Version 3.0 (Draft) Last Updated: 10 November 2011

1. AMERICA’S ARMY: THE STRENGTH OF THE NATION Cost-Benefit Analysis (CBA) Four-Day Training Briefing Step 4: Develop Cost Estimates for Each Alternative Visit our CBA Website for more information regarding locations, signing up, upcoming training sessions, and more https://cpp.army.mil Version 3.0 (Draft) Last Updated: 10 November 2011

2. Key Learning Objectives Objectives: 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

3. Step 4: Develop Cost Estimates for Each Alternative Cost Estimate: • Captures the total cost of each alternative over its relevant life cycle Cost estimate requires robust documentation to facilitate review and validation of the CBA. 3

4. Outline • Introduction and overview • Cost fundamentals – a brief primer • Principles and rules • Tools • Cost Estimating Methods • Summary and conclusion

5. Introduction and Overview

6. Cost and Cost Estimating Definition Cost: The monetary representation of resources used, sacrificed, or liabilities incurred to achieve an objective. Example: 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 estimating is thought by some to be difficult, but the skills and knowledge are logical and straightforward. It isn’t rocket science.

7. Purpose of Cost Estimating • Enable managers to • 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.

8. Characteristics of a Good Cost Estimate Well documented 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

9. Cost Fundamentals A Brief Primer

10. Examples of Cost Estimates • Cost estimates may be used in any decision-making process, but particularly in: • Contracts and acquisitions • Cost Benefit Analysis (CBA) • Analysis of Alternatives (AoA) • Economic Analysis (EA) • Business Case Analysis (BCA) • Independent Cost Assessment • 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.

11. Some Characteristics of Costs Costs may be: • Direct or indirect • Recurring or nonrecurring • Burdened or unburdened • Variable or fixed

12. Direct vs. Indirect Direct Cost • 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)

13. Recurring vs. Nonrecurring Recurring Cost • 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

14. Burdened vs. Unburdened Unburdened Cost • 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

15. Variable vs. Fixed Variable Cost • 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. Note: Most costs are semi-variable Variable Semi-Variable Fixed Cost

16. Cost Drivers Organizations perform work activities to deliver products/services to a stakeholder. Definition: Factors, activities, or events that cause costs to be incurred Usually can be quantified/measured (e.g., number of hours spent on a task, supported population) Analyst should identify and focus on the primary cost drivers that affect total cost 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

17. Second Order Effects • 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.

18. Normalization and Inflation • 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.

19. What is 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 Of all the topics discussed in cost analysis, none will be encountered more frequently than inflation.

20. Inflated Dollars – Terminology and Uses • 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.

21. Inflation Calculation and Examples • Basic calculations: • (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.

22. Example—Current Dollar Calculation • Data: We’ve calculated the annual cost for a given COA in FY12 constant dollars: • Civilian personnel: $145,000 • 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: • 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.

23. Cost Estimating Principles and Rules

24. Cost Estimating Principles and Rules • 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

25. Cost Estimating Principles and Rules • The timeframe for the cost estimate is the life-cycle of the COAs. For example: • 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).

26. Cost Estimating Principles and Rules • Timeframe example: • Two weapons systems being compared in a CBA have different life-cycles. The system in COA1 has a life-cycle of 5 years, while the one in COA2 has a life-cycle of 7 years. • 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. COA1 5 5 5 5 5 5 5 COA2 7 7 7 7 7 35 years

27. Sunk Costs • 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.

28. Include Supporting Documentation • 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.

29. What to Include in Supporting Docs • Identification of all data sources • Rationale, assumptions, and the thought process that produced the estimate • Points of contact for all data.

30. Guidelines for Excel • List cost elements in a spreadsheet • Include POCs for all preparers/analysts • Hyperlink websites • 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.

32. Tools

33. Available Tools and Models for Cost Data Data Sources Personnel Facilities Equipment Modeled costs Form 1391 – MILCON construction costs Army Equipping Enterprise System Equipment costs by LIN Unified Facilities Criteria Facilities sustainment costs estimation AMCOS must be used for military and civilian personnel compensation and benefits FORCES OPTEMPO, equipment, force structure, transportation, CONOPS Services, leases, and equipment Electronic Document Access Contract data

34. Available Tools and Models for Cost Data 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. Access links through the “Resources” tab in the CBA Portal at https://cpp.army.mil

35. AMCOS

36. AMCOS AMCOS ApplicationsAMCOSlite

37. Capabilities Knowledge Base

38. Capabilities Knowledge Base

39. OSMIS

40. OSMIS

41. Cost Estimating Methods

42. Available Cost Estimating Methods Available methods: • Analogy • Parametric • Engineering • Actual Cost • Expert Opinion • Learning Curves Most CBAs utilize all cost estimating methods.

43. Cost Estimating Methods The use of each method is based on the information available to support it. GROSS ESTIMATES DETAILED ESTIMATES Parametric Actual Costs Engineering Analogy Figure 1: A summary of the usual application of each technique. Source - Acquisition 101 Lesson 8: Financial Management: Cost Estimation

44. Cost Estimating Methods: Analogy Method Analogy Method: • Estimates the cost, based on historical data, of an analogous system or subsystem • Utilizes a current fielded system that is similarly designed to the proposed system • Adjusts historical cost of the current system to account for differences • Adjustments should be made through parameters/scaling factors based on quantitative data • These adjustments should show validity of comparison When is it used? • When an analogous case (that can be applied to a subsystem or component level) exists

45. Attribute Old System New System Engine: F-100 F-200 Thrust: 12,000 lbs 16,000 lbs Cost: $5.2M ? Q: What is the unit cost of the F-200? A: $5.2M * (16,000/12,000) = $6.9M Example - Analogy Method 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.

46. Analogy Method Estimating with Factors

47. Cost Estimating Methods: Parametric Method 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

48. Example - Parametric Method High Mobility Wheeled Vehicles Database Is ‘Cubic Ft Shipping’ a good predictor of cost? Cost of Gross Curb Cubic Ft Net VehicleFirst UnitWeightWeightShippingHorsepower M274 $ 9,585 1,770 970 81.6 12.5 M561 50,002 8,363 5,363 732.3 93 M656 93,262 24,785 14,785 1,227 183 M520 147,889 36,590 10,500 2,368 176

49. Example - Parametric Method (Cont’d) We can estimate the cost of any vehicle given the shipping capacity using the above equation.

50. Cost Estimating Methods: Engineering Method Engineering Method: • Breaks down the system of interest into lower level components, each of which is estimated separately • Work Breakdown Structure • Uses algebraic equations (bottom up approach) • Most detailed of all techniques • Requires extensive knowledge of a system’s characteristics and the respective detailed data • Is expensive and time consuming When is it used? • All potential costs can be assumed or estimated Types of Army data sources (AMCOS Lite, MILCON, SRM, historical ,execution, travel, etc.).