The Cost Estimator's Problem: Network Effects

This will provide a brief introduction to defense cost estimating and the broader economic problem of production networks that is not often addressed. 

The government, of course, is not a vertically integrated supplier of defense. It procures weapon and information systems almost exclusively from the private sector creating a relatively thin market. Government agents want to attain advanced capabilities from at a “fair” price. Thus, while expecting efficient and innovative production, they prefer suppliers to earn low and stable economic profits. Due to the scale and complexity of many defense acquisitions, government agents also prefer transparent program oversight because the direction of resources cannot often be precisely specified during contract negotiations.

The DOD’s problems are then two-fold: 1) monitoring performance on long and variable contracts; and 2) return value to the taxpayer by alleviating the asymmetric information problem for future procurement decisions. EVM reporting intends to address the former issue while CSDRs the latter. When considering the second case, it is clear that the government requires insight into both the intensity and mix of resources used to develop certain system functionality (i.e. WBS element). An important concern to the estimator, regardless of data quality or accessibility, is that future cost outcomes are contingent on the performing contractor’s current and future workflows. This is caused by joint production of multiple goods with large common costs, making it difficult to forecast the marginal cost of any one good because prices depend on production across all goods.

Industrial Base Considerations in a Defense System Cost Estimate

Since a firm will seek maximize efficiency at the level of the business unit, it is difficult to understand their net position by observing indirect rates for any given contract. Figure 1 below depicts some business base considerations in an estimate. The total facility workflow has been between theoretical thresholds represented by two horizontal dash lines. The top line represents the amount of workflow which necessitates a scaling up through major fixed investments. A workflow closer to, but not exceeding, this top line represent lower indirect rates because many of the same indirect costs are spread among more direct work. The bottom line represents the point which a downsizing of fixed investments is required, and workflows closer to this threshold represent higher rates as the same indirect costs are spread across less direct work. It would be difficult to say what “fair” indirect rates would be when observing Program A and historical analogies in a vacuum. Luckily, DCMA does much of this analysis and cost estimators often strip the historical indirect costs to apply their approved rates.

More on this later as there is much to unpack and extend.