Cost contingencies: What are the industry standard methods of determining cost contingencies?

What determines the quantum adopted? Comment on the rationality of each of the methods, particularly from the point of view of risk management (ISO31000). 1 Introduction

Civil Engineering projects require budget estimates so the financial sponsor of the project can allow for the financial commitment of the project. For contractors, cost estimating is used as a tool in preparing tenders and bidding for civil works. The nature of those projects and associated work packages is such that there is always some degree of uncertainty and inherent risks. Minor or major risks are spread throughout every project expense and can each result in cost overrun. The risk of cost overrun is managed by allowing for a cost contingency fund, which can be drawn down upon in the event of unforseen costs. Contingency has been defined as The amount of funds, budget or time needed above the estimate to reduce the risk of overruns of project objectives to a level acceptable to the organisation (PMI 2004). Analysis of cost variations during the bidding process or budget estimate is therefore highly important in helping to reduce risk and providing a justification for the contingency quantum. Traditionally, contingencies were calculated as an across the board percentage addition to the base estimate, typically derived from intuition, past experience and historical data. The highly un-scientific nature of the traditional approach has led to a search for a more robust approach. There is now a wide range of methods for estimating cost contingency. The following table presents some of the contingency estimating methods (Baccarini, 2005). Contingency Methods Estimating References (Further Reading)
Ahmad, 1992; Moselhi, 1997 Diekmann, 1983; Moselhi, 1997; Yeo, 1990 Lorance & Wendling, 1999; Clark, 2001 Hackney, 1985; Oberlander & Trost, 2001 Mak, Wong & Picken, 1998; 2000 Curran, 1989 Merrow & Yarossi, 1990; Aibinu & Jagboro, 2002 Chen & Hartmann, 2000; Williams, 2003 Paek, Lee & Ock, 1993 Diekmann & Featherman, 1998

Traditional percentage Methods of Moments Monte Carlo Simulation Factor Rating Individual Risks expected value Range Estimating Regression Analysis Artificial Neural Networks Fuzzy Sets Influence Diagrams

Theory of Constraints Analytical Hierarchy Process

Leach, 2003 Dey, Tabucanon & Ogunlana, 1994

Generally each method falls under one of two approaches. One approach is non analytical based mainly on past experience and a general feel for the nature of the project or industry, which is very similar to the traditional approach. The other approach is analytical and uses as much data as possible to form statistically based decisions upon the required contingency quantum which will keep the risk of cost overrun below a certain level. In the following report we provide an outline of three industry standard models. Model 1 (analytical). This is a three-point estimate method which requires no more detailed mathematics than the calculation of areas under triangular graphs approximating normal distribution of price ranges. Providing the data can be obtained, this method provides an excellent way to manage risk. This method developed by Singh, Shiramizu & Gautam, 2007 and was applied to a civil works project in East Timor for this assignment. Model 2 (non analytical). The contingency is set according to the amount of work completed on the project and follows industry specific recommendations (Parsons, 1999). Model 3 (analytical and requiring a small knowledge of statistics). It illustrates a routine for using spreadsheets and the normal distribution to calculate the contingency. It provides a very good model to investigate how much risk is associated with the each of the various cost components of a project (Nassar, 2002).

Each methodology has been summarised to show its approach to setting the contingency quantum and how it can be applied. We discuss our thoughts regarding the rationality of each method and what we see as the main benefits and/or potential problems. The conclusion provides a review of the three different approaches and relates them to risk management and ISO 31000. 2 Industry Standard Methods

2.1 Three Point Estimates with Risk Based Contingency Setting: This method was applied to a call for subcontractor services for the rehabilitation of irrigation systems in East Timor in 2001, just after independence from Indonesia. Six sub contractors responded, however two were eliminated early due to non -responsiveness. The civil works packages were split into three components: 2

A (contractor establishment, site preparation and sodding) B (earth works and stone works) C (concrete works, steel works and ancillary structures)

Note: the following tables in Section 2.1 are derived by the assignment authors from project data for the purpose of completing this report. Step 1: Three quotes or prices are obtained for work packages (Prices can be obtained from quotes, professional costing services, historical records or analysis from first principles) and divided in three categories: (i) most likely (ii) pessimistic (iii) optimistic (see Table 1). These are the upper, middle and lower values for possible costs for each work package.

Step 2: Triangular distributions for each work packages are developed as shown below.

(Singh, Shiramizu & Gautam, 2007 with numbers modified) The x-axis represents the quote cost (in multiples of 10,000 USD), the yaxis represents the frequency of occurrence of a quote in that cost range and h is the frequency of the most likely cost. The triangle represents the case of all possible bids, 7.1 being the lowest

and 17.34 the highest. Bids less than 14.38 are represented by triangle B1, bids greater than or equal to 14.38 are represented by B2. Judgement is quite important in step 1 on the selection of the three values. Step 3: Determine the probability of a bid falling within each of the two ranges. For the above triangle, the probability of a bid less than 14.38 = Area of B1 / (Area of B1 + Area of B2).

The total area under the graph represents all possible bid costs. Step 4: Calculate probabilities of all possible work package combinations and their costs using midpoint approximation. This means that the midpoint between the prices at each end of the triangle is chosen as the representative cost for that triangle. For the above triangle, the midpoint of B1 is (14.38+7.1)/2 = 10.74 and the midpoint of B2 is 15.86. This is done for the other two triangles A and C to give a cost and a probability to the 4 remaining triangles A1, A2 and C1, C2.

Step 5: Calculate cumulative probability of project costs by ranking combined package costs.

Step 6: Target Price The target price is 503,900 USD, defined as the total most likely price based on data from Table 1.

Step 7: Confidence Limit Price The target price is associated with a probability of 0.92, which means there is only an 8% chance of cost overrun. In normal bidding circumstances, this might be an acceptable risk, however, because the project is based in East Timor immediately after independence, the bidding contractor wants a higher assurance of profit. At this point the contractor sets the confidence level, which determines the contingency as shown below. In this example he sets the confidence level at 1 (i.e. no risk), providing 100% certainty that the project will not incur cost overrun. The bidding price for this confidence level is 530,200USD. The difference between the Target Price and the Confidence Limit Price is the Contingency. Step 8: Contingency Contingency = Confidence Limit Price - Target Price = 530,200 - 503,900 = 28,100USD Note that this is about 5% of the target price. It is possible that each contractor already factored some contingency in unit costs. The current method shows that for 100% confidence of no cost overrun, another 5 % could be added based on the range of submissions of bids. Rationality and risk management The contingency is set purely on the degree of risk, which the bidding 5

contractor is willing to accept. For this example, the contractor desired certainty of profit and hence added a contingency to his target estimate such that the probability of a cost overrun was zero (assuming no changes to quotes). The objectivity and certainty of this method is a key plus. Since the cost estimate has been carried out to cover all possibilities, it is possible for the bidding contractor to have complete freedom in applying the contingency based on the degree of risk they are comfortable with. This will of course need to be balanced against their desire to win the work and their desired profit level. Potential problems One downside with this model is that in some cases it may be difficult to obtain all possible quotes for a specific job and hence the full range of probabilities for project costs would not be known. In such a case there is an added degree of uncertainty (which might be hard to quantify) that the bidding contractor must factor in to his contingency setting. It could be something as small as an additional 5%, however in some cases it might be much larger in which case the freedom in setting the contingency solely according to risk would be somewhat limited. Obtaining the quotes in Step 1 is thus a key component of this method. 2.2 Recommended Contingency by Estimation Stage The method is adopted by the United States Department of Transportation and recommended for the Waste Management Industry in the United States. Estimate accuracy In the early stages of project design, the degree of uncertainty in the cost of a project can be very large due to many reasons, such as unforeseen construction costs and the lack of detailed project data available. As more information is available and less work is required until project completion the degree of accuracy in the final cost estimate becomes much clearer. For this reason the need for a large contingency is lower at the later stages of the project.

60% 40%
Estimate Accuracy

20% 0%
ry . ai le d t of m Bu d D et lim

-20% -40% -60%

O

rd er

Pr e

Time

(adapted from Carmichael, 2011) Contingency The Waste Management Industry (Parsons, 1999) deals with the problem of estimate inaccuracy by building a contingency into their total cost estimates. The recommendation is to initially use a high contingency and low cost estimate and gradually lower the contingency and increase the cost estimate as more information becomes known and the accuracy level improves. This situation is shown graphically in the chart below.
100 90 80 70 60 50 40 30 20 10 0 Order of mag. Preliminary Budget Detailed Final Cost estimate Contingency Total estimate

Cost

(Parsons, 1999) If the above ideal situation occurs then the total estimate is unchanged for the life of the project. A simple linear function for this recommendation might be: Contingency (at time t) = 40% x Percentage of work remaining (at time t) A cost guide such as the following table is also provided to the industry to calculate the contingency.

(Parsons, 1999) 7

Fi na l

ag

in a

ge

Where Design Complete is the amount of project work completed. A similar table is provided by the Federal Transport Agency (US Department of Transportation, 2003) for help with contingency setting in the transport industry. Work Element Breakdown Further breakdown into work elements is undertaken and similar contingency tables are provided for individual project elements. Rationality The contingency is set primarily to cover the inaccuracy in the estimate. In this regard this method works well. It is using the fact that at the start of a project we cannot hope to know all the costs with absolute certainty. Thus it is initially set high. As we observe changes and get a clearer picture of costs the contingency is lowered. To put, for example a 5% contingency at the start of a project is not best practice as it implies a certainty of estimation to within 5%, which is almost impossible. In such a case the owner would have factored in the uncertainty into a higher order of magnitude cost estimate. We like the idea that it treats the contingency as a dynamic that needs to be constantly monitored and adjusted (as an aside, this is similar to the observational method in geotechnical engineering which modifies the project as ground conditions are observed during construction, rather than trying to estimate all parameters prior to construction). Risk management In terms of risk management this contingency recommendation is less than ideal. It appears that the contingency will always be lowered as time progresses and this amount will just be added to the cost estimate or taken as profit by the owner. Perhaps, for the Waste Management industry in the US this method works well since the types of projects are all of similar natures with few black swan scenarios. However, it is a potential downside that there is no detailed risk analysis and it is merely a case of following the recommended percentage rate. There is no documentation on what the risk might be or any systematic attempt to minimise it. In this regard this method would not follow the ISO31000 risk management standard. Those owners who are more risk averse would have to factor additional risk into their cost estimate. There appears to be no recommendation for taking into account different types of risk for different projects. Simplicity A benefit of this method is the ease with which it can be applied. No statistical analysis is required. For those owners who are scared of dealing with such matters a simple recommendation like this is an attractive option. However, if a similar quantum was not adopted by all players in the tendering process it would be quite easy to undercut someone who is 8

following this recommendation since 40-50% contingency at the order of magnitude stage is a very large amount. Savvy estimators might easily fancy their chances of estimating to a much greater degree of accuracy than this.

2.3 Cost contingency analysis using spreadsheets (probabilistic approach) The following approach is used to quantitatively calculate the cost contingency based on historical databases. The method is similar in terms of the underlying theory to Model 1, however, it makes use of spreadsheets and aggregates contingency from unit costs to the entire project. The approach is based on the method of Nassar, 2002 and comprises five steps: Step 1: Determine three estimates for each major cost item Based on historical data of one particular cost item, the maximum value (M), the minimum value (N) and the most likely value (P) are determined for each cost item using Excel functions MIN, MAX and a combination of FREQUENCY and MODE. Note the similarities with Model 1 in this step. The expected value for any cost item is simply the average value assuming a Beta distribution. Expected value for each cost item= (M + 4P + N)/6 Variance of any cost item= [(M N) / 6]2

Step 2: Estimate the expected total cost of the overall project The expected total cost of the overall project is the sum of the expected cost for all cost items. Similarly, the variance of the overall project = variance of cost item 1 + variance of cost item 2 + + variance of cost item n.

Frequency distribution curve (Nassar, 2002)

The frequency distribution of the total cost will follow the normal distribution or a bell-shaped curve (due to the Central Limit Theorem in statistics). Step 3: Calculate probability of achieving the expected cost L Probability of exceeding a certain cost L. Probability Z value or the value of standard normal distribution is equal to (L expected total cost) / (Variance of the total cost) 0.5. After the Z value is calculated, Excel provides a function called NORMSDIST to calculate the probability of exceeding a certain cost item. P % = 1NORMSDIST (Z_value). Percentage changes in the upper and lower limits of each of the cost items can be entered and their effect on the shape of the curve studied. The calculation is repeated for other values of L. The contingency curves plotted for each considered cost indicates the amount of risk involved. In steep curves, or low standard deviation, the amount of contingency can result in significantly lower probability of exceeding the cost.

(Nassar, 2002) For example curve B, a steep curve, has less probability of exceeding the cost L2 than curve C, which is a flatter curve and is the result of a higher standard deviation. In the case of curve C, a larger contingency is to be allocated to offset the risk. Step 4: Sensitivity analysis of the results Knowing the amount of risk that can be tolerated, an acceptable probability can then be set. Consequently, the corresponding amount can be read from the curve. The difference between this amount and the prepared budget estimate is the contingency. We can then go back to Step

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1 to reset maximum and minimum values of each cost item and determine the new amount of contingency. Step 5: Apply the contingency to the whole life time of the project The analysis can be carried out throughout the life of the project and the expected expenditures. This can provide an idea of how the risk is spread through the project and how the contingency might change as the project progresses (which shows some similarities to the rationalities behind Model 2).

Rationality The estimation of cost contingency using spreadsheet with built in formulation in Excel provides a rational method and promotes the expert opinion. The spreadsheet routine enhances an understanding of how the analysis works. It provides a simple algorithm to obtain a visualisation of how sensitive the contingency is towards the different cost elements of the project, each of which has its own expected value and variance. Risk management The risk is managed quite well in this case because a number of costing scenarios can be looked at and the risk to cost overruns measured in a fully quantitative way. In a similar way to Model 1, a probability value p can be assigned and steps can be taken to ensure that the contingency is large enough so that the probability of cost overrun is less than p. 3 Conclusion

We have shown a way of setting the contingency based on experience or opinion, as with the industry recommendations given for Model 2. Similarly we have shown two examples of the analytical and objective approach, as illustrated by Model 1 and Model 3. The experience based approach can be a useful and risk averse approach provided the person or organisation recommending the contingency quantum has very good knowledge and experience of the types of projects in question. Such a person or organisation will often provide a solid reasoning for their use of a particular quantum. However, in many cases their justification may be nothing more than a gut feel that has worked well up until now. The problem is that it is very hard to document the risk relating to such a project and it will often be highly company specific and not following a global standard such as ISO31000.

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For projects that may be less standard in design or location and those that require more customized attention in design and costing, the use of analytical techniques based on historical data may provide a much better and more transparent approach to risk management. In this way the methods can be more closely aligned to the principles of ISO31000. The analytical approach does require more resources since its application needs to be embedded in the procedures of the organization. Historical data must be stored on a database and made available to the managers and estimators that use the information. The analytical approach is also much more objective. However, it can pose a problem if the mathematics gets so complicated that the owner finds it hard to understand and hence be relied upon. The ISO 31000 Risk Management Framework ISO 31000 seeks to provide a universally recognised paradigm for practitioners and companies employing risk management processes to replace the myriad of existing standards, methodologies and paradigms that differed between industries, subject matters and regions. (ISO_31000, Wikipedia) The ISO 31000 approach for risk management aims to have risk managed at all levels of an organization with management being aware of sources of risk and control measures. It aims to do away with company specific and non-transparent strategies towards risk management by setting a global framework. 4 References

Baccarini D (2005). Estimating Project Cost Contingency - Beyond the 10% syndrome. Australian Institute of Project Management National Conference, 09/11/2005. Victoria: Australian Institute of Project Management. Carmichael D (2011). Engineering Economics and Financial Management. UNSW Course Notes. Parsons E L (1999). Waste Management Project Contingency Analysis. Centre for Acquisition and Business Excellence, US department of Energy ISO 31000 (2009). International Organization for Standardization Nassar K (2002). Cost Contingency Analysis for Construction Projects Using Spreadsheets. Cost Engineering, vol. 44, no. 9; pp. 26-31. PMI [Project Management Institute] (2004) A guide to the project management body of knowledge, 3rd Edition, Newtown Square: PMI. Singh A, Shiramizu S & Gautam K (2007). Bid Risk and Contingency Analysis. AACE International on Cost Engineering, vol. 49, no. 12, pp. 20-27.

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US Department of Transportation (2003) Table A1 - Recommended Contingency by Estimating Stage. Federal Transit Administration

Further Reading

Ahmad I (1992). Contingency allocation: a computer-aided approach. AACE Transactions, 28 June - 1 July, Orlando, F.4.1-7. Aibinu A A and Jagboro G O (2002). The effects of construction delays on project delivery in Nigerian construction industry. International Journal of Project Management, 20, 593599. Chen D and Hartman F T (2000). A neural network approach to risk assessment and contingency allocation. AACE Transactions, 24-27th June, Risk.07.01-6 Chua D K H, Kog Y C, Loh P K & Jaselskis E J (1997). Model for construction budget performance neutral network approach. Journal of Construction Engineering and Management, 214-222 CIRIA (Construction Industry Research and Information Association) (1996). Control of risk: a guide to the systematic management of risk from construction. London: CIRIA Clark D E (2001). Monte Carlo Analysis: ten years of experience. Cost Engineering, 43(6), 40-45. Curran M W (1989). Range Estimating. Cost Engineering, 31(3), 18-26. Dey P, Tabucanon M T & Ogunlana S O (1994). Planning for project control through risk analysis; a petroleum pipelaying project. International Journal of Project Management, 12(1), 23-33. Diekmann J E & Featherman W D (1998). Assessing cost uncertainty: lessons from environmental restoration projects. Journal of Construction Engineering and Management. 124(6), 445-451 Diekmann J E (1983). Probabilistic estimating: mathematics and applications. Journal of Construction Engineering and Management, 109(3), 297-308. Fenton R E Cox R A & Carlock P (1999). Incorporating contingency risk into project cost and benefits baselines; a way to enhance realism. INCOSE Conference Gunaydin H M & Dogan S Z (2004). A neural network approach for early cost estimation of structural systems of buildings. International Journal of Project Management, 22, 595602 Kim G H, An S N & Kang K I (2004). Comparison of construction cost estimating models based on regression analysis, neutral networks, and case-based reasoning. Building and Environment, 39, 1235-1242 Hackney J W (1985). Applied contingency analysis. AACE Transactions, B.1-4 Hartman F T (2000). Dont park your brain outside. Project Management Institute. Upper Darby P A Leach L P (2003). Schedule and cost buffer sizing: how to account for the bias between project performance and your model. Project Management Journal, 34(2), 34-47.

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Lorance R B & Wendling R V (1999). Basic techniques for analysing and presenting cost risk analysis. AACE Transactions, Risk.01.1-7 Mak S & Picken D (2000). Using risk analysis to determine construction project contingencies. Journal of Construction Engineering and Management, 126(2), 130-136 Mak S, Wong J & Picken D (1998). The effect on contingency allowances of using risk analysis in capital cost estimating: a Hong Kong case study. Construction Management and Economics, 16, 615-619. Merrow E W and Tarossi M E (1990). Assessing project cost and schedule risk. AACE Transactions, H.6.2-7 Moselhi O (1997). Risk assessment and contingency estimating. AACE Transactions Dallas, 13-16th July, D&RM/A.06.1-6 Oberlender G D & Trost S M (2001). Predicting accuracy of early cost estimates based on estimate quality. Journal of Construction Engineering and Management. 127(3), 173-182 Patrascu A (1988). Construction cost engineering handbook. New York: M. Dekker. PMI [Project Management Institute] (2004). A guide to the project management body of knowledge. 3rd Edition, Newtown Square: PMI. Sonmez R (2004). Conceptual cost estimation of building projects with regression analysis and neural networks. Canadian Journal of Civil Engineering, 31, 677-683. Thompson P A and Perry J G (1992). Engineering construction risks. London: Thomas Telford. Williams T P (2003). Predicting final cost for competitively bid construction projects using regression models. International Journal of Project Management, 21, 593-599 Yeo K T (1990). Risks, classification of estimates, and contingency management. Journal of Management in Engineering. 6(4), 458-470.

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