Adjusting Price/Cost For Further Analysis

Inflation/Deflation May Obscure Trends. Often you will make a series of similar acquisitions
over a period of time. Pricing trends may develop but they may be obscured by
inflation/deflation. Adjusting prices for inflation/deflation will make it possible to more
accurately identify and track these trends.
Steps in Using Price Indexes to Analyze Price/Cost Reasonableness. Adjustment for further
analysis follows four steps similar to those used for data adjustment that are applied in
preparation for direct comparison. The major difference is that several elements of cost/price
data must be adjusted to a single time period. After adjustment, data is said to be in constant-year
dollars.
Step 1. Collect available price/cost data.
Step 2. Select price indexes for adjusting price/cost data.
Step 3. Adjust prices/costs for inflation/deflation.
Step 4. Apply appropriate analysis technique(s).
Example of Using Price Indexes to Adjust Prices/ Costs for Further Analysis. To illustrate this
analysis, consider an offer of $22,500 each for five precision presses in 20X7.
Step 1. Collect Available Price/Cost Data. The organization has purchased five similar presses
each year since 20X2. The historical unit prices are shown in Column D of the table below.
While purchase quantity changes are not present in this situation, unit prices are used to limit the
effect of quantity differences on trend analysis. In this case, the only apparent cost/price trend in
the unadjusted data are the increasing prices.
Step 2. Select Price Indexes For Adjusting Price/Cost Data. Again, the Machinery and
Equipment Index will be used. Annual indexes are presented in Column B of the table below.
Step 3. Adjust Prices/Costs For Inflation/Deflation. The adjustment calculation is presented in
Column C of the table below. Each historical price is adjusted to an equivalent price in 20X7
dollars.
Adjustment For Further Analysis
A B C D E
Year
Machinery
and
Equipment
Index
Index
Adjustment
Calculation
Historical
Prices
Adjusted
Prices
20X2 100.0 121.9
100.0
$17,391 $21,200*
20X3 103.3 121.9
103.3
$17,796 $21,000
20X4 106.0 121.9
106.0
$18,087 $20,800
20X5 110.8 121.9
110.8
$18,724 $20,600
20X6 115.0 121.9
115.0
$19,245 $20,400
20X7 121.9 121.9
121.9
-- ?
Step 4. Apply appropriate analysis technique(s). After the historical unit prices are adjusted to
20X7 dollars, a trend becomes obvious. In 20X7 dollars, prices have been dropping $200 each
year since 20X2. The obvious price estimate is $20,200 for the 20X7 acquisition. That projection
is based on the continuation of the historical trend. However, as with direct comparison, analysis
based on historical price trends must consider any changes in the contracting situation and their
possible affect on contract price. There may also be questions as to what has caused the trend and
whether those forces will continue to cause price changes.
Most trends are not so obvious, even after prices have been adjusted to constant-year dollars.
However, you can often apply techniques such as regression analysis or improvement curve
analysis to identify clear estimating relationships.
1.5 Identifying Issues And Concerns
Questions to Consider in Analysis. As you perform price/cost analysis, consider the issues and
concerns identified in this section, whenever your analysis is based on data collected over time.
• Were prices/costs collected over time adjusted for inflation/deflation?
Inflation/deflation can mask underlying price changes. Price indexes should be used to more
accurately identify and track any pricing trends.
• Is it reasonable to use the price index series selected?
The price index series selected for making the price/cost adjustment should be as closely related
to the item being considered as possible. For example, you should not use the Consumer Price
Index to adjust for changes in the price of complex industrial electronic equipment.
• Are adjustments calculated correctly?
Anyone can make a mistake in calculation. Assure that all adjustments are made correctly.
• Is the time period for the adjustment reasonable?
When adjusting historical prices for inflation, take care in selecting the period of adjustment.
There are two basic methods that are used in adjusting costs/prices, period between acquisition
dates and the period between delivery dates. The period between acquisition dates is most
commonly used because purchase dates are typically more readily available. However, be careful
if delivery schedules are substantially different.
• Is more than one adjustment made for the same inflation/ deflation?
For example, it is common for offerors to adjust supplier quotes to consider inflation/deflation
between the time when the quote was obtained and the date that the product will be required.
This is acceptable unless the supplier already considered the inflation/deflation in making the
quote.
• How far into the future can you forecast?
You can forecast any period into the future as long as you have a reasonable index estimate.
However, the price forecast risk increases as the risk of developing a reasonable index estimate
increases. The farther into the future that you forecast, the greater the risk that the economic
factors affecting the index will change.
2.0 Chapter Introduction
• 2.0 - Chapter Introduction
• 2.1 - Identifying Situations For Use
• 2.2 - Analyzing The Cost-Volume Relationship
o 2.2.1 - Algebraic Analysis
o 2.2.2 - Graphic Analysis
• 2.3 - Analyzing The Price-Volume Relationship
• 2.4 - Analyzing The Cost-Volume-Profit Relationship
• 2.5 - Identifying Issues And Concerns
In this chapter, you will learn to use cost-volume-profit analysis.
Assumptions . When you acquire supplies or services, you normally expect to pay a smaller price
per unit as the purchase quantity increases. You expect contractors to have lower costs per unit
as production quantity increases. This general expectation remains the same whether you are
buying items specifically built for the Government or items that are mass-produced for a variety
of commercial and Government customers. You can use cost-volume-profit analysis to analyze
the natural relationship between cost, volume, and profit in pricing decisions. In cost-volumeprofit analysis, you:
• Should consider only short-term operations. The short term may be defined as a period
too short to permit facilities expansion or contraction or other changes that might affect
overall pricing relationships.
• Assume that a straight line can reasonably be used in analysis. While actual price
behavior may not follow a straight line, its use can closely approximate actual cost
behavior in the short run.
o If purchase volume moves outside the relevant range of the available data, the
straight-line assumption and the accuracy of estimates become questionable.
o If you know that product variable costs per unit are decreasing as quantity
increases, consider using the log-linear improvement curve concept. Improvement
curves are particularly useful in limited production situations where you can
obtain cost/price information for all units sold.
Types of Cost . In the short run, costs can be of three general types:
• Fixed Cost. Total fixed costs remain constant as volume varies in the relevant range of
production. Fixed cost per unit decreases as the cost is spread over an increasing number
of units.
Examples include: Fire insurance, depreciation, facility rent, and property taxes.
• Variable Cost. Variable cost per unit remains constant no matter how many units are
made in the relevant range of production. Total variable cost increases as the number of
units increases.
Examples include: Production material and labor. If no units are made, neither cost is necessary
or incurred. However, each unit produced requires production material and labor.
• Semi - variable Cost. Semi - variable costs include both fixed and variable cost
elements. Costs may increase in steps or increase relatively smoothly from a fixed base.
Examples include: Supervision and utilities, such as electricity, gas, and telephone. Supervision
costs tend to increase in steps as a supervisor's span of control is reached. Utilities typically have
a minimum service fee, with costs increasing relatively smoothly as more of the utility is used.
Graphic Depiction of Cost Behavior . The four graphs below illustrate the different types of cost
behavior described above:
Profit . Profit is the difference between total cost and revenue. In cost-volume-profit analysis, a
loss is expressed as a negative profit. Breaking even, which is neither profit nor loss, is a profit
of zero dollars.
2.1 Identifying Situations For Use
Situations for Use . Cost-volume-profit analysis is an estimating concept that can be used in a
variety of pricing situations. You can use the cost-volume relationship for:
• Evaluating item price in price analysis. Cost-volume-profit analysis assumes that total
cost is composed of fixed and variable elements. This assumption can be used to explain
price changes as well as cost changes. As the volume being acquired increases unit costs
decline. As unit costs decline, the vendor can reduce prices and same make the same
profit per unit.
• Evaluating direct costs in pricing new contracts. Quantity differences will often affect
direct costs -- particularly direct material cost. Direct material requirements often include
a fixed component for development or production operation set-up. As that direct cost is
spread over an increasing volume unit costs should decline.
• Evaluating direct costs in pricing contract changes. How will an increase in contract
effort increase contract price? Some costs will increase while others will not. The
concepts of cost-volume-profit analysis can be an invaluable aid in considering the effect
of the change on contract price.
• Evaluating indirect costs. The principles of cost-volume-profit analysis can be used in
indirect cost analysis. Many indirect costs are fixed or semi - variable. As overall volume
increases, indirect cost rates typically decline because fixed costs are spread over an
increasing production volume.
2.2 Analyzing The Cost-Volume Relationship
This section examines algebraic and graphic analysis of the cost-volume relationship.
• 2.2.1 - Algebraic Analysis
• 2.2.2 - Graphic Analysis
•
2.2.1 Algebraic Analysis
Key Assumption . The assumption of linear cost behavior permits use of straight-line graphs and
simple linear algebra in cost-volume analysis.
Calculating Total Cost Algebraically . Total cost is a semi - variable cost-some costs are fixed,
some costs are variable, and others are semi - variable. In analysis, the fixed component of a
semi - variable cost can be treated like any other fixed cost. The variable component can be
treated like any other variable cost. As a result, we can say that:
Total Cost = Fixed Cost + Variable Cost
Using symbols:
C = F + V
Where:
C = Total cost
F = Fixed cost
V = Variable cost
Total variable cost depends on two elements:
Variable Cost = Variable Cost per Unit x Volume Produced
Using symbols:
V = V U (Q)
Where:
V U = Variable cost per unit
Q = Quantity (volume) produced
Substituting this variable cost information into the basic total cost equation, we have the equation
used in cost-volume analysis:
C = F + V U (Q)
Example of Calculating Total Cost Algebraically . If you know that fixed costs are $500,
variable cost per unit is $10, and the volume produced is 1,000 units, you can calculate the total
cost of production.
C = F + V U (Q)
= $500 + $10 (1,000)
= $500 + $10,000
= $10,500
Example of Calculating Variable Cost Algebraically . Given total cost and volume for two
different levels of production, and using the straight-line assumption, you can calculate variable
cost per unit.
Remember that:
• Fixed costs do NOT change no matter what the volume, as long as production remains
within the relevant range of available cost information. Any change in total cost is the
result of a change in total variable cost.
• Variable cost per unit does NOT change in the relevant range of production.
As a result, we can calculate variable cost per unit (V U ) using the following equation:
V U = Change in Total Cost / Change in Volume
or
= (C 2 - C1 ) / (Q 2 - Q 1 )
Where:
C 1 = Total cost for Quantity 1
C 2 = Total cost for Quantity 2
Q 1 = Quantity 1
Q 2 = Quantity 2
You are analyzing an offeror's cost proposal. As part of the proposal the offeror shows that a
supplier offered 5,000 units of a key part for $60,000. The same quote offered 4,000 units for
$50,000. What is the apparent variable cost per unit?
V U = (C 2 - C1 ) / (Q 2 - Q 1 )
= ($60,000 - $50,000) / (5,000 - 4,000)
= $10,000 - $1,000
= $10
Example of Calculating Fixed Cost Algebraically . If you know total cost and variable cost per
unit for any quantity, you can calculate fixed cost using the basic total cost equation.
You are analyzing an offeror's cost proposal. As part of the proposal the offeror shows that a
supplier offered 5,000 units of a key part for $60,000. The apparent variable cost is $10 per unit.
What is the apparent fixed cost?
C = F + V U (Q)
$60,000 = F + $10 (5,000)
$60,000 - $50,000 = F
$10,000 = F
Developing an Estimating Equation . Now that you know that V U is $10 and F is $10,000 you
can substitute the values into the general total cost equation.
C = F + V U (Q)
= $10,000 + $10 (Q)
You can use this equation to estimate the total cost of any volume in the relevant range between
4,000 and 5,000 units.
Using the Estimating Equation . Using the estimating equation for the relevant range, estimate
the total cost of 4,400 units.
C = $10,000 + $10 (Q)
= $10,000 + $10 (4,400)
= $10,000 + $44,000
= $54,000