Inflation Adjustments
In the development of an estimate, cost data must be expressed in like terms. This is usually accomplished by adjusting costs for inflation to express them in a base year that will serve as a point of reference for a fixed price level. Adjusting for inflation is an important step in cost estimating. If the inflation index used is not correct, the resulting estimate could overstate or understate the cost of the program, as case study 13 illustrates.
From fiscal years 2005 through 2011, the physical condition of the Coast Guard’s legacy vessels was generally poor, and the Coast Guard had taken two key actions to improve the vessels’ condition: reorganizing its maintenance command structure and implementing sustainment initiatives for portions of its legacy vessel fleet. GAO was asked to study the conditions of the legacy fleet, in part by assessing the extent to which the Coast Guard’s cost estimating process had followed established best practices. GAO found that the Coast Guard’s process for estimating related legacy vessel maintenance costs did not fully reflect relevant best practices.
The Coast Guard’s process for estimating annual legacy vessel maintenance costs was not considered fully accurate because although Coast Guard officials told us that the data they provided to us incorporated an inflation index of three percent for all years based on the consumer price index, they could not provide us with documentation explaining why the Coast Guard chose to use this inflation rate or how it was applied to the data. Applying inflation indexes is an important step in cost estimating because, in the development of an estimate, cost data must be expressed in the same terms. If the inflation index used is not correct, cost overruns can result. Ensuring that its annual-depot level cost estimates for legacy vessel fleet maintenance incorporate established best practices would have better positioned the Coast Guard to use its cost estimates to more effectively allocate available resources in the constrained federal budget environment.
GAO recommended that to strengthen the comprehensiveness, documentation, and accuracy of the Coast Guard’s annual depot-level maintenance cost estimates for its legacy vessel fleet, the Secretary of Homeland Security should direct the Commandant of the Coast Guard to ensure that the Coast Guard’s annual depot-level maintenance cost estimates conform to cost-estimating best practices. In July 2013, the Coast Guard issued the Government Estimating for Ship Repair Process Guide, which the Coast Guard reported was to incorporate best practices for cost estimating that could be adapted for use in estimating the cost of legacy vessel repairs. The document made improvements in each of the three relevant characteristics: comprehensiveness, documentation, and accuracy.Adjusting for inflation correctly is necessary if the cost estimate is to be reliable. Inflation rates are used to convert a cost from its budget year into a constant base year so that comparisons may be made across years. When cost estimates are stated in base-year dollars, the implicit assumption is that the purchasing power of the dollar has remained unchanged over the period of the program being estimated. Cost estimates are normally prepared in base-year dollars to eliminate the distortion that would otherwise be caused by overall price-level changes. This requires the transformation of historical or actual cost data into base-year dollars.
For budgeting purposes, however, the estimate must be expressed in budget year dollars to reflect the program’s projected annual costs by appropriation. This requires adjusting for inflation to convert from base-year to budget year dollars. Cost estimators must make assumptions about what inflation indexes to use, since any future inflation index is uncertain. In cases in which inflation is lower than expected, applying the wrong inflation rate will result in a higher cost estimate. When inflation is higher than projected, the estimate forecasts costs that will not be sufficient to keep pace with inflation. Thus, it is imperative that inflation assumptions be well documented and that the cost estimator always perform sensitivity analysis to study the effects of changes on the projected rates.