Well-documented data and sufficiently supportive narratives are essential for offerors who want to successfully avoid unfavorable cost realism/price adjustments.
This series of five articles addresses aspects of cost realism as it relates to labor in fast-read content. This first article specifically sets the stage with a discussion of what cost realism is versus cost reasonableness.
For cost-type contracts, the government’s source selection is based on probable cost, rather than proposed cost.[1] Probable cost is the adjusted price of an offeror’s proposal due to the government’s cost realism review.[2] Because cost realism reviews can produce upward adjustments to an offeror’s price, such reviews can neutralize an offeror’s apparent price advantage and unfavorably swing the best-value tradeoff decision to another competitor.
There are a variety of labor cost realism challenges. However, unrealistic labor rates and escalation represent a significant area of government scrutiny (and subsequent protests), especially on contract re-competes, because labor costs are a major portion of most service-type government contracts.[3],[4]
Drawing on examples from published Government Accountability Office (GAO) protests, this article highlights common sources that government evaluators rely upon to determine whether proposed labor and escalation rates are adequately substantiated to demonstrate realism.
The article also discusses several cost realism issues government evaluators encounter surrounding labor rates and associated escalation.
What Is Cost Realism?
When an agency evaluates proposals for the award of a cost-reimbursement contract, an offeror’s proposed estimated costs are not fixed because, regardless of the costs proposed, the government is bound to pay the contractor’s actual allowable costs. Therefore, the Federal Acquisition Regulation (FAR) requires cost realism analysis on all cost-reimbursement contracts.[5]
A cost realism review is the process of independently reviewing and evaluating each offeror’s cost estimate to determine whether the proposed costs are realistic for the work to be performed, reflect a clear understanding of the requirements, and are consistent with the unique methods of performance and materials described in the offeror’s proposal.
It is important to note that cost realism differs from cost reasonableness. While both can critically examine cost elements, cost realism analysis may change the total evaluated price via “probable cost.” Here are the differences.
| Realism | Reasonableness |
| Must be established via cost analysis. | Can be established with either price analysis or cost analysis. |
| Determination must be performed on all cost-type contracts. Optional for all other contract types and must be stipulated in the RFP. | Determination must be performed for all contract types. |
| Are the offeror’s costs too low? | Are the offeror’s costs too high? |
Probable Cost
FAR 15.404-1(d)(2)(ii) states that probable cost is determined by adjusting each offeror’s proposed cost, and fee when appropriate, to reflect any additions or reductions in cost elements to realistic levels based on the results of the cost realism analysis. For cost-type contracts, FAR 15.404-1(d)(2)(I) states probable cost shall be used for purposes of evaluation to determine the best value.[6]
While the FAR permits the downward adjustment of price as a result of cost realism analysis, this article focuses on salaries, direct labor rates, and labor rate escalation that result in the upward adjustment of price. The other critical part of labor cost, which is labor hours, is not addressed in this article. These upward price adjustments can tip the source selection to another competitor as the Contracting Officer must make the best value trade-off decision on probable cost/price, not the proposed price.
Michael Gallo is the Partner and Principal Consultant at Federal Pricing Group, LLC – a boutique consulting firm providing specialized advisory services and subject matter expertise in government contracts pricing. Gallo advises federal government contractors on pricing strategy, pricing models, and pricing reviews/post-mortems. He also provides cost/price evaluation consulting support services to federal agencies. Gallo has developed his unique perspectives, deep pricing insights, and expertise from his more than 30-year career covering all sides of government contracts pricing, in roles as a government cost analyst, GovCon project manager, CFO, Division VP, and federal government consultant.
ENDNOTES
[1] “The probable cost may differ from the proposed cost and should reflect the Government’s best estimate of the cost of any contract that is most likely to result from the offeror’s proposal. The probable cost shall be used for purposes of evaluation to determine the best value.” FAR 15.404-1(d)(2)(i)
[2] FAR 15.404-1(d)(2)(ii)
[3] In addition to the standards established in FAR Part 31 for determining allowability, reasonableness, and allocability, of costs, additional requirements are imposed (as applicable) on labor costs by FAR 52.222-41, FAR 52.222-43, 52.222-44, 52.222-46
[4] “Labor and material are two of the most significant cost elements billed under government Contracts,” DCAA Memorandum PIC 730.5.35
[5] “Cost realism analyses shall be performed on cost-reimbursement contracts to determine the probable cost of performance for each offeror,” FAR 15.404-1(d)(2)
[6] Importantly, for fixed price contracts, agencies cannot adjust the proposed price of a fixed price contract as a result of cost realism review. See FAR 15.404-1(d)(3).
