Pricing Reference Guides

Contract Pricing Reference Guides Volume 2
February 22, 2012
• Ch 1 – Using Price Index Numbers
• Ch 2 – Using Cost-Volume-Profit Analysis
• Ch 3 – Using Statistical Analysis
• Ch 4 – Developing and Using Cost Estimating Relationships
• Ch 5 – Using Regression Analysis
• Ch 6 – Using Moving Averages
• Ch 7 – Improvement Curves
• Ch 8 – Using Work Measurement
• Ch 9 – Using Net Present Value
• 1.0 – Chapter Introduction
• 1.1 – Identifying Situations For Use
• 1.2 – Constructing Price Index Numbers
• 1.3 – Selecting A Price Index For Analysis
• 1.4 – Adjusting Price/Cost For Analysis
o 1.4.1 – Adjusting Price/Cost for Pricing Comparisons
o 1.4.2 – Adjusting Price/Cost For Further Analysis
• 1.5 – Identifying Issues And Concerns
1.0 Introduction
In this chapter, you will learn to use price index numbers to make the price adjustments
necessary to analyze price and cost information collected over time.
Price Index Numbers. Price index numbers measure relative price changes from one time period
to another. They are so widely used that discussions related to index numbers in contract pricing
normally refers to price indexes. However, other index numbers could be used in contract
pricing, particularly indexes that measure productivity.
Simple and Aggregate Price Index Numbers. Price index numbers can indicate price changes for
one or several related supplies or services over a period of time. The Bureau of Labor Statistics
(BLS) publishes numerous simple and aggregate Producer Price Indexes (PPI) that track changes
in the wholesale price of products sold in the United States.
• Simple index numbers calculate price changes for a single item over time. Index numbers
are more accurate if they are constructed using actual prices paid for a single commodity,
product or service rather than the more general aggregated index. An example of a simple
index would be one that tracks only lemons or oranges.
• Aggregate index numbers calculate price changes for a group of related items over time.
An example of an aggregate price index would be one that tracks citris fruits.
1.1 Identifying Situations For Use
Situations for Use. You can use price index numbers to:
• Inflate/deflate prices or costs for direct comparison. You can use price index numbers to
estimate/analyze product price/cost today using the price/cost of the same or a similar
product in the past.
• Inflate/deflate prices or costs to facilitate trend analysis. You can use index numbers to
facilitate trend or time series analysis of prices/costs by eliminating or reducing the
effects of inflation so that the analysis can be made in constant-year dollars (dollars free
of changes related to inflation/deflation).
• Estimate project price or cost over the period of contract performance. Prices/costs of
future performance are not certain. One effect that you must consider is the changing
value of the dollar. You can use index numbers to estimate and negotiate future costs and
prices.
• Adjust contract price or cost for inflation/deflation. When price/cost changes are
particularly volatile, you may need to include an Economic Price Adjustment (EPA)
clause in the contract. The use of index numbers is one of the most popular methods used
to identify and define price changes for economic price adjustment.
1.2 Constructing Price Index Numbers
Steps in Price Index Number Development. If your activity repeatedly buys the same types of
services or supplies, consider developing your own price indices to track trends in price over
time. This section will demonstrate the procedures for developing a simple price index. To
develop an aggregate index, follow the same basic steps using data from the various products
selected for index development.
There are four steps to developing a simple price index number:
Step 1. Collect data for each period.
Step 2. Select an appropriate base period.
Step 3. Divide each period price by the base-period price.
Step 4. Multiply by 100 to produce an index number.
Example of Price Index Number Development.
Step 1. Collect Data for Each Period. For each index period, collect average price data for the
product, commodity, or service. For example, assume the following average yearly prices for a
hoist:
Year 20X4 20X5 20X6 20X7 20X8
Price $84.12 $90.84 $95.06 $101.97 $107.32
Step 2. Select an Appropriate Base Period. Select a base period appropriate for the data available.
In this case, we will use the 20X4 price, $84.12.
Select Base Period
A B C
Year
Average
Annual Price
20X4
Base Price
20X4 $84.12 $84.12
20X5 $90.84 $84.12
20X6 $95.06 $84.12
20X7 $101.97 $84.12
20X8 $107.32 $84.12
Step 3. Divide each period price by the base-period price. In this example, divide each period
price (Column B) by the base-period price (Column C). The result is a price relative (Column E)
as shown below. A price relative is the relationship of the price in any period to the base period
price. For example, the table below shows that the price in 20X6 is 1.13 times or 13 percent
higher than the price in 20X4.
Calculate Price Index
A B C D E
Average
Annual 20X4
Price Relative
Calculation Price
Year Price Base Price Relative
20X4 $84.12 $84.12 $84.12 /
$84.12
1.000
20X5 $90.84 $84.12 $90.84 /
$84.12
1.080
20X6 $95.06 $84.12 $95.06 /
$84.12
1.130
20X7 $101.97 $84.12 $101.97 /
$84.12
1.212
20X8 $107.32 $84.12 $107.32 /
$84.12
1.276
Step 4. Convert to an Index Number. Convert to an index number (Column F) by multiplying
each price relative (Column E) by 100. Normally, you should round index numbers to the nearest
tenth.
Calculate Price Index
A B C D E F
Year
Average
Annual
Price
20X4
Base Price
Price
Relative
Calculation
Price
Relative
Index
Number
20X4 $84.12 $84.12 $84.12 /
$84.12
1.000 100.0
20X5 $90.84 $84.12 $90.84 /
$84.12
1.080 108.0
20X6 $95.06 $84.12 $95.06 /
$84.12
1.130 113.0
20X7 $101.97 $84.12 $101.97 /
$84.12
1.212 121.2
20X8 $107.32 $84.12 $107.32 /
$84.12
1.276 127.6
1.3 Selecting A Price Index For Analysis
Points to Consider in Index Selection. Use published indexes carefully as they often do not fit the
pattern of price changes for the product or service you are analyzing. The data usually represent
national or regional averages in lieu of any specific contractor or location. Nevertheless, price
index numbers offer a practical alternative to the costly and time-consuming task of developing
index numbers from basic cost data.
When you use published indexes, choose the index series that best fits your specific analysis
effort. Usually, the closer the chosen index series relates to the item you are pricing, the more
useful the number will be in your analysis.
If you are buying a finished good, indices representing raw materials and purchased components
may not necessarily provide an accurate basis for projecting prices. The finished good price may
also be strongly influenced by trends in direct labor, cost of capital, etc. Accuracy can be
improved by the use of a weighted average index which represents changes in both labor and
material elements of price. Many contracting organizations develop weighted average indexes
for major products or major groups of products.
Sources of Published Indexes. You may not have the time or data required to develop the price
indexes that you need for a price or cost analysis. Fortunately, there are many sources of
previously constructed price indexes that you can use to estimate price changes. These sources
include:
• Bureau of Labor Statistics (BLS);
• Other Government agencies;
• Government contracting organizations;
• Commercial forecasting firms;
• Industry or trade publications; and
• Newspapers.
Indexes from the Bureau of Labor Statistics. The Government collects and publishes vast
amounts of data on prices. Four of the best known sources of index numbers are published by
the BLS:
• Producer Price Index Detailed Report. Probably the best known and most frequently used
source of price index numbers for material pricing is the Producer Price Index (PPI)
Detailed Report published monthly by the U.S. Department of Labor, Bureau of Labor
Statistics (BLS) . The indexes report monthly price changes at the producer/wholesale
level for 15 major commodity groups:
Producer Price Indexes Commodity Groups
Commodity
Code Commodity Description
01 Farm Products
02 Processed Foods and Feeds
03 Textile Products and Apparel
04 Hides, Skins, Leather, and
Related Products
05 Fuels and Related Products and
Power
06 Chemicals and Allied Products
07 Rubber and Plastic Products
08 Lumber and Wood Products
09 Pulp, Paper, and Allied Products
10 Metals and Metal Products
11 Machinery and Equipment
12 Furniture and Household
Durables
13 Nonmetallic Mineral Products
14 Transportation Equipment
15 Miscellaneous Products
• Consumer Price Index Detailed Report. The consumer price index (CPI), published
monthly in the Consumer Price Index Detailed Report , reports on changes in consumer
prices for a fixed mix of goods selected from the following categories:
o Food;
o Clothing;
o Shelter and fuels;
o Transportation; and
o Medical services.
You should normally not use the CPI in adjusting material prices because the CPI reflects retail
rather than wholesale price changes. However, the CPI can be of value in pricing services when
labor rate increases are linked to changes in the CPI.
• Monthly Labor Review. The Monthly Labor Review includes selected data from a
number of Government indexes, including:
o Employment Cost Index;
o Consumer Price Index;
o Producer Price Indexes;
o Export Price Indexes; and
o Import Price Indexes.
The data and other information presented in the publication can prove useful in analyzing prices,
especially on service contracts, where direct labor is a significant part of contract price.
• Employment Cost Index. The Employment Cost Index presents information on the
changes in earnings index for various classes of labor. Like the Monthly Labor Review,
the report can be very useful in pricing contracts in which direct labor is a significant part
of the contract price.
Indexes from Other Government Agencies. Data on contract prices are also available from
agencies other than the BLS, such as the Federal Reserve System and the Bureau of Economic
Analysis.
• Federal Reserve System. The Board of Governors publishes the Federal Reserve Bulletin
, which includes economic indexes and data on business, commodity prices, construction,
labor, manufacturing, and wholesale trade. Each bank in the system publishes
information each month with special reference to its own Federal Reserve District.
• Bureau of Economic Analysis Publications. The Bureau of Economic Analysis,
Department of Commerce, publishes the Survey of Current Business that provides
general information on trends in industry and the business outlook. It furnishes economic
indexes on business, construction, manufacturing, and wholesale trade.
• Indexes from Government Contracting Organizations. Many Government contracting
organizations have teams of analysts who develop indexes that are particularly applicable
to the organizations’ specific contracting situations. These indexes may be developed
from raw price data, or they may be developed as weighted averages of published
indexes.
Indexes from Commercial Forecasting Firms. Numerous commercial indexes are available for
use in contract price analysis. While most Government indexes only report historical price
changes, many commercial indexes also forecast future price movement. In situations where
forecasts are necessary, commercial indexes may prove particularly useful. Before using such
indexes, examine their development and consult with auditors, technical personnel, and other
contracting professionals to assure they are applicable in your analysis situation. Many federal
government departments/agencies have contracts with commercial firms that provide these
economic forecasting services. Check with your department or agency to see if you have access
to such a service.
Indexes from Industry or Trade Publications. Industry and trade publications frequently provide
general forecasts of economic conditions and price changes anticipated in the industry. To
identify which publications have economic information relevant to a particular product, ask
Government technical personnel. Contractors can also assist you in the identification of
appropriate publications. However, be sure to verify with Government personnel the
appropriateness of any information sources recommended by a contractor.
Indexes from Newspapers. Publications, such as local, national, and financial newspapers,
provide valuable forecasts of price changes in specific industries. The information reported is
normally data provided by the Government, economic forecasting firms, or industry groups.
1.4 Adjusting Price/Cost For Analysis
In this section, you will learn how to use price index numbers to adjust prices and costs for
analysis.
• 1.4.1 – Adjusting Price/Cost for Pricing Comparisons
• 1.4.2 – Adjusting Price/Cost For Further Analysis
Compensating for Inflation or Deflation. The changing value of the dollar can complicate
comparisons and other analyses using price or cost information collected over time. You
can use price indexes to adjust prices/costs to compensate for inflation or deflation to
facilitate direct comparisons and further analysis.
Calculate Relative Price Change Between Two Periods. Index numbers indicate the percentage
change in price relative to the base year. For example, the table below shows that the average
product price increased by 23.2 percent between 20X4 and 20X9.
Year Product Index
20X4 100.0
20X5 105.3
20X6 112.0
20X7 116.5
20X8 119.3
20X9 123.2
To adjust prices for inflation or deflation, you must be able to do more than determine how
prices have changed relative to the base year. You must be able to determine how prices changed
between any two time periods. For example, looking at the table above, how did prices change
between 20X6 and 20X9? To calculate the percentage price change between any two time
periods, you must follow the same procedure that you would follow if you had actual price data;
you must divide.
Index in 20X9 Index in 20×6 = 123.2 112.0 = 1.10
Based on the price index and this calculation, you could estimate that product prices in 20X9
were 1.10 times the prices in 20X6 or 10.0 percent more than the prices in 20X6.
Estimating Price/Cost Using Index Numbers. You can use index numbers to adjust prices or
costs from any time period for inflation or deflation. For example, the calculation above
demonstrated that product prices increased 10.0 percent between 20X6 and 20X9. If you knew
that the price for an equipment item in 20X6 was $1,000, you could estimate that the price
should be 10.0 percent higher in 20X9. That would result in a price estimate of $1,100 for 20X9.
These calculations can be formalized into a simple equation using either the Ratio Method or the
Price Adjustment Formula Method described below.
• Ratio Method. The Ratio Method uses an equation in the form of a simple ratio to make
the price adjustment.
I 2 I 1 = P 2 P 1
Where:
I 1 = Index in Time Period 1 — the index for the period for
which you have historical cost/price information.
I 2 = Index in Time Period 2 — the index for the period for
which you are estimating.
P 1 = Price/cost in Time Period 1 — historical cost/price
information.
P 2 = Price/cost in Time Period 2 — cost/price estimate.
Example: You purchased an item in 20X6 for $1,000 and you are trying to estimate the price in
20X9. The relevant index in 20X6 was 112.0. In 20X9, it is 123.2.
I 2 I 1 = P 2 P 1
123.2 112.0 = P 2 $1,000
123.2 x $1,000 = 112.0 x P 2
123,200 = 112.0 x P 2
123,200 112.0 = P 2
$1,100 = P 2
• Price Adjustment Formula Method. The Price Adjustment Formula is a simplification of
the Ratio Method described above.
P 2 = I 2 I 1 x P 1
Example: The calculations below use the same pricing information used above to demonstrate
the ratio method.
P 2 = I 2 I 1 x P 1
= 123.2 112.0 x $1,000
= 1.10 x $1,000
= $1,100
Adjustment Period Selection. When adjusting historical prices for inflation, take care in selecting
the period of adjustment. There are two basic methods you can use in adjusting costs/prices:
• Adjustment based on period between acquisition dates.
o This is the method most commonly used to calculate the period of price
adjustment, because acquisition dates are readily available.
For example: An item is being acquired in January 20X2 was last purchased in January 20X1.
Using this method, the logical adjustment period would be January 20X1 to January 20X2 — a
year of inflation or deflation.
•
o If delivery schedules are similar, this method should be satisfactory. However, if
delivery schedules are significantly different, you may be over or under the
adjustment required.
For example: If the January 20X1 acquisition provided for delivery in January 20X2 and the
January 20X2 acquisition also provided for delivery in January 20X2, allowing for a year of
inflation or deflation would likely overestimate the adjustment required. The pricing of the first
acquisition should have already considered the anticipated price changes between January 20X1
and January 20X2. Why make a second adjustment for the same price changes?
• Adjustment based on period between delivery dates.
o This method for determining the appropriate period of adjustment is probably
more accurate for the reasons described above. The problem with applying this
method is the collection of accurate information on delivery dates. Application
may be further complicated by phased deliveries over an extended period of time.
o For smaller dollar material purchases in periods of limited price changes, the
differences between acquisition date to acquisition data and delivery date to
delivery date adjustment may not be that significant. However, as contract
costs/prices increase or cost/price changes become more volatile, selection of the
proper adjustment period becomes more important.
o Wage rates should always be estimated for the time period in which the work will
be performed.
1.4.1 Adjusting Price/Cost For Pricing Comparisons
Should-Pay Estimates. You can use price indexes to develop should-pay estimates of current
price or cost based on historical information. These should-pay estimates can be used for a
variety of purposes including comparison with an offered price or cost as part of an evaluation of
reasonableness.
Steps in Using Price Indexes to Analyze Price/Cost Reasonableness. To perform this analysis,
follow the steps below:
Step 1. Collect available price/cost data.
Step 2. Select a price index for adjusting price/cost data.
Step 3. Adjust price/cost for inflation/deflation.
Step 4. Use adjusted price/cost for pricing comparisons.
Example of Using Price Indexes to Analyze Price/Cost Reasonableness. Consider the problem of
analyzing a contractor’s proposed price of $23,000 for a turret lathe to be delivered in 20X8.
Step 1. Collect available price/cost data. A procurement history file reveals that the same
machine tool was purchased in 20X4 at a price of $18,500. Determine whether the 20X8
proposed price is reasonable.
Step 2. Select a price index for adjusting price/cost data. Select or construct an appropriate index.
In this case, you might select a Machinery and Equipment Index as a reasonable indicator of
price movement for a turret lathe. You could extract the data from a Government publication
(e.g., the PPI) or use a similar commercial index.
Year
Machinery and
Equipment Index
20X2 100.0
20X3 103.3
20X4 106.0
20X6 110.8
20X7 115.0
20X8 121.9
Step 3. Adjust price/cost for inflation/deflation. After you have selected an index, you can adjust
prices to a common dollar value level. In this case, you would normally adjust the historical
20X4 price to the 20X8 dollar value level. To make the adjustment, you simply use one of the
methods already demonstrated.
Using the Ratio Method.
I 2 I 1 = P 2 P 1
121.9 106.0 = Price Estimate for 20X8 $18,500
121.9 x $18,500 = 106.0 x P 2
$2,255,150 = 106.0 x P 2
2,255,150 106.0 = P 2
$21,275 = P 2
Using the Formula Adjustment Method.
P 2 = I 2 I 1
= 121.9 106.0 x $18,500
= 1.15 x $18,500
= $21,275
Step 4. Use adjusted price/cost for pricing comparisons. Once you have made the adjustment for
inflation/deflation, you can compare the offered and historical prices in constant dollars. The
offered price/cost is $23,000, but the adjusted historical price/cost is only $21,275. Thus, the
offered price/cost is $1,725, or 8.1 percent higher than what you would expect, given the
historical data and available price indexes.
If you look at the percentage price/cost change between the two acquisitions, the difference is
even more pronounced. Using the price indexes, you projected an increase from $18,500 to
$21,275, or 15.0 percent. The offer increase was from $18,500 to $23,000, or about 24.3 percent.
In this case, you might ask the offeror why the price/cost rose at a rate 62 percent higher than
anticipated (24.3 is 62 percent larger than 15.0).
Do not attempt to determine whether a price or cost is reasonable based on this type of analysis
alone. You must consider the entire contracting situation, including any differences in quantity,
quality, delivery requirements, or other contract terms that might significantly affect price.
However, the above analysis does raise concern about the reasonableness of the offer.
Note that the analysis above is based on 4-year old data. You should generally place less reliance
on a comparison utilizing 4-year old data than you place on a comparison based on more current
data.