For large capital projects in the utility and heavy industrial sectors, cost overruns and schedule delays seem to be the rule, rather than the exception. In addition to the cost itself, overruns can result in loss of faith in management by boards, investors and external stakeholders.
Owners often fail to prioritize vetting and understanding the nature of the upfront cost estimates. The more able the project owner is to discuss estimating, the better able they are to assist the contractor in getting on the same page with the owner, thus decreasing the chance of future claims for costs, disputes and litigation.
To address common deficiencies in estimates, owners should consider the following seven recommendations in preparing for and executing large capital projects: address organizational depth, understand the risk shifted in the contract, develop a plan, understand the maturity level of the estimate, establish a rigorous process and ensure proper stakeholder communication.
Address Organizational Depth
Many owners lack the experience and resources to properly understand and characterize the cost estimates they receive from contractors. They also lack the expertise to properly vet the estimates they receive and are therefore wholly dependent on contractors for this function. This lack of experience can create unrealistic expectations or optimistic bias toward underestimating or understating the risk and causes for overruns.
Owners should strongly consider developing or obtaining their own independent cost estimating capability. This is not to replace or duplicate the contractor’s capability, but to enable the owner to intelligently vet the estimating submissions it receives in the planning and execution phases. Such services can be provided by external consultants, developed in house or both.
Understand the Risk Actually Shifted in the Contract
Many owners seek to shift commercial risks toward full-wrap EPC contracts, fixed or target price, though the owners tend to focus more on the terms and conditions and less on the price. Too often, owners are lulled into believing they are protected from the risk of cost increases, through fixed price or target price contracts or performance incentives/penalties, without fully understanding the pricing in those agreements. Moreover, owners using EPC contractors often strip their own organizations of the capability needed to properly vet and understand costs.
Project owners need to ensure the contract model they choose matches their needs and organizational capability, and proceed with a good methodology to determine the project’s estimated costs and the contract price.
Develop a Plan for the Estimate
A detailed, written estimating plan helps foster a good process. It establishes the responsibilities of the estimating team, estimate development milestones and deliverables, the estimating methodology, and a plan for progressive estimating reviews and validations.
For example, on a project with an open-book EPC contract, cost-plus and with a target price, the owner should have (and thus exercise) the ability to vet the contractor’s estimate more thoroughly and transparently. Concerns about the contractor’s proprietary information can be alleviated through confidentiality agreements, or by reviewing the estimate in the contractor’s home office or on its computer network.
While a full line-item, bottom-up review may be prohibitive due to time constraints, select line-item, bottom-up reviews can be conducted on key cost drivers in the estimate to verify how the costs are built up. It is also critical in such reviews with the contractor that the actual estimators are present, rather than a “talking head” or project manager who, most likely, would not possess intimate knowledge of the details. In this way, the meeting can productively address the owner’s questions and concerns.
Understand the Estimate’s Maturity Level
Estimates are only as good as the maturity of the scope and project definition on which they are based. Using a common standard for characterizing the project’s maturity is critical for owners to understand how likely changes to the scope and maturation of the project’s underpinnings can impact cost over time.
The Association for the Advancement of Cost Engineering (AACE) provides guidance on the estimating and risk management process that establishes a progression of estimate based on the level of project maturity over time. These iterations are commonly expressed in the following AACE classification (from AACE Recommended Practice #18R-97).
In the above, each estimate “class” is determined by the maturity of design or definition deliverables, with estimate accuracy expressed as a high and low range based on different confidence levels.
Understand that Estimates Will Likely Change – But Think in Advance, “How Wrong Will We Be?”
According to an old adage in the construction industry, the one thing you can predict about a cost estimate is that it will prove to be wrong. It is an “estimate,” after all. It is important to remember that, even with a good process, there is still variability in the expected accuracy range. This knowledge should be part of the process to establish contingency.
Establish a Rigorous Process for Accepting the Estimate
Owners benefit from a detailed process in which different iterations of the estimate are prepared and vetted as the maturity of the project increases. Owners should consider employing a phased-gate process, which ties project funding to the preparation of specific deliverables, including increasingly detailed iterations of the project estimate as the engineering/design matures.
If the owner is prepared to assemble a qualified estimate review team and implement an effective process, the owner will gain credibility with the contractor and the project’s chances of coming in on time and budget will improve.
A progressive review process provides the owner with the opportunity to review each iteration of the estimate as the definition deliverables mature, on a line-item, bottom-up basis. Such reviews may cover the following topics:
- Scope, constructability, completeness
- Estimate quality, including basis of estimate, methodology, rates and productivity factors, materials, resources, project management/overhead/indirects
- Key deliverables and cost drivers
- Assumptions and exclusions
- Integration with schedule, activities, resources, and cash flow
- Contingency, with integrated cost and schedule risk analysis
Properly Characterize and Communicate the Result to All Stakeholders
There is another rule in project cost estimating that, regardless of the estimate itself, projects will always “cost what they cost.” Using the above methods should reduce or eliminate the surprise from cost increases. However, even where a rigorous process is in place, management is often under pressure to give an overly optimistic view of the potential risks and outcomes. Often the board’s and other stakeholders’ approvals rest on such optimism.
Owners who employ the process described in this post benefit from informing all stakeholders of not just the number, but the process used to get there. Having such a process and sharing its potential accuracy should reassure the project’s approvers that a prudent process was used for developing the estimate.
Regardless of the process used, it is also important to note these are merely guidelines and any estimate requires the application of expert judgment and experience that can vary from industry to industry. These are not targets, specifications or standards. They are important factors to keep in mind to help establish proper expectations of the estimate deliverable.
Originally published: February 2016. Fully updated: December 2022.
