March 23, 2006

Get a handle on escalating costs

  • With construction materials and labor rates rising quickly, contractors need to have a plan for long-term projects.
    Rider Hunt Levett & Bailey

    In order to manage escalation it is necessary to understand its role in a construction project.

    Escalation is the increase in costs from one time period to another. Material, labor and profit are all subject to escalation.

    Materials have escalated well above standard rates since 2003 while labor has traditionally been the most stable component. However, in the current market, labor demand is exceeding supply and labor rates are factoring more in determining escalation.

    The dramatic increase in escalation was attributed, but not limited, to the following factors: raw cost of materials; transport and shipping; manufacturing of materials; availability of qualified labor; increase in construction activity; selectiveness of projects by main contractors (public versus private work); and world economics.

    Construction pricing since the last quarter of 2004 has experienced uncommon escalation, with rates between 6 percent and 10 percent per annum. This far exceeds previous years, such as 2000, when a rate of 2.5 percent to 3.5 percent was typical.

    How is escalation applied to a construction project?

    First, escalation is broken into two data sections: actual and future.

    Actual data is based on historical information — such as estimates, bid results and material prices — from one period to another.

    Future data is compiled by a calculated forecast, which allows for anticipated cost adjustments from one period to another.

    Most projects are planned from one to six years from when the budget is prepared. Accordingly, the project is priced using present day data with an allowance for escalation on a per annum basis applied to the base price. The bottom line number reflects the price that is anticipated at the actual date of construction.

    Another issue to consider is what base rate should you escalate to. At Rider Hunt Levett & Bailey, the standard practice is to escalate to the midpoint of construction for projects that have a construction schedule greater than 12 months.

    Here are 11 tips on how to manage escalation costs:

    1. Understand when the base date of pricing is.

    2. Develop a budget at inception. To be a truly effective tool, budgets need to be reviewed and confirmed during the beginning of the project. By doing the conceptual estimate on day one, owners can get a clear picture if their project is feasible. If the cost review is deferred to a later date, the initial work may be wasted if the project is deemed over budget and therefore not feasible.

    To be thorough, the cost estimate must include a bill of quantities providing a description of materials, a clear definition of the quantities and costs of the materials, and the cost of the labor.

    In addition to saving time during the preconstruction phase, these estimates provide coordination of the construction documentation so that all aspects of the project — from demolition, site work and structure to finishes and services — are included in the estimates. The process also saves time in evaluating bids and detecting errors or ambiguities in the documentation, which can result in costly delay claims or change orders.

    3. Familiarize yourself with historical escalation rates. Understand where escalation is at the moment and which market conditions will have an effect on escalation rates. Use this information to make an informed prediction for the short-term future.

    4. Use historical data to predict long-term escalation.

    5. Understand the escalation allowance on a per annum basis that is applied to the base budget.

    6. Update the cost estimate at regular intervals based on known market variables. This allows the unit rates to be revisited and adjusted to reflect current pricing at the updated base date.

    7. Revisit and adjust the escalation every year with current escalation rates and re-forecast escalation using predicted future rates.

    8. Distribute escalation risk between owner and contractor. Escalation risk is priced whether it is a separate line item or buried within the rates. The greater the risk, the more the money added to protect the person signing the contract. In order to limit the added cost, the risk needs to be shared. One simple method is to apply a standard cost index to which the owner and contractor/subcontractor agrees.

    Rider Hunt Levett & Bailey publishes a quarterly construction cost report that includes a national cost index compiled from 10 U.S. cities which indicates how costs are changing in each city.

    9. Manage risk by applying contingencies. Ensure that an adequate level of contingency is budgeted within the project. Estimating contingencies, design contingencies, and construction contingencies are incorporated into the base cost to allow for variances in design, minor changes in unit pricing, and unforeseen conditions.

    10. Use an expert cost consultant such as a quantity surveyor instead of pricing books with generic unit rate allowances to add credibility and provide a project-specific budget.

    11. Budgets can get off-course during the construction process. Estimators can provide security to the owner by monitoring costs and ensuring that they are inline with the original estimates. They can also manage contingencies and provide early notification of unforeseen problems as the project is built.

    What to expect in the future:

  • We are at the end of the Volcker-Greenspan era, which may lead to some uncertainty in the market place. During the last 23 years, the United States has experienced two short, mild recessions. This is an amazing act to follow for the new chairman.

  • Baby boomers are reaching 60 years of age. Labor availability will decrease and subsequently place pressure on future projects nationally and locally.

  • Unnecessary upward pressure on construction pricing could occur if potential projects planned nationally are followed through on. For instance, in Las Vegas there is over $20 billion of projects planned along the Strip.

  • Escalation for 2006 is projected to fall within 5 percent to 7.5 percent per annum.

    We recommend that all budgets be reviewed quarterly and maintained specific to the project characteristics and geographical location.

    You can't control costs, you can only manage them.

    Simon Squire is a principal of Rider Hunt Levett & Bailey Hunt, one of the world's largest construction consultants.

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