(Editor’s Note. The following is the first of many future articles we plan on addressing practical pricing issues. We would like to apply our extensive experience helping clients price their proposals to provide some insights into pricing strategies and techniques. In this article we address possible approaches found in the commercial world that contractors and the government can agree to use that differ from a cost build up approach. Whether it is to increase revenue or offer lower prices than a full cost approach would require, pricing found in the commercial world often offers better alternatives. The transfer of audit responsibilities from DCAA to buying commands where price analysis over cost analysis dominates as well as emphasis on replacing cost based pricing with commercial practices in the last 10 years provides some opportunities that contractors and the government may agree to use. The source of the following article comes from Darrell Oyer’s text Cost Based Pricing as well as our own experience.)
The FAR recognizes commercial, catalog and market based pricing. Many of our clients are simply used to pricing their products and services using cost based estimates for fixed price and time-and-material contracts and actual costing for cost reimbursable contracting. However, pricing based on commercial pricing rather than cost can either generate more revenue or less to meet lower price objectives. The following addresses certain commercial pricing concepts and contrasts them from normal cost based pricing.
Cost based pricing is detailed in many FAR provisions but commercial, catalog and market based pricing is also prevalent. For example, Part 38, Federal Supply Service (FSS) establishes market based pricing on schedules where agencies purchase items without the burden of issuing solicitations and price reasonableness is assumed to exist by comparing prices of other vendors. FAR Part 12 is dedicated to commercial item pricing. Commercial pricing can apply even to new products where various techniques are useful for pricing the items and evaluating the price for reasonableness. These techniques include value based pricing, incremental pricing, activity based costing and design-to-cost techniques.
Commercial and Market Pricing
T&M and Labor-Hour Contracts
Commercial time-and-materials contractors do not require cost or pricing data but rather a market rate for the labor being priced where pricing based on cost data is a foreign concept. These techniques are highly relevant in the government world where under similar conditions, the prices are evaluated by comparing them to other vendors and upon evidence of sales at these prices for commercial situations.
Until 2007, the FAR did not permit a prime contractor to invoice the government for subcontract labor obtained in the prime contract unless there was specific authorization in the contract. Subcontract costs had to be invoiced at cost plus any additives such as G&A or subcontract administration. However, in early 2007, the FAR was revised to allow for commercial and noncommercial T&M contracts. For commercial items and non-commercial items that were competitively awarded, the rule permitted payment based on the prime contract labor-hour rate for all labor hours that meet the qualifications in the contract whether those hours were supplied by the prime contractor or subcontractor.
Though DOD limited noncommercial contracts, all other government departments do allow T&M commercial and noncommercial contracts that are awarded with adequate price competition to invoice subcontractors at prime contract labor rates.
Commercial Pricing Additives
In the commercial market it is quite common and desirable to be able to add items and price them accordingly. For example, expedited delivery or freight charges are common examples. Such pricing is difficult when FAR required costing practices exist. Under FAR-covered negotiated contracts, a contractor must establish direct and indirect costs in its accounting structure for purposes of pricing cost-based government contracts. A contractor may have clients who pay market prices for goods or services where some costs are invoiced to the client but are not classified as direct costs in the contractor’s accounting system. For example, under cost based government contracts, if a contractor wants to charge more for the expedited delivery or freight charges, these costs must be specifically identified as direct costs in its accounting system. This is not true for market-based prices. If the prices are not cost-based, no segregation of such cost additives in the cost accounting system are needed to substantiate a price. If a contractor records these costs (e.g. delivery, freight) as indirect they may nonetheless negotiate a market based higher price for the expedited delivery or freight charges though the costs accumulated on the government contract does not reflect these costs. In this case, the government benefits by receiving additional value and the contractor is able to realize added revenues without violating the FAR or cost accounting standards. Some caution may be called for because there may be the assumption that negotiating added revenue is based on such costs being separately identified so there should be an explicit understanding that a negotiated price was made.
Price Analysis
Price analysis is the process of evaluating a proposed price without evaluating separate cost elements and proposed profit. When commercial items are priced, no cost data are required and the buyer must rely on price analysis to ensure price reasonableness exists. Price analysis is the cornerstone of ensuring prices are reasonable, both in the commercial and government world. There are many accepted techniques that government buyers find acceptable for ensuring price is fair and reasonable such as comparing proposed prices, comparing proposed with historical prices (significant time lapses and different terms of conditions should be considered), parametric estimating or rough yardsticks (e.g. dollars per pound), comparison with published price lists, market research or value analysis of the worth of a product or service.
Value Based Pricing For New Items
Imagine pricing a new product or service the government wants on cost incurred in the current year. In such cases it is certainly desirable to avoid pricing a new product on a cost basis. As an extreme example, consider a government purchase of Microsoft Office where the price must be based solely on the cost of the one dollar disc containing the software. Though the government’s first choice may be to seek cost data for the item since no market price exists but an alternative basis may be desirable. Even if the development costs were partially recovered in prior years as IR&D costs that were accumulated over several years the current year’s costs are probably negligible. Under such circumstances it is almost futile to establish a fair and reasonable price for the contractor based on costs incurred. In such circumstances, the fair and reasonable price must be based on an evaluation of output (i.e. what value the item provides to the buyer) not the input (e.g. costs). Here, the seller and buyer should compare the price of the item to similar-functioning items in the market. Alternatively, most new items like software and hardware are valuable because they reduce the buyers costs, save lives, improve processes so a valid technique would be to calculate the savings the buyer will derive from purchasing the item.
Incremental Pricing
Sometimes it is desirable for contractors to keep prices low. Under these circumstances prices based on incremental costs may be desirable. Such incremental costing is contrary to the government concept of full-absorption costing where all direct and indirect costs are taken into account but charging for incremental or marginal costs is quite common in the commercial world.
Incremental costing includes all direct costs but only a small amount or even no indirect costs caused, say, by the production line or office staying open for a little extra time. As a general rule, about 80 percent of overhead is variable (varies with direct labor dollars) and 20 percent is fixed while about 90 percent of G&A costs are fixed. So a new item may cause some additional overhead to be incurred but not much G&A so full rates as applied using FAR based full-absorption costing would not reflect actual costs incurred. Though a detailed variable versus fixed cost analysis could be performed a shortcut method might be to apply overhead but no G&A to the new or additional items.
Other Means
In the 1990s a new costing and pricing concept was emphasized both by commercial and government contractors, activity based costing, which was used to supplant or replace incremental costing described above. Like incremental costing, ABC spurns the full-absorption costing and pricing concepts and refines cost allocations in novel ways where, for example, one element allocation bases like direct labor is replaced by several cost drivers like machine setups or number of times material is moved. In addition, Mr. Oyer refers to a new concept gaining popularity in government circles called design to-cost where contrary to cost-based pricing, the first step of design-to-cost is to determine, through market research, what a realistic price would be for the item in the commercial marketplace where the contractor designs the item to stay within the price that market research establishes. If a realistic cost cannot be achieved then the item is not produced. If costs can be reduced to a level that provides a profit and produces a marketable item, then the product is put into production.
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