CHAPTER 3

Direct Material and Subcontract Costs

The starting point for estimating is, of course, the existing or prior bill of materials, a document that identifies the materials required to produce an item. The estimation of material and subcontract costs is significantly influenced by whether the product price being estimated has an established bill of materials or must be derived from an estimated bill of materials. Another fundamental concern is whether the item being priced is a product or a service. Generally, a bill of materials is not present for services because any purchases are incidental to production of the services.

MATERIAL QUANTITIES

The cost of materials and subcontracts consists of the quantities of goods and services to be purchased and the unit prices for those goods and services. Materials and subcontracts are categorized together for estimating purposes because the estimating concepts are identical; the only difference might be the terminology that contractors apply to each category. Because the Federal Acquisition Regulation (FAR) essentially recognizes no distinction in terms of estimating and supporting cost estimates, the two cost categories are almost always addressed together.

Established Bill of Materials

The first step in estimating a price is to ensure that the bill of materials is current or has been updated for any changes. Design changes may require revision to the bill of materials. Bill of materials changes may be forced due to obsolescence of parts or components or to the appearance of next-generation replacement parts. The previous bill of materials may have had initial startup costs for nonrecurring items such as tooling; these nonrecurring items may not be necessary for a follow-on production.

Quantities of parts and components must be adjusted to the current quantity being priced. Quantities must also reflect any minimum purchase requirements for some parts or components, where purchased quantities may be in excess of those actually needed for production.

Tentative Bill of Materials

The first step is to establish a structure approach to preparing a tentative bill of materials to price the work. A typical approach is to identify existing components that could be used in the new product, components that could be modified to be used in the new product, and components that will be unique to the new product. The pricing for these three conditions would be: (1) pricing of the existing components, (2) estimated prices for the extent of estimated modifications to existing components, and (3) quotes or grassroots cost buildup of unique items.

MATERIAL PRICES

In pricing material quantities, the options are generally to obtain new quotes or use historical cost data. It is seldom a good idea to seek new quotes for all items—this is time-consuming and often not fruitful, because some vendors will not provide quotes until a contractor is ready to place an order. Historical data can be a problem if the data are stale or if the historical quantities are not compared to the quantities being priced. The latter can often be resolved by a simple cost–quantity curve, which is similar to an improvement curve. A linear relationship (or more likely a curvilinear relationship represented by the improvement curve concept) can be established to adjust historical prices to current prices for a varying quantity.

Prices can vary against historical prices due to competition changes. For example, previously existing actual or potential vendors may no longer be in business, and the decreased competition will increase prices. Market conditions can impact prices and make historical data meaningless. For example, a huge demand for steel could increase prices far beyond historical levels. Also, if accelerated delivery is necessary, a premium may be demanded by a vendor. Additionally, if long lead times are required (e.g., a three-year wait for exotic metals), a pricing arrangement is usually required with the supplier as well as the customer. Material escalation is generally addressed as each item of material is estimated. However, some material escalation could be applied on the basis of published prices for commodities such as steel.

As to currency of prices, many contractors seek to price 80 percent of the bill of materials with current prices. Current is defined as either a quote or a price within the past six months. Some contractors even use a 12-month criterion. The government generally prefers prior definitive prices as opposed to new quotes, because the quotes might ultimately be negotiated to a lower price.

Another pricing consideration is changes in make-or-buy decisions. A component may have been purchased in the past but now is to be manufactured in-house (or vice versa). This condition may render the historical data irrelevant. Similarly, some materials may have been customer-furnished material or government-furnished material in the past and must now be estimated, or vice versa.

Inventory

Pricing of parts and components from inventory depends on whether the inventory is contractor or contract inventory. If a contractor maintains an inventory of parts or components (usually miscellaneous, common small parts), the acceptable means of pricing that inventory is the established inventory valuation method. This can be last-in-first-out (LIFO), first-in-first-out (FIFO), moving average, and so on. Whatever method is used must be used consistently.

Contract inventory refers to parts and components that have been purchased for a specific contract and charged to that contract rather than being charged to an inventory (asset) account. This pricing is complicated by the fact that the contract inventory may have been assigned to a cost-reimbursement contract and reimbursed by the customer. Contracting officer approval is likely needed to remove that part or component from the assigned contract to now be used on another contract. Even for fixed-price contracts this scenario can be a problem, particularly if progress payments based on costs have been received on the material.

The movement of parts and components from one contract to another is the rule rather than the exception for a manufacturing resource planning system. In government parlance, this is a material management and accounting system (MMAS) strictly monitored by the Defense Federal Acquisition Regulation Supplement. This latter regulation requires ten features for government approval of a contractor’s MMAS. A key element in the ten requirements is that transfers between contracts be priced in a consistent manner. The most logical equitable transfer basis is not necessarily LIFO or FIFO but may be a moving average—or, better yet, replacement prices, sometimes jokingly referred to as next-in-first-out. The contract receiving the transferred material should be charged for the amount that would have been incurred by obtaining the material in the market at that time. Another contract should not be penalized by being charged a higher price for the replacement material. Unless it is absolutely known that transferred material will be used to produce the proposed item, consideration of existing materials on current contracts is not necessary.

The concept of just-in-time inventory reduces some of the pricing issues but creates others. For example, some contractors do not purchase the full quantities needed for a contract or several contracts immediately but rather purchase in smaller quantities as needed. Thus, the pricing may not include consideration of quantity purchase price breaks that would have been realized had all materials been purchased at one time or if several contract requirements were combined at one time.

Residual Materials

A related topic is the existence of residual materials at the conclusion of a contract. How should the prices of such materials be considered in the pricing of a new contract? First, if the residual materials are from a cost-reimbursement contract, the material belongs to the customer and cannot be used on the new contract without special permission. If permission is granted to transfer material from a completed cost-type contract, the value for pricing is zero. If permission is granted to transfer material from a current cost-type contract, the value for pricing is the actual cost.

Second, if the residual materials are from a commercial or fixed-price contract, the accounting book value is likely zero. For pricing contracts, the value for the material could be the actual cost regardless of book value or the replacement price. The choice here is that equity would seem to dictate that replacement, or market, price should be used. However, the government often insists on the lower of actual cost and current cost. Either pricing is valid, but for negotiated contracts disclosure of these facts is required.

Assume materials remain from a completed fixed-price contract due to favorable material usage variance (i.e., less scrap than expected or estimated). These materials belong to the contractor; they were not paid for by the customer. The customer paid for a product, but the contractor ran the risk that the scrap would be greater than or less than estimated in the pricing.

Residual materials often occur in the instance of a minimum purchase. For example, assume that a contract is for four aluminum ash trays for an aircraft. The aluminum has a minimum quantity of 50 feet, but four ash trays only need 10 feet of aluminum. Assume the price of the 50-foot roll of aluminum is $1000. The pricing of the four ash trays should use the entire $1000 if a roll is to be purchased. Under a fixed-price contract, when the job is finished the 40 remaining feet belong to the contractor. For the next purchase of ash trays, it is proper to price these at 10 feet of aluminum times $20/foot ($1000/20) or $200.

Finally, the residual material may not be available for the item being priced, for a variety of reasons. The material may have deteriorated if held for a long period of time. The material may be used on another job before this contract is performed. Thus, although the residual material exists, it may not be proper or necessary to consider it in the pricing of new work. However, if it is known that the material will be used in the contract performance, this fact must be disclosed when pricing negotiated government contracts subject to the Truth-in-Negotiations Act.

Attrition

Various attrition factors are relevant to pricing materials. These include scrap, rework, spoilage, droppage, pilferage, and yields from production processes. Estimating scrap is an issue for contracts covered by Cost Accounting Standard (CAS) 401. Historical data are often critical in supporting any attrition factor. This can be either accounting or production historical data. Most contractors do not have an account or separate identification of attrition such as scrap. These data can be found in production records, not accounting records.

CAS 401 requires consistency in estimating and recording costs. Therefore, if a contractor prices a bill of materials and then adds a percentage to the bill-of-materials dollars, this is not likely to match accounting records that would support the percentage added. This would not comply with CAS 401. If accounting records support the percentage, this is acceptable. Otherwise, attrition must be supported and applied to the quantities of materials rather than the bottom line price(s). Each item or group of items in the bill of materials should have an adjustment to quantities based on production data (actual or estimated for new items). These adjusted quantities can then be priced along with the basic bill of materials. This complies with CAS 401.

Other Considerations

Another legitimate material cost is inventory adjustments that occur when a physical inventory detects differences between book values and physical existence. Generally, the costs are included in an indirect-cost pool. The same is true for miscellaneous small parts such as bolts, nuts, screws, rivets, welding rods, and so on. The physical and accounting control for these items may be more onerous than the benefits of finite accounting. The cost of these items might be included in an indirect-cost pool and allocated to contracts based on direct labor dollars or material costs depending on the circumstances. Other materials for engineering test purposes may need to be priced, as well as the production materials required.

SUBCONTRACT PRICES

In government contracting, subcontract pricing is a very significant topic above and beyond the pricing considerations already discussed. These issues are addressed in detail in Chapter 8, which covers timing of subcontract pricing reviews, providing subcontractor data to the government, and government review of subcontractor prices. In brief, the problem is that often fixed-price prime contracts are priced using subcontractor proposals before the subcontract prices are finalized. After conclusion of the prime contract price negotiation, the proposed subcontract prices may be negotiated downward. The government often views this as a “windfall” profit for a contractor and has several tactics designed to prevent it. The regulations require detailed data from subcontractors for the government customer to analyze before negotiating the prime contract price. Government analysts may apply an anticipated decrement factor to subcontract prices to prevent the potential for a windfall profit. Another tactic is misrepresentation of the requirements of the FAR in an attempt to coerce a contractor into agreeing to a lower price. Furthermore, some government officials have taken the unrealistic position that all subcontract prices must be established before the prime contract price is negotiated.

INTERCOMPANY TRANSFERS

The rules for intercompany or interorganizational transfers are also intended to prevent what is termed as pyramiding of profits—successive transfers of goods and services between affiliated organizations at prices that contain profit and inappropriately pyramid or inflate profits.

FAR 31.205-26(e) contains the requirements for interorganizational material transfers:

The term common control is the key phrase in this provision. FAR Part 19¹ states that “Business concerns are affiliates of each other if, directly or indirectly, either one controls or has the power to control the other, or another concern controls or has the power to control both.” The determination considers factors including common ownership, common management, and contractual relationships. Furthermore, any business entity may be found to be an affiliate, whether or not it is organized for profit or located inside the United States.

Intercompany transfers can be made at a price other than the incurred cost of the transferor when: (1) the contracting officer determines that prices agreed upon are based on adequate price competition, (2) the contracting officer determines that prices agreed upon are based on prices set by law or regulation, (3) a commercial item is being acquired, (4) a waiver has been granted, or (5) a contract or subcontract for commercial items is being modified². If any of these conditions is met, the price paid by the transferee is allowable (provided the contracting officer does not find the price to be unreasonable). Before 1995, this rule required that the contractor provide most favorable treatment customer status to the government.

Government contracting personnel consider this issue to be significant and are advised to give careful consideration to intercompany transfers at amounts other than cost:

As long as a profit has not been pyramided, the government is not concerned about how a contractor allocates profit between business units or entities. Generally, contractor profit is added last, in that any affiliate input is priced at cost with one profit added for all effort as the final step. However, a prime contractor affiliate may retain all profit and allocate or pay none to a subcontractor affiliate or may allocate all profit to the affiliate for its work.

BASIS OF ESTIMATE

The quantities and prices estimated must be documented as to source of estimates. A form for direct labor is provided in Illustration 3-1.

Notes

1. FAR 19.101.

2. FAR 15.403-1(b).

3. Defense Contract Audit Manual ¶ 6-314.1(a).

ILLUSTRATION 3-1: Basis of Estimate for Subcontract, Material, Consultants, or Contract Labor