Summary of approaches to control cost escalation pre- and post- contract.

1. February 2015
Dr Rupert Booth, FIET FRICS FCMA PMP CEng
Chief Economist
COST ESCLATION ACROSS
THE LIFECYCLE

2. Agenda
Pre-Tender
Government intervention
Corporate actions
Forecasting input prices
Optimism bias
Contingencies
Post-tender
Input price escalation
Pass-through
Selecting indices
Designing indices
Hedging
Cost over-runs
Baselines & stage-gates
Program control
Regional factors

3. 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

4. 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

5. 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

6. 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

7. 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

8. Introduction to Indices
Sources & Methods:
Construction Price Indices
OECD
Recent/ongoing
consultations:
BIS Construction Price
and Cost Indices (2014)
BCIS Price Adjustment
Formulae Indices for Civil
Engineering consultation
(ongoing)

9. 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

10. 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

11. Claims Analysis (UAE)
Source: Construction claims in United Arab Emirates: Types, causes, and frequency. Essam K. Zaneldin

12. Views from the field: importance of causes of delay (Saudi)
Source: Causes of delay in large construction projects, Sadi A. Assaf , Sadiq Al-Hejji

13. 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