With infrastructure projects becoming bigger, more complex and more costly, owners are facing increased scrutiny and pressure to deliver their projects within budget. To do so, owners need reliable project cost estimates early in the project lifecycle to start seeking funding from both internal and external sources. As the project advances, these cost estimates will also be the bottom line against which stakeholder and public trust will be measured. Figure 1: Typical risk factors associated with an underground construction project. Developing project cost estimates is easier said than done, as several risk factors complicate the process (Fig. 1). While most professionals focus on project execution risks, such as technical challenges that occur during design and construction, market factors can be some of the most difficult to quantify and can have some of the largest impacts on the project’s bottom line. This had been true during stable markets; however, with the market volatility observed since 2020 thrown into the mix, the uncertainties around labor costs, material prices and escalation costs have skyrocketed. To address this, project teams need to work collaboratively to develop a structured process for estimating project costs. This includes understanding how uncertainties in cost estimates change as the project progresses toward construction, as well as developing a set of reasonable assumptions on which to base the cost estimate. Developing adequate risk-based reserves is also a critical component, as it improves the predictability of project outcomes. This provides decision-makers and project team members with a more accurate assessment of the ultimate project cost and a realistic confidence level in achieving that target. This article explores these concepts and provides insights from one of Canada’s largest regional service providers, Metro Vancouver. Overview: Metro Vancouver Metro Vancouver is a partnership of 21 municipalities, one Electoral Area and one Treaty First Nation that collaboratively plans for and delivers regional-scale services to the 2.6 million residents currently living in the region. Its core services are drinking water, wastewater treatment and solid waste management. Metro Vancouver also regulates air quality, plans for urban growth, manages a regional parks system and provides affordable housing. Metro Vancouver’s funding and financing objective is to minimize the annual household impact on regional ratepayers and promote fairness among the users paying for the facilities that Metro Vancouver builds. Accurate project cost estimating is a key input to this objective. To determine the household impact, the schedule for each project is used to forecast the annual cashflow for all capital expenditures across the corporation. The resultant household impact is then calculated for upcoming budget years, and if the impact is above the target, more scrutiny is applied to both the scope and schedule of each project. Decisions are made to either reduce scope, stretch out the schedule, defer the project (or portions of it) or seek other smoothing mechanisms to avoid rate shock with respect to the impact on households and ratepayers. Project cost estimate components Several elements are included in a typical project cost estimate. These are summarized in this article, including challenges that are identified and need to be considered during development. Construction cost estimate. The construction cost estimate is prepared by the engineer and is intended to provide an accurate estimate of the contractor’s bid price. At the outset of a project, when information is limited, the estimate is often prepared using unit rates and using similar projects as baselines. As the project develops into the later stages of design, a bottom-up estimate is prepared that incorporates key information from the various contract documents, such as drawings, technical specifications, measurement and payment items, and documents like the geotechnical baseline report (GBR). Figure 2: U.S. inflation and wage increases from 2007 to 2022. (Source: Canada ConstructConnect, 2022b) The estimate itself consists of a few different components that can be arranged in several different ways, depending on the preferences of the cost estimating team: Direct costs: Costs associated with constructing the specific project elements called out in the contract documents. This includes labor costs, material costs, major equipment purchases (such as a tunnel boring machine), subcontractor costs, and power and fuel costs. Indirect costs: Costs borne by the contractor that are necessary for the execution of the project, but which are not “chargeable” to the other major cost elements. This can include items such as general mobilization and demobilization, temporary site services, supervision, equipment maintenance, servicing, weather protection and site security. Contractor markup: To reflect contractors’ profit margins. This varies depending on the type of work being done (such as tunnel excavation, chamber construction, pipe installation) and how busy the market is at the time the procurement documents are issued. Contractor risk: A contractor contingency amount to cover their productivity and construction risks as well as missed items. Similar to the markup, this amount will vary based on the type of work. Insurance and bonding: To cover the insurance and bonding requirements laid out in the contract documents. Construction escalation: An estimate of the escalation in both direct and indirect costs over the life of the project. This plays an important role in tunneling projects, as they often run for several years, with major purchases occurring throughout. The following describes some of the recent challenges encountered in properly estimating these numbers, particularly due to market factors over the past two years. Labor. Figure 2 shows a historical comparison between hourly wages in the U.S. economy and the “core” consumer price index (CPI) since 2007 (note that the “core” consumer price index for all urban consumers (CPI-U) omits distorting price movements occurring for food and energy items). As can be seen, prior to 2020, the two lines were closely linked, but in 2020, hourly wages increased sharply relative to the core inflation rate. This was primarily due to significant layoffs associated with lower-paid workers at the outset of the global COVID-19 pandemic, with many essential workers being kept on and receiving additional incentive and danger pay. Since 2020, the two lines have moved back into close alignment; however, they are significantly higher than they were historically. In November 2022, a core inflation rate of +6.3 percent stood beside an “all jobs” wage hike of +5.1 percent. This increase over historic trends is likely due to the critical construction labor shortage in North America, resulting in wages being driven higher. How these trends evolve over time will have a significant impact on construction costs in both Canada and the United States, as skilled U.S. workers are often employed on both sides of the border. Fuel. Fuel prices have been changing drastically over the last few years when compared to historic trends (Fig. 3). After the collapse of oil prices during the global COVID-19 pandemic in 2020, the future of the oil industry was unclear, leading to fuel prices rising. After the Russian invasion of Ukraine, international trade sanctions were levied against the Russian oil industry, which is one of the top producers of oil and natural gas for the global market. This subsequently led to a drop in supply and a further increase in prices (Forth & Fromberger, 2022), leading to significant year-over-year energy-related costs for diesel (+63.8 percent in March 2022) and gasoline (+61.5 percent in March 2022). Figure 3: U.S. gasoline and diesel costs between 2000 and 2020. (Source: Canada ConstructConnect, 2022a) As the underground infrastructure industry still relies heavily on diesel and gasoline for site and backup power, these price increases have had a significant impact on construction costs. Regardless of the size of the project, contractors are considering how to deal with this increased financial risk when bidding on contracts. One outcome is including higher fuel and energy costs to manage this uncertainty, therefore increasing the expected construction costs. Figure 4: U.S. construction material costs between 2000 and 2020. (Source: Canada ConstructConnect, 2022a) Materials. Increases in the costs of U.S. construction materials began in earnest for many key items in 2020 at the start of the global COVID-19 pandemic (Fig. 4). This was driven by uncertainty in the market, as well as considerable issues with material sourcing and transportation. These increases have not only affected final project materials, such as steel pipe and concrete, but also temporary materials, such as lumber used for concrete forming. As material costs make up a considerable portion of construction costs, these trends are significantly affecting project budgets. This is shown by the increase in the “final demand construction” index from the producer price index (PPI) data — otherwise known as the “bid price” index — since the start of 2021 (Fig. 5). This increase is closing the gap with material cost increases, indicating that bid margins by contractors are starting to stabilize (despite the “spikey” material cost changes), signaling the emergence of a somewhat healthier construction marketplace. Escalation. In addition to the challenges identified in selecting an appropriate basis for labor, fuel and material costs for the base project estimate, perhaps a greater issue is determining how these rates will be changing over time to accurately estimate escalation. As project cost estimates are often needed years or even decades before construction contracts are awarded, estimators are forced to interpret historic trends and use guidance from economists to forecast costs. While this process has always had an element of uncertainty in it, the “crystal ball” often used by economists and estimators has become even more foggy since the start of the global COVID-19 pandemic. Figure 5: U.S. bid prices versus material costs between 2000 and 2020. (Source: Canada ConstructConnect, 2022a) Looking back at Figs. 2–4, it is clear that in addition to the year-over-year increases resulting in higher construction costs, many items show a “spikey” up-and-down behavior (that is, labor, steel and lumber products), which creates a great deal of uncertainty when estimating project budgets. Attempting to project these trends into the future while the market is still correcting itself is fraught with issues, and leads to several different interpretations of project costs. Will the trend continue? Will it correct? Is another global market correction pending? The answers to these questions can have a considerable impact on construction cost estimates, and it seems every economist has a different answer. As such, the most useful method to account for escalation is likely a combination of projecting recent trends and carrying suitable risk-based project reserves, which allows for a confidence-based assessment of the project cost estimate. This is discussed further under risk reserves. Market competition. The timing of project procurement relative to how busy the rest of the industry is can have a significant effect on the construction cost, and therefore it is of considerable importance to owners. Putting out a request for proposal (RFP) or tender package at a time when the market is quiet typically results in market competition — multiple bids are received, and contractors are motivated to put together a competitive price to win the work. This is the ideal place to be in as an owner, as it provides confidence to the funding agencies and boards that the preferred contractor truly stood out compared to the other submissions. Conversely, when the market is “hot” and saturated with other infrastructure projects, interest to take on more work may be low, resulting in few bids and potentially higher prices. A smaller number of bids also draws more intense scrutiny from governing/approving bodies, which could result in schedule delays if a rebid is required. As the current market conditions in the underground construction industry are quite “hot,” owners are forced to compete with other projects for the best contractors. This is often done by breaking projects into several smaller elements to reduce contractor risk, providing more beneficial contract terms, and/or accepting higher construction costs. Whatever approach is selected, it will need to be reflected in the construction cost estimate so the confidence in this value can be assessed appropriately. Owner’s costs. Following the development of the construction cost estimate, the owner’s costs need to be considered. Owner’s costs include costs associated with: Land-related costs, such as site acquisition, rights-of-way and associated legal fees. Efforts required to acquire permits, and associated permit fees. Internal staff costs, including owner oversight and overhead costs for the project team and any legal staff. Owner-procured services such as community engagement, First Nations consultation, archaeologists and construction management. Any internal construction costs that are not covered by the contractor (such as disinfection and tie-ins on water mains). Owner consultants not related to technical design. For smaller projects, these costs are typically well understood by the owner. and therefore there is limited uncertainty associated with them. For larger and more complex projects, however, owners often do not have sufficient resources in-house. As such, they need to pull from a resource-constrained market, often at salaries significantly higher than their own historic target rates, thereby increasing staff costs on a project and putting even further pressure on consultants upon whom they rely to help deliver their projects. Figure 6: Metro Vancouver’s cost estimate accuracy guidelines as a function of design level. Risk reserves. Following the development of the construction cost estimate and schedule, a reserve amount is developed. There are typically two “buckets” of reserves that often have different names. Depending on the region of the project, the owner and the funding sources, they are: Contingency reserves: This amount is meant to cover project risks that can be identified and quantified as part of the risk management process (also referred to as “known unknowns”). Management reserves: This is typically an additional amount to account for impacts associated with unidentified risks (also referred to as “unknown unknowns”). The amount is often a function of the owner’s risk tolerance and therefore varies from project to project. Some owners will only focus on one of these — as an example, Metro Vancouver only considers contingency reserves for projects. Regardless, developing a total reserve amount that meets the owner’s needs requires a good understanding of risk tolerance and the desired confidence level in that number. This is not a trivial exercise and involves all members of the project team working together to confirm the desired outcome. Considerations for cost estimates Several tools are available to manage the challenges associated with developing a project cost estimate. Estimate accuracy. As part of the cost estimate development, the accuracy range of the estimate needs to be considered. This range provides an indication of the degree to which the final cost for a given project could vary from the estimated cost due to factors such as the level of project definition, the purpose of the estimate (such as end use), the level of effort (such as number of hours) for the estimate, and the estimating methodology used. Accuracy is presented as a plus/minus range around the mean estimate applied after the application of the mean contingency value. According to the Association for the Advancement of Cost Engineering (AACE), this accuracy range provides a 90 percent confidence level that the actual cost outcome would fall within this range (for example, P90 level, or nine times out of 10 the project cost will fall within this range). As the degree of project definition increases, the expected accuracy of the estimate typically improves, resulting in a narrower range of values. This is based on the premise that as more design and project details are available, project estimates will become more accurate. Similarly for the construction schedule, it is important to use expected productivities in the base schedule, as opposed to slower productivities that include potential risk impacts. Variability around these rates can be noted (that is, the range of possible advance rates); however they should be used as inputs to the risk assessment. To standardize the estimate uncertainty, Metro Vancouver has developed a project cost estimating framework that prescribes what accuracy levels are to be quoted for each design stage (Fig. 6). Metro Vancouver also includes a segregated line item for estimating uncertainty in their owner’s costs, which allows for estimating assumptions as the site and oversight model becomes further defined over the lifecycle. This ensures that an uncertainty amount is carried in the cost estimate (rather than just quotes) and allows for consideration to be given to the level of scope definition, complexity of the project, and novelty of the nature of work or delivery model. By including this number, it provides added confidence in the overall project cost estimate at each stage. Stage gate process. One of the key issues with developing cost estimates is determining when they are to be prepared, what each estimate is used for, and who will review and provide comments. One of the methods for accomplishing this is through a structured stage gate process. Stage gating is a complete, structured and transparent process for the review and oversight of project key deliverables at each stage of the project lifecycle. It includes key milestones at which certain project-specific requirements need to be met before receiving approval to progress to the next stage. A gate review is where decision-makers (that is, the gate panel) review progress and assess readiness for the project to go forward. If successful, the gate review provides the project team with authorization to move to the next stage. For example, once the project definition stage is complete, approval is sought before moving into the subsequent stage of preliminary design. Likewise, approvals are sought before proceeding with detailed design and before proceeding with construction. Cost estimates are a key component of each gate review, and the estimates become progressively more accurate at each gate as the project gains certainty in terms of scope, schedule and risk. Figure 7: Metro Vancouver stage gate process. Metro Vancouver has been developing such a process since 2020, when its board expressed an interest in undertaking a review of Metro Vancouver’s capital project delivery practices to provide value for residents. Metro Vancouver’s stage gate framework comprises five gates for major projects (Fig. 7). At each gate review, the deliverables on which the review is based includes a cost estimate for the project in its entirety, as well as a cost estimate for the subsequent stage. A summary of the stage gate process is provided below: At Gate 0, after a project is initiated, approval is sought to begin project definition. This gate review requires an AACE class 5 cost estimate for the whole project, and an AACE class 3 cost estimate for the project definition phase. At the conclusion of the project definition stage, the project is at gate 1, where approval is sought to proceed to the preliminary design stage. An AACE class 4 project cost estimate and an AACE class 3 preliminary design cost estimate are required at this gate. Gate 2 is where the project seeks approval to enter the detailed design stage, and it requires an AACE class 3 project cost estimate as well as an AACE class 3 cost estimate for the detailed design stage. Gate 3 is the final investment decision, when the panel decides whether to approve the expenditure of funds for construction, which is where the bulk of the project budget lies. At this gate review an AACE class 2 project cost estimate is required. Gate 4 is the approval to hand over the project to operations and maintenance staff, and approval of project financial close-out. Cost estimates related to the project are not required for this stage, although throughout construction (and all prior stages), annual cash flow projections are required for the purpose of calculating the corporation’s annual budget and the resulting household impact. Figure 8: Example output from a cost QRA. Utilizing such a process adds structure to the cost estimating framework and ensures that a financial basis is provided to advance a capital project to the next stage. Risk reserves. Another key item to consider when developing a project cost estimate is the development of risk-based reserves. While the construction cost estimate provides the “most likely” cost estimate, assessing an appropriate reserve amount discretely considers all risks being tracked by the project team. This point is critical, as carrying allowances for risks within the cost estimate and schedule could lead to the double-counting of risk when the reserve amount is calculated. The reserves can either be a function of the construction cost estimate (that is, a percentage of the construction costs) or determined through a more rigorous risk process involving the analysis and assessment of project risks via a probabilistic quantitative risk assessment (QRA). While a percentage may be useful at the outset of the project, when the scope is being confirmed and risks are not as well understood, a probabilistic QRA is often needed at the later design stages, particularly for complex projects. The outcome of a probabilistic QRA is a distribution of risk-loaded costs/schedule completion dates that are associated with different confidence levels (for example, P50, P75, and so on), as shown in Fig. 8. This information can then be used to determine an appropriate amount for reserves based on a confidence level. This desired confidence level is often a function of various factors: Risk tolerance of the owner: Higher confidence levels are typically desired by public clients and governments, as cost certainty is often a key project objective. Stage of the project: A higher degree of confidence is typically required as the project gets closer to the procurement stage, as project budgets need to be more firmly defined at this stage. Metro Vancouver has been a strong proponent of using QRAs to determine contingency reserves for its major projects. Engineers will work with Metro Vancouver staff to identify and capture risks for the full project lifecycle — from design through procurement, construction and operations — which are then inputted into a project risk register. With respect to market risks, Metro Vancouver has taken a hands-on approach to reviewing the estimate base case and looking at risk scenarios to address the risk of increased escalation and market factors that could result in an increase in the contractor’s bid price. The risk register is then used to prepare a cost and schedule QRA to better understand the range of possible project costs (including construction costs and owner’s costs). The selected value is based on a confidence level selected by Metro Vancouver that considers the overall project complexity. This process provides a more defendable project cost estimate when requesting funds from the board and at each gate review stage. Procurement consideration: The escalation/de-escalation clause In addition to the cost estimating approach detailed above, another tool that has been gaining exposure over the last two years to address rapidly changing market conditions is the “escalation/de-escalation clause.” This is a provision in a contract that calls for adjustments in fees, wages or other payments to account for fluctuations in the costs of raw materials or labor. The escalation clause shifts the burdens of increasing material and labor costs from the contractor to the owner, while a de-escalation clause does the opposite if costs come down. The clause can be triggered in several different ways, ranging from a simple approach (defining that an adjustment will be made if an increase in the cost of materials exceeds a certain percentage threshold) to a more complicated set of formulae based on different indicators, such as material pricing or an identified cost index in a specific geographic area. While escalation clauses can be helpful for owners because contractors will be more comfortable submitting lower bids, resulting in more contractors bidding on jobs, they can also present challenges because the prices that are being submitted are not being guaranteed. As Metro Vancouver is focused on providing cost certainty at the outset of a project, an escalation clause has not been considered at this time; however, this may be reassessed in the future. Conclusions Developing an accurate project cost estimate is critical for infrastructure projects, but recent market factors have made this more challenging. Several tools have been identified in this paper to improve the effectiveness of developing a project cost estimate, with specific examples given from Metro Vancouver, which provides regional-scale services to 2.6 million residents in the area. These include: A structured approach to defining estimate accuracy and including it in the overall project cost estimate. Developing a stage gate process that allows for a structured review and approval process at various stages over the project lifecycle. Using an effective risk management program to develop appropriate contingency reserves that discretely consider risks and uncertainties, thus providing a confidence-based approach to budgeting. This process includes quantifying market risks based on a review of historic trends. References Canada ConstructConnect. 2022a. “Construction Material Costs— Spikes Everywhere,” dated May 3, 2022. Available from: https://canada.constructconnect.com/canadata/forecaster/economic/2022/05/construction-material-costs-spikes everywhere [last accessed 13 December 2022]. Canada ConstructConnect. 2022b. “Among Sectors, U.S. Construction Workers Rank 4th for Hourly Wage Hikes,” dated December 7, 2022. Available from: https://canada .constructconnect.com/canadata/forecaster/economic/2022/12/among-sectors-u-s-construction-workers-rank-4th-for-hourly-wage-hikes [last accessed 13 December 2022]. Forth, C. & Fromberger, T. 2022. “The Cost of Urbanization—The Effects of Global-Scale Events on the Canadian Tunnelling Market” In: Tunnelling Association of Canada (TAC) 2022 Conference, Vancouver BC, November 2–4, 2022.
