Cost beniefit analysis training for decision makers and manager step4

• Obtain an introduction to cost estimating• Understand cost fundamentals • Understand the cost estimating process – Prepare for the cost estimate– Establish a framework for the estimate

Version 3.0 (Draft) Visit our CBA Website for more information regarding locations,

AMERICA’S ARMY: THE STRENGTH OF THE NATION

Cost-Benefit Analysis (CBA) Four-Day Training Briefing

Step 4: Develop Cost Estimates for Each Alternative

• Obtain an introduction to cost estimating

• Understand cost fundamentals

• Understand the cost estimating process

– Prepare for the cost estimate– Establish a framework for the estimate– Establish the timeframe for the estimate– Identify data sources and collect data– Develop the estimate

– Identify cost of second- and third-order effects– Prepare supporting documentation

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6 Define Alternative Selection Criteria

5 Identify Quantifiable and Non-Quantifiable Benefits

5 Identify Quantifiable and Non-Quantifiable Benefits

4 Develop Cost Estimates for Each

• Introduction and overview

• Cost fundamentals – a brief primer

• Principles and rules

• Tools

• Cost Estimating Methods

• Summary and conclusion

Outline

4

 The resources expended in acquiring or producing a good

 The resources expended in performing an activity or service

Cost Estimating:

• The process of collecting and analyzing data and applying quantitative models, techniques, tools, and databases to estimate the future cost of

an item, product, program, or task.

Cost and Cost Estimating Definition

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Cost estimating is thought by some to be difficult, but the skills and knowledge are logical and straightforward It isn’t rocket science.

– Make resource-informed decisions

– Develop and defend budgets

– Identify specific cost drivers

– Improve cost controls

• Translate system/functional needs associated with

programs, projects, proposals, or processes into

costs

• Determine and communicate a realistic view of the

probable costs, which will be used to inform the

decision-making process.

Purpose of Cost Estimating

– Includes source data and its significance

– Clearly details calculations and results

– Contains explanations for choosing a particular method or reference

• Comprehensive

– Ensures a level of detail where cost elements are neither omitted nor

double counted

• Accurate

– Avoids bias and overly conservative or optimistic estimates

– Bases its assessments on most likely scenarios and assumptions

• Credible

– Discusses any limitations of the analysis deriving from the uncertainty/bias

of the data or assumptions

Characteristics of a Good Cost Estimate

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– Contracts and acquisitions

– Cost Benefit Analysis (CBA)

• Analysis of Alternatives (AoA)

• Economic Analysis (EA)

• Business Case Analysis (BCA)

– Independent Cost Assessment

Examples of Cost Estimates

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 This discussion will focus on

cost estimating to support

CBAs

 But … these types of estimates

are not totally separate from

each other Concepts from

other types can also apply to

CBA

 This discussion will focus on

cost estimating to support

CBAs

 But … these types of estimates

are not totally separate from

each other Concepts from

other types can also apply to

CBA

• Can be easily and conveniently traced to a specific cost element/objective

– Example: The cost of ammunition fired in a training event at the firing range

Indirect Cost

• Cannot be easily and conveniently traced to a specific cost element/objective

– Example: Installation support to the firing range (utilities, upkeep, etc)

Direct vs Indirect

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• Cost that is incurred regularly in producing a product or providing a service

– Examples: Civilian and military personnel who conduct the activity, recurring

sustainment of facilities, supplies, personnel training, utilities, equipment maintenance, janitorial service, office supplies

Non-Recurring Cost

• Cost that only occur once or infrequently

– Examples: Major items of equipment, major and minor construction, one-time

training in new procedures, activities conducted in direct support of individual process improvement efforts

• Cost of a product/service that does not consider other related costs necessary to

provide that product/service

– Examples: Direct compensation, cost of a gallon of fuel in a theater of

operations, etc

Burdened Cost

• Cost of a product/service plus an apportioned cost of other related costs necessary to provide that product/service

– Examples: Salary plus the cost of benefits (health, retirement, etc.), facilities

support cost allocated to an activity or personnel– There are degrees of burden in a CBA For example:

• Direct compensation for military and civilian personnel is always burdened with the cost of personnel benefits

• Facilities support cost is allocated to a COA only if it can demonstrated that the COA causes the cost to be incurred

• A cost that varies based on the level of activity or output This can be either a linear

relationship or a step function

– Examples: Fuel cost for vehicles varies in a linear fashion relative to the number

of miles driven The number of instructors needed to teach a class can vary in a step function based on the number of students (e.g., 1 instructor for 25 students,

2 instructors for 26-50 students, etc)

Fixed Cost

• A cost that does not vary based on the level of activity or output

– Example: At an Army installation, the cost associated with the commander and

his/her immediate staff is unlikely to vary as the installation population or other variables change

Instructors as a Function of Class Size

5,000 10,000 15,000 20,000 0100

200

300400

500600700

8009001000

Cost of Cmd Gp ($K) as a Function of Installation Population

Note: Most costs are semi-

 Helps to ensure the accuracy and reliability of the cost estimate

 Makes it easier to control costs within the organization

 Examples:

 The labor cost associated with assembling a HMMWV at a the factory would

be driven by the quantity of vehicles produced

 Energy consumption at the PX is driven by the square footage of the

building and the operating hours

 The cost of printing budget documents for the Office of Management and

Budget is driven by the number of pages in each set and the number of sets needed

Cost Drivers

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Organizations perform work activities to deliver products/services to a stakeholder.

• The cost of second order effects—the effects of the COA under

consideration beyond the immediate effects—must be taken into account in the cost estimate.

Second Order Effects

• Adjusting for inflation is a specific form of normalization, an

adjustment intended to make a given data set consistent and

comparable with other data sets

• A frequent use of simple normalization is to adjust based on

quantities For example:

– In a manufacturing process, COA 1 produces 17,000 widgets per year at a total cost of $33,765 and COA 2 produces 14,500 widgets at a total cost of

$28,725 It’s difficult to evaluate these COAs unless we normalize by

computing a unit cost, which shows us that COA 2, with a unit cost of

$1.95 per widget, is preferable to COA 1, which has a unit cost of $1.99.

Normalization and Inflation

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Of all the topics discussed in cost analysis, none will be

encountered more frequently than inflation.

Definition

• A rise in the general level of prices

• Measure of change in the dollars’ purchasing power

• In other words

• A given dollar amount will have less buying power next year than it

does this year

• To maintain consistent buying power, we must adjust this year’s

dollars with the inflation factor from year to year

Common methods for normalization:

• Discounting

• Constant (Base) Year

d Dol lars – Ter mi nol og

y an

d Us es

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Constant Base Year

Uninflated Used in the cost estimate of a CBA to compare COAs and to make the

decisionCurrent Then-year

Inflated Used to determine the POM/budget resourcing impact of a COA For the

approved COA, the current dollar estimate is the amount that must be funded in each year

Therefore, it is also used to determine the dollar amount of required bill-payers

 Constant-dollar values must be accompanied by a base year:

The fiscal year in which the program was initially funded or the analysis was performed.

 Constant and current year data cannot be used in the same analysis.

– (Constant Dollars) * (Inflation Factor) = Current (Dollars)

– Inflation is compounded from year to year (i.e., multiplied, not added).

• Example: A loaf of bread in 1950 cost $0.25 In 2011, it costs $3.00 Supposing that the price of bread is a good indicator of the general price of goods, then FY1950 $0.25 is worth $3.00 in 2012 In other words, $0.25 could buy in 1950 what $3.00 buys in 2011—and between 1950 and 2011 there was 1100%

inflation (12 x) The average annual inflation rate can be calculated to be

about 4.1% (12 raised to 1/61 power, so that 1.041^61 = 12).

• If between 2007 and 2011 there was 3% inflation each year, then $1 in 2007 could have bought what $1 x 1.03 x 1.03 x 1.03 x 1.03 x 1.03 = $1.16 can buy

in 2011.

Inflation Calculation and Examples

– Contract support: $100,000 (paid by OMA appropriation)

• Applicable inflation factors:

– Civilian personnel: 2% per year

– OMA appropriation: 3% per year

• Calculation for the first three years of the life-cycle:

Example—Current Dollar Calculation

Factor Current- Dollar Calculation Current-Dollar Cost

To cost the COA in the CBA, the Const Dollar Cost column should be used.

To implement this COA in the POM/budget, the dollar amounts in the three right- hand columns would be used

To cost the COA in the CBA, the Const Dollar Cost column should be used.

• Use authoritative data sources

• Ensure that cost estimates support “apples-to-apples”

comparison among COAs

• Ensure the cost estimate is well-documented, comprehensive,

accurate, and credible

• Constant vs current dollars

– Use constant (uninflated) dollars for even comparison for COAs in CBAs

– Convert estimate to current (inflated) dollars to determine POM/budget resourcing requirements

Cost Estimating Principles and Rules

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– If the CBA seeks the best solution for housing Soldiers at a CONUS

installation, one of the COAs might call for constructing a barracks with a 50-year useful life In this case, the life-cycle timeframe would be 50 years.

– If the CBA addresses a requirement that will exist for only three years, the life-cycle timeframe would be three years.

– Must use the same timeframe for all COAs

• The timeframe for the POM/budget resourcing estimate is the

full POM/budget period* or the life-cycle timeframe, whichever is shorter.

* The POM/budget period includes the year of execution (current year), the budget year (next year), and the POM period (four or five years beyond the budget year).

Cost Estimating Principles and Rules

– The timeframe should be the same for both cost estimates—in addition, it should include a whole number of life-cycles for both systems.

– The appropriate timeframe in this case is 35 years This would allow for 7

complete life-cycles for COA1 and 5 complete life cycles for COA2.

Cost Estimating Principles and Rules

• In general, sunk costs—costs that have already been incurred

regardless of which course of action is chosen—should not be

included in a cost estimate.

• For example, in a CBA evaluating options for which weapons

system to deploy: if COA 1 deploys a weapon system that has

already been procured (procurement cost is a sunk cost), and

COA 2 uses a weapon system that still needs to be procured, then the procurement costs for the system in COA 1 should not be

included in the cost estimate

• In certain cases, sunk costs can be included in an estimate, but

should only be used as a baseline—it should not factor into the analysis for comparison between COAs.

Sunk Costs

• After a CBA is submitted, the analyst who prepared the cost

estimate might not be immediately available to answer

questions.

• How supporting documentation is used:

– A CBA reviewer should be able to use the supporting documentation, with

no additional input, and arrive at a cost estimate identical to that in the CBA.

– If an analyst must consult the estimate several months after it is finalized, the supporting documentation will eliminate the need to reconstruct the thought process, data sources, and calculations supporting the estimate – If the analyst is no longer available, subsequent analysts can use the

documentation to understand how the estimate was prepared so that adjustments can be made if needed.

Include Supporting Documentation

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• Identification of all data sources

• Rationale, assumptions, and the thought process that

produced the estimate

• Points of contact for all data.

What to Include in Supporting Docs

• Reference all data sources

• Use comments to document

and explain costing

methodology

• Cells that contain equations

should be free of constants—

link to other cells instead, so

that it is clear what data is

being used in the calculation.

Guidelines for Excel

30

Unified FacilitiesCriteria

Facilities sustainment costs estimation

Army Equipping Enterprise System

Equipment costs by LIN

Services, leases, and

Available Tools and Models for Cost Data

AMCOS must be used for

military and civilian

personnel compensation

and benefits

AMCOS must be used for

military and civilian

personnel compensation

and benefits

ls an

d Mo del

s for Cos

t Dat a

Tool/Model URL Purpose

FORCES Cost Models https://www.osmisweb.army.mil/forces/login.aspx Suite of models that provides quick

and reasonable unit cost estimates to

a wide variety of users Army Military-Civilian Cost

System (AMCOS) https://www.osmisweb.army.mil/amcos/app/home.aspx Personnel costs for military, civilian, and/or contractor ASA(FM&C) Website http://asafm.army.mil/Documents/OfficeDocuments/CostEconomics/

rates/indices.xls Inflation indices Capabilities Knowledge

Base http://asafm.army.mil/Documents/officedocuments/costeconomics/guidances/ckb-ui.pdf

http://asafm.army.mil/offices/CE/Ckb.aspx?OfficeCode=1400

Research, development, and acquisition costing for major weapon/material systems Operating and Support

Management Information

System (OSMIS)

https://www.osmisweb.army.mil/osmisrdb/login.aspx Operating and support information for

major weapon/material systems

Some of the websites listed here require user accounts In most cases, anyone with a dot mil address can obtain an account You are encouraged to scan these sites and request an account to any site that you think will be useful to you This will save time when you need to use any sites to support a CBA or other projects.

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Access links through the “Resources” tab in the CBA Portal at https://cpp.army.mil

The use of each method is based on the information available to support it.

Figure 1: A summary of the usual application of each technique.

g Me tho ds: An alo

gy Me tho d44

Warning 2: An adjusted analogy is,

by definition, estimating outside

the range of the data

Warning 1: An adjusted analogy

is like a regression, but the slope is just a guess

Example - Analogy Method

Analogy Method Estimating with Factors

46

c Meth od

Parametric Method:

• Uses regression or other statistical methods to develop a cost

estimating relationship based on observed patterns of how

specific parameters influence total cost.

• Utilizes:

• High-level Work Breakdown Structure (top down approach)

• A database from elements of one or more systems

When is it used?

• Historical data is available but not detailed

• In earlier stages of the system or project life cycle