Cost beniefit analysis training for decision makers and manager step4

AMERICA’S ARMY: THE STRENGTH OF THE NATION

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

Step 4: Develop Cost
Estimates for Each Alternative

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Last Updated: 10 November 2011



Key Learning Objectives
Objectives:

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• 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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1. Define the Problem/Opportunity and
Objective
2. Define the Scope; Formulate Facts and
Assumptions

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3. Define Alternatives

4. Develop Cost Estimates for Each
Alternative

5. Identify Quantifiable and
Non-Quantifiable Benefits
6. Define Alternative
Selection Criteria

Step
4:
Deve
Cost Estimate:
• Captures the total cost of each alternative lop
over
its relevant life cycle
Cost
Estim
ates
for
Each
Cost estimate requires robust documentation
to
Alter
facilitate review and validation of the CBA.
nativ
e

7. Compare Alternatives
8. Report Results and Recommendations
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Outline
•
•
•
•
•
•

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

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Introduction and
Overview

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Cost and Cost Estimating Definition
Cost:
•

The monetary representation of resources used, sacrificed, or liabilities
incurred to achieve an objective.

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– 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.

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Purpose of Cost Estimating

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• 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.
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Characteristics of a Good Cost Estimate
•

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•

•

•

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

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Cost Fundamentals
A Brief Primer

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Examples of Cost Estimates

 This
This discussion
discussion will

will focus
focus on
on
cost
cost estimating
estimating to
to support
support
CBAs
CBAs
 But
But …
… these
these types
types of
of estimates
estimates
are
are not
not totally
totally separate
separate from
from
each
each other.
other. Concepts
Concepts from
from
other
other types

types can
can also
also apply
apply to
to
CBA.
CBA.

• 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

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

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Direct vs. Indirect
Direct Cost
•

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

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– 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)

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Recurring vs. Nonrecurring
Recurring Cost

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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

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Burdened vs. Unburdened
Unburdened Cost

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•

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

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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.
Fuel Cost as a Function of Miles Traveled

Instructors as a Function of Class Size
5

100

3

60

2

40

1

20
0

100

1000
900
800
700
600
500
400
300
200
100
0
5,000 10,000 15,000 20,000

4

80

0
200

300

Variable

400

Note: Most
costs are semivariable

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

Semi-Variable

Fixed Cost

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Cost Drivers

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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

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Second Order Effects

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• 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.

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Normalization and Inflation

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• 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.

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What is Inflation?
Definition

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• 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.

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Infl
ate
Type of Dollar
Other Terms
When Used
Constant
Base Year
Used in the cost estimate of a CBA to
Uninflated
compare COAs and to make the
d
decision
Current
Then-year
Used to determine the POM/budget
Inflated
resourcing impact of a COA. For the Dol
approved COA, the current dollar

estimate is the amount that must be
lars
funded in each year.
Therefore, it is also used to determine
–
the dollar amount of required billpayers.
Ter
mi
 Constant-dollar values must be accompanied by a base year:
The fiscal year in which the program was initially funded or the
nol
analysis was performed.
 Constant and current year data cannot be used in the same
analysis.
og

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Inflation Calculation and Examples

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• 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.

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Example—Current Dollar Calculation
• Data: We’ve calculated the annual cost for a given COA in FY12
constant dollars:
To implement this COA in the
– Civilian personnel: $145,000
– Contract support: $100,000 (paid by OMA appropriation)

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• Applicable inflation factors:
– Civilian personnel: 2% per year
– OMA appropriation: 3% per year

To implement this COA in the
POM/budget, the dollar
amounts in the three righthand columns would be used.
To cost the COA in the CBA, the

Const. Dollar Cost column
should be used.

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

Const.
Dollar
Cost

Infl.
Factor

Current- Dollar Calculation

Civ per

145,000

2%

FY12
145,000

Contract

100,000

3%

100,000

Total cost

245,000

FY13
145,000
* 1.02
100,000
* 1.03

FY14
145 *
1.02^2
100,000
* 1.02^2

Current-Dollar Cost
FY12
145,000

FY13
147,900

100,000

103,000

245,000

250,900

FY14
150,858

256,948

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Cost Estimating Principles and Rules

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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

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Cost Estimating Principles and Rules

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• 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).
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