escalation estimating principles and methods

8/19/2019 Escalation Estimating Principles and Methods

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Lecture 5-1CE-591 Cost Engineering and Control

© Dr. Farrukh Arif, Assistant Professor, NED UET© Dr. Farrukh Arif, Assistant Professor, NED UET

CE-591- Cost Engineeringand Control

ESCALATION ESTIMATINGPRINCIPLES AND

METHODS USING INDICES


© Dr. Farrukh Arif, Assistant Professor, NED UET

Introduction Recommended practice (RP) of AACE

Defines basic principles and methodological buildingblocks for estimating escalation costs using

−forecasted price

−or cost indices

Escalation estimating is an element of both the costestimating and risk management processes

RP is focused on quantification, not on escalationtreatment


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Outline

Background

General Principles and Methods

General Principles

Basic Escalation Cost EstimateRelationship Using Indices

Price and other Econometric Indices

Pricing Versus Costs

Price Index Forecasts

Addressing Costs Over Time (CashFlow)

Addressing Cost Account Detail

Matching Indices to Cost Accounts(Weighting Indices)

Adjusted or Composite Indices

Using Price Indices to NormalizeHistorical Project Costs

Escalation on Contingency

Escalation Uncertainty andProbabilistic Methods

Lag and “Sticky Prices”

Accuracy



Background

Escalation is a provision in costs or prices for changes intechnical, economic and market conditions over time.

Increases with the volatility and uncertainty of Economy

Can have a tremendous impact on estimates, bids,profitability

A common source of claims and disputes if not addressed

explicitly Escalation as defined here excludes contingency and

currency exchange impacts, but includes inflation

Inflation is generally defined as the overarching effect onprices of excess money supply


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Background

Some of the drivers of escalation, in addition to inflation include

−Changes in market conditions,

−Technology,

−Regulation,

−General industry or regional-wide productivity and

−Other economic factors that generally affect an economic sector orsegment.

Technology and regulation changes covered by escalation are generalevolutionary changes in design tools or regulations not immediately

impacting the project Major technology changes or regulations that directly or immediately

impact the project would be covered in contingency or reserves



Background

Escalation does not include changes in cost or priceresulting from potential changes in company or projectspecific strategies, actions, risk events or other changes

Those pricing risks should be addressed by contingencyestimates.

Segregating escalation from exchange rate impacts ismore challenging because both are driven by economicfactors

This RP deals only with quantification not the escalationtreatment


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Basic Escalation Cost Estimate Relationship

Using Indices

Methods covered in this RP require input from economistsas appropriate

Such as measured or forecast cost and prices, usuallyexpressed with a relative index

Convert the base year cost to a value of 1.00 or 100 andexpress the costs in all other years relative to that base

Escalation cost is the escalated cost minus the base costas shown below



Basic Escalation Cost Estimate RelationshipUsing Indices

Example

An item costing $100 in the base year (index = 1.00) and a forecast index of1.15 for the year of payment, the escalation cost is as follows:

= $100 · [1.15/1.00 −1] = $100 · 0.15 = $15

The target date can be in the past or future depending upon the purpose ofthe estimate

The time period that you have indices for can vary; however, reliable cost andindex data are rarely available for periods more frequent than monthly

Quarterly or annual periods are more commonly used

When dealing with economics evaluation, the terms “nominal” versus “real”cost may arise in discussions

Real costs are more or less synonymous with the “base” estimate

Nominal cost with escalated costs


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Escalation is driven by economic trends

The primary econometric measures of price change over time (i.e., escalation)used by economists are price indices

Economists usually measure price levels using market surveys

−Survey of the price charged by producers (Producer price index,PPI)

−Prices paid by consumers (Consumer price index, CPI)

Other econometric indices

−employment cost indices, average hourly earnings, etc.), capital spending, laborproductivity

Primary sources of Historical price/indices

−U.S. Bureau of Labor Statistics (BLS), Eurostat or Statistics Canada




Using Consumer Price Index (CPI) as index for escalationestimation is not an effective practice for accurateescalation

The consumer targeted by the CPI reflects a personwhose spending patterns and market generally have littlerelevance to capital project ending or markets

The only time that the CPI works well is when the only escalation occurring is inflation


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Pricing Versus Costs

The prices paid by (or cost to) a consumer may differ from the supplier’s costs

Supplier prices charged to the consumer include markups for their overheadand profit, contingency and other premiums

Understanding these distinctions is important in escalation estimating becauseit affects the

“As an example of the subtleties of indices, consider the employment cost index (ECI)from the BLS, which is commonly used to track the cost or price of labor. The ECI measures changes in wages and compensation paid to a given type of worker. This may fairly track the costs to an employer for that worker. However, consider the price that a contractor employer will charge a customer for contract services. That price will include not only trends in wages, but trends in markups and premiums that the contractor will add to their bid or invoice. In a volatile market, the markups generally will

not follow the same trend as wages. Therefore, the ECI may work for the contractor estimator who is estimating their internal escalation costs, but not for the customer’s estimator who is estimating the price they will have to pay for the contracted labor services. selection and use of indices “




Economists study historical trends and build econometric modelsthat forecast future price index values, generally at an aggregatelevel

The models of price change for specific goods or services areusually tied to macroeconomic models

Some economists rely less on models and more on expert opinion,market surveys

Some companies tend to rely more on the forecasts of theirprocurement and contracting specialists who have some level ofinsight as to the specific market of their company


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Estimators must recognize that most economists are notexperts in specific capital project costs or sub-markets

Estimators and economists must work together to find anadjusted combination of indices that can serve as proxies forelements of project or product costs

Most government agencies do not prepare long-term forecastsof detailed indices



Addressing Costs Over Time (Cash Flow)

The basic escalation cost estimating relationship (CER)presented at the start of the RP assumes spending on oneitem in one point of time such as for purchasing a discreteitem

Spending is usually spread out over time for manyaccounts such as labor or bulk materials

For this RP, we will use the phrase cash flow to representspending distributed over time


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Figure 1 illustrates three primary methods for addressingcosts incurred over time




Mid-point spending method: This

method sets the single target date as the mid-point between the start and end

of spending on the subject cost

account. This is the simplest approach and requires no knowledge of the

actual spending pattern. It is most amenable for Class 5 and 4 base cost

estimates for which cost and schedule

information is limited. It is not very reliable if either cash flow or index

trends are inconsistent over time.


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Median spending method: This method

sets the single target date as the

median date of the cash flow distribution (i.e., half the spending is

before and half after this date). This requires some knowledge of the

spending pattern even if just to know if it has an early or late bias (i.e., before

or after the mid-point). It is most

amenable for Class 5 and 4 base estimates for which cost and schedule

information is limited. While it addresses asymmetric spending

patterns, it is still not very reliable if

index trends are inconsistent over time.




Period spending method: this method breaks the spending into time increments, typically by month, quarter or year depending on the typical duration of the spending (i.e., monthly estimates are usually not justified for projects of many years duration). For each time increment of spending for each account, the simple method in the previous section is applied with the target date for the increment as the mid-point of the incremental period. Alternatively, the percent index change for each period can be applied

cumulatively to derive the target year index.For example, if you are estimating costs in year 0 (index=1.00), and the spending willbe in year 3, and prices increase 5 percentper year, the price index for year 3 is 1.05 x1.05 x 1.05 = 1.16 (i.e., escalation for thatitem is 16%).


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The basic escalation CER and cash flow treatments canbe applied to any level of detail of cost breakdown fromoverall cost, to very detailed cost accounts

However, neither a single account value nor an extremelydetailed account breakdown is recommended for a project

Users should establish accounts that meet the followingprinciples

−Use accounts/indices that address differential price trends

between accounts.−Use accounts/indices that address levels of detail for variousestimate classes.




At the highest level, material, office and field labor costaccounts typically have different price trends and need to besegregated

Further breakdowns of material are equipment (generally bymajor types), steel, concrete, piping, etc

For buildings and infrastructure work, this corresponds roughlyto the Masterformat division accounts excluding the process

equipment subgroup For capital projects, breakdowns by work breakdown (e.g.,

area/unit/system, CSI Uniformat, etc.) can be used

However, more index weighting will be required in thisarrangement


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Matching Indices to Cost

Accounts (Weighting Indices) It is a challenge to determine the best way to apply disaggregated

indices to aggregated or overall project, product or service costs forwhich no single reliable aggregated forecast index is available

There are separate indices for each of the major resources that go intoor make up a project’s cost structure

The estimator must create weighted composite indices to apply to anestimate category based on the composition of the estimate categoryrelative to the items represented by the indices



Matching Indices to CostAccounts (Weighting Indices)

For Example

A typical process plant has significant pipe material costs. Most of thepiping material cost, as estimated, is for pipe spools from a fabricator.The spool price includes the cost for pipe, fittings and shop laborcosts. The available disaggregated indices do not cover spool prices;therefore, the estimator must create an aggregate or “proxy” index forshop-fabricated pipe that includes a weighted mix of pipe costs, fittingcosts and shop labor as shown in the following example:


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Matching Indices to Cost

Accounts (Weighting Indices) The following criteria will help the user select and develop price indices for use

in escalation estimating: Indices should

Use or be based on industry or government sources that are generallyrecognized as reliable and are readily available.

Be generally applicable to the subject industry in the primary regions where acompany performs or will perform capital projects, maintenance andoperations or manufacturing.

Be specific to the major cost types found on all the company’s projects orproducts.

Be easy to update, modify and maintain as an ongoing reference source.




A challenge to using indices is dealing with the fact thatthey do not track micro-economic trends, markups, and soon

This is because contractor’s prices include markups,premiums, productivity factors

Estimators and other team members (e.g., procurementlead) must add their knowledge for adjusting the indices tomicroeconomic conditions


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One method is to start with a base index that is independent of micro-market trends (e.g., an ECI from the BLS), and then use an index ofcapital spending (a proxy of market conditions) in the micro-market tomodify the base index

This approach is based on two rational hypotheses−1) a given market’s pricing will be correlated to the extent that demand is more orless than the supply in that market, and

−2) supply will be more or less inelastic in the short term (period of interest toprojects) for items that require significant investment of time and/or resources tocreate (e.g., skilled labor, major equipment, etc). Fortunately, economists do track

and forecast capital spending in many markets

The general form of the index adjustment can be expressed asfollows:




Example

Consider the prior unadjusted example given of an item costing $100in the base year (index = 1.00) and a forecast index of 1.15 for theyear of payment. The unadjusted escalation cost is as follows:

= $100 · [1.15/1.00 − 1] = $100 · 0.15 = $15

If the capital expenditure spending level index was 1.00 in the base year,

and 1.25 for the year of the payment, and the exponent was 0.5, the

adjusted escalation cost is as follows= $100 · [1.15/1.00 · (1.25/1.00)0.5 − 1]

= $100 · [1.15 · 1.12 − 1)

= $100 · [1.29 − 1)

= $29


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Escalation on Contingency

Contingency, by AACE’s definition, is a cost expected tobe spent

It is logical to apply escalation to contingency like anyother estimated cost account

The weighted index for contingency will typically reflect theweighting of cost accounts for the project as a whole



Exchange Rate Interaction

This RP recommends segregating escalation and exchange rateimpacts for projects with resources priced in currencies other than the“base” currency

However, perfectly clean segregation is not possible because bothescalation and exchange rates are driven by economic conditions

The optimal approach using segregation is to estimate escalation onan item using a price index that reflects the price trend for that item inthe location where it is sourced

For example, if a base estimate was reported for a Canadian project inCanadian dollars at current exchange, but an item was to be boughtfrom the US using US dollars, use a US-based price index for thatitem. Then, estimate the $US/$CAN exchange rate impact separately.


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Exchange Rate Interaction

Example

Given:

Price index from US reference source today is 1.10 and 1.32 at plannedpurchase date

Exchange rate is 0.85 $US per $CAN today and 1.02 at plannedpurchase date

Then:

Escalation: ($100 price in $CAN) x (1.32/1.10-1)

= $100 x 0.20 = 20 $CANExchange: ($100 price in $CAN) x (0.85/1.02-1)

= $100 x -0.17 = $17CAN



Miscellaneous Points Probabilistic Estimation: One method of obtaining a range is to apply

Monte-Carlo simulation to the estimate model. In this approach, theuncertain index, factors and timing inputs are substituted withdistributions.

Lag and “Sticky Prices” : Another uncertainty in escalation estimating,particularly as it regards consideration of market swings, is thatsuppliers do not immediately change their bidding and pricing levels orstrategies in lock-step with underlying trends in commodity, wages and

other costs to them

Accuracy: Estimators are cautioned not to expect too much accuracyfrom cost indexes and escalation estimates. The indices areapproximations intended to represent the average trends for a largegroup of projects in a broad region


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End of Lecture

escalation estimating principles and methods

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