Cost Analysis

The Pump Division

The Pump Division has one plant dedicated to the design and manufacture
of large, highly technical, customized pumps. Typically the contract
life (production cycle) is one to three years. Most original equipment
(OE) orders are obtained by preparing and submitting a bid proposal from
a cost estimate analysis and conducting negotiating sessions with the
customer. Sometimes orders are accepted as loss leaders in order to
establish a position in the more profitable aftermarket business.

The contracts generally are fixed price. When coupled with the highly
technical specifications and the length of the "in process" time, there
is a high risk of job cost overruns. Company policy is to record revenue
and costs on a completed contract basis, rather than as a percent of
completion.

After a major decline in profitability, combined with several
unfavorable year-end surprise inventory adjustments, new plant
management decided to undertake a review of the operation to identify
the key factors that affect inventory control. Management analysis
revealed the following:

The cost estimating function reported to the sales department.

Final job costs varied significantly from original cost estimates. It
was difficult to determine the source of variances until analyses were
made upon completion of the jobs.

The negotiated pricing of a contract was almost always on the basis of
"whatever it takes to get the order," particularly when there was excess
productive capacity in the industry.

Progress payments/advanced payments were secured on some contracts, but
such payments often were dropped if pricing competition was severe.

When inflation was at double-digit levels, the company attempted to
insert escalation clauses into contracts based on government indexes.
However, most often, this resulted in fixed-price contracts with some
estimate of inflation included.

During the audit at the end of each year, a lower-of-cost-or-market
analysis was made on major jobs in process. It was this exercise that
revealed unfavorable inventory adjustments in recent years. Two examples
are shown below:

(In Thousands) Job 1 Job 2

Original cost Estimate $2,113 $1,800

Costs Incurred to Date:



Manufacturing 2,100

Engineering 373 100

Estimate to Complete 367 2,500

Total Current Estimate 2,840 2,600

Lower-of-cost-or-market Contract Sales Price 2,520 2,000

Less 10°r6 Allowance for Normal Profit Margin (252) (200)

Inventory Value 2,268 1,800

Inventory Reserve Adjustment (loss) $(572) $(800)



On job 2, the engineering department determined that the pump would not
meet specifications in accordance with the original cost estimate and
re-engineered the pump. This led to an increased estimate before the job
entered the manufacturing stage.