COST APPROACHES Cost Accounting Managerial Accounting

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ECONOMICS IN SHIP ACQUISITION, DESIGN AND CONSTRUCTION

COST APPROACHES

• Cost Accounting

• Managerial Accounting

• Activity Based Costing/Management

• Life Cycle Cost

• Design “to” versus “for” Cost

• Total Ownership Cost

• Cost as an Independent Variable

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COST ACCOUNTING - AN INTRODUCTION

• Accounting is not an end in itself, but only a means to helpachieve business success.

• Specific accounting techniques or systems must be consideredin terms of the role they are intended to play.

• Cost analysis traditionally is viewed as the process ofassessing the financial impact of alternative business ormanagerial decisions.

• Thus we will consider the differences between CostAccounting and Management Acounting.

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Cost Accounting• Cost Accounting serves two fairly distinct purposes, namely

cost finding and managerial accounting.

• Cost accounting follows long established accounting rules toeventually prepare income statements and balance sheets.

• Traditional cost accounting is useful to financial people but arealmost useless to managers of a company from the point ofview of decision making.

• Cost accounting identifies, classifies, records and summarizesthe monetary aspects of a business in a systematic andstandard way (Generally Accepted Accounting Principles) topermit financial managers, investors and creditors to evaluate acompany’s business results and worth.

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Management Accounting• Management Accounting resulted from the fact that the data

developed by cost accountants was not useful to managers inthe day to day as well as long run business.

• Its purpose is to provide managers with information whichaids decision making.

• There are no generally accepted principles which specify howmanagement accounting information should be reported.

• While systems such as direct costing and standard costing areused in management accounting, each management accountingreport should be customized to the needs of the decision andthe decision maker.

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Activity Based Costing/Management (ABC)• Fundamentally, each component of overhead is caused by

some activity. Therefore, each product should be charged fora share of the overhead component based on the proportion ofthe activity that it causes.

• An activity is the description of work that occurs in anorganization and consumes resources.

• ABC is a method of measuring the cost and performance ofactivities and cost objects.

• Assigns cost to activities based on their use of resources and tocost objects based on their use of activities ABC empowersmanagers and other users with the information and tools toimprove business performance

• ABC recognizes the causal relationship of cost drivers toactivities

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Activity Based Costing/Management (Continued)• The ABC approach presumes that meaningful allocation of

fixed costs is possible and worth doing.

• Cost object is the reason for performing an activity such as tomake a product or serve a customer.

• Cost driver is an event of causal factor that influences the leveland performance of activities and the resulting consumption ofresources.

• Non-value added activity is an activity that is judged not tocontribute to customer value.

• Conventional costing systems do not assist management tomake world class decision making.

• In fact, conventional costing methods often cause the wrongdecision to be made.

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Activity Based Costing/Management (Continued)

• Conventional Cost System– Based on approach that products consume costs uses

historical and derived information not suited to measuringflow of work which moves across department boundaries

• Activity-Based Costing– Based on approach that activities consume resources and

products consume activities– Uses predictive and causal information– Can be used to measure cross department flow of work

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Activity Based Costing/Management (Continued)Examples of ABC terms:

Activity Release engineering drawingFunction EngineeringProcess DesignActivity The process of designing the system,Definition selecting the components, preparing and

issuing the drawingInputs Specifications and design standardsOutputs DrawingOutput Number of drawings per weekCost Driver Quantity and quality of material

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Activity Based Costing/Management (Continued)ABC Characteristics• Trace, assign and record activity cost to a product

• Improve cost by identifying non-value added activities

• Make visible the causes of complexity that does not contributeto customer value

• Focus and monitor continual cost improvement

• Provide meaningful information for product design anddevelopment decisions

By mirroring manufacturing process, designers and production

managers can easily determine how design changes will affect

product costs.

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As an example, consider the case of two products A and B. A isa mature product and it requires very little of the overheadsupport. B is a new product and its complexity requires a lot ofoverhead support.

The problem is that when overhead is taken as a percentage ofdirect hours it does not give the correct cost for the products.

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Activity Based Costing/Management (Continued)PRODUCT A PRODUCT B100 Units 100 UnitsUse of O/H $100 Use of O/H $5003 direct Labor Hours 2 Direct Labor Hours

CONVENTIONAL COSTINGLabor 3 x $120 = $360 Labor 2 x $120 = $240O/H 3 x $120 = $360 O/H 2 x $120 = $240

Total $760 Total $480OR $7.20 each Unit $4.80 each Unit

ACTIVITY BASED COSTINGLabor 3 x $120 = $360 Labor 2 x $120 = $240O/H = $120 O/H = $500Total $480 Total $740

OR $4.80 each Unit $7.40 each Unit

So if you sold more of B than A you would be losing money. This meansthat decision of quantities A and B would be incorrect based on conventionalcosting.

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Activity Based Costing/Management (Continued)• However, ABC is not the solution to all managerial financial

decision making.• A shipyard making only one product would not have any

accounting benefit, but ABC could still show ineffectivefacility/equipment usage, and thus improve overhead bygetting rid of such waste.

• ABC can be used to identify and eliminate non-value addedactivities.

• ABC has a number of basic problems with regard to amanagement decision tool for today. They are:

Static view rather than dynamic.Obsolete distinction between Product and Period Costs.Costing with ABC assumes no change in strategy.Not enough attention to activity management rather than activity costing.The focus is too narrow

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Activity Based Costing/Management (Continued)• Activity Based Management (ABM) is a way to provide the

missing dynamic capability to ABC.• ABM is the management of the activities in order to improve

those inefficient activities that add value and eliminate theactivities that do not add value.

• Like all general-ledger based accounting systems, ABC isinvolved with inventory versus expensed costs. This has norelevance to any management purpose. In most companieslarge portions of product cost are incurred long before theproduct manufacture, such as R&D, design, and procurement.

• ABM can overcome the fact that ABC is based on a fixedproduct strategy by focusing on the activities that are beingconsidered for change.

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ACKNOWLEDGEMENTMost of the material for the remainder of this part of the cost

presentation, including:

Total Ownership Cost and

Cost As An Independent Variable

has been developed from NAVSEA documents. Fullacknowledgement for this is given. However, theorganization. Presentation and inferences are the responsibilityof the presenter.

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Life Cycle Cost• The cost of ownership of a ship continues to increase. This

causes problems to owners in obtaining initial financing forconstruction of the ship as well as adequate operating incometo cover the cost of crewing, fuel, maintenance, etc.

• In traditional acquisitions, operation and support coststypically account for 60 to 80 % of the total LCC.

• Today, if ever, it is no longer acceptable for program managersand designers to consider only acquisition cost in makingplanning and design decisions. They must attempt to considercosts throughout the life of the ship.

• One way to do this is by considering life cycle costs (LCC).

• The LCC for s ship can be divided into fixed acquisition costsand a variable, often hard to predict life support cost.

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Life Cycle Cost• Life cycle costing is an economic assessment of either a single

product or competing alternatives, considering all significantcosts of ownership over the economic life of the single productor each alternative.

• For the single product approach it is important to consider aprediction of inflation over the life so that actual dollars arecomputed.

• For LCC trade-off analysis, especially if some of thealternatives have different lives, it is necessary to computeevery thing in equivalent dollars, most likely by discounted topresent year or year that product will enter service.

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Life Cycle Cost (Continued)• Life cycle costing is the systematic consideration of cost, time

and quality.

• Life cycle costing is not new, but its need is greater today thanever due to desire to have an affordable ship in order to becompetitive or to us public money well.

• The biggest problem with LCC is that the type of informationit needs is not normally possessed by one person. Thus theteaming approach is almost a given.

• That does not mean that an individual designer should notattempt to apply it, but , simply that he will need help indeveloping the model and obtaining the information.

• LCC uses pre-construction, design, construction, operation,logistics, and disposal costs to derive the total LCC.

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Life Cycle Cost (Continued)

• A major component of LCC is Operating and Support (O&S)cost.

• For Naval ships the major components of O&S cost are:Crew 30 to 45 %Fuel 12 to 17 %Maintenance 40 to 50%

• For commercial ships it is:Crew 20 to 30%Fuel 40 to 50%Maintenance 20 to 30%

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Life Cycle Cost (Continued)• Navy tools for O&S Cost Analysis consist of:

Visibility and Management of O&S Costs (VAMOS)This consists of a database of ship and ship system O&SCosts

O&S Cost Analysis Model (OSCAM)Model predicts ship and ship system O&S Costs fordifferent ship types.

Cost of Manpower Estimating Tool (COMET)Tool predicts the cost of naval and civilian crew

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DESIGN “TO” VERSUS “FOR” COST

• Most design is performance driven.

• This has led to escalating cost in constant year dollars.

• Initial attempts to deal with this have focused on holding tocost, such as Design to Cost.

• Only recently has the approach been to reduce cost butmaintain performance.

• Design for Cost is an approach that can accomplish this.

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DESIGN “TO” VERSUS “FOR” COST (Continued)• Design to Cost is the iterative redesign of a project until the

estimated cost of the project meets a given budget cost.

• Design for Cost is the deliberate use of engineering processtechnology to reduce life cycle cost.

• Design to cost usually reduces performance until the budget ismet.

• Design for Cost seeks to improve performance while reducingcost.

• Design to Cost reduces the level by which customer demandsare satisfied until the cost budget is met.

• Design for Cost is an engineering driven process.

• Design to Cost is a management driven process.

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DESIGN “TO” VERSUS “FOR” COST (Continued)• Design for Cost engineers the product once and is not an

iterative process.

• Design for Cost minimizes the Life Cycle Cost by designsuperior quality into the product.

• Design for Cost involves designing both the product and theproduction process for simplicity.

• Design for Cost should therefore be an integral part of theengineering process, not an add on.

• Low cost cannot be managed into a product. It must bedesigned into it.

• Design for Cost uses the engineering process to reduce LifeCycle Cost while satisfying customer requirements.

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DESIGN “TO” VERSUS “FOR” COST (Continued)• Design for Cost uses many tools and there are more that could

be applied.

• Such tools includeEstablished Rules of ThumbTotal Quality ManagementConcurrent EngineeringQuality Function DeploymentTaguchi MethodsAnalytical Hierarchy ProcessProcess Mapping and FlowActivity Based Costing

• Each of these tools have demonstrated that they can reducecost if used in the engineering process

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DESIGN “TO” VERSUS “FOR” COST (Continued)• Design for Cost can only be applied by knowledgeable

engineers.• This means that engineers be willing and able to accept this

additional responsibility to gain and use the knowledge.• How often have you heard people say that you should not try

to find ways to reduce structure man hours in naval ships asthey have less percentage man hours for structure than thetypical cargo ship?

• It is a correct end statement but the wrong conclusion.Naval Ship Commercial Ship% ManHrs % Manhrs

• Structure 30 300,000 55 110,000• Machinery and Outfit 70 700,000 45 90,000

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DESIGN “TO” VERSUS “FOR” COST (Continued) TYPICAL MAN HOUR PERCENTAGE BREAKDOWNPRODUCTIONSYSTEM OSV VLCC NAVALSTEEL 36 56 37OUTFIT 24 16 13MACHINERY 6 6 12PIPING 22 14 21ELECTRICAL 12 8 17LABOR/MATERIAL 40/60 45/55 35/65

ENGINEERINGSTEEL 23 35 20OUTFIT 27 10 20MACHINERY 8 15 15PIPING 28 32 30ELECTRICAL 14 8 15

% OF PRODUCTION 10-25 4-10 20-35

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Total Ownership Cost• Total Ownership Cost (TOC) is the cost of research,

development, design, construction, operations, maintenanceand follow-on logistics support of the product and itsassociated support systems, including the costs associated withmodification, environmental considerations, and disposal.

• The difference between LCC and TOC is that the latterincludes “linked-indirect” costs, such as:

Common support itemsCommon support systemsInfrastructure for planning, managing, operating andexecuting

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Total Ownership Cost (Continued)

• The TOC Strategic Initiative is to reduce the TOC of US Navyproducts.

• TOC establishes an affordable price for a product and thentrade-offs either performance or schedule to meet the price.

• TOC requires a behavioral paradigm shift in which costs arenot accepted, but challenged.

• TOC involves all Navy departments including ProgramExecutive Officers, Program Managers, Field Support Team,Fleet, Depots, NAVICP, OPNAV and SYSCOM.

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Cost as an Independent Variable• STRATEGIC GOAL

Understand and manage Total Ownership Costs over the entirelife cycle to produce savings for recapitalization andmodernization. (This implies an urgency for reducing near-term operating & support costs.)

• STRATEGYDevelop processes, tool-sets, and models to support OPNAVforce level decisions and the affordability decisions made byProgram Managers and Industry from system concept throughdisposal.

John Douglass, ASN (RDA) 1996-1997 Strategic Plan

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Cost as an Independent Variable (Continued)• Cost as an Independent Variable (CAIV) is a U.S. DOD

initiative.

• CAIV has many of he same tenets as Design to Cost which isbased on the concept of establishing a cost budget and using itas a design constraint.

• CAIV however, recognized that program managers consideredcost as a DEPENDENT variable which would change in orderfor other variables to remain more constant.

• CAIV actually is more like the Design for Cost approach inthat the design is developed so that the cost does not increasewith other changes and may even decrease.

• CAIV is a way to manage Total Ownership Cost.

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Cost as an Independent Variable (Continued)• CAIV changes the Program Managers focus to one of

establishing aggressive, but achievable objectives for the totallife cycle cost of the program and then making managementdecisions to achieve the objectives.

• This requires a change from the DTC average unit cost to atotal life cycle cost.

• Basically CAIV is an acquisition philosophy intended tointegrate proven successful, business-related practices withpromising new DoD initiatives to obtain superior, yetaffordable, war-fighting capabilities.

• Specifically, CAIV philosophy means that cost should betreated as an independent variable among the three traditionalvariables - cost, schedule and performance.

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Cost as an Independent Variable (Continued)• CAIV means picking the right, affordable cost objective and

sticking with it.

• If the war-fighting requirement cannot be met after exhaustingthe available range of cost-performance trade-offs, themilestone decision authority will determine if cost targetsshould b raised or if the program should be cancelled asunaffordable.

• CAIV will only work if the other acquisition reformstreamlining initiatives it is built on are successful. Theseinclude:

Stating requirements in terms of performance, rather than detailed, designspecific military specifications.The adoption of commercial practices and the use of commercial products.The use of IPT Management.

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Cost as an Independent Variable (Continued)CAIV PROCESS

• Establish Cost/Performance Integrated Process Team

• Develop Cost Baseline

• Identify Process/Mission Cost Drivers

• Identify Hardware/Software Cost Drivers

• Establish Life Cycle Cost Metrics

• Set Realistic Cost Reduction Goals

• Set incentives

• Develop TOC Reduction Plan

• Pursue Cost Reduction Opportunities and Manage to Goals

• Monitor and Update TOC Goals

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Cost as an Independent Variable (Continued)• CAIV is a DoN strategic management process.

• CAIV is both a top-down and bottom-up, continuous andcomprehensive approach.

• CAIV recognizes that limited resource availability drivesTotal Ownership Cost target.

• CAIV employs a hierarchy of cost reduction activities,expanding the potential trade-off space.

• CAIV requires risk management due to the aggressive butrealistic cost objectives

• CAIV is applied to an end item, from cradle to grave.

• CAIV is evolving into Affordability Readiness.

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Cost as an Independent Variable (Continued)• Incentives are key to the success of CAIV.

• CAIV recognizes that there must be incentives to bothProgram personnel as well as contractors. Without them thereis no motivation for change.

• CAIV must use existing incentives such as value engineeringand other cost saving sharing as well as new ones yet to bedeveloped, especially for program personnel.

• Program Managers and their staff must not only be allowed,but encouraged, to take risks to gain high future benefits.Navy headquarters will need to change how they measureProgram Manager performance to one based on best effortrather than just success.

• Contractors will like-wise need to be encouraged.

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Cost as an Independent Variable (Continued)TENETS

Warfighter Participatation - earlyand continuous role in setting andadjusting program goals

Requirements - stated as a set ofcapabilities, or performances, andthe are fungible

Capabilities - established at thesystem level, not at lower levels

Cost Objective - define the tradespace and realistic, but aggressive,set early and update at eachacquisition phase

APPROACH

Set realistic, but aggressive costobjectives:• based on cost-performance trade-

offs

• consistent with out-year resources

Manage risks to achieve cost,schedule and performance objectives

Devise metrics for tracking progressin setting and meeting costobjectives

Motivate government and industry toachieve objectives

Implement incentives for fieldedsystems to reduce O&S costs

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Cost as an Independent Variable (Continued)CAIV METRIC CAIV OBSERVATIONS

Are Cost objectives defined and consistent withrequirements programmed and projected fiscalresources?

• Out-year resourcces identifed? ($)• Production and O&S cost objectives included in the RFP?• Key trade-off issues addressed? (e.g. In COEA)•

Is DoD managing to achieve cost objectives? • RFP contains a strict minimum number of performance specifications? (#)• CP-IPT functioning: trade-off space identified in program baseline and RFP?• Risks to achieve cost objectives identified and program steps to address thes

defined? (Risk Plan)• Incentives for achieving cost objectives included in RFP and contract? (%

related to total contract $s)• Mechanism for contracting suggestions to reduce production and O&S costs in

place and operating?• Allocation of cost objectives provided to IPTs and key suppliers?• Measurement and estimation of reliability and maintainability in place?• Robust contractor incentives plan in place?•

Are contractors managing to achieve costobjectives?

• Providing appropriate tools for cost-performance trade-ffs (including incentivesfor corporate management) and participates in cost-performance trade-offprocess?

• Identifying (and when appropriate implements) new technologies andmanufacturing processes that can reduce cost?

• Identifying procedural/process impediments to cost reduction measures?• Establishing strong relationship with vendor base, including sound incentive

structure?

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COST ESTIMATING

• Not a lot of literature on marine cost estimating but the firstbook goes back to the 1920’s (DESIGN AND COST OFSHIPS, by Kari).

• Approaches vary depending on type of bid, and availableinformation.

• Approaches continue to evolve with the developments inmanufacturing technology.

• Cost estimates are prepared by people not by machines.

• Before a person can develop an estimate, they must acquirepertinent knowledge

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COST ESTIMATING (Continued)

AcronymsBCC Basic Construction/ConversionBOM Bill of MaterialCOA Chart of AccountsCER Cost Estimating RelationshipEBS Estimating Breakdown StructureESWBS Extended Ship Work Breakdown Structure GFM Government Furnished MaterialOFE Owner Furnished EquipmentPODAC Product Oriented Design and ConstructionROM Rough Order of Magnitude

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COST ESTIMATING (Continued)• Marine Cost Estimating is not an exact science.

• It has grown through application of methods and historicaldata.

• It is an area where significant improvement would help allshipbuilders.

• World Class shipbuilders use more parametric estimating thanthe U.S. shipbuilders. Why?

• In U.S. it is really pricing of estimated quantities of rawmaterial and equipment.

• A shipbuilder can be asked to give Rough order of Magnitude(ROM), Preliminary or Contract (Detailed) estimates.

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COST ESTIMATING (Continued)• Before an estimate will be started the shipbuilder first has to

decide to bid.

• Because of the time and cost of preparing designs, estimatesand bids, shipbuilders are usually selective on what they willbid on. Most shipbuilders have a “Bid-No Bid” meeting foreach invitation to bid.

• The bid decision is based on many factors, including:Shipowner’s reputationOngoing workProduct fit to facilities and capabilitiesExtent of perceived competition

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COST ESTIMATING (Continued)• In most shipyards Engineering is very involved in the

estimating process, usually responsible for the material take-off and definition of system design and associated equipment.

• In addition, Engineering must estimate how much man hoursand material it will require to design the ship.

• To facilitate the estimating process a product breakdownstructure is used. In the U.S. the two best know structures arethe Navy’s SWBS and the MarAd SBS.

• These are both “system” based and recent work on costestimating is to apply product and process based approaches

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COST ESTIMATING (Continued)ROM Estimates• Based on high level parameters such as ship type,

displacement and speed.

Preliminary Estimates• Based on weights of the major systems such as First Digit

SWBS.• May be divided into labor and material.• Recent development is trying to introduce process based

estimates at this stage.• Treats labor rate, overhead and profit as individual inputs

which can be varied to see impact.

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COST ESTIMATING (Continued)Detailed Estimates• Line item listing for every system and purchased component.• Material cost based on estimated quantities of raw material and

quotes for most of the equipment.• Labor man hours based on historical CERs, usually based on

weight or linear feet.• Direct labor cost results from applying labor rate to total man

hours. Sometimes divided into different trades in order todifferentiate different labor rates.

• Overhead applied as a percentage of direct labor cost.• Material, direct labor and overhead, as well as some incidental

service costs, are summed and a profit percentage applied todetermine bid price.

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COST ESTIMATING (Continued)Commonly Used Approach• Comparison and estimation of Differences• Extrapolation• Parametric/Statistical• Detailed

Selection of Approach Based On• Purpose of Estimate• Program Phase• Level of Product Definition• Availability of relevant cost data• Quality of cost data• Time to prepare

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COST ESTIMATING (Continued)Comparison of U.S. Shipbuilding with World Shipbuilders• Most foreign shipbuilders use parametric cost estimating for

their final estimate. They are able to do this because:Small well defined product rangeBuilding many ships per yearBetter organized and developed estimating systemCost collection directly compatible with estimating systemUse of re-use modules

Comparison with other industries• Manufacturing and construction industries use very similar

approaches, except that they use more standards including theapproach throughout the industry.

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COST ESTIMATING (Continued)Re-use Modules and Estimating• Standard method in software industry• New products are designed by re-using a maximum number of

existing parts or assemblies• Known costs of re-use modules are summed to give new cost• Fast development of new products and estimates

Computer Aided Estimating• Can be for either detailed or parametric estimates• Estimator completes input cost elements, usually within a

specific template• Can be linked to CAD/CAM Systems• Can incorporate probability calculations presenting cost

estimates as a distribution to aid in price decisions.

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COST ESTIMATING (Continued)Cost in Preliminary Design and Trade-off Analysis• In preliminary ship design naval architects normally want to predict the

economics of large numbers of alternative designs. This means that theestimating methods should be relatively simple.

• The alternatives under consideration usually exist only as imaginaryconcepts about which few details have been established.

• This, too, suggests that the techniques must be relatively simple.

• Moreover, except in rare cases, one need not worry about exact costs;relative costs are what matter.

• The estimating methods should strive to emphasize differences in costsbetween the various alternatives.

• Absolutely accurate costs are not necessary.

• For Trade-off analysis, which usually looks a a few differences, the samearguments apply.

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COST ESTIMATING (Continued)• The Estimate is a predicted cost of a body of work under

anticipated conditions of performance.• The estimate requires a greater proportion of the shipyard’s

resources to accomplish than all other elements of he biddingprocess combined. It is the single most important input to thepricing decision.

• The estimate provides the point of departure and essential toolsfor the shipyard’s budgeting and cost control and scheduling.

• The pricing is an instrument and expression of the shipyard’sbusiness and marketing policies and a principal means ofestablishing and maintaining its competitive position.

• The price is a forecast of market conditions and a pricingdecision, which is based, in part, on this forecast and in part onthe cost estimate.

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COST ESTIMATING (Continued)• When the cost estimate is complete it must be resented to

management.

• Suggested points to be presented are:Type of estimatePercentage of material pricing from quotesPercentage of labor from detailed take-off parametersComparison of new design with other similar ships built by theshipyard.Labor and overhead rates used.

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COST ESTIMATING (Continued)Management must use the cost estimate, along with thefollowing considerations to decide the bid price:

• Does the projected work fit in well with available laborresources, facilities and ongoing work?

• Can they make desired profit at prevailing competitive prices?

• Have the risks been adequately analyzed and covered?

• Does the shipyard have the necessary financial resources tosuccessfully perform the contract?

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COST ESTIMATING (Continued)

• After the project is awarded it is always necessary to conduct apost bid review, whether your shipyard won or lost thecontract.

• This is a very important activity to ensure the competitivenessof the shipyard. It is essential for future pricing decisions.

• To do this it is necessary to attempt to get the prices bid byother shipyards. This is not as easy as it used to be with theMarAd Open Bid Meeting. However, it is possible to find out.

Documents

COST APPROACHES Cost Accounting Managerial Accounting