Construction – You Need Risk-Based Cost Estimating

Construction – You Need Risk-Based Cost Estimating Contracting Practices Session, June 8, 2015 John Reillyjohn@johnreilly.us Philip Sandersander@riskcon.at Alfred Moergelialfred.moergeli@moergeli.com 1101 Worchester RoadFramingham Massachusetts10701 USAwww. johnreilly.us moergeli consulting, llc (mcllc) 11921 Ferdinand Street, P.O. Box 2852 St. Francisville, 70775 LA www.moergeli.com Technikerstr. 32 6020 Innsbruck Austria www.riskcon.at

Presentation Will Cover Dealing with uncertainty Components of cost estimates Value at Risk (Level) Types of cost estimates • Deterministic • Bandwith, square-root approach • Risk based (probabilistic) Comparison of cost methods Benefits, risk-based approach • Better, more complete information • Explicit definition of risks Summary • Contractor’s advantage / Strategies • Owner’s advantage / Strategies Example, RIAAT process Questions

Dealing With Uncertainty Every cost estimate is uncertain. • Underestimating construction costs can lead to problems for owners in the planning and design phase • Underestimating construction costs – e.g. by contractors in the bidding phase - can lead to loss of profit, disputes, claims, and litigation A better understanding of potential costs helps: • Owners to budget and get authorization for projects - leading to a reduced chance of “cost overruns” • Contractors to determine base cost and margin plus: • Strategies to secure the work - in low-bid environment • Strategies to maximize profit, avoid loss and recover costs of changes Consider low probability / high impact “black swan” events

Risk and Uncertainty Risk is the combination of the probability of an event and its consequences (if positive = opportunity)

Components of Cost Estimates Components of cost which need to be sufficiently addressed in an estimate include: • Base cost – the cost that will result if “all goes according to plan” • Risk costs

Value at Risk (VaR) Value at Risk (VaR)= A certain amount, within a distribution,that will not be exceeded according to the corresponding probability. VaR 70 here means that a $5M budget would not be exceeded in 70%of all simulated scenarios(there remains a 30% probabilitythat the $5M budget will be exceeded)

Cost Estimates Must Also Address Escalation – costs resulting from inflation (with variability) - driven by economic factors. Effect of competition and market factors Other uncertain costs – e.g. from events external to the project team’s control, including: • “Unanticipated” events • Management changes / lack of continuity • Politically related changes, and • “Black Swan” events Transition to Alfred

Types of Cost Estimates Deterministic:Aggregated unit quantities multiplied by unit prices.Usually with some degree of conservatism built in.Plus an added reserve or contingency Bandwidth:Range approach with minimum, most likely, and maximum cost.The total cost is obtained by simply adding these parameters for all line items. Square Root:Delivers one single figure which is the sum of all base costs plus the square root of the sum of the squares of the risk contingencies. Probabilistic:Range approach which characterizes cost informationwith probability distributions

Cost Estimating Methods in Comparison:Tunnel Excavation Category (Base Cost only) 1. Deterministic Approach 2. Bandwidth Approach 223.36 USD Most likely quantity x most likely price 306.95 USD 306.95 USD 453.86 USD 3. Square Root Approach 4. Probabilistic Approach = 375.67 USD

All Four Cost Estimating Methods in Comparison: Visualized Probabilistic Approach Square Root Approach Deterministic Approach Bandwidth Approach C A B D Ml. Max. Min. VaR5 VaR50 VaR95 223 286 376 321 307 362 454 B D C D D B B 307 A

Pro’s & Con’s of the Methods

Tornado Diagram - Risks/Opportunities Transition to John

Benefits of Risk-based Cost Estimating Risk-based methods give more detailed and specific information of risk and potential cost impacts – with the following possibilities in the planning & bidding phases: • Allows strategies to protect public funds and interests • Allows the owner to develop better and more equitable contract documents and provisions for risk • Allows a better understanding, by owner and contractor, who will “own” risks – leads to contractual clarity • Allows the contractor to assess risk in bidding vs. the competition – to better evaluate chances of securing the work at a specific price – and to make an informed “go-no go” bid determination • Allows the contractor to determine a risk management strategy for construction in order to best obtain a profit

Concerns – “Low-Bid” Environment A concern has been expressed that if an improved risk identification process is used the contractor’s estimate will include higher potential costs, which will mean that their bid will be higher and they are likely not to be successful This is a valid concern – however, we would argue that more detailed and realistic information about potential risk events is an advantage if: • Appropriate bidding and construction management strategies are used by the owner and contractor and • These strategies are compatible and consistent

Risk & Risk Registers If the owner includes a sufficiently comprehensive risk register in the bid documents, and the potential contractor prepares their own detailed risk register, they will better understand the risk environment and can also judge if the owner’s risk register is accurate. There are several possibilities in this regard: • If the potential contractor thinks that the owner has estimated the consequence or probability of some risks too high, they may see a bidding advantage compared to other bidders. • If the owner has estimated the consequence or probability of some risks too low, it may mean that the potential contractor, using a reasonable assessment of risk, may submit too high a bid and may not win the project over other bidders who have a lower appreciation of risk.

Summary - Owner’s Strategies Planning & Design: • A risk-based approach gives a better understanding during design of potential costs and mitigation strategies which help manage the design to meet available budget • Risk definition and characterization allows better contract documents with a more equitable sharing of risks • Sharing of risk registers with contractors can “level the playing field” – more realistic bids with less “contingency” • Owner’s definition of specific risks can clarify who owns the risk as reflected in the owner’s risk management plan • Owner’s definition of specific risks can help avoid “unanticipated” events that can lead to disputes, claims and litigation.

Summary – Contractor’s Strategies Risk-based cost estimating for construction allows: A better understanding of potential cost to inform the contractor’s bidding strategy re potential profitability • Whether to bid • What level to bid • What potential profit/loss may be possible A better understanding of potential risks will allow: • Understanding who “owns” each risk • More specific risk management plans in construction • More specific risk mitigation and claims avoidance procedures

How can you do this? A concern is that the risk-based approach is complex • Requires experienced practitioners • Requires sophisticated software • Some systems are proprietary • Has a significant learning curve But, benefits outweigh the investment • For owners and contractors Example of current software (RIAAT) follows Transition to Philip

RIAAT Approach, Software Video: https://www.youtube.com/watch?v=Y_dHxxRZFBAWebsite: http://riaat.riskcon.at

Where is your project on this curve?How do you know?

Thank you for your attention……Questions? Philip Sandersander@riskcon.at Alfred Moergelialfred.moergeli@moergeli.com John Reillyjohn@johnreilly.us 1101 Worchester RoadFramingham Massachusetts10701 USAwww. johnreilly.us moergeli consulting, llc (mcllc) 11921 Ferdinand Street, P.O. Box 2852 St. Francisville, 70775 LA www.moergeli.com Technikerstr. 32 6020 Innsbruck Austria www.riskcon.at

Construction – You Need Risk-Based Cost Estimating