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Appendix 3.4.5 - Project Cost Estimate and Contingency

Created by Guy Henley, last modified by Mustafa Abusalah on Feb 17, 2015

3.4.5.1 The Development of a Project 3.4.5.1 The Development of a Project Estimate

3.4.5.2 What Contingency is not meant to cover
Estimate
3.4.5.3 Development of Allowances, Escalation and Contingency
An estimate is developed by considering the 3.4.5.4 What is the Estimate Range?
scope of a given project and estimating the 3.4.5.5 Estimate Accuracy
quantities of material and resources needed 3.4.5.6 How do we set Contingency?
to successfully complete the project within a
given schedule.
Any estimate carries risk. The allocation of allowances, escalation and contingency within an estimate and the assignment
of an accuracy range to that estimate is a means by which a bidder endeavours to identify and manage the risks
associated with any estimate.
Allowances
Allowances cover incremental resources (for example, hours and money) included in estimates to cover expected but
undefined requirements for individual accounts or sub-accounts. They cover design allowance for engineered equipment,
bulk material take-off allowance, overbuy allowances, unrecoverable shipping damage allowance, provisional allowances
for poorly defined items and freight allowance (equipment and materials). There are two main types of allowances,
assumed (based on the bidders perception of the project requirements) and validated or historical (based on the bidders
estimating database).
Escalation
Escalation is a provision in actual or estimated costs for an increase in the costs of equipment, material, and labour from a
set point in time and is due to a continuing price change over time until the completion of the project. Escalation does not
cover hyper-escalation, that is escalation which is outside what is expected from published indices, Hyper-escalation
should be covered by contingency and allocated based on the perceived risk.
Contingency
A bidder will typically include three main types of contingency in an estimate, estimate contingency, event contingency and
management Reserve.
Estimate contingency is defined as a special monetary provision in the project budget to cover uncertainties or
unforeseeable elements of time/cost in the estimate associated with the normal execution of a project, for example, labour
rates and design development. Estimate contingency is calculated using a risk model with input from a knowledgeable
team.
Event contingency is defined as a monetary provision in the project budget to cover the costs associated with the
occurrence of one or more specific risks, for example incurring liquidated damages or impacts from severe weather or
hyper-escalation.
Management reserve is a further contingency included based on the bidders management perception of the overall
likelihood of the project cost and associated risks.

3.4.5.2 What Contingency is not meant to cover

Contingency is not meant to replace the development of an accurate estimate commensurate with the stage of the project
and the associated definition at that stage.
It is not meant to cover project scope change for example a change in pipeline throughput or terminal storage volume.
It does not cover for design allowance which should form part of the normal project estimate basis.
Contingency does not cover for management reserve or profit. These areas will also be discussed.

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3.4.5.3 Development of Allowances, Escalation and Contingency

Pipeline Materials
Most of the material qualities can be relatively easily quantified following the FEL process, the number and size of valves
will be set, the location and specification of pig-traps will be defined. The associated allowances will be set based on
historical data and escalation will be set based on the appropriate published indices. These do not cover the full estimate
risks. The supply price that is the price at the time of purchase from the supplier is still likely to be subject to change as this
often cannot be fixed until some months after the bid has been made to the developer. The risks associated with this will
need to be assessed and appropriate contingency allocated.
Other Materials
Other materials are likely to be subject to more significant quantity variations. For example, the allowances for weight
coating will cover some repair and damage and additional usage as part of the overbuy allowance. However, contingency
may also be included in the estimate to allow for potential local rerouting which might be required to solve problem and
undefined ground issues.
Construction Labour
The construction manpower estimate has many more variables. It starts with an assessment of the volume of work to
perform, how many welds, how much ditch to dig etc.
Following assessing the volume of work the construction schedule is developed to meet the requirements of the bid, as
described in the March chart section of the The Road. Resourcing by activity is then developed to achieve the required
speed of production.
In generating the construction estimate many assumptions will have to be made for example how easy the soil is to dig,
how much of the soil can be reused in the ditch, whether the ditch stand up without batter or stepping, and how well the
ROW will stand up to multiple heavy traffic movements. All of these will be captured in the estimate basis.
An assumption is made of construction labour productivity and equipment availability rate. The weather in the construction
season is reviewed and the impact on progress evaluated. Many more risks are also inherent in this estimate. (A review of
the risk register will demonstrate the issues confronting the bidder.)
All elements of the buildup of the construction labour in the estimate will be reviewed and appropriate allowances,
escalation and contingency included and defined in the bidders estimate basis. The determination of these figures can be
complicated since, for example, the productivity/quality of the construction labour will not just influence the number of
hours and therefore the number of people required to execute a project, it will also influence the loss and damage of
materials due to poor installation or handling.
General
As the various areas of the estimate are developed the variability and risk in each is different. However the bidders
estimate cannot assume that all the potential problems associated with the construction will occur on the same job, his bid
price would not be competitive. Similarly it would be unwise to assume that no mishaps will occur either. A Monte Carlo
analysis, or similar statistical analyses, will determine the overall level of contingency that will be required to bid a project
at a level of risk that is acceptable to the bidder.

3.4.5.4 What is the Estimate Range?

The range of an estimate is defined as the difference between the lowest and highest probable values of the estimate.
In single-point estimating, the estimator assigns a single cost value to the estimate. But picking a single point is equivalent
to stating the project WILL cost this much and clearly does not take into account that this is an estimate with surrounding
uncertainty. The single point tends to be the most likely cost in the estimators view, the probability of achieving this cost is
not fully evaluated.
Three-point estimating allows for uncertainty around the estimated cost. To help establish the most likely value of the
estimate many approaches can be used. One such approach is a risk based assessment using Monte Carlo techniques. It
is normal to represent each area of the estimate as a triangular distribution.

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In the example above 20 individual costs could be found for the cost of a commodity. However the estimator can idealize
the cost by knowing just three points as follows

minimum = $2,000

likely = $5,000

maximum = $11,000

Using a simulation and allowing the cost to vary between the high and low values in a random way described by the shape
of the triangular distribution results in a total project cost distribution as shown in the diagram below. In this example the
most likely cost (mean) or the 50/50 estimate P50 is $74.5 million. This contrasts with the base case estimate of $70.9
which was found by adding only the most likely figures together.

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The above graphic represents the output of a real estimate the distribution is slightly squewed. For the purposes of the
ongoing discussion this distribution will be represented by a smooth normal distribution as follows.

In a normal distribution without skew the mean, median and mode are aligned and have the same value, all equal the
50/50 or P50 probability.
A good estimate from a developers perspective should have equal probability of overrun and under-run (i.e., a 50%
probability). This is a risk neutral approach, the assumption being that some projects will overrun while others will
under-run and, in the long run, they will balance out.
The more conservative, risk-averse attitude used by companies that need to ensure each project returns a profit to their
company (true for contracting organisations) normally specifies a probability of 80% or higher that the project will not
overrun. This is a safer route but by specifying a high probability the required contingency (or contingency and
management reserve) will increase and with it the project cost to the developer.
This results in a sub-optimal use of funds. Large contingencies on projects in the developer organisations project portfolio
will sequester monies that could otherwise be put to productive use (e.g., funding additional projects, beefing up R&D,
investing in product improvement, new equipment). This is a key reason why reduction of risk to the bidder by the
provision of a good FEL and by equitable allocation of risk, as discussed in The Road , is beneficial to the developer. The
excessive contingency is removed and the funds remain with the developer for his use. Contingency added to the bid by a

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bidder, due to poor project scope definition, becomes part of his bid and is lost to the developer.
Contingency is released or consumed by the project team as each of the risks is passed. It must be noted that the
contingency which is determined in the development of the estimate is total required contingency. It does not reflect what
is sometimes called "management reserve", a discretionary amount which is added to the estimate for possible scope
changes or unknown future events which cannot be anticipated by the project team. Addition of this reserve increases in
proportion to the lack of project definition and to the history the bidder has of the way in which the client manages change.
At the final management review of the estimate past project metrics are commonly used to gauge the result and to provide
a reality check.
Some special risks also impact the assessment of the final project contingency. These include commercial terms of
contract, for example, liquidated damages. Whilst these can play a part in a contract with well-developed conditions and
FEL they are often applied without full consideration of the impact on schedule and, as such, when the bidder performs his
risk analysis they are found to result in significant risk and a high probability of occurrence. In such cases the bidder adds
the risk-based impact of these items to his final estimate expecting that they will be paid in full or in part. The developer
has just unwittingly increased his cost for the project development.

3.4.5.5 Estimate Accuracy

What does a stated estimate accuracy of 15% mean?

Any discussion of accuracy must be related to a specified confidence interval.
In the next figure the median/mean/mode cost is $200 million. The 80% confidence interval in this example (i.e., the
confidence that the actual cost will fall within this range 80 times out of 100) corresponds to costs between $170 and $230
million. The difference between $200 million and $170 or $230 million is $30 million, which is 15% of $200 million. Hence
in this example the estimate of $200 million has a + or - 15% accuracy with 80 % confidence.

3.4.5.6 How do we set Contingency?

Contingency is only meant to cover the project development as it has been described in the scope and basis of design,
which at the current state of project definition cannot be accurately quantified, but which history and experience show will
be necessary to achieve the given project scope.
There is a tendency for those not involved or unfamiliar with estimate development to view contingency as evidence that
the estimator is inflating or "sand-bagging" the estimate to improve the chance of bringing in a successful project i.e. one
that achieves its budgetary goals. In an effort to reduce the projected cost of a project, clients and those unfamiliar with the
process often try to limit contingency to a fixed percentage of the base estimate or in some cases delete it entirely.
However, contingency forms an important and integral part of the estimate; it is not potential profit and as we will discuss
later should be expected to be spent in the development of the project.

Continue with 4. Dealing with Risks in Pipeline Projects

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Back to Appendix 3.4.4 - Contractual Topics that have a Particular Importance for Onshore Pipeline Projects
Back to 3. The Baseline of a Construction Contract

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