Finance Commentary

May/June 2008

Managing Construction Costs

Unpredictable price hikes can derail projects—and companies

By Simon Squire

Simon Squire Principal with contributions by Julian Anderson President Simon Squire has a bachelor’s degree in construction economics from the University of Technology in Sydney, Australia. He relocated to the United States in 2000 and has had more than 19 years of experience on both sides of construction, as a consultant and as a contractor. Currently, he is a principal for the global quantity surveying firm Rider Levett Bucknall in Seattle. Website: www.rlb.com

The much-talked-about increase in construction costs since late 2003 has been the result of many factors, including but not limited to:

> The increased cost of raw materials

> The cost of transport and shipping, driven significantly by both the rising price of oil and the shortage of shipping

> Manufacturing costs and the availability of materials

> Availability of qualified labor

> The increase in construction activity

> Selectiveness of projects by main contractors (public versus private work)

> Speculative trading in base metals

> World economic circumstances

Since the last quarter of 2004, construction pricing has experienced escalation not seen since the 1980s, with rates ranging between 6% and 11% per annum. Compare this, for example, with previous years such as 2000 when a rate of 2.5% to 3.5% was more common.

First, escalation should be considered on two levels, historical and future. Historical escalation data is based on bid results, BLS indices, price comparisons and cost records analyzed from one period to another. Future escalation data is based on an assessed forecast, which anticipates cost adjustments from one period to another. Most projects are completed one to six years from when budgets are prepared, so they are typically priced using present-day data with an assessed allowance for escalation (on a per annum basis) applied to the base price. The bottom-line number reflects the anticipated price at the actual date of construction.

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Another issue to consider is the point at which escalation applies. There are two schools of thought on this. When anticipated-bid pricing is used, escalation to the start of construction is appropriate. When first-principles pricing is used, such as on military projects, escalation is calculated to the midpoint of construction.

Here are 12 tips on how to manage escalation costs:

1. Understand the pricing base date.

2. Develop a budget at inception.

To be a truly effective tool, budgets need to be reviewed and confirmed at the beginning of the project. By preparing a conceptual estimate on day one, owners can get a clear picture of whether their project is feasible. If this review/check of costs is deferred to a later date, then the initial design work may be wasted if the project is found to be over budget.

3. Establish a cost plan for the project.

Cost plans help to guide the design phase, providing an estimate that describes the anticipated building in enough detail to help designers with intended materials usage and design standards, and provide a tool for understanding the cost of changes as the design evolves.

4. Familiarize yourself with historical escalation rates.

Understand current escalation trends and which market conditions might have an effect on escalation rates. Use this information to make an informed, short-term prediction.

5. Don’t just use historical data to predict long-term escalation.

Escalation beyond a few years is notoriously difficult to predict—and beyond five to seven years virtually impossible (lucky guesses excepted).

6. Understand the escalation allowance on a per annum basis as applied to the base budget.

Blanket escalation allowances are less likely to be right than those that give weight to the likelihood of escalation changing from one year to another.

7. Update the cost estimate at regular intervals.

This allows the unit rates to be revisited and adjusted to reflect current pricing at the updated base date.

8. Revisit and adjust the escalation every year with current escalation rates and reforecast escalation using predicted rates .

By revisiting escalation and verifying the budget for long-term projects, high-level program decisions can be performed with greater certainty, removing the need to “slash and burn” to maintain the budget. Most importantly, it can prevent embarrassing budget shortfalls later on.

9. Distribute the escalation risk between owner and contractor.

Escalation risk is priced whether it’s separated as a single line item or included within the rates. Projects with higher future risks will typically attract higher escalation rates. The team must identify the risk and develop a tool that can share future risk, using industry-recognized escalation rates to target changes.

10. Manage risk by applying contingencies.

Budget within the project for an adequate level of contingency. Estimating, design and construction contingencies are incorporated into the base cost to allow for variances in design, minor changes in unit pricing and unforeseen conditions.

11. Use an expert cost consultant such as a quantity surveyor instead of pricing books with generic unit rate allowances to add credibility and provide a project-specific budget.

12. Beware of budgets that can get off course during construction.

Expert cost consultants can provide security to the owner by monitoring costs and ensuring they are in line with the original estimates. They can also help owners manage contingencies and provide early notification of unforeseen problems.

> We are at the end of the Federal Reserve’s Volcker-Greenspan era, which may lead to some uncertainty in the marketplace. We are also in the middle of a credit crunch and a housing slump.

> The baby boomers are turning 60. Construction labor availability will likely decrease and place pressure on future project costs nationally and locally.

We recommend that all budgets be reviewed at least quarterly and specific to the project characteristics and geographic location. You can’t control costs; you can only manage them.