Forecasting Cost Escalation on Large Infrastructure Investments
Herbert M Barber, Jr, PhD, PhD
One of the most misunderstood topics associated with costing on large infrastructure projects involves cost escalation; it seems to be a problem with no definitive solution. In fact, last week I read an article published in a prominent engineering and construction trade journal by a senior cost estimator with a Top 10 ENR construction firm discussing how they handle cost escalation on large infrastructure projects. I could not help but chuckle at the, as I say, “useless infinite wisdom,” the estimator offered for the taking as he rambled on and on regarding how best to predict cost increases during the life cycle of a project. Unfortunately, he could not have been more wrong in his attempts to educate his colleagues. Let’s just hope none of his projects end in court, as his method held no scientific merit. Making matters more problematic, the method he used was one yet another Top ENR construction firm advocates in their madness to understand cost escalation on large infrastructure projects. This very company even publishes an annual report discussing cost escalation. Once again, here we find one too many experts who are, well…not.
Many, many construction companies today have become merely labor brokers with relatively little accountability, having long given way to the idea of serving as the old-school general contractor, where quality and price were staples of his reputation. As such, many of these same companies no longer work at-risk, or perhaps I should say, with as much risk as would a general contractor, or otherwise, working against a fixed, lump sum price—with penalties. So, estimating low to be awarded the project and making it up differences on cost overruns is often the norm, rather than the exception. As such, cost overruns, be them via engineering design errors, construction estimating errors, unforeseen construction issues, or in our case, raw cost escalation, serves many construction companies well today—very well. But consider cost escalation from the perspective of the fixed, lump sum general contractor working at-risk, or from the perspective of the owner. Both have enormous exposure on these multi-billion-dollar projects, and cost escalations can financially destroy the at-risk general contractor or owner. As a point for consideration, if owners fully understood on the front end how cost escalation would adversely affect their construction projects on the back end, they would pay closer attention to the means and methods used when predicting cost escalation.
To this end, anticipating cost escalation is one thing, while knowing how to forecast it is an altogether different animal; so, mind you, it is not for the math-averse person. Then again, it is not overwhelmingly complex. The key lies in understanding basic statistical modeling, and in so doing, knowing how to leverage independent variables as predictors of cost escalation, just as one would in other methods of prediction. It is not, as our friends above essentially suggested, adding a percent here or there to costs based upon some non-scientifically developed cost index.
Simply determine the variables associated with your project having the potential to affect your cost estimate, or areas within your cost estimate. Say unemployment; or, local, state, and US GDP. How about the ever-changing price of steel in China; or what about material and labor costs? These and similar variables are those you will leverage as predictors of cost escalation. Now simply develop a probabilistic model to predict cost escalation using a variety of statistical modeling techniques—but with likely only one or two methods yielding the strongest model fits. In this case, I suggest you model construction indices as opposed to construction output, e.g. sector GDP… Read the article…
About the Author
Herbert M Barber, Jr, PhD, PhD is a respected author, engineer, economist, researcher, and expert in financial and economic performance of large infrastructure investments. Over the last 30 years, Dr. Barber has provided advisory and consulting in engineering economic systems as it relates to the implementation of large economic endeavors in industry and infrastructure across multiple countries. He is a seasoned scientific researcher with a keen understanding regarding the statistical and econometric effect and causality large financial and economic endeavors have on companies, governments, industries, and economies around the world in both developing and developed economies.
About Xicon Economics
Xicon Economics brings intellectual rigor, objectivity, and real-world experience together to solve complex engineering, economic, and financial problems in an effort of increasing financial and economic output. Whether calculating the economic and financial feasibility of constructing a new high-speed rail system, analyzing policy changes in various regulatory agencies, mining smart grid data to develop real options valuations, or developing advanced energy algorithms, Xicon Economics stands ready to meet the challenge. More simply, we leverage our backgrounds in the hard sciences to grow entities in the private and public sectors in an effort of growing economies while serving as experts in economics, research, and statistics.