COTM Cost Engineering

Risk Analysis for Cost Estimation

Miniwuyelet Ejigu, Msc
Miliyon Fikre , Msc

December, 2021
 Outline

Outline
 Introduction
 Inherent Risk in Construction
 Reserve Funds
 Benefits of Risk Analysis
 Cost Risk Assessment Methods
 Introduction
 Construction cost estimating is considered one of the most essential
tasks in the budget development of any project life cycle.
 "Risk! construction projects have an abundance of it, contractors cope
with it and owners pay for it“.
 In the context of project management, different definitions could be
found for 'risk;
• Risk and Uncertainty characterize situations where the actual
outcome for a particular event or activity is likely to deviate from
the estimate or forecast value“.
• Project Management Institute’s “Body of Knowledge” defines risk
as: "… an uncertain event or condition that, if it occurs, has a
positive or negative effect on a project objective“.
 Introduction
 Risk is a characteristic of a situation, action, or event in which a
number of outcomes are possible, the particular one that will occur is
uncertain, and at least one of the possibilities is undesirable.
 Uncertainty is a situation in which a number of possibilities exist and
which of them has occurred, or will occur, is unknown.
 All risks are uncertain but not all uncertainty is risky.

RISK AND UNCERTAINTY VENN DIAGRAM

 Introduction
 Schedule Planning and Development, Cost Estimating and Budgeting,
Resource Planning,Procurement Planning, Profitability Study, etc.
always involve some uncertainty since not all the components that go
into the study are exactly known.
 Most are estimates, thus it is required to pay attention to and inclusion
of uncertainty as well as understand the impact of risk and uncertainty.
 Risk Analysis: Reducing/effectively addressing uncertainty which
improves quality of estimate to make Better decisions.
 Inherent Risk in Construction
Inherent Risk
There are two potential sources of risk namely, inherent risk and
contingent risk (Evans and Peck 2008a).
 Inherent (range) Risk in the measured items (that have a 100%
likelihood of occurring) included within the various components
(direct costs, indirect costs, margin and owner’s costs )of the Base
Estimate (such as Rates, Quantities, Assumptions, etc).
Contingent Risk
 Contingent Risk being the risk attached to items outside the base
estimate (that have a less than 100% likelihood of occurring).
 Inherent Risk in Construction
Contingent Risk
 Contingent risk is the risk due to unmeasured items. Typical
contingent risks include weather impact, industrial issues, safety,
planning approval conditions, design development, owner
requirements, geotechnical investigations and potential claims from
contractors.
 Contingent risk should include the risk of changes to standards and
minor changes due to slight changes to owner’s requirements.
 Inherent Risk in Construction
Contingent Risk includes;
• Acts of God: Flood, Earthquake, Landslide, Fire, Wind damage;
• Physical: subsurface conditions;
• Financial & Economic: uncertainty with high inflation and interest rates,
Availability of funds, Exchange rate fluctuations, Financial default;
• Construction Related: Labor strikes, Different site conditions, Design changes,
Equipment failure, inability of a subcontractor to perform, Damage to structure,
Damage to equipment, Labor injuries, Fire, Theft, offsite accidents by vehicles;
• Design Related: Incomplete design scope, Design assumptions, Defective design/
constructability, Errors and omissions, Inadequate specifications;
 Inherent Risk in Construction
Contingent Risk includes;
• Political/public and Environmental: Changes in laws and regulations (such as
environmental protection and public safety regulations), Requirement for permits/
disapproval of the required project permits, Law and order, Pollution and safety
rules; and
• Organizational and contractual : Contractual relations, Attitudes of participants,
Communication, risk, risks assigned by contract over which the contractor has no
control.
 Reserve Funds
 Reserves are amounts included in a cost estimate to mitigate cost risk
by allowing for future situations that are difficult to predict.
Contingency Reserve
 An amount added to an estimate to allow for items, conditions, or events
for which the state, occurrence, and/or effect is uncertain and that
experience shows will likely result, in aggregate, in additional costs.
 Contingency usually excludes;
• major scope changes such as changes in end product specification, capacities,
building sizes, and location of the asset or project (see management reserve),
• extraordinary events such as major strikes and natural disasters,
• management reserves, and
 Reserve Funds
Management Reserve
 An amount added to an estimate to allow for discretionary
management purposes outside of the defined scope of the project as
otherwise estimated.
 Use of management reserve requires a change to the project scope and
the cost baseline, while the use of contingency reserve funds is within
the project’s approved budget and schedule baseline.
 Benefits of Risk Analysis
 Two broad categories of benefits from cost estimation risk analysis
include:
• Improved accuracy of cost estimates, and
• Improved decision making.
Improving Accuracy of Cost Estimates
 Risk analysis offers several options for improving the likelihood that
the estimate of an unknown cost will be correct .
 Estimate owner’s exposure to overrun risk, and
 Identify key components in exposure in determining the uncertainty in
a project’s overall costs.
 Benefits of Risk Analysis
Improving Decision Making
 Single point contingencies Vs. contingencies with confidence
intervals.
 Single point contingencies/ traditional methods of contingency
estimation: do not enable cost estimators or decision makers to
understand the confidence associated with that point estimate plus
contingency.
 However, with risk analysis, it is possible to select a contingency so
the cost estimator is 60, 70, 80, 90, 95, 99 or any other percent sure
that the cost estimate will not be exceeded.
 Benefits of Risk Analysis
Improving Decision Making
 Selecting a contingency to acquire a desired level of confidence in a
cost estimate is possible under risk analysis cost estimating techniques
but not under traditional techniques.
 This process is similar to the current method of assigning a
contingency. It entails adding a sum of money to the baseline, best
guess estimate. The difference now is that the desired confidence level
to manage the risk of a cost overrun can be chosen by the cost
estimator.
 Cost estimators are free to use their professional judgment to choose a
risk averse (i.e., conservative) cost estimate or a risk seeking (i.e.,
 Cost Risk Assessment Methods

 The general approach to think about risk assessment includes:

• Recognize that uncertainty exists;

• Identify the key sources of significant uncertainty;

• Reduce the uncertainty whenever possible;

• Account for the uncertainty that cannot be reduced; and

• Probabilistic Vs. Deterministic.

 Cost Risk Assessment Methods

Step:1 Identify the key sources of significant uncertainty

 It is important to rigorously investigate and identify the key sources of
significant uncertainty in a cost estimate.
 Tactical Risk Assessment: Focus Areas:
• Definition Risks:
 Definition/scope factors
• Performance Risks:
 Construction methodology and time line factors;
 Price factors; and
 Performance factors.
 Cost Risk Assessment Methods

Step:2 Reduce the uncertainty whenever possible.

 Reducing significant uncertainties whenever possible within the

resource constraints (time, money, personnel, and expertise).

 Step 3: Account for the uncertainty that cannot be reduced

 Finally, when significant uncertainty has been identified and cannot

be reduced it must be accounted for in an explicit fashion.

 Cost Risk Assessment Methods

Step 3: Account for the uncertainty that cannot be reduced

 The four significant risk analysis tools that will be useful to cost

estimators include:

• Estimating using risk analysis

• Monte Carlo Simulation; and

• Sensitivity Analysis/Scenarios;

• Range Estimating/Probability Analysis

 Cost Risk Assessment Methods

Cost Escalation
 Escalation: the provision in actual or estimated costs for an increase in the
cost of equipment, material, labor, etc, over that specified in the purchase
order or contract due to continuing price level changes over time.
 It should be noted that escalation is included to provide adequate
capital funding to compensate the project for forecast cost increases
due to inflationary imposts in the construction sector.
 Applications of Price Indices in Forecasting (noting the price level
changes over time): Trends in price changes can also serve as a basis
for forecasting future costs.
 Cost Risk Assessment Methods

Calculation of Cost Escalation

 Escalation is usually calculated by examining the changes in price

index measures for a good or service.

 Future escalation can be forecast using econometrics. Unfortunately,

because escalation (unlike inflation) may occur in a micro-market, and

it may be hard to measure with surveys, indices can be difficult to

find.
 Cost Risk Assessment Methods
Elements of construction industry Prices
INPUT PRICE INDEX OUTPUT PRICE INDEX SELLER’S PRICE INDEX
Elements paid by Contractor Elements paid by Client Elements paid by Final Owner

A B C
Materials Materials Materials
Labor Labor Labor
Plant & Equipment Plant & Equipment Plant & Equipment
Transport Transport Transport
Energy Energy Energy
Other Costs Other Costs Other Costs

Contractor’s Indirect Cost Contractor’s Indirect Cost

( Preliminaries +contractor’s ( Preliminaries +contractor’s
offsite OH Expenses) offsite OH Expenses)
Productivity Productivity
Contractor’s Margin Contractor’s Margin

VAT
Land
A/E and PM Services Fees
 Cost Risk Assessment Methods
Applying Cost Escalation
Approach 1
 Escalation can be assessed in an overall way by multiplying the cash
flow for a specific year by the expected percentage figure to cover
escalation for the entire cash flow in that year.
 The usual method of applying cost escalation is to use the midpoint of
construction as the end date of the escalation.
 Cost Risk Assessment Methods
Applying Cost Escalation
Approach 2
 An alternative methodology can also be used that breaks down the
annual expenditure into key components (such as pavement,
structures, drainage, etc for roads or formation, track,
signaling, etc for rail) and apply the expected unit price escalation
percentages to each key element.
 Cost Risk Assessment Methods
Applying Cost Escalation
Approach 3
 The Construction Input Index is used to project escalation due to
inflationary factors. The indices are based on forecasts of anticipated
escalation for the future fiscal years and are issued by the recognized
authority/institutions. The index shall be updated annually.
 When escalation is minimal, it is sometimes estimated together with
contingency. However, this is not a best practice, particularly when
escalation is significant.
 Cost Risk Assessment Methods
Price Adjustment for Cost Escalation
 Base price/Document Proof/Proxy Method.
 Price Indices/Formula Method: PPA 2006 Clause 47.1, FIDIC 1999,
FIDIC 2006 MDB Clause 13.8.

Ln Mn En
Pn  a  b  c  d  etc.
Lo Mo Eo
 Cost Risk Assessment Methods
Price Adjustment for Cost Escalation
Amount of Interim Payment
Requested= 1,245,000.00

Item Unit Initial Price Weight Current Price 1 Current Price 2

Cement Birr/qtl 275.00 18% 300.00 240

Rebar Birr/kg 13.00 16% 15.00 12

Fuel Birr/lt 9.00 10% 10.00 8

Currency Birr/USD 12.75 25% 13.00 12.25

Total 69%
A= (1-Total) 31%
Pn1= 105.7%
Pn2= 94.4%

Adjusted Payment 1= 1,315,955.16

Adjusted Payment 2= 1,175,115.89

 Cost Risk Assessment Methods
Price Adjustment for Cost Escalation
Amount of Interim Payment
Requested= 1,245,000.00

Item Unit Initial Price Weight Current Price 1 Current Price 2

Cement Birr/qtl 275.00 18% 300.00 240

Rebar Birr/kg 13.00 16% 15.00 12

Fuel Birr/lt 9.00 10% 10.00 8

Currency Birr/USD 12.75 25% 13.00 12.25

Total 69%
A= (1-Total) 31%
Pn1= 105.7%
Pn2= 94.4%

Adjusted Payment 1= 1,315,955.16

Adjusted Payment 2= 1,175,115.89