Cost estimates on cost reimbursement contracts are not to be taken at face value. FAR 15.404-1(d) says a cost realism analysis is the process of independently reviewing and evaluating specific elements of proposed cost estimates to determine if they are realistic for the work to be performed, reflect an understanding of what's required and are consistent with the contractor's technical proposal. The analysis is mandatory on cost reimbursement contracts. The purpose is to determine probable costs. The probable (not face value) costs are then used to determine best value. That's the regulation.
What does GAO say? In a recent decision, GAO said that when an agency evaluates proposals, the offeror's proposed estimated costs are not controlling because the government is bound (in cost reimbursement contracts) to pay actual allowable costs. Based on the cost realism analysis, proposed costs should be adjusted. FAR 15.404-1(d)(2)(ii). Government agencies are obliged to employ analysis methods which provide a "measure of confidence" that the "most probable costs" are "reasonable and realistic" in view of the information available at the time of evaluation.
In another decision within the last year, GAO sustained a protest where the agency failed to conduct a meaningful analysis of why it accepted the contractor's proposed costs at face value. GAO said: "When an agency evaluates proposals for the award of a cost-reimbursement contract, an offeror's proposed costs are not controlling since such costs may not accurately reflect the actual costs the government will incur." It's really a "should cost" exercise. GAO will test the agency evaluation to see if it is "reasonable, not arbitrary, and adequately documented." GAO will sustain a protest where the cost realism analysis is not adequately documented.
The government is not required to conduct an in-depth cost analysis or to verify each and every cost item. Determination of the probable cost is, after all, a matter of informed judgment. But the judgment must be rational. The cost realism analysis must be performed with an eye to what the contractor proposes in its technical proposal. It is not rational for an agency to apply the same mechanical test and analysis to all contractors without reference to their specific technical approaches. And even where the contractor puts a cap on its costs, an agency must still consider whether capping costs may so constrain the contractor that its ability to perform the work may be impaired.
Perhaps the biggest area of costs open to question is the estimated number of labor hours required to perform the work. Proposed staffing levels may be unrealistic according to any number of measurements (the technical proposal itself and prior staffing levels for similar work). Whether labor rates are realistic also is often challenged.
In the end, the cost analysis should be used to test the contractor's risk of nonperformance. Performance risk in today's world is of the highest concern. A proper cost analysis should inform the government's assessment of the performance risks.