Slides 14 3 calculate volume and performance variances for

Stabilized Pricing Objectives• The rationale behind stabilized pricing is that government customers value stability • Customers are appropriated organizations subject to Anti-Deficiency

Calculate Volume and Performance Variances for Output-Based

Control Case Study Scenario

Letterkenny Army Depot

Intermediate Cost Analysis

and Management

© Dale R Geiger 2011 2

Go to http:// www.letterkenny.army.mil/Video%203.wmv to play the video

Terminal Learning Objective

• Task: Calculate Volume and Performance Variances for

Output-Based Control Case Study Scenario

• Condition: You are training to become an ACE with access to

ICAM course handouts, readings, and spreadsheet tools and awareness of Operational Environment (OE)/Contemporary

Operational Environment (COE) variables and actors

• Standard: with at least 80% accuracy

• Describe the cost-rate-price structure at Letterkenny Army Depot

(LEAD)

• Calculate surcharge and price for depot services based on

Accumulated Operating Result (AOR)

• Discuss performance control issues in revolving funded organizations

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Letterkenny Army Depot

Teaching Points

Letterkenny is typical of many, manufacturing-like revolving funded operations that have common issues:

1 Price Setting: non appropriated organizations generate revenue

by providing goods or services

• This requires a mechanism to set prices

• How does this work?

2 Performance Evaluation

• Does “revenue less cost” yield a meaningful performance measure?

• How important is volume variance in manufacturing operations with significant fixed costs?

• How does one evaluate performance in such a complex environment?

Price Setting in the Business World

• The theory in the business world is that the market sets the price

• The forces of supply and demand clear the market at an efficient price

• This appears to work fairly well for commodity goods

• There are circumstances where this doesn’t apply

• Specialty items where there is not a market and/or

there are significant barriers to entry

• Internal transfers where one division of a company sells

to another (vertical integration)

Price Setting in Government

• Most government organizations are funded by

appropriation and have no pricing

• Some are non-appropriated and generate revenues

by charging for their goods or services

• Usually not competing in the market place so market pricing not applicable

• Sometimes there are social motivations to consider

• Budget constraints are expected to increase the

interest of government organizations in charging for

services

Price Setting in Government: Examples

• Public water department:

• Sets price of water to cover all costs of water acquisition and delivery

• May also include a sewer charge

• Parking meter:

• Covers more than the costs of meters

• Provides revenue source to cover other city costs

• Public bus fare:

• Covers less than the costs of transportation

• Subsidized by appropriated funds to encourage use

Consider Some Federal Examples

• National Institutes of Health: Supply and Service Fund

• Supplies thousands of laboratory supply items via catalog

• Competes with outside sources

• General Services Administration: Public Building Service

• Charges all users a basic standard charge

• Provides optional services on a fee basis

• National Institutes of Health: Management Fund

• Maintains capabilities but doesn’t charge on basis of usage

• Negotiates agreements from users like an allocation

• U.S Army: Army Material Command

• Sets prices for outputs based on previous profit and loss record

• Over time profits and losses offset each other

Revolving Fund Pricing

• The Army has many non-appropriated organizations: depots, labs, arsenals

• These are sometimes called revolving, industrial, stock,

enterprise, or working capital funded

• Usually have no social motivation or political agenda

• Generally have no comparable free market

• Represent internal transfers

• General rule is that the price or user fee must reimburse the costs of providing the goods or services

• Some “contracts” specify frequent invoices of incurred cost

• Other “contracts” utilize a “stabilized pricing” practice that gives

customers a firm price for the budgeted years

Stabilized Pricing Objectives

• The rationale behind stabilized pricing is that government customers value stability

• Customers are appropriated organizations subject to

Anti-Deficiency Act violation

• Changing incurred costs would create problems

• Increased incurred costs reduce the quantity that can be purchased or create ADA violations

• Decreased incurred costs increase the quantity that could be

purchased or result in unused budget

• The revolving funded organization absorbs the variations of

incurred cost to stabilized price:

• Adjusts future years pricing accordingly

• (Incurring cash flow risk in the process)

Stabilized Pricing Process

• Books a gain or loss in the current period

• Adds a compensating pricing surcharge to the third year

• Seeks a long run breakeven = full reimbursement

• Timing issues result in a three year lag

• Execution Year: Uses prices set in previously and books a gain or loss compared to incurred cost

• Budget Year: Experience in execution year is evaluated and projected into Budget Year +1 pricing

• Budget Year +1: Uses prices set in budget year based on execution year experience

AMC Pricing Sequence

• NOR (net operating revenue) is the AMC term for profit

• The goal is that NOR over time (AOR) is zero

Year -2 Year -1 Execution Year Budget Year Year +1 Budget

AMC Pricing Sequence

• NOR (net operating revenue) is the AMC term for profit

• The goal is that NOR over time (AOR) is zero

Year -2 Year -1 Execution Year Budget Year Year +1 Budget

note the time lags note the time lags

ISO 9001 ISO 14001

Why do we have “rates”?

• Industrial Operations (AWCF) sites are

different from Appropriated (OMA) funded

installations

• Army Working Capital Fund is a Revolving

Fund account

ISO 9001 ISO 14001

OMA Basis

• For example Ft Belvoir, Ft Detrick and Ft Meade

• Are provided annual operating funds from various

Operations and Maintenance, Army sub accounts:

– To pay military and civilian employee salaries and

benefits

– To pay utility bills

– To fund real property maintenance and improvements

– To maintain its vehicle fleet (to include Motor Pool)

– To fuel and operate vehicles, facilities and base

infrastructure

ISO 9001 ISO 14001

Industrial Sites

• Do not receive Operating Funds

• We receive orders to execute assigned

missions that involve core competencies,

or new missions

• We are granted “Cost Authority”, which

allows us to incur costs that must be

recovered via “rates”

ISO 9001 ISO 14001

Rates Functionality

• We add an overhead piece onto our

labor rates that generate operating

dollars for the depot to spend

– Example: The cost of labor on a

HMMWV is $5,000 but we charge

$9,000 and use $4,000 to pay for

indirect labor and base operating

expenses

ISO 9001 ISO 14001

Working Capital Fund Sites

• Working capital fund sites strive to break

even over the long term i.e have no overall

profit or loss (Accumulated Operating

Result [AOR])

• When the depot records an overall profit at

the end of a fiscal year, in the next year’s

rates we give our stabilized customer base

a price discount (AOR rate)

• When the depot records an overall loss at

the end of a fiscal year, in the next year’s

rates we tax our stabilized customer base

ISO 9001 ISO 14001

Rate Process

At the end of FY10, Budget and the Sales/Operations

Planning Branch reviewed the year’s expenses by cost

center and known workload data for the out-years

Rates are built to encompass those planned expenses

through the planned workload

These rates set the FY12 pricing exercise where

stabilized workload prices are determined

In the May budget submission these estimates will be

reviewed and updated

This will identify FY12’s income which equates to

operating dollars, which will be distributed back to

directorates in the internal operating budgets (IOBs)

ISO 9001 ISO 14001

What’s in the Rates?

• Rates are split into labor and overhead

• Labor consists of employee salaries and includes costs

incurred by the depot for employees on paid leave and the

portion of employee benefits the government pays

• Overhead burden consists of indirect operating expenses

for support areas to include salaries for overhead staff like

Command Group DRM, DPW, DOM leadership,

Engineering staff, Security, CPAC support, ACC-LEAD

support, LMP bills, worker’s compensation bills, etc.

• A “fully burdened rate” is labor + overhead

ISO 9001 ISO 14001

What’s in the Overhead Rates?

ISO 9001 ISO 14001

What’s in the Overhead Rates?

ISO 9001 ISO 14001

What’s in the Overhead Rates?

• Above shop

– Captures the non-production mission costs

– Applies to Maintenance mission cost centers only

– DOM, TRMD, DST and DPA have separate/distinct

ISO 9001 ISO 14001

What’s in the Above Shop Rate

Labor Depreciation Contracted Labor

Biggest opportunity for cost cutting

Travel

Supplies

ISO 9001 ISO 14001

What’s in the Overhead Rates?

• BASOPS

– Captures costs related to the support side of the depot

• Directorate of Resource Management

• Directorate of Public Works

– Facilities projects

– Environmental projects

– Utilities

– Custodial Support

• ACC- LEAD support

• Directorate of Information Management

– IT equipment

ISO 9001 ISO 14001

What’s in the Overhead Rates?

• General and Administrative

– Costs related to depot management

support

ISO 9001 ISO 14001

What’s in the BASOPS/GAE rate?

Postage & Printing Pavement Clearance Leases

Fuel Environmental DRSK

DRM DPW Support DPW Staf DOIM Depreciation Custodial Services Command Staf

FEP Program

IT

Custodial DPW

Environmental

Retail Operations

Vehicles/Equip

Command Staf Depreciation

DRM DRSK Leases

Utilitie s

Learning Check

• How do revolving or working funds differ from other government entities in regards to

funding?

• What is NOR? AOR?

• What is the purpose of the stabilized pricing methodology?

Stabilized Pricing: Five Step Process

• The process results in a plan for Year +1 that

• Considers inflationary cost increases

• Reflects changes in workload volume

• Adds surcharge that generate a NOR for the year that brings AOR to breakeven (i.e 0)

• The process begins once the execution year books are closed

• Labor, material, and in shop overhead are considered on a cost center basis

• Above shop, BASOPS, and General and Administration

overheads are considered on a site wide basis

Starting Point: Actual Results

• Assume three cost

centers with the

following costs and

prices and a beginning

overhead rate per hr 5.00 4.00 20.00 9.00

above shop overhead 1000 10.00

Step 1: Adjust Material & Rates for

unit price revenue direct material 525 525 1260 23.10

direct labor $ direct labor hrs labor rate per hr 52.50 42.00 105.00 63.00

shop overhead overhead rate per hr 5.25 4.20 21.00 9.45

above shop overhead 10.50

total cost NOR (profit) beginning AOR ending AOR (cum profit)

Step 2: Adjust for Future Workload

• Assume that A goes

direct labor $ direct labor hrs 200% 50% 300%

labor rate per hr

shop overhead 200% 50% 300%

overhead rate per hr

above shop overhead BASOPS

general and admin

total cost NOR (profit) beginning AOR ending AOR (cum profit)

Step 3: Build Plan at Adjusted & Inflated

bring AOR to zero

• (We have assumed

here that the budget

year NOR is zero so

that beginning AOR

overhead rate per hr 5.25 4.20 21.00 14.23

above shop overhead 1627.5 10.50

Step 4: Calculate the Price Surcharge Needed

• Consider the projected AOR

• If negative, a price increase

is needed to breakeven

• If positive, a price decrease

is needed to breakeven

• Determine the rate by

which revenue needs to

change to accomplish the

• Therefore revenue must increase by 1662.5 to create the needed extra profit

• This is a percentage surcharge of 5.038%

Step 4: Calculate the Price Surcharge Needed

• Consider the projected AOR

• If negative, a price increase

is needed to breakeven

• If positive, a price decrease

is needed to breakeven

• Determine the rate by

which revenue needs to

change to accomplish the

• Therefore revenue must increase by 1662.5 to create the needed extra profit

• This is a percentage surcharge of 5.038%

Step 4: Calculate the Price Surcharge Needed

• Consider the projected AOR

• If negative, a price increase

is needed to breakeven

• If positive, a price decrease

is needed to breakeven

• Determine the rate by

which revenue needs to

change to accomplish the

• Therefore revenue must increase by 1662.5 to create the needed extra profit

• This is a percentage surcharge of 5.038%

Step 4: Calculate the Price Surcharge Needed

• Consider the projected AOR

• If negative, a price increase

is needed to breakeven

• If positive, a price decrease

is needed to breakeven

• Determine the rate by

which revenue needs to

change to accomplish the

• Therefore revenue must increase by 1662.5 to create the needed extra profit

• This is a percentage surcharge of 5.038%

Step 5: Apply Required Surcharge to All Prices

• Increase all unit

overhead rate per hr 5.25 4.20 21.00 14.23

above shop overhead 1627.5 10.50

Individual Exercise

• Assume the same actual costs as the “Starting Point” for previous example except beginning AOR was 5100

• Assume a 10% inflation

• Assume all workload decreases by half

• Calculate prices for A, B, and C using the

stabilized rate process

overhead rate per hr 5.00 4.00 20.00 9.00

above shop overhead 1000 10.00

Solution Step 1: Adjust Material & Rates for Inflation

• Assume that material

and labor rates will

reflect a 10% inflation

in budget year +1

cc A cc B cc C Total Per hr units

unit price revenue direct material 550 550 1320 24.20

direct labor $ direct labor hrs labor rate per hr 55.00 44.00 110.00 66.00

Shop overhead overhead rate per hr 5.50 4.40 22.00 9.90

above shop overhead 11.00

total cost NOR (profit) beginning AOR ending AOR (cum profit)

SolutionStep 2: Adjust for Future Workload

• Assume that A goes

direct labor $ direct labor hrs 50% 50% 50%

labor rate per hr

Shop overhead 50% 50% 50%

overhead rate per hr

above shop overhead BASOPS

general and admin

total cost NOR (profit) beginning AOR ending AOR (cum profit)

overhead rate per hr 5.50 4.40 22.00 9.90

above shop overhead 550 11.00

Step 4: Calculate the Price Surcharge Needed

• Consider the projected AOR

• If negative, a price increase

is needed to breakeven

• If positive, a price decrease

is needed to breakeven

• Determine the rate by

which revenue needs to

change to accomplish the

breakeven goal

• In our example AOR is 4195

• Reduced profit of the same amount is needed to

breakeven

• Therefore revenue must drop by 4195

• This is a percentage surcharge of -55.93%

Step 5: Apply Required Surcharge to All Prices

• Decrease all unit

overhead rate per hr 5.5 4.4 22 9.90

above shop overhead 550 11.00

Short Group Exercise

• Assume that $ and hours in actuals are $K and K hours

• Assume that employees average $70K salary and benefits per

person

• How much must employment decline to achieve the budget year +1 plan given the following initial cost structure and no change in fixed cost?

$K actual material 2200 salary and benefits 4300 supplies and travel 4300

15100