Financial Management

Cost Estimating Methods

Cost estimating is a valuable tool that is used in each of the acquisition phases.  There are a number of cost-estimating techniques that can be used in estimating the costs of a future and current weapon system.   The use of a specific approach will depend on how much information is available and where the weapon system is in its development and lifecycle. Most programs will use multiple techniques to get a good cross-reference of the accuracy of their estimates.

Definition: Cost estimating is the examination and study of anticipated expenses, typically determined from comparing the price, performance, schedule, and technical information of comparable goods and services in the past.

Cost Estimating Techniques

The main analytical techniques used — Analogy, Parametric (Statistical), Engineering (Bottoms Up),  Actual Costs,  and Three-Point—are employed to create cost estimates for acquisition programs are listed below.

  • Parametric: The parametric technique uses regression or other statistical methods to develop Cost Estimating Relationships (CERs). A CER is an equation used to estimate a given cost element using an established relationship with one or more independent variables. The relationship may be mathematically simple or it may involve a complex equation (often derived from regression analysis of historical systems or subsystems). CERs should be current, applicable to the system or subsystem in question, and appropriate for the range of data being considered. [1]
  • Analogy: An analogy is a technique used to estimate a cost based on historical data for an analogous system or subsystem. In this technique, a currently fielded system, similar in design and operation to the proposed system, is used as a basis for the analogy. The cost of the proposed system is then estimated by adjusting the historical cost of the current system to account for differences (between the proposed and current systems). Such adjustments can be made through the use of factors (sometimes called scaling parameters) that represent differences in size, performance, technology, and/or complexity. Adjustment factors based on quantitative data are usually preferable to adjustment factors based on judgments from subject-matter experts. [1]
  • Engineering Estimate: With this technique (Also called Bottoms Up), the system being costed is broken down into lower-level components (such as parts or assemblies), each of which is costed separately for direct labor, direct material, and other costs. Engineering estimates for direct labor hours may be based on analyses of engineering drawings and contractor or industry-wide standards. Engineering estimates for direct material may be based on discrete raw material and purchase part requirements. The remaining elements of cost (such as quality control or various overhead charges) may be factored in from the direct labor and material costs. The various discrete cost estimates are aggregated by simple algebraic equations (hence the common name “bottoms-up” estimate). The use of engineering estimates requires extensive knowledge of a system’s (and its components’) characteristics and lots of detailed data. [1]
  • Actual Costs: With this technique, actual cost experience or trends (from prototypes, engineering development models, and/or early production items) are used to project estimates of future costs for the same system. These projections may be made at various levels of detail, depending on the availability of data. Cost estimates that support a full-rate production milestone decision should be based on actual cost data to the greatest extent possible. A common mistake is to use contract prices as a substitute for actual cost experience. Contract prices should not be used to project future costs (even when firm-fixed-price) unless it is known that the contract prices are associated with profitable ventures and that it is reasonable to assume that a similar price experience will be obtained for subsequent contracts. [1]
  • Three-Point Estimate: This Program Analysis and Review Technique (PERT) style cost estimate has the project manager identifying three separate estimates. One estimate is  “optimistic”, the other is “pessimistic” and the last is “most likely”.  This scenario has the estimate typically fall somewhere in the middle.

Other Types of Methods

  • Expert Judgement: Individuals or organizations with particular knowledge or training in team and physical resource planning and estimating should be taken into consideration. It is influenced by historical data, offers insightful knowledge about the environment, and contains details from earlier initiatives with a similar scope. Additionally, it can be used to decide whether to combine several estimation techniques and how to handle discrepancies between them.
  • Delphi Approach: A panel of experts anonymously provides their estimates of the expenses of a project, and a mediator evaluates the responses to help them come to a consensus. In a series of panels, the experts use their statistical expertise and answer a questionnaire. The number they agree upon serves as the project’s final estimate, and they are free to modify it when they acquire more information.
  • Vendor Bid Analysis: For projects that call for the exclusive employment of suppliers, vendor bid analyses may be useful. You start by sending interested vendors a request for proposals (RFP) letter. The suppliers share their responses with you and list the cost and caliber of their services in the paper. The cost of the complete project is then estimated by comparing the costs.

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Updated: 4/26/2023

Rank: G8

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