Construction – You Need Risk-Based Cost Estimating Contracting Practices Session, June 8, 2015 John Reilly Alfred Moergeli Philip Sander sander@riskcon.at john@johnreilly.us alfred.moergeli@moergeli.com 1101 Worchester Road moergeli consulting, llc (mcllc) Technikerstr. 32 Framingham Massachusetts 11921 Ferdinand Street, P.O. Box 2852 6020 Innsbruck 10701 USA St. Francisville, 70775 LA Austria www. johnreilly.us www.moergeli.com www.riskcon.at
Presentation Will Cover Dealing with uncertainty Components of cost estimates Value at Risk (Level) Types of cost estimates Deterministic a) Bandwith, square-root approach b) Risk based (probabilistic) c) Comparison of cost methods Benefits, risk-based approach Better, more complete information a) Explicit definition of risks b) Summary Contractor’s advantage / Strategies a) Owner’s advantage / Strategies b) Example, RIAAT process Questions Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 2
Dealing With Uncertainty Every cost estimate is uncertain. o Underestimating construction costs can lead to problems for owners in the planning and design phase o Underestimating construction costs – e.g. by contractors in the bidding phase - can lead to loss of profit, disputes, claims, and litigation A better understanding of potential costs helps: o Owners to budget and get authorization for projects - leading to a reduced chance of “cost overruns” o Contractors to determine base cost and margin plus: o Strategies to secure the work - in low-bid environment o Strategies to maximize profit, avoid loss and recover costs of changes Consider low probability / high impact “black swan” events Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 3
Risk and Uncertainty Risk is the combination of the probability of an event and its consequences (if positive = opportunity) Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 4
Components of Cost Estimates Components of cost which need to be sufficiently addressed in an estimate include: o Base cost – the cost that will result if “all goes according to plan” o Risk costs Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 5
Value at Risk (VaR) Distribution Function (Impact in kUSD) 7% 100% 90% 6% Value at Risk (VaR) 80% = A certain amount, within a distribution, 5% 70% that will not be exceeded according to Relative Frequency the corresponding probability . 60% Value at Risk 4% VaR 70 here means that a $5M budget 50% would not be exceeded in 70% 3% 40% of all simulated scenarios (there remains a 30% probability 30% 2% that the $5M budget will be exceeded) 20% 1% 10% 0% 0% 1,000 2,500 5,000 7,500 10,000 Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 6
Cost Estimates Must Also Address Escalation – costs resulting from inflation (with variability) - driven by economic factors. Effect of competition and market factors Other uncertain costs – e.g. from events external to the project team’s control, including: o “Unanticipated” events o Management changes / lack of continuity o Politically related changes, and o “Black Swan” events Transition to Alfred Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 7
Types of Cost Estimates 1. Deterministic: Aggregated unit quantities multiplied by unit prices. Usually with some degree of conservatism built in. Plus an added reserve or contingency 2. Bandwidth: Range approach with minimum, most likely, and maximum cost . The total cost is obtained by simply adding these parameters for all line items. 3. Square Root: Delivers one single figure which is the sum of all base costs plus the square root of the sum of the squares of the risk contingencies. 4. Probabilistic: Range approach which characterizes cost information with probability distributions Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 8
Cost Estimating Methods in Comparison : Tunnel Excavation Category (Base Cost only) Quantity Unit Price [USD] Price [USD] Cost Item Distribution min ml max unit Distribution min ml max ml Shotcrete 10 cm - Top Heading Triangular 13.83 15.37 17.68 m² Triangular 9.696 12.12 15.756 186.28 Steel Mesh AQ50, outer layer- Top Heading Triangular 13.83 15.37 16.91 m² Triangular 0.976 1.22 1.586 18.75 Swellex 3.0 m - Top Heading Triangular 1.73 1.82 2.00 pc Triangular 20.712 25.89 33.657 47.12 Shotcrete 5 cm - Bench Triangular 5.18 5.76 6.62 m² Triangular 5.992 7.49 9.737 43.14 Swellex 3.0 m - Bench Triangular 0.43 0.45 0.50 pc Triangular 20.712 25.89 33.657 11.65 306.95 1. Deterministic Approach 2. Bandwidth Approach ∑ Most likely quantity x most likely price 223.36 USD CostItem (min Q * min P ) ∑ 306.95 USD CostItem ( mlQ * mlP ) 306.95 USD ∑ 453.86 USD CostItem (max Q * max P ) 3. Square Root Approach 4. Probabilistic Approach ( ) ∑ ∑ − + 2 CostItem max min min = 375.67 USD Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 9
All Four Cost Estimating Methods in Comparison: Visualized Square Root Approach Probabilistic Approach Deterministic Approach Bandwidth Approach C A B D Ml. Max Min. . VaR5 VaR50 VaR95 223 286 321 376 307 362 454 B D C D D B B 307 A Risk-Based, Probabilistic Cost Estimating Methods www.moergeli.com www.johnreilly.us www.riskcon.at Slide 10
Pro’s & Con’s of the Methods Estimating Pro Con Method 1. Deterministic One single fig ure No probability information - single value Well-known & accepted No VaR information More often than not on the unsafe side Quick (high, unknown probability of cost Can be performed “manually” overruns) 2. Bandwidth Three values No probability data, range values only - minimum, most likely and No VaR information maximum, ranged More often than not on the unsafe side Quick (high, unknown probability of cost Can be performed “manually” overruns) Range maximum and minimum very unlikely No probability information for single 3. Square Root One single value value Bandwidth information is lost Quick No VaR information Can be performed “manually” Range limits are extreme values and very unlikely 4. Probabilistic Full probability information Needs probabilistic thinking & understanding Needs (a little bit) more time Needs software support Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 11
Tornado Diagram - Risks/Opportunities Transition to John Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 12
Benefits of Risk-based Cost Estimating Risk-based methods give more detailed and specific information of risk and potential cost impacts – with the following possibilities in the planning & bidding phases: o Allows strategies to protect public funds and interests o Allows the owner to develop better and more equitable contract documents and provisions for risk o Allows a better understanding, by owner and contractor, who will “own” risks – leads to contractual clarity o Allows the contractor to assess risk in bidding vs. the competition – to better evaluate chances of securing the work at a specific price – and to make an informed “go-no go” bid determination o Allows the contractor to determine a risk management strategy for construction in order to best obtain a profit Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 13
Concerns – “Low-Bid” Environment A concern has been expressed that if an improved risk identification process is used the contractor’s estimate will include higher potential costs, which will mean that their bid will be higher and they are likely not to be successful This is a valid concern – however, we would argue that more detailed and realistic information about potential risk events is an advantage if: Appropriate bidding and construction management strategies are used by the owner and contractor and These strategies are compatible and consistent Construction – You Need Risk-Based Cost Estimating www.johnreilly.us www.moergeli.com www.riskcon.at Slide 14
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