Chemical Engineering September 2020 - 24

Facts At Your Fingertips
Cost Estimation and Risk
Department Editor: Scott Jenkins
U
nderstanding project risks is
critical to arriving at useful cost
estimates. Since each capital
project in the chemical process industries
(CPI) is somewhat unique,
it can be difficult for engineers and
project leaders to price risks in their
estimates and project budgets. This
one-page reference provides information
on project risk, contingency
and accuracy in cost estimation.
Cost estimates include two main
parts: the " base, " which encompasses
the risk-free costs, other than
specific allowances, and the " risks, "
which include contingency, reserves,
escalation and currency exchange.
Definition of terms
The following terminology is associated
with cost estimates and risk.
Risk. An uncertain event or condition
that could affect a project objective or
business goal.
Base estimate. Estimate including
allowances, but excluding escalation,
currency risk, contingency and management
reserves.
Allowances. Resources included in
(base) estimates to cover the cost of
known, but undefined, requirements
for an individual activity, work item,
account or sub-account.
Contingency. An amount added to
allow for items, conditions or events
for which the state, occurrence or effect
is uncertain, and that experience
shows will likely result, in aggregate,
in additional costs (this excludes major
scope changes, catastrophic risk
events and conditions, escalation and
currency risk).
Management reserves. An amount
added to an estimate to allow for
discretionary management purposes
outside the defined scope of the project,
as otherwise estimated. May include
amounts that are within the defined
scope, but for which company
leadership does not want to fund as
contingency, or that cannot be effectively
managed using contingency.
Escalation. A provision in costs or
prices that accounts for uncertain
changes in technical, economic and
market conditions over time. Inflation
24
Table 1. aaCeI esTImaTe Classes, DelIverable sTaTus anD range-of-ranges
range of ranges
aaCe Class
Class 5
Class 4
Class 3
Class 2
Class 1
Key deliverable status
Block flow agreed upon by stakeholders
Process flow diagrams issued for design
Process and instrumentation diagrams issued
for design
All specifications and datasheets complete
Most or all engineering and design work complete
(or deflation) is a component of this.
Accuracy range. An expression of
an estimate's predicted closeness to
final actual costs or time. Typically expressed
as high or low percentages by
which actual results will be over and under
the estimate (base or funded), along
with the confidence interval that these
percentages represent.
Estimation accuracy
A capital cost estimate is expressed
as a range of possible costs, rather
than a discrete " number. " Effective
cost estimators work to understand
(and be honest about) the details and
factors that they do not know. Those
preparing estimates must communicate
the project risks, the range of
possible outcomes and, most importantly,
how those two go together.
Accuracy ranges are expressed as
low and high percentages that form
a boundary around the expectation of
how final actual costs will differ from
the estimate. For example, a range
of +30%/-10% tells management
that the final costs may be as much
as 30% more or 10% less than the
estimate after taking into account all
of the identified risks. To be complete,
range statements should inlcude the
confidence in the range. (for instance,
stating that 80% of the time, the project
will be within these bounds). It is
also important to specify the reference
point upon which the range is
based (it can be relative to the base
estimate or to the funded amount, including
contingency).
Scope definition and risk
The level of scope definition is the
greatest driver
of cost uncertainty.
Estimate accuracy improves with the
low end (p10) High end (p90)
-50 to -20% +30 to +100%
-30 to -15%
-20 to -10%
+20 to +50%
+10 to +30%
-15 to -5%
-10 to -3%
+5 to +15%
+3 to +15%
level of scope definition. Since the
1990s, almost every major CPI owner
company has implemented a phasegate
project system, and the phases
usually line up with the Association for
the Advancement of Cost Engineering
(AACE) International (Morgantown,
W.Va.; www.aacei.org) AACE
Estimate Classes (Table 1). Other key
risk drivers within the project scope
include the introduction of new technology
into the process and the level
of complexity in the physical system,
as well as the execution strategy.
Bias
Capital project management is a realm
of intense cost pressures and biases.
If high estimates scuttle project sanction,
the estimator's performance rating
and career development may be
put at risk. In slow economic times,
cancellation of a large project may
mean the loss of the team's jobs. For
decision makers, optimism bias often
prevails. For many reasons, the desire
and pressures to make a " go-ahead "
project decision can be immense.
The more strategic the project, the
more these biases create pressure for
lower cost estimates, resulting in discrepancies.
On the other hand, overruns
may be punished, and this drives
conservative estimating practices by
those afflicted, particularly in small
project systems.
These biases and their effect on
estimating behavior are major sources
of cost uncertainty. If the bias is
toward decreased base estimates,
more contingency will be required,
and vice-versa if the bias is toward
increased base estimates.
n
Editor's note: This column is based on information found in Hollman,
J., Improve Your Contingency Estimates for More Realistic
Project Budgets, Chem. Eng., December 2014, pp. 36-43.
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