Solutions to Managing Construction Cost Escalation

The design and construction industry has responded to similar crises in years past. Notable solutions include project delivery methods such as construction management and fast-track. The consistent application of such proven methodologies—in combination with innovative approaches—is helping owners manage today’s risk of construction cost escalation.

Despite macro-economic forces beyond individual control, escalation can be contained. Owners can contain construction cost escalation indirectly, by controlling three factors:

Time: Set an aggressive schedule & stick to it.
Scope: Build space required to meet (not exceed) functional needs.
Information: Obtain & share objective data from multiple sources.

Five Challenges

While you may hope the current run-up in construction cost is temporary, the evidence suggests otherwise. Owners face a variety of challenges at every stage of the project.

It’s a Flat World (with Peaks & Valleys, too!)
With materials costs averaging 40 percent of a typical project (the balance being labor), a volatile, global commodities market can unexpectedly roil your budget. A case in point was last year’s demand for steel in China. Yet, labor supply is a regional factor. Despite our living in a “flat” world, peaks and valleys in escalation abound.

Where Have All the “Boomers” Gone?
A baby boomer turns 60 every eight seconds. How many are skilled construction tradespeople? What is the expected productivity of their replacements, especially for complex buildings? Scarcity and unpredictability drive bid prices upwards.

Design to Budget (or, Design to Scope?)
Design to budget is not new. What is new, is that budgets today are “hard and fast”, i.e., without the flexibility of appropriate contingencies. “Design to budget” is an owner direction, intended to prevent over-design. Its effectiveness has proven nil during this period of rapid cost escalation. Owners must face the dilemma: Either design to budget (and change the scope) or design to scope (and change the budget).

Time is Money
Owners must look to their internal processes and eliminate delay. For too many institutions, the approval process remains overly complex. Oversight intended to prevent bad decisions also delays good ones.

Denial
The news that a project is severely over budget is catastrophic. An organization stuck in denial cannot make progress. Putting the current period into perspective may be helpful. The Engineering News Record’s Construction Cost Index reflects a century-long median rate of annual increase at 4.5 percent—with the exception of the years from the late 1980s to the early 2000s. Costs are escalating rapidly now; we forget they weren’t for most of the past 20 years.

Solutions and Strategies

In order to understand your project’s situation, you need to ask these questions:

Construction cost problems surface before or after a budget has been established.
If your project has not yet established a budget, you might think you can solve future problems by simply adding money now to cover escalating costs. Trouble is, there’s a capital budget somewhere. It will apply the brakes to your project if estimates are too high.

Your first step, after estimating the cost of building systems, is to assign three required contingencies—design, construction, and owner—along with escalation. The designer owns the design contingency; the constructor owns the construction contingency; and the owner owns the owner contingency. Separating responsibilities this way enables monies to be reallocated without a time-consuming, divisive process.

Design contingency accounts for estimating inaccuracy due to both quantitative error (take-offs) and qualitative error (design intent). Construction contingency accounts for inaccuracy due to both unforeseen site conditions and contractor risk. Owner contingency accounts for Murphy’s Law—things that are overlooked, scope creep, regulatory change, and so on.

Escalation is different. Contingencies are for what may happen. Escalation is for what shall happen. Escalation accounts for the persistent inflation of construction costs. The value is reduced to zero when all bids are in.

All project stakeholders must share a sense of urgency. Owners must establish the most urgent schedule their team can deliver. Then, stay on schedule. Of course, the schedule must be coordinated with the budget and space program as part of a comprehensive Basis of Design.

When milestone dates are missed, team confidence is eroded. Design delays have two negative impacts. First, the completion date for trade buy-outs is pushed back, reducing your purchasing power. Second, bidders may assume a pattern of missed dates will continue, causing them to increase their bids.

A common approach is to apply escalation up to the mid-point of construction. This is arbitrary. Escalation need only be applied up to the point in time at which all construction buyouts are complete.

Selective Scoping

A project should begin with three well-defined, coordinated components: program, budget, and schedule. Each describes the project’s scope-of-work through a unique perspective. Retain the professional advice you need to establish these components.

Selective scoping is a method that establishes a “scope contingency” to complement cost contingencies. Selective scoping examines user needs to select what is truly required to perform their work. This is an advanced strategy, requiring sensitivity to internal politics. It makes use of objective data, especially benchmarking, to deal with subjective workplace issues.

The program of space requirements is the key component here. Typically, programming questionnaires, interviews, focus groups, and headcount projections tell us how a user group envisions itself. To understand how a user group actually works requires additional analysis, such as equipment inventories, workflow analysis, and extended on-site observations.

Selective scoping provides two sets of data. The first is the space program established in the Basis of Design. The second is a shadow program--smaller in area, but equal in function. The delta between the two areas is the scope contingency. When and if this is used depends upon circumstances. Scope contingency may be your last opportunity to keep a project within the budget, by reducing its size.

Develop a shadow program by asking key questions:

Post-budget considerations include evaluating how much of your required scope of work is really needed on the first day of occupancy. Are there building components which may be deferred--and covered by another budget? For example, if you will need a standby generator at some future date, can you install it after your project is done?

Bid “add alternates.” These are best applied to components of building systems. In the example of the standby generator, it makes sense to test the market and see how much more that generator would cost by bidding it as an “add alternate.”

Talk to your engineer about diversity—the difference between the total connected demand for a utility and the actual demand at any given time. The classic example is an electrical system that runs both your home furnace and air conditioner. Only one is running at a given time. The difference between connected load and actual demand is the diversity.

In complex facilities, diversity should be established as part of the Basis of Design. The wrong assumptions will add unnecessary cost.

Estimating Solutions

Estimating solutions parallel the design process and are most effective when used pre-budget. Looking to the estimator to fix a cost problem after the budget is established is an invitation to creative accounting.

Typically, the owner begins with a budget in mind. How was it developed? You may learn (as we once did) that it was based on “…a similar project built in Texas six years ago with three percent added for yearly inflation.” In this case, the client needs to understand that in the six-year period, say 1999 to 2005, the real increase was 21.67 percent, and that the cost differential from Dallas to, in this case, Chicago is 32.4 percent (merit shop vs. union). This is an example of a normalization failure. The client began with an unrealistic budget; containing cost escalation would have been impossible.

Be skeptical of claims that an estimate is guaranteed. Larry L. Cockrum, CPE, wrote on this topic in the April 1999 issue of “The Estimator.” His research indicated that a group of general contractors bidding with the same documents typically cannot get much closer than a 15 to 20 percent spread. How then can the estimator guarantee accuracy, when the bidders are so imprecise? (Such guarantees should not be confused with the construction contingency, a hedge against risk.)

Reasonable Rate of Escalation

Effective escalation data is three-dimensional: across time—representing historic, present and future states; location—specific to the project’s marketplace; and sample size—data from multiple sources.

The past and present contain clues toward the future rate of escalation. Historical escalation is the cost differential at separate time periods for the same thing—the cost of carpenter wages in 1990 vs. 2002. The ratio of the two costs expressed as a percentage is the escalation. The index is that ratio expressed as a decimal number.

The further out an escalation rate is projected, the less accurate it will be. Project budgets for master plans, which may require decades to complete, are frequently established in present day dollars—a common-sense admission that “the future ain’t what it used to be.”

Construction industry standards include the Engineering New Record (ENR) Construction Cost Index and the Building Cost Index. These are “input indexes” with information on the costs going “into” your project. The Turner General Building Index is an “output index” with information on what bidders are proposing. In a sellers market, output index escalation outstrips that of the input indexes.

Another resource is the Urban Land Institute’s annual report, “Emerging Trends in Real Estate.” Also, the U.S. Census Bureau offers projections of population growth by state. If projections hold, and Florida actually becomes the fastest-growing, large population state over the next 25 years, how might that impact future construction costs? Add in cyclical destruction by hurricane and it appears the construction industry as a whole may be looking southward for years to come.

Owners and contractors active in your project locale are good sources for predicting escalation. Look also at the regional economic outlook as published by local government. Industry economists are another resource, such as the AGC (Associated General Contractors of America) economist. Historic escalation data which is location specific, such as the ENR “20 Cities Index,” is also useful.

With enough historic data points, past rates of escalation may help project future cost of construction. Of course, the best solution to construction cost escalation is having more money to spend. Second best (and far more practical) is to know what construction will cost in the future. Here’s a rough guide:

Worst Case Escalation
• Middle states 7% annually for 2006 and 2007
• West Coast 12% annually for 2006 and 2007
• East Coast 10% annually for 2006 and 2007
• 2008: 6% during the presidential election year

Best Case Escalation
• Middle states 6% annually for 2006 and 2007
• West Coast 12% annually for 2006; 9% for 2007
• East Coast 8% annually for 2006; 6% for 2007
• 2008: 4½% during the presidential election year

We are in a classic “sellers market.” Bid prices are escalating faster than the cost of materials and labor going into projects. Contain escalation by setting these goals for your project team:

By Sam Spata, AIA, LEED® AP and Frank A. Kutilek, Jr., LEED® AP, FCPE

Biographies

Sam Spata is the chief administrative officer for the New York office of HOK, where his main responsibility is to assure that facilities plans and projects effectively meet the business objectives of the corporate, academic, and government institutions that HOK serves in the Northeastern U

For more information

Click here to contact Sam Spata and Frank Kutilek, Jr.

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