You are on page 1of 26

Cost Drivers Learning Event, 2nd November 2005

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.mcri.com
E-mail: rcovert@mcri.com
1
© 2005 MCR, LLC
Cost Drivers Learning Event, 2nd November 2005

Agenda
z Introduction
z Cost Improvement Factors
z The Plant Model
z Nonrecurring and recurring costs
z Nonrecurring cost improvement
z Recurring cost improvement
z Example hardware cost improvement model
z Summary
z Acronym List
z References

16 September 2005 2
Cost Drivers Learning Event, 2nd November 2005

Introduction
z This presentation is intended for an audience with an
intermediate understanding of cost analysis methods
z We will discuss the phenomenon of “cost
improvement”, which is loosely defined as the
observed reduction of cost of successive units or
projects 400
350
Recurring Cost, $

300
250
200
150
100
50
0
0 10 20 30
16 September 2005 3
Unit Number
Cost Drivers Learning Event, 2nd November 2005

Cost Improvement Factors and Learning


z 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”

z *True “learning” is a subset of cost improvement, so cost


improvement is more than learning

16 September 2005 4
Cost Drivers Learning Event, 2nd November 2005

The Plant Model


z Can use a plant economic model to show the effects
of different factors on cost improvements [Ref. 1, p. 183]
Skills Labor Rates

Engineering 1 2 3 4 5

Manufacturing

Quality and Reliability


Labor Hours $
Tooling Fee

Testing Labor Overhead G&A


Labor
Other + Overhead
Travel and Other Direct Costs $ $ Price
Material Prices Total Cost

Material Measures A B C D E Material


+ Overhead
Pounds G&A

Yards Fee
Material quantities $
Gallons

16 September
Linear Feet 2005 Material Overhead 5
Cost Drivers Learning Event, 2nd November 2005

The Plant Model


z The plant economic model contains the three classic
Elements of Cost: Labor, Materials and Expenses
z These costs can be
„ Project related or Pooled (period costs)
„ Direct or Allocable (overhead and fringe)
„ Nonrecurring or Recurring costs
Materials (M) Labor (L) Expenses (E) Total = M+L+E
Direct 105,000.00 2,500,000.00 80,000.00 2,685,000.00
Project Costs Burden 26,250.00 3,000,000.00 64,000.00 3,090,250.00
Total 131,250.00 5,500,000.00 144,000.00 5,775,250.00
Administration 10,000.00 125,000.00 6,250.00 141,250.00
Distribution 5,000.00 25,000.00 1,250.00 31,250.00
TOTAL Corporate Transfer 125.00 250,000.00 12,500.00 262,625.00
COSTS Pooled Costs Marketing 30,000.00 200,000.00 10,000.00 240,000.00
(Period) Research 50,000.00 275,000.00 13,750.00 338,750.00
Development 20,000.00 125,000.00 6,250.00 151,250.00
Finance 20,000.00 195,000.00 9,750.00 224,750.00
Total 135,125.00 1,195,000.00 59,750.00 1,389,875.00
Total 266,375.00 6,695,000.00 203,750.00 7,165,125.00
16 September 2005 6
Cost Drivers Learning Event, 2nd November 2005

Areas of Cost Improvement


z Cost improvement can be obtained in two areas:
„ Between subsequent programs
„ Within programs between subsequent production units

z Between Programs
„ Nonrecurring cost improvements between successive programs
„ Recurring cost improvements continuing to the subsequent
programs
z Within programs
„ Recurring cost improvements

z The next step is to define these terms precisely and show how
to model them

16 September 2005 7
Cost Drivers Learning Event, 2nd November 2005

Nonrecurring and Recurring Costs


z 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
z 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?

16 September 2005 8
Cost Drivers Learning Event, 2nd November 2005

NR/T1 Factors for Space Programs


z NR/T1 is the ratio of NR costs to T1 costs
z Analysis of NR/T1 Ratios of 100 programs from the
NAFCOM database* provide the following results:
ML = most likely
= 3 * mean - (min + max)

min ML mean (average) max

Rocket Earth Launch


Orbiting Vehicle Manned Planetary
TYPE Engine
NUMBER 4 61 10 8 17
MIN 27.65 0.00 2.61 1.29 2.38
MAX 202.24 7.59 39.78 11.56 18.35
MEDIAN 128.83 2.02 16.00 3.48 6.18
MEAN 121.89 2.35 16.93 4.44 6.52

* 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
16 September 2005 9
Cost Drivers Learning Event, 2nd November 2005

New Design and Reuse*


z 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 NR/T1 vs. % New Design
Design Description NR/T1
0.0 Off the Shelf 0.1
3.5
0.1 0.2 3.0
0.2 Tech Maturity 0.3 2.5
0.3 0.5
NR/T1

2.0
0.4 Min Mods 0.8 1.5
0.5 1.3 1.0
0.6 Moderate Mods 1.7 0.5
0.7 2.1 0.0
0.8 Major Mods 2.5 0.0 0.2 0.4 0.6 0.8 1.0
0.9 2.8 % New Design
1.0 New Design 3.0
16 September 2005 10
* For earth orbiting spacecraft
Cost Drivers Learning Event, 2nd November 2005

Modeling NR Costs Using Reuse


z Use our plant economic model to build-up the T1
costs
z Use T1 costs and reuse (or percent new design) to
determine NR costs
z Look at effect of reuse on NR cost
z How does this affect total cost improvement?
„ Total acquisition costs = NR+ REC costs

z Not really interesting until we look at other cost


improvement factors like learning and amortization

16 September 2005 11
Cost Drivers Learning Event, 2nd November 2005

The Learning Curve


z (Wright) Cumulative Average Learning Curve
„ Based on accumulated experience and ability to do the
same task with less labor (time)
 ln( LCS ) 
 
 ln( 2 ) 
„ Cumulative Average Unit Cost = $Cum _ Ave = T1 * N
 1+ ln( LCS )   
 ln( LCS ) 
1+ 
„ Cost of ith Unit = $Unit _ i = T1 * (i )  ln( 2 ) 
− (i − 1)  ln( 2 ) 

 
„ Where:
1.20

‹ T1 = Theoretical 1st unit cost 1.00


Cumulative average

‹ N = number of units 0.80

‹ i = unit number
Cost, $

0.60

Unit
‹ LCS = learning curve slope 0.40

‹ ln = natural log
0.20

0.00
0 2 4 6 8 10 12

16 September 2005 Units 12


Cost Drivers Learning Event, 2nd November 2005

Observations on Learning
z Can be measured in hours and dollars (Euros and Pounds are
OK as well!)
z This implies that it covers the same work content
„ Accounting standards need to include NR and REC cost definitions
z 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”

16 September 2005 13
Cost Drivers Learning Event, 2nd November 2005

The Production Rate Curve


z 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 = $ = $ fixed + $ var iable
Unit
N
„ “Bath tub” shape due to added capital equipment and labor when
production capacity is exceeded
Max capacity
1.2
Unit Cost
1.0

0.8
Cost, $

0.6

0.4
Increase
0.2
fixed costs
0.0
0 2 4 6 8 10 12
16 September 2005 14
Units
Cost Drivers Learning Event, 2nd November 2005

Yield
z "Yield" is the fraction of units that meet specifications
„ Unit cost = $ fixed + $ var iable
$unit =
N * yield

1.2
Unit Cost
1.0
Unit Cost, $

0.8

0.6

0.4 Does Not Meet Meets


0.2 Specifications Specifications
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Yield

N Units Pass = Meets


Process Screening
Started Specifications

16 September 2005
Fail = Does Not Meet 15
Specifications
Cost Drivers Learning Event, 2nd November 2005

Sensitivity Analysis
z What affects cost improvement the most?
„ Reuse?
„ Amortization (production rate)?
„ Yield?
z 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
z Use plant model with uniform distributions of quantity,
reuse, amortization and yield to show sensitivity

16 September 2005 16
Cost Drivers Learning Event, 2nd November 2005

The Plant Model Equations


z 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)
MIN MAX BASE
1 2 Total Projects 1
0.999 1 LCS 1
800 1200 FinalQuantity 1000
Start Quantity 2000
0.2 0.7 Yield 0.5
0.2 0.8 Reuse 0.8
1 3 Pooled Rate Factor 2

z 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
z Add indirect costs to direct costs using these factors
„ Materials (5%), Labor (150%), Expenses (70%)
z Add period costs (constants adjusted by pooled rate factor) 17
16 September 2005
Cost Drivers Learning Event, 2nd November 2005

Small Quantity Satellite Production


MIN MAX BASE
z Most sensitive to new design 1
0.9
2 Total Projects
1 LCS
1
1
1 3 FinalQuantity 2
Start Quantity 2
0.99 1 Yield 1
0.2 0.7 Reuse 0.5
250 400 Pooled Rate Factor 300

16 September 2005 18
Cost Drivers Learning Event, 2nd November 2005

Medium Quantity Satellite Production


MIN MAX BASE
z Most sensitive to: 1
0.9
2 Total Projects
1 LCS
1
1
4 10 FinalQuantity 5
„ New Design Start Quantity 5
0.99 1 Yield 1
„ Learning curve slope 0.2 0.7 Reuse 0.5
250 400 Pooled Rate Factor 300

16 September 2005 19
Cost Drivers Learning Event, 2nd November 2005

Large Quantity Satellite Production


MIN MAX BASE
z Most sensitive to: 1
0.98
2 Total Projects
1 LCS
1
1
20 40 FinalQuantity 30
„ Learning curve slope Start Quantity 30
0.99 1 Yield 1
0.2 0.7 Reuse 0.5
250 400 Pooled Rate Factor 300

16 September 2005 20
Cost Drivers Learning Event, 2nd November 2005

Electronic Box Production


MIN MAX BASE
z Most sensitive to: 1
0.98
2 Total Projects
1 LCS
1
1
20 80 FinalQuantity 50
„ Period costs (amortization) Start Quantity 63
0.5 0.8 Yield 0.8
0.2 0.8 Reuse 0.8
10 30 Pooled Rate Factor 20

16 September 2005 21
Cost Drivers Learning Event, 2nd November 2005

Integrated Circuit Production


z Most sensitive to yield MIN MAX BASE
1 2 Total Projects 1
0.999 1 LCS 1
800 1200 FinalQuantity 1000
Start Quantity 2000
0.2 0.7 Yield 0.5
0.2 0.8 Reuse 0.8
1 3 Pooled Rate Factor 2

16 September 2005 22
Cost Drivers Learning Event, 2nd November 2005

Results of Scenarios
z Model results tell us what we probably already know
Scenario Quantities Primary Cost Improvement Factor:
Small quantity satellite production 1-3 Reuse (New design)
Medium quantity satellite production 4-10 Reuse & Learing curve slope
Large quantity satellite production 20-40 Learning curve slope
Electronic box production 20-80 Amortization (production rate)
Integrated circuit production 800-1200 Yield

z In small quantity production, reuse is the most important cost


improvement factor
z In large quantity, labor intensive production, learning is the most
important factor
z In large quantity electronic box production, production rate is the
most important factor
z In very large quantity, automated processes, yield is the most
important factor
16 September 2005 23
Cost Drivers Learning Event, 2nd November 2005

Summary
z Many factors affect cost improvement
z Cost improvement can be obtained between
subsequent programs or subsequent production units
z Use plant model to show sensitivities of these factors
z We chose reuse, learning, amortization (production
rate) and yield
z 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

16 September 2005 24
Cost Drivers Learning Event, 2nd November 2005

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

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

16 September 2005 26