KPMG Major Projects Advisory Project Leadership Series: Budgeting, Estimating, and Contingency Management for Construction Projects

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1 KPMG Global Energy Institute KPMG International KPMG Major Projects Advisory Project Leadership Series: Budgeting, Estimating, and Contingency Management for Construction Projects Construction projects inherently contain a significant amount of risk to the owner. In many instances, an owner s core business does not involve construction activities, and when a company decides to proceed with a construction project, they may not be aware of the resources available to assist them in identifying and minimizing their risk exposure. This installment of Major Projects Advisory Project Leadership Series is designed to provide insight related to some of the common challenges identified when assessing construction projects and the resources available to owners to minimize their risks. The process of developing a comprehensive project budget with a reasonable contingency amount is critical for a project to be considered a success upon completion. According to KPMG s 2012 Global Construction Survey, 54 percent of respondents failed to identify up front the issues that later caused margin erosion. Once an owner decides to proceed from the feasibility or conceptual phase of a construction project, the next steps are to identify the method of funding based on an estimate of total project costs. Depending on the accuracy of project estimating techniques employed, the development of the overall project budget may or may not include a reasonable contingency amount. If an estimate is too low, the project contingency will most likely be insufficient, leading to budget overruns. On the flip side, an overly conservative estimate can tie up valuable capital that could be used for other capital projects, and the project may be deferred or rejected by senior management. How do I prepare an accurate project estimate during planning & development? The degree of accuracy of a construction cost estimate depends on the phase of the project. In general, the accuracy of the estimate will be proportional to the level of project definition. At the initial feasibility or conceptual stage, parametric, order-of-magnitude, unit price, or other estimating methods for projects of similar type and scale may be used. At this stage, there is a wide range of variability in the estimate, so the estimate should include allowances and design contingencies to address unknowns. Subsequent estimates will be more detailed and comprehensive as the design progresses and as the construction drawings are developed. Following the completion of the construction drawings and specifications and prior to bidding, the design team or an outside cost estimator should prepare the detailed estimate Estimating energy projects is often very challenging due to the nature of how many energy projects are approved and funded. Regulated utility projects, as well as generation projects with loan guarantees and incentives, require the development of comprehensive estimates during the planning phase in order to obtain approval and funding despite the large number of assumptions and risks that have often not been properly vetted or analyzed. based on actual quantity take-offs and current market pricing for labor, equipment, materials, and subcontractor services. Appropriate mark-ups for labor burdens, supervision, indirect field expenses, general and administrative costs, profit, insurance, bonds, etc., must be added to the direct cost of construction to arrive at a complete, detailed estimate. The owner will review the construction bids relative to the detailed estimate prepared by the design team or outside cost 1 MAJOR PROJECTS ADVISORY PROJECT LEADERSHIP SERIES

2 consultant. Any significant variation between the values for individual line items should be investigated. Some differences are usually due to costs being included in different areas of each estimate, so there should always be discussions with the contractor, construction manager, or design-builder to understand these differences. If significant differences remain after these discussions, the owner may consider obtaining a third-party cost estimate to validate the construction bids. If the construction bids exceed the budgeted costs, owners must determine if a budget increase is both warranted and possible. Alternatives include providing the bidders with further clarifications, requesting new bids from other sources, or dividing bid packages into smaller packages. How should historical construction costs be used to develop an estimate for a project? Construction cost estimates typically utilize historical cost data in the development of a project estimate. Supplemental information specific to the project maintained by the owner may be combined with this cost data, such as: Actual construction project cost information from other completed or ongoing projects Published cost estimating manuals Construction cost indexes Manufacturer s catalog information including price information. This information should be used cautiously as the historical cost information and indexes are constantly changing and errors in the application of this information during the preliminary phase of the project may not be possible to correct at a later date. In addition, the owner should confirm that project-specific variables have been accounted for in the cost estimate, including cost index adjusting for location and inflation, as well as regulatory and other location factors such as more restrictive building codes. What is the benefit of getting third-party validation of project costs during budgeting? Depending upon a number of variables including the maturity of an owner s organization and controls and the complexity of a given construction project it may be useful for an owner to solicit a third-party validation study of the projected construction costs. Such a study can help to control costs and thereby minimize the risk of exceeding the budget by validating the projected costs for a project. This validation can utilize additional information that may not be available in cost indexes such as data collected from other construction projects. This information can be used for an individual construction project, or, if an owner is embarking on a larger capital program, it may be useful to incorporate this information into an updatable database. A database of construction cost information allows an owner to incorporate data from previously completed construction projects with the current cost pricing, which may improve the accuracy of the construction estimates. Many energy companies have an extensive amount of historical project data regarding past projects which often leads some energy companies to rely solely on internal project estimates as well as architect/engineer or contractor estimates to prepare project budgeting and funding authorization requests. This lack of independent project estimates often leads to inflated or overly optimistic project estimates as well as missing or unclear scope of work packages. What is the process for developing a comprehensive budget? The project budget should be comprehensive and should include not only the construction contract costs, but also the costs associated with land acquisition, planning and feasibility studies, architectural and engineering design, field supervision and inspection, construction equipment, financing, incentives, insurance, and taxes. Project-specific variable costs such as municipal requirements and weather conditions should be accounted for in the budget as well. While the construction contract may represent the largest cost item, the other project costs are not insignificant and should be carefully estimated and included in the overall budget. The owner is responsible for developing the budget for costs that are not included in the construction contract, while Establishing an acceptable and agreed-upon contingency for regulated utility projects is extremely challenging due to the extensive scrutiny and often competing objectives of the regulator. By leveraging data from similar past projects as well as acceptable industry standards and resources, utility operators can develop well-supported and justifiable contingencies for their capital projects. 2 MAJOR PROJECTS ADVISORY PROJECT LEADERSHIP SERIES

3 the construction manager or the contractor prepares the construction budget. Before commencing construction, the construction manager or the contractor may engage in a value engineering exercise which involves the review of building systems and major equipment items in an attempt to improve functionality or reduce costs while maintaining the scope of the project. Any proposed value engineering substitutions should be reviewed by the owner and the design team to determine the impact to both construction costs as well as operational costs. How should contingency be established? Most projects include a contingency fund to cover both anticipated costs due to the project s phase and unexpected costs. Project contingency is an amount included in the construction budget to cover unknown conditions, allowance for design growth, errors in the contract drawings, inaccurate pricing, price escalation, and minor changes within the project scope. The optimal amount of project contingency permits the owner to adequately address project risks while not restricting the use of capital funds that can be assigned to other projects. The contingency fund is to absorb additional project costs within the project scope without the necessity of preparing multiple funding requests and obtaining authorization for every change encountered during the project. Control of the contingency fund varies depending on the project delivery method, but the owner s project team should be cautioned to avoid using the contingency fund to pay for added scope items. Developing the contingency fund is not a one-size-fits-all approach. Some projects include a percentage of the total construction value as a contingency fund based on experience with previous projects. This approach, however, may not be appropriate for complex construction projects or those without established historical costs. For these situations, the owner should engage all stakeholders during the design phase to identify project risks and develop appropriate risk responses. The risk assessment process should include a review of all high-risk budget items with the goal of confirming that the contingency budget is appropriate to cover the costs of all probable risks, as well as including contingency for unknown risks. Each item in the risk assessment should include the following: Best and worst case cost and schedule impacts Potential costs related to the risks Probability of the risk occurring Overall probable cost and schedule impact to the project When the risk is expected to occur How the risk will be addressed Individual responsible for developing and implementing the risk management plan for each risk. How do I manage and track contingency once established? The management of the contingency is critical to the success of a project and should be monitored on a continuous basis. It is important to note that the contingency fund is included in the owner s budget to address risks and unforeseen events that may occur during a project. Contingency is risk dependent and, Given the importance of meeting financial projections, recovery targets, and loan commitments, the ability to accurately report and track progress against the approved budget is critical for energy projects. If there is limited visibility or accuracy with regards to budgetary performance, regulatory pressure increases, lending terms get more stringent, and investor confidence is eroded. therefore, not a budget allowance. Furthermore, contingency should not be used to fund significant changes to the scope of the project. The project management team should review the contingency fund balance along with project risks throughout the duration of the project to determine if adjustments to the fund are needed. Managing the contingency fund is as important as developing it and may provide the owner with advance notice of serious financial issues. What controls should be in place to avoid budget overruns? The project management team should review the contingency fund balance along with project risks on a continuous basis throughout the duration of the project to determine project budget variances, including contingency and if adjustments are required. As part of this analysis, individual cost line items and variances should be evaluated to determine if future variances are anticipated, to estimate the total cost at project completion. Tools that facilitate budget monitoring include project earned value and a cost to complete analysis. The risk register should be updated to reflect the progress of the project as well as any additional risks or opportunities identified, updating the contingency accordingly. All changes to the contingency forecast should be communicated to all relevant parties by means of a formalized communication process, as this information allows for proactive decisions that may avoid serious financial issues. 3 MAJOR PROJECTS ADVISORY PROJECT LEADERSHIP SERIES

4 Conclusion The process of developing a comprehensive project budget with a reasonable contingency amount is critical for the project to be considered a success upon completion. The project budget is refined as the project progresses from the conceptual phase to the check estimate or bid phase. The contingency fund should be developed as part of a project risk assessment and should adequately address project risks, while not overly restricting the use of capital funds that can be assigned to other projects. Managing the contingency fund proactively allows the owner s project management team to analyze trends and respond to cost pressures relative to the overall budget. Contact Us Geno Armstrong Principal, Advisory T: E: garmstrong@kpmg.com Clay L. Gilge Principal, Advisory T: E: cgilge@kpmg.com Gordon Postle Director, Advisory T: E: gpostle@kpmg.com kpmg.com The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. NDPPS KPMG is a global network of professional firms providing Audit, Tax and Advisory services. We operate in 152 countries and have 145,000 people working in member firms around the world. The independent member firms of the KPMG network are affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. Each KPMG firm is a legally distinct and separate entity and describes itself as such.

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