February 2015

Dr Rupert Booth, FIET FRICS FCMA PMP CEngChief Economist

COST ESCLATION ACROSS

THE LIFECYCLE

Agenda

Pre-Tender

Government intervention

Corporate actions

Forecasting input prices

Optimism bias

Contingencies

Post-tender

Input price escalation

Pass-throughSelecting indicesDesigning indicesHedging

Cost over-runs

Baselines & stage-gatesProgram controlRegional factors

Government interventions

Price controls or subsidies. Usually backfire (reduce supply, increase

demand and deter inventory holding)

Market development: reduce regulatory barriers to entry of suppliers and

allow substitution (material and labour)

Bottleneck removal: reduce physical barriers to supply and arrange

inventory holding

Supplier development: set-up suppliers or encourage start-up via tenders,

encourage new entrants

Procurement strategies: widen pool of bidders, review contract terms

Corporate actions

Capacity planning

Matching resource supply to demand

Productivity improvement

Investment in skills and equipment

Re-engineering of program of work to avoid supply constraints

Portfolio level

Owner’s specification, e.g. Concrete vs. Steel frame

Use of pre-fabricated components, e.g. Water-proofing approaches

Global service centres

Design centres

Forecasting input prices (1)

Time series:

• Simple method for established trends (e.g. real wages)

• Construct multi-factor model

• Assumes past guide to the future

Regression models

• Links one factor (y) to another (x)

• Useful if clear relations exists (e.g. Bitumen or Fuel price link to oil price)

Leading indicator analysis

• Identify leading indicators, e.g. consumer price index, crude oil price, producer price

index, housing starts, and building permits are explanatory variables

• Adjust for events, e.g. Regulatory changes

Forecasting input prices (2)

Reference case benchmarking:

• Finding a reference case (e.g. Asian Games, Dubai Boom)

• Making adjustments (e.g. scale, supply elasticity)

Build-up Models

• Identify ‘stack’ of factors, e.g. global inflation, regional factors, local

overheating etc.

• Build up forecast by addition, but avoiding double-counting

Econometric models

• Model supply, demand, inventories, elasticity etc

• Wide range of assumptions that often cannot be verified

Optimism bias and contingencies

Classic paper: ‘Underestimating costs in public work projects: Error or

Lie?’ by Flyvbjerg et al (2002)

Subsequnet tsunami of ‘Mega-project’ publications, especially relevant to

sporting events

Practical Guidance:

At appraisal stage, optimism bias by project sponsor almost

inevitable, so independent review is required

At tender stage, need to develop into risk-based multi-level

contingencies with governance framework linked to funds, to control

escalation

Introduction to Indices

Sources & Methods:Construction Price IndicesOECD

Recent/ongoing consultations:

BIS Construction Price and Cost Indices (2014)

BCIS Price Adjustment Formulae Indices for Civil Engineering consultation (ongoing)

Post-Tender : Input Prices

Pass-through

Full transfer of risk away from contractor

No incentive to minimise cost

Can be appropriate where the principal sets prices, e.g. Government

Selecting indices

General inflation (may track wages but not materials)

Input cost (clarity of definition)

Output price (integrity of data collection)

Tender price (but sampling issues)

Designing indices

Benefit must outweigh the cost of collection, calculation and dissemination

Direct measurement or indirect calculation (e.g. collect input or output data and

infer the other)

Hedging

Relevant for larger contractors where hedge for commodity exists, e.g. fuel, steel

Post Tender: Cost Overruns

Baselines & stage-gates

1st protection: Clear baseline, e.g. London Olympic Baseline Legacy report (123pp)

2nd protection: stage-gate process for disciplined progression

3rd protection: change and configuration management control

Program control

Early detection of issues and update of risk register

Frequent, regular update of costs and earned value within agency and to fund holders

Contingency and variation management within governance/delegation framework

Regional factors (informal survey, September 2014):

1. Misallocation of risk leading to increased risk premia

2. Awarding contract to lowest bidder hoping to profit from variations

3. Late specification changes

4. Tortuous change management process

5. Poor coordination of overlapping projects

6. Inaccessibility of contract principal

7. Skill shortages worsened by visa problems

Claims Analysis (UAE)

Source: Construction claims in United Arab Emirates: Types, causes, and frequency. Essam K. Zaneldin

Views from the field: importance of causes of delay (Saudi)

Source: Causes of delay in large construction projects, Sadi A. Assaf , Sadiq Al-Hejji

Conclusions

Governments, Owners/principals, consultants, and contractors should have a

common interest in avoiding unexpected cost escalations

Escalation avoidance begins with market development, risk allocation and

procurement strategy

For market participants, pre-tender cost and price forecasting is feasible, with

some potential for risk transfer

Post-tender, escalation avoidance starts with good baselines and controls

Regional factors worsen tendency to cost escalation

Once escalation has occurred, opinions of course diverge but with a wide variety

of outcome by sector