Document created: 24 March 04
Air University Review, September-October 1972

^“Should Cost^”

A Multimillion-Dollar Savings

Major David N. Burt

Since the end of World War II, the defense industry has experienced significant increases in both technological and organizational complexity. Defense systems costs have increased manyfold. The government's responsibility to assess and analyze these costs accurately has increased at a commensurate rate. Management reviews of contractors were begun in the early 1960s to supplement the traditional cost analysis performed by the government. Despite these efforts, traditional analysis sometimes fails to supply the scope and detail required to evaluate a contractor's proposal accurately.

The ^“Should Cost^” approach is one attempt to supply the required scope and detail. Should Cost is a procedure used to determine what a system ought to cost, assuming reasonably attainable economy and efficiency in the contractor’s operation. It differs from traditional pricing methods in two ways: the depth of analysis and the purposeful challenging of inefficiencies in the contractor’s operation. Its objective is to provide the government with a more supportable negotiation position. But the benefits of the method extend beyond this. In addition to the short-term benefit of better pricing of current requirements, there is the long-term benefit of more efficient contractor performance on future requirements.

The Should Cost review is performed by a team of specialists who conduct a comprehensive, detailed analysis at the contractor’s facility. The review may take as long as six months, and its scope presents cost and staffing problems that limit its use to high-dollar, major programs. However, some of the techniques of Should Cost can be used to strengthen traditional analysis methods. This use, coupled with Should Cost effectiveness in analyzing major programs, provides a stronger base for detailed analysis over the cost evaluation spectrum.

The principles underlying Should Cost were used by the Air Force in the early 1960s, but Should Cost as we know it today did not emerge until 1967. At that time a forty-man team spent five months reviewing cost growth under a large letter contract for jet engines. The team approached its objective by determining what the engine “should cost” if produced under optimal conditions. This effort resulted in estimated savings of approximately $100 million and stimulated interest by both the Department of Defense and the General Accounting Office. These organizations are currently planning or conducting Should Cost analyses, and Congress is watching closely.

In the following pages I shall briefly examine the evolution of the highly technical pricing environment from which the Should Cost method sprang. A brief discussion of traditional pricing methods is included to provide a basis for comparison. The Should Cost philosophy, objective, and technique are discussed, and several of the Should Cost efforts to date are reviewed. Finally, the advantages and limitations of the method are examined, and conclusions are drawn as to the method’s effectiveness.

Insight into this “new” pricing method begins with an understanding of the environment out of which it evolved. Innovation and technological advancement since World War II have been great, by any standard. The defense industry has been a leader in this rapidly changing environment. Pushed by government demands for increasingly more sophisticated defense systems, the defense industry has developed a highly complex and intricate technology. New defense systems have ceased to be simple improvements to existing ones. They are new in concept, design, and function.

This increasing complexity has not been limited to defense systems alone. Technology has forced intricate tasks to be broken down into smaller and smaller subtasks that are more capable of being managed. The completed elements are then assembled into an integrated whole. The impact of technology and the subsequent specialization within the defense industry have resulted in a longer time span from project beginning to project end, increased capital requirements, less flexibility in commitment of time and money, more requirements for specialized manpower, more complex business organizations, and more emphasis on planning. It is reasonable to expect continued changes in these areas as technological growth continues to accelerate.

Increases in technological and organizational complexity have resulted in significant increases in the costs of government procurements. This in turn has placed an increasingly heavier burden on the government to assess and analyze costs accurately when procuring new defense systems. The government’s methods of cost evaluation must be capable of intricacy in analysis that is parallel to the intricacy of the system being analyzed.

In 1960 the Air Force recognized the need for more detailed analysis of a contractor’s organization and management. Industrial Management Surveys—later called Program Management Evaluations—were introduced. These reviews provided a detailed examination of the contractor’s organization and management of engineering, contract management, production and quality control, logistics, and materiel management. Contractors were selected for review based on their efforts under current and future Air Force programs, dollar backlog of defense contracts, and history of performance. These surveys, usually performed by a staff of from ten to fifteen individuals, took about three weeks and were directed toward the contractor’s management of a program or contract. The contractor was encouraged to correct any deficiencies noted, and the Air Force maintained a follow-up system until the deficiencies were corrected. These reviews were intended to be an evaluation of the contractor’s management, with the understanding that the results were to be treated confidentially and that the data were not intended for use in future negotiations.

To date, the bulk of government analysis in procurement has been limited to cost analysis of a contractor’s proposal. This is the traditional government preaward review. The Armed Services Procurement Regulation (ASPR) defines cost analysis as follows:

Cost analysis is the review and evaluation of a contractor’s cost or pricing data. . . and of the judgmental factors applied in projecting from the data to the estimated costs, in order to form an opinion on the degree to which the contractor’s proposed costs represent what performance of the contract should cost, assuming reasonable economy and efficiency. It includes the appropriate verification of cost data, the evaluation of specific elements of costs. . ., and the projection of these data to determine the effect on prices of such factors as:

    (i) the necessity for certain costs,

    (ii) the reasonableness of amounts estimated for the necessary costs,

    (iii) allowances for contingencies,

    (iv) the basis used for allocation of overhead costs, and

    (v) the appropriateness of allocations of particular overhead costs to the proposed contract.¹

The ASPR then goes on to say that proposed costs should be compared with previous costs for similar items and with current cost estimates from other sources. It also emphasizes the importance of forecasting future cost trends from historical cost experience.

The traditional cost analysis is generally performed by a number of field pricing teams. These teams include the pricing analysts, responsible for developing a field pricing objective; the technical specialists, responsible for technical review of the contractor’s proposal (engineering, quality control, production, etc.); and the Defense Contract Audit Agency, responsible for analyzing the contractor’s accounting records to determine the acceptability of incurred or estimated costs, with emphasis on labor and overhead rates. The effectiveness of the traditional method depends on close cooperation and communication between these teams.

This traditional approach is conceptually sound. Unfortunately, the method has not proved fully effective for several reasons: the time allowed for the pricing review may not always be sufficient, the scope of a pricing review is often limited, and coordination between the procuring contracting officer and the field teams is not always effective.

A clear understanding of the Should Cost approach begins with a definition. Should Cost is a concept used to determine what a defense system ought to cost, assuming reasonable economy and efficiency in the contractor’s operation. Raymond E. Harris, Chief of Pricing, Procurement Policy Division, Army Material Command, offers a more thorough definition:

“Should Cost” describes a coordinated analysis of a contractor’s business management, cost estimating, and production engineering procedures in connection with the evaluation of a major non-competitive proposal. This approach assumes that the inefficiencies associated with non-competitive procurement may be identified through the coordinated effort of a government cost estimating business management and production engineering evaluation team, and that the cost impact of these inefficiencies may be eliminated during contract negotiations.²

The philosophy of Should Cost has been well expressed in a government letter printed in The Federal Accountant:

The Should Cost method of pricing must not be construed as an attempt on the part of the Government to tell a contractor how to conduct his operation. If, for example, a contractor wishes to conduct a potentially inefficient operation, with excess indirect employees, poor estimating, labor that consistently fails to meet standards, lack of proper competitive subcontracting, abnormal spoilage and rework, etc., that is his business. It is the Government’s responsibility, however, not to pay taxpayers’ money for demonstrable inefficiencies in the manufacturing process of a sole-source supplier regardless of the quality of the ultimate product.³

The ultimate objective of the Should Cost approach is to provide the government with a more supportable negotiation position. This goal is accomplished by providing the government with an in-depth analysis and by challenging inefficiencies in the contractor’s operation. The actual methodology consists of a five-phase program: Planning, Data Acquisition, Analysis, Report, and Negotiation.

The Planning Phase begins with the identification of a candidate for a review. The general criteria for selection are found in the following questions: (1) Is the program a major, ongoing program of high dollar value? (2) Does the contractor have substantial amounts of negotiated government sales? (3) Has the contractor been operating in a sole-source atmosphere or another environment that is not conducive to effective cost control? (4) Has there been substantial cost growth associated with the item being procured? (5) Will there be a significant number of follow-on production contracts? (6) Does the planned award date allow adequate time for the review? (7) And, finally, is there reasonable assumption on the part of the project manager that the type of effort that goes into a major Should Cost analysis will payoff?

Selecting the team members is the next step in the Planning Phase. The size of the team will vary with the magnitude of the effort. Ideally, the team will have ten to thirty highly capable members. Great care must be taken during selection to insure that the proper balance of talent is obtained. The skills required generally include those of industrial engineers, design engineers, production specialists, statisticians, accountants, cost analysts, management analysts, and any additional specialists required to analyze the company’s product line (e.g., nuclear engineers, aerospace engineers, computer specialists). The Planning Phase concludes after the work has been apportioned to the team members and a master schedule has been established.

Phase two, the Data Acquisition Phase, takes from one to four months. This is the actual on-site investigation of the contractor’s operation. Before the investigation begins, however, the contractor must be briefed on the goals of the analysis, to insure his cooperation in the team’s gaining access to required information. Then every aspect of the contractor’s operation is reviewed by the appropriate team members, including plant layout machine capacity and utilization, production scheduling and control, labor standards, make or buy policy, industrial engineering standards, quality control, general and administrative expenses, cost estimating, tooling labor, production engineering, design engineering, engineering overhead, manufacturing overhead, and any other areas that are vital to efficient operations. These evaluations must be completely coordinated to ensure that all pertinent facts are gathered without duplication of effort.

Analysis, the third phase, overlaps both the preceding and following phases. During this period the team members discuss and integrate their findings.

The Report Phase is the realization of the team’s efforts. Team reports may be either combined or individually incorporated into the price negotiation memorandum. The reports will be the basis for the government’s position during negotiations. The reports consist of five parts: Introduction, Plan Used in Study, Summary Report, Detailed Report, and Lessons Learned. The third and fourth parts comprise the heart of the reports. The Summary Report contains suggested primary and alternative negotiation positions, findings, and recommendations. The Detailed Report contains the supportive data to back up the information in the Summary Report.

The Negotiation Phase is the finale of the effort. The team reports provide a sound basis for negotiations. The reports contain the basis for challenging contractor methods as well as contractor costs. During negotiations the government is concerned with areas such as more efficient plant layout, better inspection and sampling techniques, and improved material purchasing practices, as well as the actual costs proposed for these elements. Individual team members are utilized during these negotiations to provide expertise in the area which they have evaluated.

If the Should Cost method is successful, the benefits are twofold: the short-term benefit of better pricing on the current requirement and the long-term benefit of more efficient contractor performance on future requirements. As a measure of the method’s success or effectiveness, let us briefly examine several of the Should Cost studies conducted to date.

• The first study was conducted by the Navy in late 1967. A forty-member team spent five months at Pratt & Whitney analyzing costs on the TF-30 engine for the F-111 aircraft. The team performed an extensive analysis and found the following weaknesses:  (1) lack of adequate labor standards, (2) high employee turnover, (3) inefficient plant layout, (4) idle machine capacity, (5) noncompetitive procurement practices, (6) excessive spoilage, (7) poor production scheduling and control, and (8) improper costs incurred in the overhead and general and administrative expense accounts. After heated negotiations, a $100 million reduction was negotiated in the $1.2 billion contract, and the ground work was laid for long-range management improvements at Pratt & Whitney.

• The next use of the concept was in 1970 when the Army received a $90 million proposal from the Raytheon Company for 600 Hawk missiles. The Army sent a thirty-man team to Raytheon to perform a Should Cost analysis. In addition to the government specialists, the Army retained two civilian consultants. The results: a price reduction of $17 million plus a possible additional savings of $14 million over the next two years if suggested management improvements were carried out.⁴

• The Army’s second effort in 1970, at Bell Helicopter, was on a smaller scale. A twenty-man team spent twenty weeks reviewing a $60 million contract. The review resulted in a $6 million cost reduction. The Army attributed a significant portion of the reduction to the Should Cost effort.⁵

• During the past year the Air Force has completed two major Should Cost analyses at General Electric-Valley Forge and Boeing-Seattle. These two efforts have had a significantly favorable impact on expenditures under the two contracts. The long-run potential savings are even greater. It is anticipated that improved operating procedures resulting from the two Should Cost reviews will benefit the Air Force on future work at these two locations.

At this point it appears reasonable to ask if there is a difference in concept between Should Cost and the traditional method of developing a negotiating position. The traditional method, through the various contract administration agencies and activities, has always been interested in the full spectrum of contractor operations. So is Should Cost. The difference is in the implementation. Should Cost takes an integrated team approach to a comprehensive evaluation. Rather than having several small field pricing teams working independently and then submitting their findings to another team for consolidation, Should Cost gathers all the specialists into one coordinated team that integrates its own findings. Rather than performing cost analyses and management analyses separately, Should Cost performs them simultaneously. Rather than having one government specialist to evaluate several major areas in the contractor’s operation, Should Cost provides for a highly qualified specialist in each area.

The primary advantages in the Should Cost approach are found within the framework of this different methodology. Performance of the cost and management analyses simultaneously makes the impact of the contractor’s management on the program costs more readily apparent. The use of highly qualified specialists enables a more detailed review of specific areas of the contractor’s operation. This increases our ability to locate problem areas in the operation. The coordinated team effort enables better integration of the detailed information gathered by the specialists. The end result is a detailed, comprehensive negotiation tool that should not only improve contract pricing but also provide leverage to encourage the contractor to correct deficiencies noted in his operation.

Methodology is also the source of the major limitations of Should Cost. The first problem encountered is in staffing. Initially, a number of qualified specialists must be located. This in itself is a difficult task. Since the individuals selected are highly competent, they will be performing important functions in their regular job. Who, then, replaces these men while they are serving on an ad hoc Should Cost team for several weeks?

The most obvious limitation is cost. Deploying a team of high-level, skilled specialists to a contractor’s plant for several weeks can cost a great deal of money. Added to that are the implicit costs of finding and training personnel to replace the specialists selected for the team, the lower productivity of the replacements, and the specialists’ reduced productivity upon returning to the job. These cost and staffing considerations force the price so high as to restrict the use of Should Cost analysis to major high dollar procurements.

The Should Cost method was born out of a need for detail in analysis of complex major defense systems which the traditional method failed to supply. The Should Cost method has all the capabilities of traditional analysis plus several unique advantages of its own. Despite these advantages, the method is not the complete answer to better procurement. A detailed and comprehensive analysis is also needed in many programs of a magnitude too small to warrant a Should Cost review. Such an analysis may also be appropriate for any procurement where full and adequate competition is absent. Perhaps one answer is to apply, to a lesser degree, some of the techniques of the Should Cost concept to traditional pricing methods. Audit and administration activities could be strengthened with additional specialists. More attention could be given to the problems of coordinating and integrating field team reports. In other words, give these activities the capability for a more detailed analysis on smaller major programs.

While Should Cost is not a panacea, it has proven its effectiveness in analysis of high-dollar, major programs. As the method is further refined, its effectiveness should increase. The use of Should Cost principles to strengthen traditional analysis, coupled with the Should Cost review of selected major programs, will make detailed analysis more effective.

Notes

1. Armed Service. Procurement Regulations 3-807.2(C). Department of Defense, 1969.

2. Raymond E. Harris “Should Cost,” briefing presented at 1970 DCAS Pricing Conference Proceedings, October 1970.

3. “Recent Development and Future Trends In Government Contract Accounting,” The Federal Accountant, XIX. 3 (September 1970), 26.

4. “Should Cost Is the New Weapons Test,” Business Week, May 30, 1970, pp. 48-49.

5. Dr. Fred W. Forman, lecture notes on Should Cost used in Defense Weapon Systems Management Course, Wright. Patterson AFB, Ohio.