Cost contingency

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When estimating the cost for a project, product or other item or investment, there is always uncertainty as to the precise content of all items in the estimate, how work will be performed, what work conditions will be like when the project is executed and so on. These uncertainties are risks to the project. Some refer to these risks as "known-unknowns" because the estimator is aware of them, and based on past experience, can even estimate their probable costs. The estimated costs of the known-unknowns is referred to by cost estimators as cost contingency.

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Contingency "refers to costs that will probably occur based on past experience, but with some uncertainty regarding the amount. The term is not used as a catchall to cover ignorance. It is poor engineering and poor philosophy to make second-rate estimates and then try to satisfy them by using a large contingency account. The contingency allowance is designed to cover items of cost which are not known exactly at the time of the estimate but which will occur on a statistical basis." [1]

The cost contingency which is included in a cost estimate, bid, or budget may be classified as to its general purpose, that is what it is intended to provide for. For a class 1 construction cost estimate, usually needed for a bid estimate, the contingency may be classified as an estimating and contracting contingency. This is intended to provide compensation for "estimating accuracy based on quantities assumed or measured, unanticipated market conditions, scheduling delays and acceleration issues, lack of bidding competition, subcontractor defaults, and interfacing omissions between various work categories." [2] Additional classifications of contingency may be included at various stages of a project's life, including design contingency, or design definition contingency, or design growth contingency, and change order contingency (although these may be more properly called allowances).

AACE International has defined contingency as "An amount added to an estimate 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. Typically estimated using statistical analysis or judgment based on past asset or project experience. Contingency usually excludes:

  1. Major scope changes such as changes in end product specification, capacities, building sizes, and location of the asset or project
  2. Extraordinary events such as major strikes and natural disasters
  3. Management reserves
  4. Escalation and currency effects

Some of the items, conditions, or events for which the state, occurrence, and/or effect is uncertain include, but are not limited to, planning and estimating errors and omissions, minor price fluctuations (other than general escalation), design developments and changes within the scope, and variations in market and environmental conditions. Contingency is generally included in most estimates, and is expected to be expended". [3]

A key phrase above is that it is "expected to be expended". In other words, it is an item in an estimate like any other, and should be estimated and included in every estimate and every budget. Because management often thinks contingency money is "fat" that is not needed if a project team does its job well, it is a controversial topic.

In general, there are four classes of methods used to estimate contingency. ." [4] These include the following:

  1. Expert judgment
  2. Predetermined guidelines (with varying degrees of judgment and empiricism used)
  3. Simulation analysis (primarily risk analysis judgment incorporated in a simulation such as Monte-Carlo)
  4. Parametric Modeling (empirically-based algorithm, usually derived through regression analysis, with varying degrees of judgment used).

While all are valid methods, the method chosen should be consistent with the first principles of risk management in that the method must start with risk identification, and only then are the probable cost of those risks quantified. In best practice, the quantification will be probabilistic in nature (Monte-Carlo is a common method used for quantification).

Typically, the method results in a distribution of possible cost outcomes for the project, product, or other investment. From this distribution, a cost value can be selected that has the desired probability of having a cost underrun or cost overrun. Usually a value is selected with equal chance of over or underrunning. The difference between the cost estimate without contingency, and the selected cost from the distribution is contingency. For more information, AACE International has catalogued many professional papers on this complex topic. [5]

Contingency is included in budgets as a control account. As risks occur on a project, and money is needed to pay for them, the contingency can be transferred to the appropriate accounts that need it. The transfer and its reason is recorded. In risk management, risks are continually reassessed during the course of a project, as are the needs for cost contingency.

See also

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AACE International was founded in 1956 by 59 cost estimators and cost engineers during the organizational meeting of the American Association of Cost Engineering at the University of New Hampshire in Durham, New Hampshire. AACE International Headquarters is located in Morgantown, West Virginia, USA. AACE is a 501(c)(3) non-profit professional association. AACE International is a member of the Board of the Council of Engineering and Scientific Specialty Boards (CESB).

Event chain methodology

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  1. Calibrated probability assessment. This is a method for training estimators and experts to be neutrally confident about their assigned probabilities. That is, their probabilities are neither overconfident nor underconfident.
  2. Computing the value of additional information. AIE uses information value calculations from decision theory such as the expected value of perfect information and the value of imperfect (partial) information. Often, this is done for a large number of uncertain variables in some type of decision model or business case. The result will reveal where efforts to reduce uncertainty by making further measurements are best spent.
  3. Empirical methods applied according to the information value of the measurement. This step is, in fact, the reason for the name of the method. Most Monte Carlo modeling experts stop modeling after the first (uncalibrated) probability estimates from experts and there is usually little emphasis on further measurements with empirical methods. Since AIE computes the value of additional information, measurement can be selective and focused. This step often results in a very different set of measurement priorities than would otherwise have been used.
  4. Various optimization methods including modern portfolio theory. MPT and other methods are applied to determine ideal risk and return positions for a set of alternatives.

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Project management triangle

The Project Management Triangle is a model of the constraints of project management. While its origins are unclear, it has been used since at least the 1950s. It contends that:

  1. The quality of work is constrained by the project's budget, deadlines and scope (features).
  2. The project manager can trade between constraints.
  3. Changes in one constraint necessitate changes in others to compensate or quality will suffer.

Probability bounds analysis (PBA) is a collection of methods of uncertainty propagation for making qualitative and quantitative calculations in the face of uncertainties of various kinds. It is used to project partial information about random variables and other quantities through mathematical expressions. For instance, it computes sure bounds on the distribution of a sum, product, or more complex function, given only sure bounds on the distributions of the inputs. Such bounds are called probability boxes, and constrain cumulative probability distributions.

The following is a glossary of terms relating to construction cost estimating.

References

  1. ↑ Frederic C. Jelen, James H. Black, Cost and Optimization Engineering, Third Edition, McGraw-Hill Book Company, 1983, pg 456-457
  2. ↑ Standard Estimating Practice Sixth Edition, American Society of Professional Estimators, Bni Publications, Inc, 2004, ISBN   1557014817, Pg 103
  3. ↑ "Cost Engineering Terminology", Recommended Practice 10S-90, AACE International, WV, rev. 2007
  4. ↑ Hollmann, John K., "The Monte-Carlo Challenge: A Better Approach", 2007 AACE International Transactions, AACE International, Morgantown, WV, 2007.
  5. ↑ Uppal, Kul (editor), Professional Practice Guide (PPG)#8, "Contingency", 2nd Edition, AACE International, Morgantown WV, 2007.
  6. ↑ Rameezdeen, R.; Palliyaguru, R.S; Amaratunga, D. "Financing Contractors in Developing Countries: Impact of Mobilization Advance Payment" (PDF). www.irbnet.de. Retrieved December 5, 2019.
  7. ↑ "Item 01699.1010 M – Site Mobilization" (PDF). www.dot.ny.gov. Retrieved December 5, 2019.
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