SECTION I INDUSTRY OUTLOOK AND COST ESTIMATE FORMING
3.4 Cost Escalation and Estimation Inaccuracy
Project cost increases, also known as cost escalation, can be caused by a variety of factors that have been identified in previous studies (Lawrence, 2007; McFadden, 2013; Towler and Sinnott, 2021). These factors, which contribute to inaccurate esti- mates and cause problems with cost estimation, vary depending on the phase of pro- ject development and the complexity of the project. By identifying the key factors that lead to cost escalation, measures can be taken to mitigate their impact on pro- ject and program costs.
There are several internal factors that can contribute to the underestimation of pro- ject costs during the planning and design development stages. These factors include bias, the procurement approach, changes to the project schedule, engineering and construction complexities, scope changes, scope creep, and poor estimating. Addi- tionally, there may be issues with the inconsistent use of contingencies. Project cost escalation can also occur during construction, and it is important to focus on these internal factors early on in order to reduce the likelihood of cost growth at the bid time or during construction. (Shane et al., 2009) A figure depicting the compound- ing issues which may substantiate when not accounting for the risk-negating factors in early-stage planning is pictured in Figure 11.
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Figure 11. The 'downward productivity spiral' found in large construction projects. (McFad- den, 2013)
Factors that impact the cost estimate for each phase of a project's development can be divided into two categories, into internal and external factors. Internal factors are those that the agency or owner can control, while external factors are those that exist outside the agency or owner's direct control. This arrangement of factors is shown in Table 10. The order in which the factors are presented should not be inter- preted as a ranking of their effects on the cost estimate. It's worth noting that while some of the factors relate to difficulties in accurately estimating labor and material costs, many of them relate to influences that impact the scope and timing of the project. (Shane et al., 2009)
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Table 10. Cost escalation factors by cause and development phase. (Shane et al., 2009)
Source Cost escalation factor
Internal • Bias
• Delivery/procurement approach
• Project schedule changes
• Engineering and construction complexities
• Scope changes
• Scope creep
• Poor estimating
• Inconsistent application of contingencies
• Faulty execution
• Ambiguous contract provisions
• Contract document conflict External • Local concerns and requirements
• Effects of inflation
• Scope changes
• Scope creep
• Market conditions
• Unforeseen events
• Unforeseen conditions
In addition to the factors presented above, estimate accuracy is also driven by other systemic risks such as:
• Level of familiarity with technology
• Unique or remote nature of chosen project location
• Quality of reference cost estimating data
• Time and level of effort budgeted to prepare the estimate
• Currency exchange
• The accuracy of the composition of the input and output process streams.
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In order to account for small project overruns because of the reasons discussed, pro- ject estimates usually entail some level of contingency charge.
Contingencies are a natural part of any project cost estimate, as they are by nature imprecise. Contingencies are used to decrease the risk of overshoots in the real pro- ject costs compared to the base estimate. However, contingency should not be equated to estimate accuracy. The aim of including contingency is to bridge the gap between the base cost estimate (the “most likely” point, or the mode) and the out- come probability point that the project team is expected to control to (usually the 50/50 outcome point, or the median) as depicted in Figure 12 (Lawrence, 2007).
Figure 12. A distribution curve illustrating how contingency bridges the gap between the mode and median of the investment cost estimate. (Lawrence, 2007)
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Still, the role of contingency is a very contested topic both in literature and in prac- tice. In addition to the role of accounting for practically unaccountable factors af- fecting the base estimate (e.g., equipment cost increase because of rising raw mate- rial prices, currency fluctuation, labor disputes), some authors claim contingencies should also account for minor changes in project scope (Towler and Sinnott, 2021).
Conversely, other authors explicitly state that contingency should not account for any scope changes, and should only be applied to the original scope put forth in the original estimate (Lawrence, 2007). Instead, estimate accuracies of individual cost should be defined in a way that accommodates minor changes to the scope.
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4 CLASSIFYING AND ESTIMATING REQUIRED INVESTMENT CAPITAL
Deciding how investment costs should be categorized in industrial investment pro- jects is highly dependent on the scope, magnitude, and nature of the investment in question. Similarly to investment planning methods, there is no single “correct” way to categorize investment costs, as there are numerous methods that fit the tasks at hand; Some methods are developed inhouse in consultancies (e.g., AFRY) and oth- ers by professional cost estimation organizations (e.g., the AACE). An overview of the main methods of categorization and the basis of estimating costs within these categories are presented in this chapter. The categorization method in place at AFRY is also presented. Quantifying the impact of chosen project location on the appro- priate cost areas is discussed in chapter 7.