58R 10
58R 10
58R 10
Management
Framework:
Total Cost
Management is a
systematic approach
to managing cost
throughout the life
cycle of any enterprise, program, facility, project, product or service.
AACEs agship publication, the TCM Framework: An Integrated
Approach to Portfolio, Program and Project Management, is a
structured, annotated process map that for the rst time explains each
practice area of the cost engineering eld in the context of its
relationship to the other practice areas including allied professions.
Visual TCM
Framework:
Visual TCM graphically
demonstrates the
integration of the
strategic asset
management and
project controls
process maps of the TCM Framework. The Visual TCM application has
been designed to provide a dynamic view of the TCM processes, from
the overall strategy process maps to the mid-level processes and
detailed activities. The processes are hyperlinked, giving the user the
ability to move to and from related process maps and reference
Recommended Practice
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Center:
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eld of total cost
Conferences:
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Annual Meeting brings
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forum focused on
learning, sharing, and
networking. Over 100
hours of technical presentations and an industry tradeshow that will
challenge you to better manage, plan, schedule, and implement
technology for more eective and ecient business practices.
The International TCM Conference is a similar event that is held outside
of North America complete with technical presentations, seminars
and exhibits.
Recommended Practice
Discussion
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Participate anytime at your convenience and receive automatic e-mail
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Included with your membership, AACE oers a comprehensive
mentoring program for individuals interested in sharing knowledge with
others or advancing their own careers to the next level.
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Periodicals
Members receive a
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It is published as both a print version and an online version.
Our bi-monthly digital publication, Source, focuses on AACE activities
and items of interest to the total cost management community, with
special features for our members.
Salary and
Demographic
Survey:
Conducted annually,
salary survey is a great
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employers that want
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understanding of the competitive marketplace for talent and for
employees interested in knowing how their compensation compares
with their peers in the profession.
Recommended Practice
Recommended Practice
Acknowledgments:
John K. Hollmann, PE CCE CEP (Author)
Mohamed H. Abdel-Mageed, CCE
Michael S. Anderson
Luis Alejandro Camero Arleo, CCE
Rene Berghuijs
Rani Chacko, CCE
Dr. Ovidiu Cretu, PE
Dr. Utpal Dutta, PE
Fabio Leonardo da Silva Fernandes
Carlton W. Karlik, PE CEP
Rod Knoll
Pankaja P. Kumar, CCE
Rose Mary Lewis, PE
Michael Shawn Longfellow
Bruce A. Martin
Joseph L. N. Martin
Copyright 2011 AACE International, Inc.
Outline
The following is an outline of this RPs content:
Background
General Principles and Methods
General Principles
Basic Escalation Cost Estimate Relationship Using Indices
Price and other Econometric Indices
Pricing Versus Costs
Price Index Forecasts
Addressing Costs Over Time (Cash Flow)
Addressing Cost Account Detail
Matching Indices to Cost Accounts (Weighting Indices)
Adjusted or Composite Indices
Using Price Indices to Normalize Historical Project Costs
Escalation on Contingency
Escalation Uncertainty and Probabilistic Methods
Black Swans
Lag and Sticky Prices
Accuracy
The Soft Side: Customer and Business Behavior, Politics, Psychology
Summary
References
Contributors
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Background
The current full definition of escalation is provided in AACEs recommended practice 10S-90, Cost
[2]
Engineering Terminology , but in summary, escalation is a provision in costs or prices for changes in
technical, economic and market conditions over time.
As the volatility and uncertainty of the economy and the potential for escalation increases, it demands
greater attention from decision makers and cost engineers; i.e., escalation is a major risk. It can have a
tremendous impact on estimates, bids, profitability, and so on. In volatile times, it may be the largest cost
account in an estimate; in stable times, it may seem insignificant, but could change suddenly. In
contracting and procurement, it is a common source of claims and disputes if not addressed explicitly.
While in some usages, the term escalation is associated with increase, escalation estimating addresses
the impact of change whether that change is an increase or decrease (i.e., in risk terms, it can be either a
threat or an opportunity).
Escalation as defined here excludes contingency and currency exchange impacts, but includes inflation.
These are all risks, but the principal estimating practices differentiate these. Some of the drivers of
escalation, in addition to inflation (inflation is generally defined as the overarching effect on prices of
excess money supply), include changes in market conditions, technology, regulation, general industry or
regional-wide productivity and other economic factors that generally affect an economic sector or
segment. Technology and regulation changes covered by escalation are those that are general in nature
such as evolutionary changes in design tools or regulations not immediately impacting the project. Major
technology changes or regulations that directly or immediately impact the project would be covered in
contingency or reserves. Escalation typically varies between different economic sectors or segments,
different regions, and so on. Further, each good and service may be part of a different micro-economy
facing its own escalation situation.
Escalation does not include changes in cost or price resulting from potential changes in company or
project specific strategies, actions, risk events or other changes. Those pricing risks should be addressed
by contingency estimates. Segregating escalation from exchange rate impacts is more challenging
because both are driven by economic factors. However, segregation is recommended so that financial
and other mitigation strategies can be considered (e.g., hedging of currencies for exchange rate and
hedging of commodities for escalation). While this is a general guide, each company must clearly define
what is in escalation versus allowance, contingency and currency exchange in its estimating practice.
This should be documented in the basis of estimate.
Escalation estimating is typically used to either bring past costs or prices to a current basis (i.e., an
element of normalization), or to forecast what costs or prices will be in the future. While past escalation
can be measured and is therefore less uncertain than the future, the measurements are difficult to make
and are rarely of high accuracy. .
As an uncertain cost, escalation is always a risk to consider in the risk management process. However,
escalation is usually quantified using different methods than used for other risks (i.e., contingency). Being
driven by conditions in the economy, which are external to the project, it is less amenable to quantification
techniques that use project system empirical data (e.g., parametric contingency estimating), or project
team input (e.g., range estimating, expected value, etc.). Given its economic nature, it is recommended
that those with the most economics expertise (e.g., economists) be included in the process of developing
escalation estimating methods and estimates.
Like other risks, escalation is amenable to mitigation and control. This RP does not cover the treatment
and control of escalation (i.e., how it is addressed through contracting, bidding, schedule acceleration,
hedging, etc.) or control. However, while this RP deals only with quantification, the unique characteristics
of escalations drivers and impacts mean that it should be controlled and otherwise managed as a unique
[2]
cost control account (i.e., by AACEs definitions, contingency specifically excludes escalation ). As such,
it is necessary to ensure that all stakeholders agree as to what escalation, contingency and currency
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exchange are, and estimate and manage them distinctly and appropriately. One reason for this careful
attention is that in times of economic volatility, escalation tends to be used as an excuse for cost
increases that are really caused by ineffective project practices.
RECOMMENDED PRACTICE
General Principles and Methods
General Principles
There is no single best way to quantify risks, including escalation. Each method has advantages and
disadvantages and its advocates. However, there is general agreement that any recommended practice
or method for estimating or forecasting the cost of uncertainty should address the principles identified in
[3]
the AACE RP 40R-08, Contingency Estimating: General Principles . The methods discussed in this RP
are consistent with those principles.
For escalation, the principles in RP 40R-08 are clarified or expanded as follows in recognition of the
differences between contingency and escalation estimating:
The escalation estimating methods described below address the above principles.
Estimating escalation at a root level involves measuring or forecasting the performance of macro and
micro-economies. Typically, cost engineering skills and knowledge do not include econometric practices.
As such, practices that support escalation estimating such as macroeconomic modeling are not included
in this RP. This is also in keeping with the principle of leveraging economists knowledge. As an example
of a violation of this principle, it is not uncommon to find estimators taking the shortcut of simply
extrapolating past price trends without the benefit of any economic insight. This is not an effective
practice and is not recommended.
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$Escalation =
$Base estimate [(Index for target date)/(Index for est. basis date) 1]
For example, for an item costing $100 in the base year (index = 1.00) and a forecast index of 1.15 for the
year of payment, the escalation cost is as follows:
=
The target date can be in the past or future depending upon the purpose of the estimate. The time period
that you have indices for can vary; however, reliable cost and index data are rarely available for periods
more frequent than monthly. Quarterly or annual periods are more commonly used depending on the time
duration, availability of cash flow information and so on.
When dealing with economics evaluation, the terms nominal versus real cost may arise in discussions.
These terms can be illustrated by the following relationship. At face value, this indicates that real costs
are more or less synonymous with the base estimate and nominal cost with escalated costs. However,
in communications with business and economists, the use of terms must be clarified.
Real Cost
While the basic equations above are simple, the remainder of this RP discusses many issues that a fully
developed methodology or system must address in applying this equation in an effective way.
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May 25, 2011
not a safe assumption in a changing world (i.e., there is always some change in market conditions,
technology, regulation, general productivity and other economic trends relevant to the project).
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May 25, 2011
Some companies tend to rely more on the forecasts of their procurement and contracting specialists who
have some level of insight as to the specific market of their company. Such input should always be
obtained and considered, if available. However, there are risks to total reliance on procurement
department forecasts. One is that they tend to under-appreciate relevant macroeconomic trends outside
of their specific market. They also tend to lack long-term insight. Another is the tendency to be swayed by
bias in supplier information. That said, for short-term specific market procurement decisions, the
specialists information tends to be the most reliable.
Estimators must recognize that most economists are not experts in specific capital project costs or submarkets. Also, third-party sources do not have tailor-made indices for your cost items (particularly
concerning labor services and specialized equipment as previously discussed). Many companies are
frustrated because economists do not have canned solutions for them. Estimators and economists must
work together to find an adjusted combination of indices that can serve as proxies for elements of project
or product costs. It is then the estimators responsibility to apply the indices.
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(index=1.00), and the spending will be in year 3, and prices increase 5 percent per year, the price index
for year 3 is 1.05 x 1.05 x 1.05 = 1.16 (i.e., escalation for that item is 16%).
This method requires specific knowledge of the spending pattern. It is amenable for any Class base
estimate, but particularly Class 3 or better estimates for which cost and schedule information is fairly
detailed.
At the highest level, material, office and field labor cost accounts typically have different price trends and
need to be segregated. Further breakdowns of material are usually warranted; e.g., equipment (generally
by major types), steel, concrete, piping, etc. For process plants, this level of detail roughly corresponds to
[6]
the AACE RP on project code of accounts or the level 2 accounts of the process equipment divisions of
[7]
the CSI Masterformat . For buildings and infrastructure work, this corresponds roughly to the
Masterformat division accounts excluding the process equipment subgroup. Where item cost is sensitive
to metallurgy or other raw material composition, segregating items by major commodity type is typically
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May 25, 2011
advisable (e.g., carbon vs stainless piping). These cost accounts tend to align well with commodity price
indices (e.g., the BLS has many steel price indices). Generally, adding accounts beyond a summary level
has a diminishing return in estimating accuracy. If a company has a robust estimating process, they will
be able to segregate accounts such as steel from concrete even for a Class 5 estimate (i.e., based on
typical factors, etc.).
For capital projects, breakdowns by work breakdown (e.g., area/unit/system, CSI Uniformat, etc.) can be
used. However, because the cost broken down this way will not align as well with price indices, this will
require more index weighting as described in the following section.
Capital project estimates tend to be largely unambiguous in their cost item content. For operating and
maintenance or product pricing, cost breakdowns may include more indirect or allocated cost items that
can be somewhat ambiguous in nature. The principles of this RP still apply to these items; however the
task is made more challenging by account content ambiguity.
% of Piping Account
40%
20%
40%
100%
Item Indices
1.25
1.20
1.15
Weighted Indices
0.5
0.24
0.46
1.20
The economists can provide forecasts for hundreds of wage, price and other indices (typically aligned
with government historical series). As the estimator builds up weighted indices or otherwise lines up cost
categories with indices, there is a risk of going overboard with detail that can greatly complicate the effort
without adding much accuracy. For example, there may be wage indices available for many different
crafts, but in general, the wages for all crafts follow the same relative trend over time (although absolute
costs will differ). Using one of these wage indices as a proxy measure for all crafts may be appropriate.
For weighted indices (e.g., fabricated pipe) some costs can be ignored in the weighting if they are less
than about 5 or 10 percent of the total costs and are not extremely volatile costs (e.g., primer paint on
pipe spools).
Typically, no more than about 15 to 30 wage, commodity, and other detailed price indices (used in
different combination of weighted indices) are necessary to effectively estimate process plant capital cost
escalation (depending on plant scope and regions covered). The range of indices for operating and
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May 25, 2011
maintenance or product costs may be wider depending on their scope. However, the following criteria will
help the user select and develop price indices for use in escalation estimating: Indices should:
Use or be based on industry or government sources that are generally recognized as reliable and are
readily available.
Be generally applicable to the subject industry in the primary regions where a company performs or
will perform capital projects, maintenance and operations or manufacturing.
Be specific to the major cost types found on all the companys projects or products.
Be easy to update, modify and maintain as an ongoing reference source.
A simple capital expenditure function or adjustment used successfully by one source based on calibration
[8]
with empirical data is to take the change in capital expenditure indices to an exponential power.
Experience has shown that an exponent of 0.5 tends to reflect the escalation cost impact for a market
where there is significant supply/demand imbalance (scaling down to 0 where there was no market
imbalance).
As a simple conceptual example, consider the prior unadjusted example given of an item costing $100 in
the base year (index = 1.00) and a forecast index of 1.15 for the year of payment. The unadjusted
escalation cost is as follows:
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May 25, 2011
If the capital expenditure spending level index was 1.00 in the base year, and 1.25 for the year of the
payment, and the exponent was 0.5, the adjusted escalation cost is as follows
=
=
=
=
0.5
1]
The exponent value was originally determined or calibrated using the same equation substituting known
historical cost information and base indices and solving for the exponent. If the base index was
inappropriate to start with, the resulting exponent may be inappropriate; one should examine historical
data from stable capex periods to determine if the base index is tracking actual cost trends.
Using an objective method that is easily updatable such as this is preferable to more anecdotal manual
adjustments because it addresses the following principles previously stated:
Escalation on Contingency
Contingency, by AACEs definition, is a cost expected to be spent. Therefore, it is logical to apply
escalation to contingency like any other estimated cost account. Because it is highly uncertain as to what
contingency will be spent on, the weighted index for contingency will typically reflect the weighting of cost
accounts for the project as a whole, possibly weighted more for accounts that tend to consume the most
contingency (i.e., labor). A forecast of contingency drawdown (i.e., the cash flow for contingency) will be
needed to estimate the escalation on it.
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May 25, 2011
As with contingency estimates, it is the estimators responsibility to quantify the uncertainty of the
escalation estimate, usually by providing a distribution or range (e.g., 80% confidence or P10/P90 range),
so that management can make effective investment and project decisions and fund the escalation
account as they see fit in accordance with their decision and risk management policies.
One method of obtaining a range is to apply Monte-Carlo simulation to the estimate model. In this
approach, the uncertain index, factors and timing inputs are substituted with distributions. The base cost
uncertainty is addressed by contingency which will be escalated. Schedule uncertainty (timing) has a
major impact on escalation. The model is then run to obtain an escalation cost outcome distribution from
which management can select a value based on their desired confidence of underrun (usually 50%).
Such a Monte-Carlo model can be quite complex for several reasons. One is that the timing of spending
needs to be quantified in a model (i.e., a logistic function) that is amenable to Monte-Carlo manipulation
and reflects the schedule uncertainty resulting from contingency evaluations (e.g., replace a key form
1
factor in the logistic function with a distribution) . Linking the method to a cost-loaded schedule risk tool to
deal with probabilistic timing is not simple because escalation cash flow must reflect the spending by the
supplier and not as incurred or expended by the party doing the estimate. Also, escalation cost items may
not be aligned with the schedule activities. Another complication is that a price index in one period will
have some dependence on the index in the prior period. For example, if costs skyrocket this year, they
are less likely to do so the following year (i.e., in the long run price trends do regress to the mean).
Given the complexity of Monte-Carlo modeling, another approach is to perform scenario analysis. In this
practice, the economists will provide a range of indices that reflect worst, most likely and best economic
scenarios (i.e., they may correspond to a P10/P50/P90 level of confidence or to various market
conditions). The estimator can add to these scenarios, the effect of early and late spending timing
scenarios to obtain a good idea of the overall escalation cost range.
If the above methods are not practical, simply quoting a range based on the team, estimators and
economists judgment or empirical experience (e.g., worst is +100% on escalation, best is -50%) will add
useful information for management consideration so long as the basis of this judgment is well
documented in the basis of estimate document.
The discussion above is only intended to introduce general potential approaches of dealing with
uncertainty. Specific practices will be covered in other AACE RPs
In terms of timing, one risk is that the project completion date will slip which can greatly increase base cost as well as escalation
cost; teams need to be clear on whether the cost risk of slip is included in contingency or escalation.
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May 25, 2011
business decision making. Scenario analysis is generally best for this purpose. Economists often do
foresee the possibility of market turns and will express this as say 10 percent probability of scenario X. If
ones method only considers the consensus view, this risk will be missed.
Accuracy
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May 25, 2011
Estimators are cautioned not to expect too much accuracy from cost indexes and escalation estimates.
The indices are approximations intended to represent the average trends for a large group of projects in a
broad region. The indices are generic and conceptual in nature and judgment must be applied in using
them in any given situation. In and of themselves, escalation estimates should be considered Class 5
[2]
estimates per AACEs classifications regardless of the class of the base estimate.
[8,9,10]
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May 25, 2011
Apply the indices appropriately to the cash flow for each cost account.
Decide how to handle escalation on contingency
Decide on how to apply a probabilistic approach
The method and key inputs used to estimate escalation should be documented in the basis of
estimate documentation.
It is expected that future RPs will cover industry, asset and cost type specific applications of the principles
and general process in this RP.
REFERENCES
1. AACE International, Recommended Practice 17R-97, Cost Estimate Classification System, AACE
International, Morgantown, WV, (latest revision).
2. AACE International, Recommended Practice 10S-90, Cost Engineering Terminology, AACE
International, Morgantown, WV, (latest revision).
3. AACE International, Recommended Practice 40R-08, Contingency Estimating: General Principles,
AACE International, Morgantown, WV, (latest revision).
4. Taleb, Nassim Nicholas, The Black Swan; The Impact of the Highly Improbable, Random House,
New York NY, 2007.
5. Cioffi, Denis F., A tool for managing projects: an analytic parameterization of the S-curve,
International Journal of Project Management, Volume 23, Issue 3, April 2005.
6. AACE International, Recommended Practice 21R-98, Project Code of Accounts: As Applied in
Engineering, Procurement, and Construction for the Process Industries, AACE International,
Morgantown, WV, (latest revision).
7. Construction Specifications Institute, Masterformat 2004 (or latest revision at www.csi.net)
8. Hollmann, John K, and Larry Dysert, Escalation Estimation: Working With Economics Consultants,
AACE International Transactions, 2007
9. Hollmann, John K, and Larry Dysert, Escalation Estimating: Lessons Learned in Addressing Market
Demand, AACE International Transactions, 2008
10. Stukhart, George, Estimating the Cost of Escalation - Chapter 9, The Engineers Cost Handbook
(Richard Westney, editor), Marcel Dekker, NY, 1997
11. Bunni, Nael G. The FIDIC Form of Contract: The Fourth Edition of The Red Book. MPG Books Ltd,
UK, 2004
CONTRIBUTORS
John K. Hollmann, PE CCE CEP (Author)
Mohamed H. Abdel-Mageed, CCE
Michael S. Anderson
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