Developing the Solution Cost

Costing requirements vary by market and are unique to every organization. In government markets with one customer and few sellers, sellers might be required to base their prices on a defined set of costing rules plus an allowable profit margin.

Introduction

In open markets with many customers and sellers, cost is one of many factors used to set the price. In proposals to governments, costs often must be disclosed, profit margins must follow prescribed guidelines, assumptions and rationales will be questioned, and the final price will typically be negotiated.

Most sellers say that customers in their market select the solution with the lowest price, whereas most customers say that they seldom select the solution with the lowest price. The reality is that most customers try to select the best value solution within their budget.

Best Practices

1. Differentiate cost, price, and value.

Understand the definitions:

  • Cost is what it costs you to deliver the solution—not the cost to the customer
  • Price is what you charge for a product or service
  • Value is your customer’s perception of what the product or service is worth based on what it will deliver to their business

Added value is the difference between the customer’s perception of the total value of the solution and what it costs them to fully implement the solution.

Even for government procurements, price is rarely the single factor that determines a buying decision. Other less-tangible factors influence the buying decision, contributing to the customer’s perception of value. This is true even for commodity items. When buying a gallon of fuel, a driver will value the relative safety, cleanliness, convenience, and courtesy of a service station to justify or rationalize a higher or lower fuel price.

2. Develop should costs or target costs early.

Early in the opportunity/capture phase, try to understand the approximate cost of the customer’s needs and the potential budget to eliminate their problem. The earlier in the opportunity/capture process this is carried out, the less precise this will be. Most customers have some idea of what a reasonable estimate should be but are reluctant to disclose it. Avoid giving your initial solution development and costing team a broad description of the customer’s requirements with a target cost. Without a target, the first cost rollup often reveals that the cost of your solution far exceeds the customer’s budget. Work with the customer to objectively rationalize the costs as the requirements become defined.

Develop your should cost using top-down and bottom-up approaches (see Price-to-Win) until they converge. Alternative approaches to costing and their advantages and disadvantages are summarized in the table below:

Approach

Advantages

Disadvantages

Research: Collect information on customer budget and program funding

Rough target for bid price can be developed by deleting customer administrative costs from funding

Does not consider competitive approaches; funding estimates typically are based on outdated historical data and poor understanding of the solution

Expert judgment: Consult with one or more experts

Little or no historical data needed; good for new or unique projects

Experts tend to be biased; knowledge level can be questionable

Parametric models: Use design parameters and mathematical algorithms

Fast and easy to use; useful early in the program; objective and repeatable; often used by customer early in funding development

Can be inaccurate if not properly calibrated and validated; expensive to maintain models; historical data used for calibration may not be valid for new project

Analogy techniques: Examine competitor history and technology to determine the likely offering

Based on actual experience

Often, no truly similar program exists; not used alone; better used to check estimates

Bottom-up techniques: Total up unit costs to determine cost, effort, and margin

Provides a detailed basis for cost estimating; promotes individual accountability; useful mainly for cost tracking after award

Time and cost intensive; sometimes results in double dipping on estimates and usually results in higher costs; historical data not always available to support estimates; may not capture costs of integration; focuses on individual requirements, not the overall program

Top-down techniques: Base unit costs on customer budget and historical data

Begins with the customer budget information and results in customer-focused solution; helps enforce traceability between cost and technical; uses historical actuals

Requires good information on customer and competition; requires significant amount of work and adherence to a pricing process; often is erroneously based on conjecture rather than supported with validated information

Figure 1. Organizations Tend to Select Costing Approaches Based on Traditional Methods, History, or Convenience. If alternative approaches converge on a common cost, confidence increases. Consider the customer’s views; customers seriously question estimates based on expert judgment.

3. Define a costing strategy that supports your sales strategy.

A sales strategy that emphasizes leading-edge performance is inconsistent with a costing strategy that emphasizes selecting the lowest cost solution. Similarly, a sales strategy that emphasizes the seller’s efficiency and productivity is inconsistent with a high cost. When technical and cost teams are physically separate without an agreed-upon costing strategy, the solution is usually technically superior and high cost.

First, influence—or at least determine—whether the customer is seeking:

  • Lowest total added value
  • Maximum technical performance
  • Market image
  • Minimum acquisition cost
  • Total cost of ownership

Next, determine competitors’ probable approaches. Finally, adopt a discriminating position aligned with the customer’s needs.

  • Develop your solution based on what the customer values
  • Add low-cost features that the customer values highly
  • Eliminate costly features that the customer does not value

Try to persuade the customer to require a solution that is better matched to your capabilities than to those of your competitors. The key is influencing the bid request early. Your aim is to establish requirements that are expensive for your competitors to meet.

If you’re late in the competition and trying to find a solution for a bid request influenced by a competitor, try to reengineer the customer’s vision. Persuade the customer to value your discriminators. The success of this strategy relies on whether the customer has the latitude to change the requirements or to select a noncompliant solution.

Do all you can to influence the requirements favorably. For example, when competing for a cost-driven services contract, brainstorm ways to reduce your cost by asking the following questions:

  • How can we reduce management layers?
  • Can we increase management’s span of control?
  • Where should we place people within grades?
  • 4. Base your cost-estimating rationale on the assumption that nothing is new—everything has been done before.

    Many customer cost analysts assume everything has been done before. Base your estimating rationale on the same assumption.

    In any selling environment, few customers want to purchase version 1 or serial 001. The risk of being first is often too great. Base estimates on the most similar historical tasks. Break down the project until you can identify subtasks that are similar to subtasks from prior projects.

    5. Prepare or tailor written estimating guidelines for each opportunity.

    Unique complex programs require new estimating guidelines for each opportunity. For services or products that are similar from opportunity to opportunity, consider whether your current guidelines need tailoring.

    Estimating guidelines cover the following types of assumptions:

    • Program schedule and milestones to determine when costs occur
    • Work Breakdown Structure (WBS) to indicate what work will be done by which cost centers
    • A make-versus-buy subcontracting determination
    • A Statement of Work (SOW) and WBS dictionary to define the services and products to be delivered
    • Relevant financial ground rules regarding escalation, facility capitalization, work facilities and locations, direct labor and overhead rates, and preapproved rates
    • A deliverables list, including all hardware, services, and data
    • The level at which costs will be estimated, disclosed, and reported, if required

    Estimating guidelines should be written for the following reasons:

    • Only written guidelines are auditable and defensible, both externally and internally
    • Estimators working in teams must be consistent
    • When costs must be disclosed, include the ground rules in the cost volume introduction to increase your credibility
    • Partners, vendors, and subcontractors need guidelines to give accurate and competitive estimates
    • Written guidelines reduce both schedule and cost risk

    6. Minimize negotiated price decreases by using the most credible rationale.

    Government procurement officials typically require full disclosure of all task and activity descriptions, cost estimates, and rationale. The soundness of the rationale determines their subsequent price-negotiating position. A poor rationale leads to requests for larger price decreases during negotiation.

    Summary

    Plan activities early in the opportunity/capture phase to work with the customer to establish their requirements—and, if they have one budget, develop a realistic target cost. Keep the target cost under constant review when helping the customer develop a budget for the opportunity. Continually and clearly differentiate between cost, price, and value with the customer and with the solution team. Manage the development of a cost strategy that is aligned to and supports the win strategy. Prepare estimating guidelines for each opportunity. Develop a firm and objective rationale for your cost estimates to reduce requests to lower the price during negotiation.

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