical division managers. 

The interview focused on the following three questions; 

1. the criteria for classifying nonrecurring costs in 
setting up production facility. 



3 



2. the classification of nonrecurring cost items as variable 
or fixed costs. 

3. the method of tracking and accounting start-up nonrecurr- 
ing costs to segregate from follow-on production efforts. 

SCOPE AND LIMITATIONS OF THE STUDY 

As mentioned earlier, this study relied heavily on first-hand data 
gathering from defense contractors' files due to the paucity of 
prior research. Some contractors, however, were reluctant to 
discuss even their procedures, because of their perceptions of the 
"competition-sensitive" nature of this information. In addition to 
this problem of cooperation, the conduct of this study was further 
hampered by two built-in difficulties related to the maturity of 
the programs studied. The second supplier was either established 
several years ago or had only recently been announced. For the 
former, some of the techniques used to estimate the startup costs 
were often lost to corporate memory. For the latter, either the 
methods to be used for cost estimation had not been decided on or 
the information was considered to be competition sensitive. As a 
result, information disclosed tends to be of a general nature. 
However, the researchers were able to partially reconstruct the 
picture from supplemental documents accompanying proposals submitted 
to the Government procurement office. Therefore, the results of 
the research provide the reader with a comprehensive but incomplete 
overview of cost elements and costing methods used by the defense 
aerospace industry in the treatment of nonrecurring investment 
costs in a reprocurement environment. 



4 



CHAPTER 2 



DATABASE AND PARAMETRIC COST ESTIMATION 

Cost estimation is a projection into the future from a database 
compiled from past experiences. Accuracy of the projection depends 
on many things, not the least of which is the validity of the 
database. The need for a comparable and consistent database has 
long been recognized in the cost estimation community. This 
chapter discusses various cost estimation techniques, their 
database requirements, and related current Government regulations. 

COST ESTIMATING METHODS 

In subsequent chapters reference will be made to the different 
methods of cost estimation used by defense aerospace contractors. 
This section discusses the three basic methods most widely used. 

Analogy Method 

The method of analogy is based on direct comparisons with historical 
information on like components of existing systems. 2 There is 
intuitive and logical appeal to the popularity of this method. For 
example, the use of new structural material for aircraft often 
requires the development of special cutting and forming techniques 
with manufacturing labor requirements that differ significantly 
from those based on a sample of primarily aluminum airframes. 

2 C. A. Batchelder, et al . , An Introduction to Equipment Cost 
Estimating , Memorandum RM-6103-SA, The Rand Corporation, Santa 
Monica, CA, December 1969, pp. 2, 6-8. 



5 



Faced with this problem when titanium was first considered for usel 
in airframe manufacture, airframe companies developed standard-hourB 
values for titanium fabrication on the basis of shop experience ini 
fabricating test parts and sections. Although the experience ofB 
fabricating test parts is not identical to the effort necessary toll 
build the entire airframe, an estimate can be made by consideringll 
the similarities and extrapolating . 3 I 

Most often it works as follows. The item(s) to be produced is 
first compared with a recent project to determine if there are any 
common elements. If it is found that a significant portion of the 
new system is similar to the former one, the hours of effort and 
material expended to produced the previous item are used as a base 
estimate. Differences in the design and performance of the two 
systems are then considered. Estimates are made for these and 
added to the base. 

The strength of the analogy method is that it can provide 
sufficient accuracy for the least cost in the shortest time. 4 xhe : 
key requirement is to ascertain the similarity of items to be 
compared. Therefore, the database requirement is mainly concerned 
with establishing an objective basis to characterize an item for 
analogy. This requirement is best exemplified by recent Air Force 



3 Batchelder, pp. 7-8; Joseph W. Lemire, Jr., "Cost 
Estimating Methods Utilized by the Defense Aerospace Industry in 
the Production of Technical Data, Masters' Thesis, Naval 
Postgraduate School, Monterey, CA, June 1985, p. 21. 

^ Lemire, pp. 35-36. 



6 



attempts to establish a cost estimating model for tools . 5 
Engineering Method 

The industrial engineering approach involves breaking down the 
system into separate segments of work. These segments are then 
examined in detail and estimates are made for each segment. The 
detailed estimates are then consolidated into a total estimate for 
the overall system. This method is normally used when a thorough, 
detailed analysis is required for all the processes involved. 

The system must be relatively well-defined before this method 
can be used. It is often applied using a work breakdown structure 
(WBS) in which the system is organized in levels and each of the 
levels is comprised of a number of elements. A cost is estimated 
for each component element and totaled at each level. An overall 
estimate consists of the total of all the levels. 

The engineering method is more expensive than analogy, 
requiring more time and personnel and is used most often when the 
data cannot be directly fitted to an analogy. 6 

Parametric Method 

The parametric method is a statistical approach in which cost 
estimating relationships (CERs) with parametric explanatory 

® See James L. Storrs, "Taking the Art Out of Tool 
Estimating; Business Research Report, Proceedings of 1985 Federal 
Acquisition Research Symposium, Defense Systems Management College, 
pp. 241-45. 

® Lemire, p. 36. 



7 



variables, such as weight, speed, power, frequency, and thrust are 
used to predict costs. For example, in the area of airframe 
manufacturing, known CERs exist in terms of dollars per pound of 
weight, per pound of thrust, and so forth. These relationships are 
used with the variables of a new airframe to develop its estimated 
cost. This method is applied at a higher level of aggregation than 
the industrial engineering approach. 

Worthwhile use of this method requires that sufficient data 
exist and that historical costs are fairly consistent for statis- 
tical analysis. In an area where there are constant changes in 
technology, the CERs are invalidated faster than new ones can be 
developed. Hence, the parametric method is difficult to apply in a 
case like this. 

CURRENT GOVERNMENT REGULATIONS 

The government published Military Standard 881A in order to 

standardize the process of defense material acquisition. It is a 

summary of the upper three levels of a work breakdown structure. A 

work breakdown structure is defined by Military Standard 881A as; 

...a product-oriented family tree composed of hardware, 
services and data which result from project engineering 
efforts during the development and production of a defense 
material item, and which completely defines the project/- 
program. A WBS displays and defines the product (s) to be 
developed or produced and relates the elements of work to be 
accomplished to each other and to the end product. ^ 

Military Standard 881A is to be used by both contractors and 



^ Department of Defense, "Work Breakdown Structure for Defense 
Material Items," Military Standard 881A, 25 April 1985, p. 2. 



8 



the government during the acquisition process. The work breakdown 
structure has become a foundation of DoD cost estimation data 
requirements . 

In 1973, the Secretary of Defense introduced the Contractor 
Cost Data Reporting (CCDR) system which was intended "to maximize 
effective utilization of data resources... to provide the the 
primary database for use in most cost estimating efforts. "8 The 
CCDR is, by law, the fundamental cost data reporting guide for all 
contractors doing business with the government. 

Although the Military Standard 881A and CCDR guidelines are 
clear, there is no systematic procedure for applying them. An 
examination of contractors' WBS and cost estimating relationships 
based upon them shows that, at the lowest level of the WBS, both 
analogy and parametric approaches can be found in costing the work 
element . 



AN OVERVIEW OF CURRENT PRACTICE 

To estimate nonrecurring costs associated with establishing a 
second source, both analogy and parametric CER methods have been 
used. However, government cost analysts face several difficulties 
under the current cost data reporting system. This section 
discusses these difficulties. 

Difficulty of Using The Analogy Method At the Aggregate Level 

® Department of Defense Instruction 7000.11, "Contractor Cost 
Data Reporting (CCDR)," September 5, 1973. This instruction was 
reissued on March 27, 1984. 



9 



The analogy method as applied here bases the second source's 
nonrecurring costs, especially tooling and test equipment costs, on 
the original producer's cost. A study by the Institute for Defense 
Analysis (IDA) cited the opinion of a cost analyst that the cost of 
special tooling and test equipment is about 80^ of the amount 
incurred by the original source. 9 But available data examined by 
the IDA authors do not allow generalization of this estimate. Our 
earlier work also found other attempts to use the analogy method for 
nonrecurring cost estimation. 

Results from our interviews with contractors shed some light 
on the difficulty of using the analogy method at the aggregate 
level. First, the sole source or the original source supplier of a 
system is also the developer of the system. Some of the production 
tooling costs are actually incurred during the development phase 
(sometimes called system planning phase in contractor's WBS ) and 
never specifically identified. Therefore, the data for nonrecurring 
costs are not entirely consistent with what might be incurred by a 
second source. Second, a study by Garrick shows that the original 
source's production capacity is sometimes larger than necessary. 10 
A second source, if determined to be desirable, is most likely to 
be sized to some production rate smaller than the original source. 



3 See G. G. Daly, H. P. Gates, and J. A. Schuttinga, The 
Effect of Price Competition on Weapon System Acquisition Costs , the 
Institute for Defense Analysis, P-1435, Arlington, VA, 1979. 

P. M. Garrick, "Estimating the Savings from Competitive 
Acquisitions: A Review of Previous Investigations," Chapter III of 
a draft Institute for Defense Analysis report, "Competition as an 
Acquisition Strategy: An Assessment of Selected Army Weapon System 
Procurements . " 



10 



However, initial production start-up costs are not separated from 
production rate related start-up costs under the current cost data 
reporting system. These initial costs are driven by design 
considerations, while the rate-related costs are driven by the 
number of units. Therefore, use of the analogy method faces the 
built-in difficulty of noncomparable data. 

Difficulty of Using Parametric CER models at the Aggregate Level 

The second method commonly used by government cost analysts calls 
for using parametric CERs . However, parametric models are based on 
statistical analysis of historical data. As mentioned earlier, 
worthwhile use of this method requires that a sufficient data base 
exists and that historical costs are fairly consistent for statist- 
ical analysis. Due to the limited number of second-sourced major 
programs and the absence of systematic accumulation of nonrecurring 
cost data it should be obvious that any attempt to construct a 
parametric CER for nonrecurring costs is premature at this stage in 
time . 

REQUIREMENTS FOR A PARAMETRIC MODEL 

Since nonrecurring costs consist of several catagories of cost 
items, a parametric cost estimating model with a small number of 
available observations and a large number of potential explanatory 
variables would be unreliable, even if possible. A feasible 
solution is to disaggregate the nonrecurring costs into relatively 
homogeneous groups of cost items for data accumulation purposes. 



With a consistent data base and relatively homogeneous cost items, 
a parametric model for each group may be constructed with a 
relatively small number of observations, a typical constraint in 
major weapon system cost estimation. 

Our research effort focused on identifying the components of 
nonrecurring second source start-up costs, their general patterns 
of variation, and cost drivers. It is important to identify the 
cost drivers of most nonrecurring cost items, as the development of 
a parametric cost estimating model requires a comparable database 
of costs as well as cost drivers. The results of our field study 
are discussed in the next chapter. 



12 



CHAPTER 3 



ANALYSIS OF COST BEHAVIOR OF NONRECURRING COSTS 

To become a competitive second supplier the new source incurs 
nonrecurring costs in six areas: the preparation of bid and 
proposal, research and development, data management, production 
start-up, test and evaluation, and project management. This 
chapter will present research findings regarding functions typically 
included in each cost element and the cost estimating methods, 
which includes cost behavior and cost drivers, used by the contrac- 
tors studied. A summary of findings and our recommendations can be 
found in Chapter 4 . 



BID AND PROPOSAL 

This group of cost items include preparation of bid packages, 
contract bidding, and document preparation for meeting reporting 
requirements. Since these costs are considered to be part of 
future business expenses, they are included in overhead expenses 
and distributed across all government contracts. We found that for 
all contractors, the amount budgeted for a project proposal is 
considered a fixed cost and is determined by the analogy method. 

RESEARCH AND DEVELOPMENT 



Cost Components 

Included in this group of cost items are engineering efforts 
ranging from initial design analysis and interpretation/translat ion 



13 



through design integration. It is important to note that the level 
three drawings that become government property in the technical' 
data package are not the same as the level-three drawings maintained 
in-house by the first source. The original contractor is not 
required to reveal the processes used to translate the drawings 
into hardware. The level-three drawings available to the Government 
and the second source shows dimensions, surface finishes, and 
materials, but no processes. 

A second source may be provided a technical data package 
containing level-three drawings and a system engineer to help 
interpret the drawings but may still have to redo everything the 
original source has done, except for the original development of 
the system. In the reinterpretation of the drawings to redevelop 
the drawing base in accordance with the way that second contractor 
does business, it can be as though it were redesign. 

It should be pointed out that the research and development 
cost discussed in this section refers to initial design analysis, 
interpretat ion/translat ion , or reverse engineering. It is not the 
independent research and development (IR&D) covered by Cost 
Accounting Standard 420. The cost discussed here is typically 
accounted for by the second source as a part of "Design, Testing & 
Evaluation Engineering Labor". 

Cost Estimation Method 

The R & D tasks involved in becoming a competitive second source 
depend largely on the acquisition strategy employed by the Govern- 



14 



merit. At one extreme, the second source may be required to produce 
a model identical in every aspect to the sample provided by the 
original source, or the so-called "Chinese copy". To do this, the 
second source and its subcontractors must do reverse engineering. 
In this case the R & D costs are roughly the same as the R & D 
costs incurred by the first producer. 

At the other end of the spectrum, the contractor can be 
relatively free of constraints as long as the final product is 
compatible in form-fit-function. This strategy allows the second 
source to explore some cost savings alternatives, but the savings 
may be offset by the additional R & D costs incurred. 

The amount of material cost varies with the competition 
strategy and system complexity. Direct labor and overhead costs 
are driven by the amounts of hours for various engineering special- 
ties. For cost estimation purposes, it is logical to estimate the 
number of engineering hours needed and apply the applicable labor 
and overhead rates to derive the total direct labor and overhead 
costs. Contractors' cost estimating personnel indicated that 
engineering hours are variable and are affected by both the 
complexity of the system and whether the contractor has prior 
experience with a similar system. 

TECHNICAL DATA 

Nonrecurring cost items related to technical data include technical 
manuals and drawings, engineering data, and data management. It 
should be noted that, although some separate contracts may exist 



15 



which purchase technical data, these costs are incremental, 
nonrecurring costs from the standpoint of second sourcing decision. 
Some technical data packages include clauses which prohibit the 
second source from altering technical manuals and drawings. In 
such cases, engineering changes must be proposed to and made by the 
first source. This process involves Engineering Change Proposals 
( ECP ) and Engineering Change Orders (ECO). The typical cost 
components are discussed below. 

Technical Manuals and Drawings 

The nonrecurring cost items in this category include the preparation 
of technical manuals and maintenance support for preliminary 
design. Design personnel are supported by draftpersons in the 
preparation of drawings, parts lists, system correlation drawings, 
and design instructions. 

These costs are considered variable; the causal factor is the 
complexity of the task, which determines the level of effort 
necessary to deliver a finished product. For cost estimation 
purposes, it is logical to estimate the number of drafting hours 
needed and apply the applicable labor and overhead rates to derive 
the total direct labor and overhead costs. Contractors' cost 
estimating methods vary, with one using the total number of 
drawings and another using the number of drawings to be modified. 
These are then multiplied by an average hours per drawing to obtain 
total hours. 

If there is an ECO involved, cost estimation relies on a 



16 



complexity score and a schedule impact index. As an example, 
complexity may be measured by the range or weight of a missle. The 
value for the complexity score is influenced by the degree of 
uncertainty concerning design requirements, the level of risk due 
to technical advancement, whether the program is joint or single 
service, and whether it will be a single or multi-purpose system. 

Engineering Data 

Cost items in this category include the preparation of a variety of 
coordinating and correlating documents (e.g., drawings, plans, 
procedures, specifications, computer programs, and flow diagrams), 
corrective design, and documentation update. 

As in technical manuals and drawings, these costs are considered 
variable; the causal factor is the complexity of the task, which 
determines the number of labor hours necessary to deliver a finished 
product. It is interesting to note that, although different 
classes of technical personnel are used and separately identified, 
no such distinction was made in computing the cost data in all 
supporting documents we examined accompanying contract proposals. 
Only the total number of direct labor hours are used in cost 
computation. This rudimentary method seems to be an accepted 
practice. Therefore, it seems to be logical to group cost items 
related to technical manuals and engineering data into a single 
element. This grouping is advantageous for parametric model 
building and estimation purposes. However, for budgetary purposes, 
these costs may need to be separately reported. 



17 



Data Management 



Tasks such as maintaining master documents at the latest approved 
revision level, assuring that all data items are prepared and 
submitted in accordance with contract requirements, and monitoring 
subcontract data are included in this cost element. For one group 
of contractors this cost element was treated as a variable cost of 
total engineering labor hours. Under this circumstance, this cost 
element can be grouped with the preceding two cost elements. For 
another group of contractors, data management cost was estimated on 
a per Contractor Data Requirement List (CDRL) item basis. It 
should be noted, however, that the number of CDRL items can be an 
alternative measure of the complexity of a system, since more 
tracking of business/financial items may be required for a more 
complex system. Therefore, it is reasonable to conclude that, 

although different measures have been used as cost drivers for 
technical data handling, these different measures all reflect the 
degree of complexity of the system. 

PRODUCTION START-UP COSTS 

Nonrecurring costs incurred by the second source in production 
start-up generally fall into one of three categories: tooling, 

production engineering, and buildings or facilities. Test equipment 
will be treated in the following section. 

Tooling 

Tooling equipment needed to produce the contract item is included 



18 



in this cost element. It should be noted that some contractors 
distinguish initial tooling from rate tooling, but some do not. As 
we noted above, initial tooling costs tend to be driven by design 
and complexity considerations while rate tooling costs tend to be 
driven by the number of production units. However, separation into 
these two categories is not necessary in concept if both cost 
drivers are available for model building. All contractors stressed 
that production phase special tooling equipment is not directly 
charged to the government at the outset. However, the cost to the 
government remains the same, as this cost item is charged to the 
government through amortization. Alternative policies merely 
change the form of recoupment from the government for these 
expenditures . 

Labor and labor related costs account for mast of the cost 
items in this cost element. Material costs include purchased tools 
or tool manufacturing material if the tool is made in house. This 
presents a problem for forecasting purpose, as making the tool in- 
house increases labor costs but decreases the cost of tool purchas- 
es. Tool manufacturing material was typically estimated according 
to tool manufacturing and tool proofing labor hours based on prior 
history . 

The major factors affecting labor estimates are the complexity 
of the system and the production rate. It is apparent that the 
former is more related to the initial tooling and the latter is 
related to rate tooling. In most cases, the distinction between 
initial tooling and rate tooling is not made. Where the distinction 



19 



is made, a rather crude method is used by the contractor to project 
nonrecurring tooling costs. The nonrecurring ramp (to increase 
monthly rate) is treated as variable dependent on quantity and 
rate. A ratio of dollar increase to rate increase is calculated by 
using prior experience, and this delta factor is applied to prior 
costs , 

Production Engineering 

The original industrial engineering efforts to translate design 
into an efficient manufacturing technique (for example, redesigning 
plant layout and operations planning) are included in this cost 
element . 

This cost element is estimated by determining the engineering 
hours on the basis of the level of effort required. Therefore, the 
real driver is the complexity of the system involved. In this 
case, it is clear that the complexity of the weapon system is 
serving as a proxy for the complexity of production of the system. 
In cases where this is not true, production complexity will have to 
be treated directly. 

Buildings or Facilities 

Unless the program is going to be a long term effort, no new 
facilities will usually be built. Contractors track existing 
programs to see when they will terminate and what facilities will 
become available for the new program. Therefore, the cost items 
involved are primarily related to conversion of existing facilities 



20 



and construction of special facilities. 

The cost is estimated by the number of square feet of floor 
space adjusted for the level of effort required to modify it. The 
the level of effort requires a surrogate measure, such as the 
degree of similarity between the existing program and the proposed 
new program. The number of square feet of floor space required is 
variable, depending on the production rate desired. 

TEST AND EVALUATION 

Nonrecurring costs incurred by a second source in test and evaluation 
include first article test quantities, test equipment, and related 
engineering costs. Cost items included in this element exhibit two 
kinds of cost behavior: variable cost and fixed/variable cost. 

Variable costs include assembly and test labor and materials. 
These cost items clearly are related to the quantity of test items. 
For comparison across programs, however, one must add another 
explanatory variable, complexity of the system. 

Fixed/var iable costs, which are both time dependent and 
quantity dependent, are also affected by the complexity of the test 
and test equipment. Cost items included in this category consist 
of hardware as well as engineering support costs. 

In the case of quality assurance, engineering inspection is 
estimated as a percentage of the number of hours required to build 
test units. Receiving inspections are factored against total 
engineering material. 



21 



PROGRAM MANAGEMENT 



Included in this cost element are program planning and technical 
direction, system engineering, administrative support, procurement 
planning, liaison with the government, preliminary design reviews, 
systems requirements review, management support, subcontract 
selection and coordination, scheduling, and cost analysis. 

Cost estimation depends upon the structure of the program 
management effort. In the pure or functional program management 
structure all resources, personnel and material, are dedicated to a 
specific program. Contractors view this cost element as mostly 
fixed and use past experience with similar programs. 

In a matrix program management structure, personnel in the 
organization may work on a variety of projects and material 
resources are drawn from a shared pool. In this case, labor 
estimates are variable and estimated on a labor hours basis 
according to prior experience with similar programs. In essence, 
the degree of complexity determines the labor hours. 

FIRST SOURCE COSTS 

In developing a competitive environment, technical transfer to and 
coordination with the second source are the two areas in which 
nonrecurring costs accrue to the original source of supply. 

Technical Transfer 

There are two types of nonrecurring costs in technical transfer. 
These are the costs of the engineering task of preparing a technical 



22 



data/reprocurement package and the costs of production of hardware, 
for example, missiles. Missile hardware in various stages of 
completion and special test equipment are transferred to the second 
source to assist in the learning process. Note that the hardware 
involved is the training version which differs from the tactical 
unit in that the tactical unit warhead, rocket motor, and hydraulic 
actuation system are replaced with a ballast, a signal processor, 
and a tape recorder unit with cartridge loading capability. In 
some cases, however, for cost estimation purposes, no distinction 
is made between the two versions since the cost of the deleted 
items is not significantly different from the cost of the added 
items . 

The data/reprocurement package cost estimation is done by 
experienced engineering staff based on manhours, much as the 
preparation of technical manual and drawings discussed earlier in 
this chapter. The missile hardware costs are variable. The total 
cost of labor and material are driven by the quantity supplied as 
well as the complexity of the system. 

Coordination 

Coordination with the second source is primarily the task of 
training and supporting the second source's engineers. The costs 
involved are primarily travel expenses and labor costs. 

Cost estimation is based on the time required which is related 
to the quality/experience of the engineers as well as the adequacy 
of the data package. 



23 



CHAPTER 4 



SUMMARY OF FINDINGS AND RECOMMENDATIONS 

This study was designed to examine the nature of nonrecurring cost 
items and develop systematic procedures for the government and 
contractors to follow in order to generate a database of nonrecurr- 
ing costs which is both consistent and comparable. The objective 
was to develop a method for generating an analyzable set of data 
for parametric estimation of nonrecurring costs. 

This study relies heavily on first-hand data gathering. Five 
missile system contractors were visited. Individuals interviewed 
included cost-estimating specialists, financial managers, program 
managers, contract managers, and engineering/technical division 
managers. Cost estimation documents supporting contractors' 
proposals were examined to determine the cost estimation practice 
and identify relevant cost drivers. 

SUMMARY OF FINDINGS 

In Chapter 2, we have shown that, given current practices of cost 
reporting, it is impractical to develop a viable model for 
estimating nonrecurring costs when second sourcing is contemplated. 
The analogy method at the aggregate level has been shown to be 
unreliable. The development of a parametric CER model, however, 
requires a sufficient data base which is not currently available. 
To develop such a data base, knowledge of major nonrecurring cost 
categories and their cost drivers is necessary. Exhibit 1 summarizes 



24 



the results of our endeavour for this purpose. It contains the 
cost elements discussed in the previous chapter, measures of the 
cost elements, whether that particular element is fixed or variable, 
and the cost drivers for that element. Relative sizes for the 
major groupings of cost elements are discussed in our previous 
report . 1 1 

A few notable observations should be mentioned. First, it is 
necessary to separate nonrecurring material costs from labor and 
overhead costs for estimating purpose. The main reason is that the 
cost drivers for each are not always the same. Lumping material 
and labor costs together requires adding more explanatory variables 
to a CER model, which would quickly exhaust the degrees of freedom 
because of the limited database for major weapon systems. 

Second, parametric CER models for nonrecurring labor costs must 
be based on labor hours, not on labor dollars as some cost analysts 
do now. There are several reasons for this. For one, all contrac- 
tors interviewed indicate that they estimate anticipated manpower 
levels (in labor hours) required to support the contract before 
they cost it. For another, although different types of engineering 
elements are distinguished in the Work-Breakdown-Structure, all 
engineering hours for a given work element are grouped together for 
costing purpose. Furthermore, different contractors have different 
labor and overhead rates, which would cloud the development of CER 
models if labor dollars are used as the dependent variable. 

Third, the most important explanatory variable that needs to 

H Boger and Liao, September 1985, 



25 



be operationalized is the complexity of the weapon system. Most of 
the manpower needed is variable and is driven, according to 
contractors, by both labor hours and complexity. When prodded to 
define how this is predicted, contractors' cost estimating personnel 
typically indicated that they use the analogy method if the firm 
has prior experience or a commercially available model which uses 
several relatively subjective inputs (such as complexity) if a task 
is new. One can infer that "prior experience" was most likely the 
result of using such a model when the firm performed a specific 
task for the first time. Note that the use of such a model 
requires calibration of the model according to the complexity level 
of the item. Therefore, defining the complexity level of a system 
in objectively measurable terms is of paramount importance if a 
reliable parametric CER model for nonrecurring cost is to be 
developed. In fact, most contractors have used certain surrogate ‘ 
measures for complexity level, such as the number of Contract Data 
Requirement List items, the number of drawings, etc. 

COMPLEXITY AND ITS MEASUREMENT 

Throughout Chapter 3 the complexity of a weapon system is repeatedly 
mentioned as the main cost driver. Picking those particular 
variables which can precisely measure the complexity of a missile 
system is a difficult task, since little, if any, work has been 
accomplished in this area. Therefore, we propose that several 
variables be examined for their adequacy in generating good cost 
estimating relationships. Subsequent to this exploratory examina- 



26 



tion, requirements may be more closely focused on those variables 
which yield the best results. 

The candidate variables which we propose are analogous to 
surrogate measures of aircraft complexity, i.e., range of the 
missile, speed of the missile, weight of the missile, and weight of 
the guidance and control section of the missile. That each of 
these variables might serve as a proxy for complexity under certain 
conditions is quite clear. Which one or two of these is best under 
all, or almost all, conditions is an empirical question which 
cannot be settled until data are available. 

RECOMMENDATIONS 

Apart from responses to our interview questions, much of our 
information about the behavior of nonrecurring cost items comes 
from supporting documents accompanying contractors' proposals. 
Therefore, implementing a modified cost reporting system to 
facilitate the development of a parametric CER model for nonrecurring 
cost would not be a major task. 

Two major pieces of information are missing from current 
contract proposal supporting documents that are needed to develop a 
consistent database for statistical analysis. The first is the 
breakdown of costs and labor hours according to the major cost 
elements outlined in Chapter 3. The second is data on explanatory 
variables, the cost drivers. 

The cost breakdown available in the supporting documents 
accompanying contractors' proposals typically follows the Work 



27 



Breakdown Structure which does not distinguish between recurring and 
nonrecurring costs, because the Work Breakdown Structure is based 
upon work elements and not costs. If the breakdown of costs and 
labor hours according to the major cost elements outlined in 
Chapter 3 is to be accomplished, it requires only regrouping of 
costs and labor hours already available to the contractor. 

Our recommendation is that material and labor costs should be 
separately reported. The main reason is that separate CER models 
must be developed for each, one with material cost in dollars as 
the dependent variable and another with labor hours as the dependent 
variable. The labor hours can then be used as the basis for 
estimating labor and overhead cost according to each contractor's 
labor and overhead rates structure. The secondary reasons for 
separate CER models are that cost drivers for each are not always 
the same and that separate models would require fewer explanatory 
variables, a major consideration when the database is limited. 

Defining the complexity level of a system holds the key to 
developing viable parametric CER models for nonrecurring costs. 
The RCA/PRICE model and the Air Force's tool cost estimating model 
are the prime examples of using complexity level as the explanatory 
variable. The cost drivers for tooling and test equipment costs 
developed by Naval Weapon Center in China Lake include per unit 
hardware cost as well as production rate. 12 xhe conventional method 
for estimating hardware costs typically takes into consideration 

1 2 Advanced Intercept Air-to-Air Missile (AIAAM) Life Cycle 
Cost Estimates (U), Naval Weapons Center, Code 081, NWC TM 4899, 
September 1982. (C) 



28 



the capability of the system via inclusion of physical or performance 
characteristics of the system. For example, aircraft and missiles 
typically use some measures of speed, range, etc. It may be 
logical to examine the feasibility of using capability as a measure 
of the complexity of a system. The production rate variable was 
confirmed in our study as a major cost driver. However, we believe 
that the China Lake CER model would have been more reliable had 
they estimated materials cost and labor hours separately. 



29 



Exhibit I 

flajor Nonrecurrinq Cost Eleients and Cost Drivers 



Cost Eleients 


Measure 


Cost Behavior 


Cost Drivers 


Bid 4 Proposal: 


(Included in contractor’s overhead expenses) 


1 B: R 4 D: 








1 

1 

Material 


$ 


Variable 


Coaplexity, lethods of second source developient 


Labor and overhead 


hrs. 


Variable 


Coiplexity, prior experience 


C: Technical Data: 








Technical lanuals/draiinqs 


hrs. 


Variable 


Coiplexity, 1 of drawings, 1 of drawings to be aodified 


Engineering data 


hrs. 


Variable 


Coiplexity 


Data Manageient 


hrs. 


Variable 


Coiplexity, 1 of CDRL iteis 


D: Production Start-Up: 








Tooling (initial) 


hrs. 


Variable 


Coiplexity 


Tooling (rate) 


hrs. 


Variable 


Production rate, predeteriined raip ratio 


Production engineering 


hrs. 


Variable 


Coiplexity 


Facility conversion 


s.f. 


Variable 


Level of efforts depends on siiilarity to previous prograi 


Special construction 


s.f. 


Variable 


Production rate 


E: Test and Evaluation: 








Hardware- Labor 


hrs. 


Variable 


Quantity of test iteis, coiplexity 


Material 


$ 


Variable 


Quantity of test iteas, coiplexity 


Quality assurance 


hrs. 


Variable 


Fabrication hours, engineering laterial 


F: Prograi Manageient: 








(functional structure) 


hrs. 


Fixed 


Past experience 


(latrix structure) 


hrs. 


Variable 


Coiplexity 


G: First Source Cost: 








Technical Transfer- Data 


hrs. 


Variable 


Coiplexity 


Harewa 


e $ 


Variable 


Complexity, quantity supplied 


Coordination 

L . . 


$ 


Variable 


Experience of engineer k adequacy of data 

j 



30 



DISTRIBUTION LIST 



Agency No 

Defense Technical Information Center 
Cameron Station 
Alexandria, VA 22314 

Mr. James Weathersby 
Code 524 

Naval Air System Command 
Washington, D. C. 20361 

Mr. Tom Gilbride 
Code 524 

Naval Air System Command 
Washington, D. C. 20361 

Dr . Dan Nussbaum 

Naval Center for Cost Analysis 

Washington, D. C. 20350-1100 

COL Robert Skipp 

Air Force Business Research Management Center 
Building 125, Rm. 2063 
Wright-Patterson AFB , OH 45433-5000 

Director 

Air Force Cost Center (AFCCE) 

c/o HQ USAF/ACC 

Washington, D. C. 20330-5018 

Dr. Robert F. Williams 
Director 

Army Procurement Research Office 
Ft. Lee, VA 23801-6045 

Dudley Knox Library, Code 0142 
Naval Postgraduate School 
Monterey, CA 93943 

Office of Research Administration 
Code 012 

Naval Postgraduate School 
Monterey, CA 93943 

Professor Dan C. Boger 

Department of Administrative Sciences 
Naval Postgraduate School 
Monterey, CA 93943 

Professor Shu S. Liao 

Department of Administrative Sciences 
Naval Postgraduate School 
Monterey, CA 93943 



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