Chemical Engineering December 2014 - 44

Cover Story
the project will encounter rock requiring
blasting in the soils during
foundation excavation, and the most
likely cost for this was $50,000. If
the cost of rock-blasting was <1% or
so of the base estimate, it probably
would not constitute a " critical " risk
and the team would move on to the
next risk. If it was critical, say 20%
probability, then the expected value
to include in the contingency sum
would be 0.2 × $50,000 = $10,000.
Another consideration is whether
this risk is a binary, discrete or
overwhelming risk.
The Expected Value method
works best for risks with a continuous
range of impacts. In this case,
the rock blasting could be $1,000 to
$100,000 depending on severity. But
if the impact is all-or-nothing, there
is no point in putting a percentage
of the impact in contingency. These
types of risks should be presented to
management as possible " management
reserve " items that they may
wish to fund in their entirety (or
not) with the funds to be disbursed
to the team only if the risk occurs.
Using this approach, the total mean
contingency is the sum of the two
parts, as shown in Equation (3).
Ctotal = (MSC × BE) + ∑(MPSC) (3)
This equation calculates a total
(mean) contingency cost (Ctotal,
in $). It is the sum of MSC from
Equation (1) times the base estimate
cost (BE), and the summation
of the mean PS contingency
values for each of the PS risks from
Equation (2).
For example, if the systemic
contingency was 10%, the base estimate
was $1,000,000, and the
sum of the PS risk expected values
was $50,000, the total contingency
would be 0.1 × 1,000,000 + $50,000
= $150,000. Again, the corresponding
worst-case value for businesscase
analysis would be three times
this amount.
Full cost distribution
The two methods above produce a
point value and worst-case for contingency.
However, the best practice,
as shown in Figure 4, is to develop
the full cost distribution so that
management can select contingency
and worst-case values depending
on their level of risk tolerance.
This can be done using inferential
statistics applied to the Parametric
Estimation model, along with
MCS applied to the Expected Value
method, with the parametric outcome
included as risk number one.
For this, one must have an MCS
add-on to Microsoft Excel, such as @
RISK, available from Palisade Corp.
(Ithaca, N.Y.; www.palisade.com), or
Crystal Ball, available from Oracle
Corp. (Redwood Shores, Calif.;
www.oracle.com).
MCS application description is
beyond the scope of this article.
However, for those with knowledge
of the practice, a simple MCS model
can be developed by applying MCS
to Equation (3). This is done by replacing
the systemic contingency
percentage and each PS risk-impact
estimate in the worksheet with distributions
per the software procedure,
and simply running the simulation.
The Table 5 method provides
the most-likely, and p10/p90 values
for systemic contingency percentage.
The team, in their project-specific
risk workshop, will not only estimate
the most likely impacts, but
the low and high range as well. The
MCS software will generate a distribution
similar to that in Figure 4.
Communicating the risks
Contingency is one of the most controversial
topics for CPI capitalproject
management. Every stakeholder
on the team has a different
perspective as to what contingency
represents, the extent to which it
is necessary, and how it should be
managed. This article assumes that
the owner company agrees with the
AACE definition; that contingency
is expected to be spent. They also
practice disciplined management
of change on their projects. They
understand that for a safe and
cost-effective project, contingency
under the authority of an experienced
project manager is necessary
to respond to risks in near realtime.
Delays in response, such as requiring
a committee or senior manager
to review all contingency use,
often result in the compounding
of risk impact. The engineer must
communicate this point of view to
those responsible. Any distortion
of these conditions will result in
contingency being something other
than what is described here, and
its quantification tends to become
more of a game.
If the company shares a common
view about contingency, then communication
can focus on making
sure that management understands
the risks' drivers and their relative
impacts. Per Figure 4, contingency
is selected by management decision-makers
based on their risk tolerance.
Ideally, risk-analysis will be
done well ahead of the funding decision,
so that the team has time to
recycle plans to manage risks and
impacts that are found to be unacceptable.
The methods in this article
facilitate risk communication
and treatment because they are
risk-driven, meaning that the risks
and impacts are explicitly linked. ■
Edited by Mary Page Bailey
References
1. AACE International, RP-10S-90: Cost Engineering
Terminology, Jan. 2014.
2. AACE International, RP-18R-97: Cost Estimate
Classification System - As Applied in
Engineering, Procurement and Construction
for the Process Industries, Nov. 2011.
3. Dysert, L., Sharpen Your Capital-cost Estimation
Skills, Chem. Eng., Oct. 2001.
4. Merrow, E., " Industrial Megaprojects, " John
Wiley & Sons Inc., New York, N.Y., 2011.
5. AACE International, RP-40R-08: Contingency
Estimating: General Principles.,
June 2008.
Author
John K. Hollmann is the
owner of Validation Estimating,
LLC (21800 Town Center
Plaza, Suite 266A-180,
Sterling, VA 20164; Email:
jhollmann@validest.com;
Phone: 703-945-5483). With
37 years of experience in design
engineering, cost engineering
and project control,
including expertise in cost estimating
and risk analysis for
the process industries, Hollmann is a life member
and past board member of AACE International.
He was editor and lead author of AACE's
technical foundation text, " Total Cost Management
Framework " (2006). Hollmann has a degree
in mining engineering from the Pennsylvania
State University and an MBA from the
Indiana University of Pennsylvania. He is a registered
professional mining engineer in the state
of Pennsylvania and holds the following AACE
professional certifications: Certified Cost Professional,
Cost Estimating Professional and Decision
and Risk Management Professional.
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Chemical Engineering December 2014

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