1. Cost Drivers Learning Event, 2 nd November 2005 1 Cost Improvement Curves: Modeling Reuse, Learning, Amortization and Yield Improvement Cost Drivers Learning Event, 2nd November 2005 Raymond P. Covert MCR, LLC 2000 Corporate Ridge, Suite 400 McLean, Virginia 22102 (703) 506-4600 www.mcr.com E-mail: rcovert1@cox.net © 2005 MCR, LLC

2. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 2 Agenda Introduction Cost Improvement Factors The Plant Model Nonrecurring and recurring costs Nonrecurring cost improvement Recurring cost improvement Example hardware cost improvement model Summary Acronym List References

3. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 3 Introduction This presentation is intended for an audience with an intermediate understanding of cost analysis methods We will discuss the phenomenon of “cost improvement”, which is loosely defined as the observed reduction of cost of successive units or projects 0 50 100 150 200 250 300 350 400 0102030 Unit Number Recurring Cost, $

4. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 4 Cost Improvement Factors and Learning Cost Improvement is the observed reduction of costs between successive units or projects Factors affecting cost improvement:  Nonrecurring and recurring accounting standards affect measurement  Reuse of existing designs, materials, equipment, effort, or products  Learning or gained experience in value added effort  Skill Mix changes  Process shortcuts that eliminate effort or expenses  Yield improvements that reduce cost  Production Rate increases allowing for amortization of pooled costs and greater efficiency  Technological advances allowing greater yield and efficiency  Inflation which measures the time variable cost of a “basket of goods” *True “learning” is a subset of cost improvement, so cost improvement is more than learning

5. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 5 The Plant Model Can use a plant economic model to show the effects of different factors on cost improvements [Ref. 1, p. 183]

6. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 6 The Plant Model The plant economic model contains the three classic Elements of Cost: Labor, Materials and Expenses These costs can be Project related or Pooled (period costs) Direct or Allocable (overhead and fringe) Nonrecurring or Recurring costs

7. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 7 Areas of Cost Improvement Cost improvement can be obtained in two areas: Between subsequent programs Within programs between subsequent production units Between Programs Nonrecurring cost improvements between successive programs Recurring cost improvements continuing to the subsequent programs Within programs Recurring cost improvements The next step is to define these terms precisely and show how to model them

8. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 8 Nonrecurring and Recurring Costs Nonrecurring (NR) and recurring (REC) cost definitions Nonrecurring costs - unique costs of effort, material and expenses tied to a production run rather than a particular unit Recurring costs – costs of repeated effort, material and expenses repeated for each subsequent unit Hard to segregate NR and REC in small or single unit production What was recurring work if we only build one unit? What was the theoretical first unit cost (T1)? What if we build a prototype unit and make it the first production unit? What was the fist prototype unit cost (P1) and T1 cost? What will the theoretical second unit cost (T2) be?

9. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 9 NR/T1 Factors for Space Programs NR/T1 is the ratio of NR costs to T1 costs Analysis of NR/T1 Ratios of 100 programs from the NAFCOM database* provide the following results: TYPE Rocket Engine Earth Orbiting Launch Vehicle Manned Planetary NUMBER46110817 MIN27.650.002.611.292.38 MAX202.247.5939.7811.5618.35 MEDIAN128.832.0216.003.486.18 MEAN121.892.3516.934.446.52 min ML mean (average) max ML = most likely = 3 * mean - (min + max) * NASA / Air Force Cost Model (NAFCOM) Includes subsystem hardware, systems engineering, program management, integration, assembly and test, ground test equipment, launch and orbital operations support

10. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 10 New Design and Reuse* The amount of new design on a program and reuse from previous programs is a key factor in determining NR/T1 Reuse = 1 – New Design Assumes all have some prototype development Almost never have 0% redesign or 100% redesign Use table to estimate NR/T1 cost ratio from % new design % New DesignDescriptionNR/T1 0.0Off the Shelf0.1 0.2 0.3 0.5 0.40.8 0.51.3 0.61.7 0.72.1 0.82.5 0.92.8 1.03.0 New Design Tech Maturity Min Mods Moderate Mods Major Mods * For earth orbiting spacecraft

11. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 11 Modeling NR Costs Using Reuse Use our plant economic model to build-up the T1 costs Use T1 costs and reuse (or percent new design) to determine NR costs Look at effect of reuse on NR cost How does this affect total cost improvement? Total acquisition costs = NR+ REC costs Not really interesting until we look at other cost improvement factors like learning and amortization

12. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 12 The Learning Curve (Wright) Cumulative Average Learning Curve Based on accumulated experience and ability to do the same task with less labor (time) Cumulative Average Unit Cost = Cost of i th Unit = Where:  T1 = Theoretical 1 st unit cost  N = number of units  i = unit number  LCS = learning curve slope  ln = natural log Cumulative average Unit

13. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 13 Observations on Learning Can be measured in hours and dollars (Euros and Pounds are OK as well!) This implies that it covers the same work content Accounting standards need to include NR and REC cost definitions True learning should be independent of other factors such as: Reuse of existing designs, materials, equipment, effort, or products Skill Mix changes Process shortcuts that eliminate effort or expenses Yield improvements that reduce cost Production Rate increases allowing for amortization of pooled costs and greater efficiency Technological advances allowing greater yield and efficiency Inflation which measures the time variable cost of a “basket of goods”

14. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 14 The Production Rate Curve Production Rate Curve Division of labor and overheads with number (N) of units produced over a period of time Strongly influenced by amortization of period and fixed costs  Unit cost = “Bath tub” shape due to added capital equipment and labor when production capacity is exceeded Max capacity Increase fixed costs

15. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 15 Yield "Yield" is the fraction of units that meet specifications Unit cost = Process Screening Fail = Does Not Meet Specifications Pass = Meets Specifications N Units Started Meets Specifications Does Not Meet Specifications

16. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 16 Sensitivity Analysis What affects cost improvement the most? Reuse? Amortization (production rate)? Yield? Depends on the scenario (looked at 5 scenarios) Small quantity satellite production Medium quantity satellite production Large quantity satellite production Electronic box production Integrated circuit production Use plant model with uniform distributions of quantity, reuse, amortization and yield to show sensitivity

17. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 17 The Plant Model Equations Start with parameters we wish to vary: Total number of projects over which non-pooled costs will be amortized Learning curve slope (LCS) Yield parameters (start quantity, yield, final quantity) Percent reuse for nonrecurring costs Pooled rate factor (factor for adjusting pooled / period costs) Determine Direct costs T1 costs are constants  T1(labor) = 100, T1(material) = 20, T1(expenses) = 12 NR costs = f(T1, Reuse) from reuse table Recurring Costs from learning curve Total direct costs = NR + Rec costs Add indirect costs to direct costs using these factors Materials (5%), Labor (150%), Expenses (70%) Add period costs (constants adjusted by pooled rate factor)

18. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 18 Small Quantity Satellite Production Most sensitive to new design

19. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 19 Medium Quantity Satellite Production Most sensitive to: New Design Learning curve slope

20. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 20 Large Quantity Satellite Production Most sensitive to: Learning curve slope

21. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 21 Electronic Box Production Most sensitive to: Period costs (amortization)

22. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 22 Integrated Circuit Production Most sensitive to yield

23. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 23 Results of Scenarios Model results tell us what we probably already know In small quantity production, reuse is the most important cost improvement factor In large quantity, labor intensive production, learning is the most important factor In large quantity electronic box production, production rate is the most important factor In very large quantity, automated processes, yield is the most important factor

24. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 24 Summary Many factors affect cost improvement Cost improvement can be obtained between subsequent programs or subsequent production units Use plant model to show sensitivities of these factors We chose reuse, learning, amortization (production rate) and yield Effects are scenario dependent Depends on quantity of production and production volumes Also depends on amount of process automation and external factors such as plant amortization

25. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 25 Acronym List NR = Nonrecurring cost T1 = Theoretical first unit recurring cost T2 = Theoretical second unit [recurring] cost P1 = Theoretical first prototype unit cost REC = Recurring cost LCS = Learning curve slope ML = Most likely NR/T1 = Ratio of NR to T1 costs N = number of units i = unit number ln = natural log

26. Cost Drivers Learning Event, 2 nd November 2005 16 September 2005 26 References 1. Stewart, R. and Wyskida, R., “Cost Estimator’s Reference Manual”, 1997, John Wiley and Sons, New York. 2. “Pricing Handbook: Cost Accounting Standards”, Federal Aviation Administration, http://fast.faa.gov/archive/v1198/pguide/98-30C14.htm http://fast.faa.gov/archive/v1198/pguide/98-30C14.htm