Cost Estimation
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Cost Estimation

Methods and Tools

Gregory K. Mislick, Daniel A. Nussbaum

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eBook - ePub

Cost Estimation

Methods and Tools

Gregory K. Mislick, Daniel A. Nussbaum

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About This Book

Presents an accessible approach to the cost estimation tools, concepts, and techniques needed to support analytical and cost decisions

Written with an easy-to-understand approach, Cost Estimation: Methods and Tools provides comprehensive coverage of the quantitative techniques needed by professional cost estimators and for those wanting to learn about this vibrant career field. Featuring the underlying mathematical and analytical principles of cost estimation, the book focuses on the tools and methods used to predict the research and development, production, and operating and support costs for successful cost estimation in industrial, business, and manufacturing processes.

The book begins with a detailed historical perspective and key terms of the cost estimating field in order to develop the necessary background prior to implementing the presented quantitative methods. The book proceeds to fundamental cost estimation methods utilized in the field of cost estimation, including working with inflation indices, regression analysis, learning curves, analogies, cost factors, and wrap rates. With a step-by-step introduction to the practicality of cost estimation and the available resources for obtaining relevant data, Cost Estimation: Methods and Tools also features:

  • Various cost estimating tools, concepts, and techniques needed to support business decisions
  • Multiple questions at the end of each chapter to help readers obtain a deeper understanding of the discussed methods and techniques
  • An overview of the software used in cost estimation, as well as an introduction to the application of risk and uncertainty analysis
  • A Foreword from Dr. Douglas A. Brook, a professor in the Graduate School of Business and Public Policy at the Naval Postgraduate School, who spent many years working in the Department of Defense acquisition environment

Cost Estimation: Methods and Tools is an excellent reference for academics and practitioners in decision science, operations research, operations management, business, and systems and industrial engineering, as well as a useful guide in support of professional cost estimation training and certification courses for practitioners. The book is also appropriate for graduate-level courses in operations research, operations management, engineering economics, and manufacturing and/or production processes.

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Information

Publisher
Wiley
Year
2015
ISBN
9781118536216
Subtopic
Management
Edition
1

“Looking Back: Reflections on Cost Estimating”

We are delighted that you have chosen to learn about a vibrant career field that few people know about in any significant depth: the field of cost estimating. However, before we discuss the background, terminologies, statutory requirements, data sources, and the myriad quantitative methods involved and introduced within this textbook to help you become a better informed or better cost estimator, I would like to first discuss with you the idea of cost estimation as a profession. There are two facts that are most important in this field that are in seeming contradiction of each other: first, that cost estimating is “ubiquitous,” always existing either formally or informally in every organization; and second, that it is often “invisible,” or at least many times overlooked. My goal in this chapter is to provide some personal observations from my 30+ years of experience to shed light on the many significant purposes and roles played by cost estimation. These experiences also provide the opportunity for me to thank the many leaders, mentors, coworkers, and others who have provided me skills and insights throughout my career and whose contributions are reflected in this book. Lastly, I will comment on important changes that have been occurring in the profession within the last 30 years and some forecasts of future changes.
In the past, nobody went to school to become a cost estimator. To illustrate this point, I studied mathematics and economics in school, while my co-author, Greg Mislick, also studied mathematics and flew helicopters for the U.S. Marine Corps in his previous career. By different routes, we became practitioners of operations research and specialists in addressing the issue of “What will it cost?” In recent years, however, there have been graduate-level certificate and master’s degree programs introduced to hone the skills of, and establish professional standards for, cost estimators. This textbook is our attempt to pass those skills and lessons learned on to you and to increase the knowledge and experience of those working in this field.
Every organization – from a typical household to the greatest nation – relies upon the disciplines and processes of this profession. The one question that typically comes up in a conversation about most topics is “What does it (or what will it) cost?” It is a question that you and I will ask numerous times in both our professional and personal lives. The most frequent response that we get to this question (especially from those who do not really want to give us an answer) is “I can’t tell you exactly,” as if this were a useful or satisfactory response. The answer is just a dodge. We were not expecting an exact dollars and cents answer. Rather, we were looking for an approximate answer to help us plan for the expense while we sort through the various options that we may be considering.
The characteristics of a useful answer to the “What does it cost” question that we look for in the circumstances of our daily lives are remarkably similar to those answers in commercial and government applications of cost estimating, although complexity and scale may camouflage this similarity. The essential characteristics of any good cost estimate are completeness, reasonableness, credibility, and analytic defensibility. Note that this list does not include the need to make sure the answer has plenty of precision. While the budgets we develop and the cost-benefit analyses that we construct require specific numbers in them, our professional work as cost estimators does not rely on getting answers “correct to the penny.” A cost estimator should not agonize over the lack of a narrow range of possible costs for the cost estimate. If the ranges are overly large, the user of the estimate, such as your sponsor, consumer, boss, or other person who asked for the cost estimate, may tell you that they need a tighter range of costs, and you will then need to seek additional data or another methodological approach to support the refinement of your estimate. However, it may also be that a wide-ranging estimate that meets the criteria of completeness, reasonableness, credibility, and analytical defensibility is all that is required in the case of rapidly changing conditions and immature technologies. In fact, in the absence of data, it may be all that is possible.
This textbook is designed specifically to provide context to those cost estimating objectives of completeness, reasonableness, credibility, and analytical defensibility. Moreover, it will teach those mathematical techniques and procedures that are relevant to develop cost estimates and it will provide you with significant guidance through that development process.
I would like to share with you now six examples/stories that illustrate some of the lessons that I have learned while holding various positions in the corporate and government worlds. This includes positions while at a headquarters and during duty in the field, while inside the United States and abroad, and mostly (but not exclusively) while serving in defense-related positions. These examples are diverse, indicating the broad applicability of the tools of cost estimating. I hope that you will find them helpful while tackling programs and assumptions of your own in your present (or possibly future) career in cost estimating.
Example 1.1 Cost Estimation in Support of a Major Ship Program As the Navy proceeded to build the inaugural (lead) ship in a new class of ships, large cost growth began to challenge the project. I was asked to figure out why this was occurring. After much analysis, I found that there were several reasons for the growth. One reason, in particular, that is useful to discuss for the education of new cost estimators, was that one of the cost driving assumptions made during the original cost estimate was simply, and significantly, incorrect. The original cost estimate had assumed that when the Navy’s lead ship was being built in the shipyard, there would be another commercial ship under construction at the same time, and these two ship programs would share the shipyard’s overhead costs. This would relieve the Navy’s ship from carrying the full burden of the shipyard’s overhead costs by spreading these costs over the two ships. The cost estimators who produced the original cost estimate had relied upon credible information and had exercised appropriate due diligence. They had confirmed that the shipyard had the work for the second ship on its order books, and they received confirmation from the Defense Contract Audit Agency (DCAA) of this order, as well as DCAA’s satisfaction that this commercial ship would be built in accordance with the contract. It was thus reasonable to assume that the shipyard’s overhead rates would be split between the two ships. However, when the Navy ship was being built, the commercial firm canceled its ship building order, for its own business reasons. Consequently, it turned out that there was no second ship in the yard with which to share overhead rates, and these overhead costs had to be covered entirely by the US Navy!
Naturally – and through no fault of the US Navy – there were indeed significant (and legitimate) cost increases. They did not occur due to inexperience or due to naïve program management by either the government or the shipyard. Thus, the first lesson learned in this example is that assumptions always drive cost. The second lesson learned is that assumptions can be fragile. While a key assumption in your program may be accurate at one moment in time, it may not be accurate at a later time. This was indeed the case here. The third lesson learned in this example is that the one constant you can always rely on is change. Change will always occur! Even a cost estimate completed with due diligence and reasonableness can be wrong. After all, in this example, all the evidence pointed to the fact that there would be a second ship in the yard. In conclusion, be aware that plans and circumstances do change during the life of your program, and they most likely will. Ultimately, these changes will affect your estimated and actual costs.
Example 1.2 Cost Estimation in Support of a Major Missile Program A frequent root cause of underestimation in a cost estimate (and therefore a strong invitation to a cost overrun) is the omission of the cost of a significant component of the necessary work. In cost estimating, we refer to such a component of the necessary work as a work breakdown structure element (WBSE). Whether the omission occurs purposely or accidentally makes no difference, for as the project is executed, labor costs and material costs associated with the missing WBSE will still accrue, the bills will be presented for payment, and a cost overrun will then occur.
A cost estimate on a missile that was an expensive new major defense weapon system provides an example. Let’s call our missile program that we are costing Program A. Experience with such weapon systems that were part of Program A had taught me that a sensor would be part of this weapon system; in fact, I expected that the development of this sensor would be one of the major cost elements in the research and development (R&D) phase of the lifecycle cost estimate. The program office confirmed that a new sensor was indeed part of the design of this weapon and that the new sensor was integral to the weapon’s successful performance. However, the program manager’s R&D cost estimate did not include the sensor!
When I asked the PM why there were no sensor costs included, he stated that a separate program (which we will call Program B) was developing the sensor and that his Program A would do a “technology lift” from Program B, thereby avoiding any sensor development R&D cost to his program. While I understood this argument, I also knew that there was no guarantee that Program B would be able to complete its development of the sensor and make it available within the timelines of our program, and I was skeptical that there would be no sensor-related R&D charges in our program. The key problem, however, was that if the sensor development in Program B was delayed, it would then delay Program A, extending our schedule until the sensor technology was in fact completed. Any extension would then cause additional costs. Consequently, I argued for the identification of contingency funds in the program to cover this possibility. Fortunately, the program manager agreed, which proved to be fortuitous when Program B (that was developing the sensor) was ultimately canceled. Thus, we had to restructure Program A to incorporate the sensor development project within our own budget.
The major lesson learned here is that technology that is not developed or “mature” always presents the very real possibility that it just may not work, or may be delayed in its development, and a dependent program will then also be delayed, with corresponding increases in costs. For instance, when a program is delayed, personnel costs will increase since the workers still need to be paid, but now over a much longer period of time. There is also a more general lesson, which is that it is important to identify all technological and other risks to any program and consider their cost impacts, and to then develop contingency cost estimates under the assumption that these risks may unfortunately come to pass.
Example 1.3 Cost Estimation in Support of a Major Ship Program For years, the US Navy knew that it needed to modernize its combat logistics fleet (CLF). However, during those years, the shipbuilding appropriations were being used nearly in their entirety to develop and procure surface combatant ships instead. To work around this funding problem, a clever idea suggested that a commercial shipyard build the next generation of CLF ships, with the intention that upon completion of each ship, the Navy would then enter into a “long-term lease” for the ships. This would thus allow the CLF to be funded from the operations and maintenance account (the O&M, N appropriation) of the Navy, rather than funding it from the shipbuilding appropriations, as was the norm. I was asked to analyze whether this arrangement made financial sense, while others were examining the financial and legal implications of this potential arrangement. My analysis was to be a “cash flow” and/or “net present value” cost benefit analysis, comparing the cost of the conventional method of procuring this ship from shipbuilding appropriations with the proposed “build-to-lease” option using operations and maintenance dollars. I also needed to include the many “what-if” analyses to test the sensitivity of the bottom line cost to variations in the assumptions and values of variables being used in the analysis.
After significant study, we found that under a wide variety of reasonable circumstances, the proposed idea of “build-to-lease” made financial sense. If you were to consider only the financial metrics of the analysis, a reasonable person would be led to propose the course of action which leveraged savings from the “build-to-lease” option. This cost beneficial proposal, however, was not brought to the attention of the Secretary of the Navy despite its cost and benefits, since it was deemed to be “poor public policy and practice” for a variety of reasons. In other words, no matter how financially attractive or analytically defensible this proposal was, it was matters of public policy that trumped the analysis and drove the decision to not “build-to-lease.” The lesson learned here is that cost issues are always a major concern, but they are almost never the only concern. Cost estimating is a function that informs and supports decision-making. An analyst should not assume that decision-makers will inevitably follow the recommendations of his or her analysis, regardless of how complete, reasonable, credible, analytically d...

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