Contingency, Allowances & Escalation in Estimating

CONTINGENCY

Introduction
three basic types of contingency

tolerance in specification float in schedule money in budget (This topic deals with this)

most misunderstood, misinterpreted, misapplied word in projects. Contingency means different things to different people is highly subjective, inconsistently interpreted, inadequately estimated

Definitions
"amount of money added to the estimate to allow for changes that experience shows will likely be required" "specific provision of money in estimate for undefined items which statistical studies of historical data have shown will likely be required" allowances added to an estimate to represent the best judgement of undefined or uncertain items of work which it is considered should be provided for.... They are 'areas of space' in an estimate which help a PM to meet the project cost objectives, as they face exposure to project risk and uncertainty"

Attributes
It is a reserve of a sum of money. It is part of the project cost estimating process It is linked to the existence of risk - caters for
events unknown, undefined, uncertain, or unforeseeable.

It is a risk management tool - reduces impact if

risks eventuate

Inclusion means estimate represents total financial commitment:

increases probability that final cost will not exceed our estimate

Coverage
a) Incomplete Scope Definition
Allows for incomplete scope definition.

Order-of-magnitude & budget estimates developed early in PLC. With more scope definition, estimate invariably increases.
Contingency sum caters for increases in costs due to present incomplete definition

Coverage (cont.)
b) Inaccuracy of Estimating Methods & Data
no method or data is perfect Contingency is added to the estimate to cover for these inadequacies But Contingency should not be an excuse for poor estimating

Coverage (cont.)
c) Identified risks Contingency may be created for identified risks. - eg. contractor tendering, allows Contingency for:
scope error interpretations, minor design changes, inaccuracy in quantification, abnormal construction problems, liabilities in the contract, unforeseen regulations, safety requirements, equipment breakdowns, weather interruptions, labour productivity, technological change

Coverage (cont.)
d) Unidentified risks to allow for unidentified risks: excludes unforeseeable major events (see below). d) Items not part of contingencies Contingency should cover for scope development but not scope changes. Other items not considered appropriate for inclusion in Contingency:
escalation, unforeseeable major events (extreme weather, earthquakes, riots, acts of war, new government regulations, economic collapse, .terrorist activity)

Contingency Calculation Methods

A) Calculation by percentage add-on
C calculated as % of base estimate, based on experience & historical data. For example:

incomplete scope definition in early estimates: 30% - 50% once scope fully developed: 3% - 5% inaccuracy of estimating method &/or data: 5% - 10%
organisation and the type of business type of estimate. (eg. order-of-magnitude estimate demands a high C to cover for the inherent inaccuracies of this method) PLC phase (eg estimate at concept phase = high C to allow for limited information used to prepare an estimate) type of project. (eg new/unproven technology High C type of work - eg underground work = uncertainty = High C

Level of contingencies will depend on:

Variation to single % additional to base estimate is to apply different % to each major component of the estimate.

Contingency Calculation Methods

B) Calculation by Risk Analysis
contingencies by % mark-up not recommended:

dealt with in an arbitrary way (simply adding a 10%) contingency should definitely be based on an experienced review of uncertainties of estimate details

Allocating % insufficient unless linked to a confidence level. (i.e. level of probability that final cost will be within estimate, including C). Nowadays, more rigorous & defendable approaches for calculation of C typically derived from probability analysis, eg Central Limit Theorem and Monte Carlo simulation.

Contingency Management
Level of Contingency constantly monitored & reassessed through PLC Success of contingency management:
establish

procedures for proper use of C establish information system showing each manager & C under their control, C used, trends, when possible to transfer balances to other less successful areas or general reserve

Contingency Management
2 basic ways to manage Contingency

Single account

Disadvantages:

single line item account.

use C first-come, first-serve basis with potential exhaustion well before project is over control likely to be responsibility of PM - but other commitments are intense and may lead to neglect of contingency management.

Individual Allocations - & responsibility assigned for their control. If expenditure exceeds C, negative variance reported. Unexpended C can be transferred to a general contingency account.

ALLOWANCES
Contingency = unforeseeable and undefined items Allowance is for known and undefined items, foreseen
to be spent redefined each time an estimate is revised allowance should only be made if "there is a better than 50% chance of it happening" document the basis Following NOT allowances: major scope changes weather extremes, earthquakes accidents acts of God strikes because "these items are unpredictable, both in terms of
probability and magnitude of cost impact if they do occur".

ESCALATION
Escalation = "provision in estimated costs for continuing price level increase over time" Often receives less attention than other smaller items Escalation a result of two factors:
general inflation in costs, invariably upwards. specific market factors

selling price of an item is determined more by the level of economic activity (i.e., competition) than by the actual costs of making the item"

ESCALATION
Estimates may or may not allow for inflation of costs:

Ignore Inflation - Estimate for feasibility - costs & revenues expected to inflate at same rate, then inflation ignored Include Inflation - Contractor must allow for inflation in fixed price tender.

If significant items with volatile price patterns, seek advice Escalation can be

1 amount for project or individual elements.

Can break down estimate into cost elements, (labour, materials), & escalation factors for each component.
Furthermore, each element broken down eg labour into various trades & apply escalation rates to each trade.

ESCALATION
Two Phases

2 main time periods for cost escalation

consideration:
i. From the Past ii. Into the Future

ESCALATION
i. From the Past Escalate historical costs to the present date of estimate. Relatively easy, typically applying cost indices ii. Into the Future Escalation from date of estimate up to project completion 1 simple approach:
annual escalation rate x time period = total escalation rate; then total escalation rate x present estimate = total escalation costs total escalation costs + present estimate = predicted final cost.

ESCALATION

SHORT DURATION escalate cost estimate from base year of the estimate to, say:
the date of the award of the project; or, mid-point between award & completion; or, two-thirds through project's life (allows for S-Curve profile)

LONG DURATION dissect project into annual cashflows

Project estimated to cost $10M in 1991 dollars. Projected cashflows: 1993-$1m; 1994-$6m; 1995-$3m. Escalation rate of 5% pa is expected, escalated costs are:
1993 1994 1995 $1m $6m $3m x x x ((1.05)2 - 1) ((1.05)3 - 1) ((1.05)4 - 1) 102,500 945,750 646,519

TOTAL ESCALATION

1,694,769

ESCALATION
Cost Indices
Indices - use & limitations
Several cost indices exist eg. Consumer Prices Index. Limitations: Indices = averages. Unlikely to represent exact escalation of project Indices lack sensitivity to allow for short-term swings report time-lag in formulation - may not be representative

Indices - example
Estimate required for building a house at December 1992 : Cost of a very similar house in June 1990 was $100,000 Building Price Index: Jun 90: 102.49 Dec 92: 106.04 Estimated cost: (106.04/102.49) x $100,000 = $103,500.

PROBLEMS for estimating

project = uniqueness = lack of suitable precedents. project changes due to scope changes & new knowledge poorly defined scope = incorrect estimates. Often due to time pressure long projects - further project extends from original estimating base, less accurate original estimates likely to be

PRACTICES
estimating method must fit purpose concentrate on large-cost items use a standardised approach define the scope consult other interested parties list assumptions and exclusions indicate the base prepare a complete, not partial, estimate provide all relevant back-up information allow sufficient time to prepare the estimate

Do's

PRACTICES
Don'ts
no arithmetic errors. Check calculations do not work towards a preconceived number do not accept outside estimates at face value do not be influenced by interested parties do not claim higher accuracy than is really available

End of topic