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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 34

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35 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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36 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.