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Appendix B
PROBLEMS IN MEASURING COST REDUCTION: AN EXAMPLE
Current criteria used to evaluate the Manufacturing
Technology program emphasize cost reduction. To
demonstrate that projects have been successful, ManTech
program managers have attempted to measure cost reductions
that are attributed to investments by contractors in the
results of ManTech projects. Many factors limit the
utility of this approach:
· The program has no control over whether contractors
decide to invest in equipment or processes developed under
the program.
· When investments are made, they are difficult to
link to changes in price, since price can change for many
reasons.
· For new weapon systems, no cost or price baseline
exists, so that showing the effect of one investment is an
estimate at best.
· Several years may elapse between the end of a
project and an investment that uses the technology
developed in the project.
Cost reduction is also difficult to measure, however,
even when a baseline exists and changes in direct costs
can be accurately measured. Once indirect costs are
calculated, as they must be if changes to price are to be
measured, then the system produces major inaccuracies.
The following example illustrates the errors that arise
from using existing direct-labor-based cost accounting
systems to measure the cost reduction improvements
resulting from a ManTech project.
A plant produces several products only for DOD. The
prices for the products are negotiated on the basis of
direct and indirect costs. The contractor has decided to
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invest in new technology, based on the results of a
ManTech project, that will improve part of its production
process, but for only one product.
Based on a normal workload, the plant has 160 workers
billing 320,000 direct labor hours (DLH) per year to the
defense contracts. The investment that uses the results
of the ManTech project will affect the single largest DOD
contract in the plant. It employs 100 of these workers,
billing 200,000 DLH per year. The plant's overhead costs
are $28,800,000 per year.
Following procedures established by the Cost Accounting
Standards Board, the indirect costs are allocated to the
various DOD projects via a burden rate on direct labor.
Currently, this rate is S90 per hour (S28,800/320~; the
full cost of a direct labor hour, including salary and
fringes is $20 per hour. Virtually all of the overhead is
considered fixed; it does not vary in the short run with
fluctuations in the plant's work load. (Material costs
in this example can be ignored as they will be assumed
unchanged by the ManTech investment.)
The plant invests $1 million to improve a production
process and significantly reduce labor costs. The new
technology produces a 16 percent reduction in the labor
hours required to build the designated defense product.
At the end of the year, consultants to the ManTech
program review the project to assess the benefit-cost
ratio. The 16 percent labor hour reduction meant that
instead of 200,000 hours being billed to the project, only
168,000 hours were billed. The savings of 32,000 DLH is
valued at the $20 direct labor hour rate plus the 390
burden rate on the direct labor producing a total savings
of $3.52 million (32,000 x [20 + 903~. Thus, the ManTech
program had a benefit-cost ratio in excess of 3.5 to 1, a
success story.
What has not been assessed, however, is the change in
the burden rate caused by fewer direct labor hours.
Therefore, when DOD auditors attempt to validate the
amount, they find a somewhat different situation. The
plant now has an overhead burden rate of $100 per hour,
not the $90 assumed in the budget projection. This figure
is computed as the ratio of the factory overhead costs of
S28.8 million divided by the 288,000 actual labor hours
worked (168,000 on the project receiving ManTech funds
and 120,000 on all the other proJects). The auditors now
compute a different estimate for the savings from the
ManTech funding:
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Estimated costs before funding:
200,000 DLH @ ($20 + S90)
Actual costs after funding:
168,000 DLH @ ($20 + $100)
"Audited" savings
S22.000, 000
20.160.000
S 1,840,000
Thus, the auditors find that the "true" savings were
S1 . 84 million--only half the amount claimed by the ManTech
consultants. But fortunately, the savings still exceeded
the ManTech investment of $1 million. Of course, the
auditors might also note that the defense products being
produced in the remainder of the plant are now more
expensive than had been expected. The higher cost is due
to the Jump in the overhead burden rate from $90 to $100
per hour.
In fact, neither the consultant's savings estimate of
$3.S4 million nor the auditor's estimate of $1.84 million
is valid. The only real savings from the process-
improving investment arises from the reduction in direct
labor. Assuming that the S20 per hour rate is valid for
measuring the savings from reducing each hour of direct
labor worked, the total savings from the ManTech
investment is $640,000 (32,000 hours saved ~ S20 DLH).
While the setting has clearly been simplified to make
a point, it should be obvious that cost savings computed
using existing cost accounting systems cannot possibly
provide a valid estimate of the savings in process
efficiency from ManTech investments.
Representative terms from entire chapter:
burden rate
