PRICING AND ESTIMATION:GLOBAL PRICING STRATEGIES, TYPES OF ESTIMATES

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LESSON 31

PRICING AND ESTIMATION

BROAD CONTENTS

Computerized Software Packages

Pricing and Estimating

Global Pricing Strategies

Types of Estimates

Pricing Process

31.1

COMPUTERIZED SOFTWARE PACKAGES:

It has been seen that over the past ten years there has been an explosion in project management

software packages. Small packages may sell for a few thousand dollars, whereas the price for

larger packages may be $70,000.

Computerized project management can provide answers to such questions as:

How will the project be affected by limited resources?

How will the project be affected by a change in the requirements?

What is the cash flow for the project (and for each WBS element)?

What is the impact of overtime?

What additional resources are needed to meet the constraints of the project?

How will a change in the priority of a certain WBS element affect the total project?

The more sophisticated packages can provide answers to schedule and cost based on:

Adverse weather conditions

Weekend activities

Unleveled manpower requirements

Variable crew size

Splitting of activities

Assignment of unused resources

Regardless of the sophistication of computer systems, printers and plotters prefer to draw

straight lines rather than circles. Most software systems today use precedence networks, as

shown in Figure 31.1 below, which attempt to show interrelationships on bar charts. As shown

in the figure, task 1 and task 2 are related because of the solid line between them. Task 3 and

task 4 can begin when task 2 is half finished. (This cannot be shown easily on PERT without

splitting activities.) The dotted lines indicate slack. The critical path can be identified either by

putting an asterisk (*) beside the critical elements, by making the critical connections in a

different-colored ink, or by making the critical path a boldface type.

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Figure 31.1: Precedence Network

The more sophisticated software packages display precedence networks in the format shown in

Figure 31.2 below. In each of these figures, work is accomplished during the activity. This is

sometimes referred to as the activity-on-node method. The arrow represents the relationship or

constraint between activities.

Figure 31.2: Typical Precedence Relationships

Figure above 31.2 (A) illustrates a finish-to-start constraint. In this figure, activity 2 can start no

earlier than the completion of activity 1. Figure 31.2 (B) illustrates a start-to-start constraint.

Activity 2 cannot start prior to the start of activity 1. Figure 31.2 (C) illustrates a finish-to-finish

constraint. In this figure, activity 2 cannot finish until activity 1 finishes. Lastly, Figure 31.2 (D)

illustrates a percent-complete constraint. In this figure, the last 20 percent of activity 2 cannot

be started until 50 percent of activity 1 has been completed.

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Figure 31.3: Computerized Information Flow

Figure 31.3 above shows the typical information that appears in each of the activity boxes

shown in the previous figure. The box identified as ''responsibility cost center" could also have

been identified as the name, initials, or badge number of the person responsible for this activity.

Figure 31.4 below shows the comparison of three of the different network techniques.

Figure 31.4: Comparison of Networks

31.2

PRICING AND ESTIMATION:

As we know that with the complexities involved, it is not surprising that many business

managers consider pricing an art. Having the right intelligence information on customer cost

budgets and competitive pricing would certainly help. However, the reality is that whatever

information is available to one bidder is generally available to the others. Even more important,

intelligence sources are often unreliable. The only thing worse than missing information, is

wrong or misleading information.

When it comes to competitive pricing, the old saying still applies: "Those who talk don't know;

and those who know don't talk!" It is true, partially, that pricing remains an art. However, a

disciplined approach certainly helps one to develop all the input for a rational pricing

recommendation. A side benefit of using a disciplined management process is that it leads to the

documentation of the many factors and assumptions involved at a later point in time. These can

be compared and analyzed, contributing to the learning experiences that make up the managerial

skills needed for effective business decisions.

Estimates are not blind luck. They are well-thought-out decisions based on the best available

information, some type of cost estimating relationship, or some type of cost model. Cost

estimating relationships (CERs) are generally the output of cost models. Typical CERs might

be:

· Mathematical equations based on regression analysis

· Costquantity relationships such as learning curves

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Costcost relationships

Costnoncost relationships based on physical characteristics, technical parameters, or

performance characteristics

31.3

GLOBAL PRICING STRATEGIES:

Specific pricing strategies must be developed for each individual situation. Frequently,

however, one of two situations prevails when one is pursuing project acquisitions competitively.

First, the new business opportunity may be a one-of-a-kind program with little or no follow-on

potential; a situation classified as type I acquisition.

Second, the new business opportunity may be an entry point to a larger follow-on or repeat

business, or may represent a planned penetration into a new market. This acquisition is

classified as type II.

Clearly, in each case, we have specific but different business objectives. The objective for type I

acquisition is to win the program and execute it profitably and satisfactorily according to

contractual agreements. The type II objective is often to win the program and perform well,

thereby gaining a foothold in a new market segment or a new customer community in place of

making a profit.

Accordingly, each acquisition type has its own, unique pricing strategy, as summarized in Table

31.1 below.

Comparing the two pricing strategies for the two global situations (as shown in Table below)

reveals a great deal of similarity for the first five points. The fundamental difference is that for a

profitable new business acquisition the bid price is determined according to actual cost, whereas

in a "must win" situation the price is determined by the market forces. It should be emphasized

that one of the most crucial inputs in the pricing decision is the cost estimate of the proposed

baseline. The design of this baseline to the minimum requirements should be started early, in

accordance with well defined ground rules, cost models, and established cost targets. Too often

the baseline design is performed in parallel with the proposal development. At the proposal

stage it is too late to review and fine-tune the baseline for minimum cost. Also, such a late start

does not allow much of an option for a final bid decision. Even if the price appears outside the

competitive range, it makes little sense to terminate the proposal development. As all the

resources have been sent anyway, one might just as well submit a bid in spite of the remote

chance of winning.

Clearly, effective pricing begins a long time before proposal development. It starts with

preliminary customer requirements, well-understood subtasks, and a top-down estimate with

should-cost targets.

This allows the functional organization to design a baseline to meet the customer requirements

and cost targets, and gives management the time to review and redirect the design before the

proposal is submitted. Furthermore, it gives management an early opportunity to assess the

chances of winning during the acquisition cycle, at a point in time when additional resources

can be allocated or the acquisition effort can be terminated before too many resources are

committed to a hopeless effort.

The final pricing review session should be an integration and review of information already well

known in its basic context. The process and management tools outlined here should help to

provide the framework and discipline for deriving pricing decisions in an orderly and effective

way.

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Table 31.1: Two Global Pricing Strategies

31.4

TYPES OF ESTIMATES:

Note that projects can range from a feasibility study, through modification of existing facilities,

to complete design, procurement, and construction of a large complex. Whatever the project

may be, whether large or small, the estimate and type of information desired may differ

radically.

The first type of estimate is an order-of-magnitude analysis, which is made without any detailed

engineering data. The order-of-magnitude analysis may have an accuracy of ±35 percent within

the scope of the project. This type of estimate may use past experience (not necessarily similar),

scale factors, parametric curves or capacity estimates (that is, $/# of product or $/KW

electricity).

Next, there is the approximate estimate (or top-down estimate), which is also made without

detailed engineering data, and may be accurate to ±15 percent. This type of estimate is prorated

from previous projects that are similar in scope and capacity, and may be titled as estimating by

analogy, parametric curves, rule of thumb, and indexed cost of similar activities adjusted for

capacity and technology. In such a case, the estimator may say that this activity is 50 percent

more difficult than a previous (i.e., reference) activity and requires 50 percent more time, man-

hours, dollars, materials, and so on.

The definitive estimate, or grassroots buildup estimate, is prepared from well-defined

engineering data including (as a minimum) vendor quotes, fairly complete plans, specifications,

unit prices, and estimate to complete. The definitive estimate, also referred to as detailed

estimating, has an accuracy of ±5 percent.

Another method for estimating is the use of learning curves. Learning curves are graphical

representations of repetitive functions in which continuous operations will lead to a reduction in

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time, resources, and money. The theory behind learning curves is usually applied to

manufacturing operations.

Each company may have a unique approach to estimating. However, for normal project

management practices, Table 31.2 below would suffice as a starting point.

Table 31.2: Standard Project Estimating

Many companies try to standardize their estimating procedures by developing an estimating

manual. The estimating manual is then used to price out the effort, perhaps as much as 90

percent. Estimating manuals usually give better estimates than industrial engineering standards

because they include groups of tasks and take into consideration such items as downtime,

cleanup time, lunch, and breaks. Table 31.3 below shows the table of contents for a construction

estimating manual.

Estimating manuals, as the name implies, provide estimates. The question, of course, is "How

good are the estimates?" Most estimating manuals provide accuracy limitations by defining the

type of estimates (shown in Table 31.4 below). Using Table below, we can create the next three

tables which illustrate the use of the estimating manual.

Not all companies can use estimating manuals. Estimating manuals work best for repetitive

tasks or similar tasks that can use a previous estimate adjusted by a degree-of-difficulty factor.

Activities such as Research and Development do not lend themselves to the use of estimating

manuals other than for benchmark, repetitive laboratory tests.

Proposal managers must carefully consider whether the estimating manual is a viable approach.

The literature abounds with examples of companies that have spent millions trying to develop

estimating manuals for situations that just do not lend themselves to the approach.

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Table 31.3: Estimating Manual Table of Contents

During competitive bidding, it is important that the type of estimate be consistent with the

customer's requirements. For in-house projects, the type of estimate can vary over the life cycle

of a project:

Conceptual Stage:

Venture guidance or feasibility studies for the evaluation of future work. This estimating is

often based on minimum-scope information.

Planning Stage:

Estimating for authorization of partial or full funds. These estimates are based on

preliminary design and scope.

Main Stage:

Estimating for detailed work.

Termination Stage:

Re-estimation for major scope changes or variances beyond the authorization range.

Table 31.4: Classes of Estimates

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Table 31.5: Checklist for Work Normally Required for the Various Classes of Estimates

31.5

PRICING PROCESS:

This activity schedules the development of the Work Breakdown Structure (WBS) and provides

management with two of the three operational tools necessary for the control of a system or

project. The development of these two tools is normally the responsibility of the program office

with input from the functional units.

Note that the integration of the functional unit into the project environment or system occurs

through the pricing-out of the work breakdown structure. The total program costs obtained by

pricing out the activities over the scheduled period of performance provide management with

the third tool necessary to successfully manage the project. During the pricing activities, the

functional units have the option of consulting program management about possible changes in

the activity schedules and work breakdown structure.

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Table 31.6: Data Required for Preparation of Estimates

The Work Breakdown Structure (WBS) and activity schedules are priced out through the lowest

pricing units of the company. It is the responsibility of these pricing units, whether they are

sections, departments, or divisions, to provide accurate and meaningful cost data (based on

historical standards, if possible). All information is priced out at the lowest level of performance

required, which, will be the task level. Costing information is rolled up to the project level and

then one step further to the total program level.

Under ideal conditions, the work required (that is, man-hours) to complete a given task can be

based on historical standards. Unfortunately, for many industries, projects and programs are so

diversified that realistic comparison between previous activities may not be possible. The

costing information obtained from each pricing unit, whether or not it is based on historical

standards, should be regarded only as an estimate. How can a company predict the salary

structure three years from now? What will be the cost of raw materials two years from now?

Will the business base (and therefore overhead rates) change over the duration of the program?

The final response to these questions shows that costing data are explicitly related to an

environment that cannot be predicted with any high degree of certainty. The systems approach

to management, however, provides for a more rapid response to the environment than less

structured approaches permit.

Remember that once the cost data are assembled, they must be analyzed for their potential

impact on the company resources of people, money, equipment, and facilities. It is only through

a total program cost analysis that resource allocations can be analyzed. The resource allocation

analysis is performed at all levels of management, ranging from the section supervisor to the

vice president and general manager. For most programs, the chief executive must approve final

cost data and the allocation of resources.

Proper analysis of the total program costs can provide management (both program and

corporate) with a strategic planning model for integration of the current program with other

programs in order to obtain a total corporate strategy. Meaningful planning and pricing models

include analyses for monthly man-loading schedules per department, monthly costs per

department, monthly and yearly total program costs, monthly material expenditures, and total

program cash-flow and man-hour requirements per month.

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Figure 31.5: The Vertical Horizontal Interface

Previously we identified several of the problems that occur at the nodes where the horizontal

hierarchy of program management interfaces with the vertical hierarchy of functional

management.

The pricing-out of the work breakdown structure provides the basis for effective and open

communication between functional and program management where both parties have one common

goal. This is shown in Figure 31.5 above. After the pricing effort is completed, and the program is

initiated, the work breakdown structure still forms the basis of a communications tool by documenting

the performance agreed on in the pricing effort, as well as establishing the criteria against which

performance costs will be measured.

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