This important book was among the three books launched by Engr. Johnson Awoyomi in February this year at Lagos. We intend to carry chapter two of the book here because of its significance to the topic, which is Cost Engineering and Cost Control, especially, in Medium and Large Projects.
CHAPTER 2: ELEMENTS OF COST
Contingency: AACE International defines 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 or time. In essence, contingency is an amount to reduce the chances of overrunning the point estimate to an acceptable level of risk. Management must determine this “level” based on their risk tolerance (i.e., how risk-averse are they?). The amount of contingency is determined statistically by the Monte Carlo analysis. The funds added to the point estimate to achieve a given probability of not overrunning the estimate (given the relative stability of the project scope and the assumptions upon which the estimate is based) are the contingency. Estimate contingency is the amount added to the point estimate to provide the desired level of confidence related to underrun or overrun.
In essence, contingency is an amount to reduce the chances of overrunning the point estimate to an acceptable level of risk. The difference between the selected funding value and the point estimate is the contingency. The Management should establish an acceptable level of risk. And contingency should exclude escalation (a separate risk fund to account for changes in costs over time).
(4) Overhead cost
Overhead is a cost or expense inherent in the performance of an operation (engineering, construction, operating, or manufacturing). It cannot be charged or readily allocated to a specific work item, product, or asset. It may be allocated on an arbitrary basis, such as divided among production units, in a manner believed to be equitable. It may be segregated as a business expense independent of the volume of production. It consists of two major sub-components: Home office or general overhead and Job-specific overhead.
Home Office Overhead: This includes fixed costs and expenses incurred in doing business regardless of the amount of work completed or contracts received. Home office overhead includes costs of items such as:
home office rent or lease, utilities,
communications (telephone, fax machines)
advertising, salaries of home office employees,
salaries of executive personnel, donations,
legal costs, accounting expense,
None of these costs are chargeable to any specific project.
The detailed approach to controlling this kind of cost is a subject of an entire chapter in my book titled “Maximization of Government Take from Oil Sector – Cost Engineering Perspectives.” It is the eighth chapter titled, “How to Control the Home Office Cost.”
Job Overhead: Job overhead is another name for general requirements or job indirect, and it includes costs incurred at the job level in performing a specific contract but not chargeable to any specific item or element of that contract. Job-site overhead costs are those costs that can be associated with a particular project, such as trailers, sanitation, security, utilities, bonds, and insurance.
Below is a list of job indirect on typical EPC jobs:
Salaries, Supervision
Salaries, Engineering
Salaries, Wages, Other
Automotive
Buildings and Major Equipment
Temporary Horizontal Construction
Support Systems
General Expenses
It should be noted that all these costs must be controlled to enable the successful delivery of our projects. Other classifications of costs are: Fixed and variable costs, capital equipment, and temporary equipment.
Fixed and Variable Cost: Fixed costs are those costs independent of short-term variations in the output of the system under consideration. It includes such costs as maintenance, plant overhead and administration, selling, and research expense. In construction, fixed cost includes general and administrative costs. Variable costs are a production function, e.g., raw materials costs, by-product credits, and those processing costs that vary with plant output (such as utilities, catalysts and chemicals, packaging, and labour for batch operations).
Capital equipment Costs: These are the costs of the engineered items (usually long lead) performing a function in a process or facility (e.g., pump and HVAC unit) that become part of the asset.
Temporary Equipment: These are the equipment used in the construction process that do not form part of the permanent asset (usually treated as an indirect cost).
Expired or unexpired costs: Unexpired costs (assets) are those applicable to production of future revenues. In contrast, the expired costs do not apply to production of future revenues and are treated as deductions from current revenues or are charged against retained earnings.
2.3 Cost engineering terms and definitions
The AACE International has published all cost engineering definitions and terms. They can be downloaded from the AACE International website – www.aacei.org in a document titled RPS-90. A few terms are defined and explained in this section:
Escalation and Inflation
Escalation refers to changes in price levels driven by underlying economic conditions, and it reflects changes in price drivers such as productivity and technology and changes in market conditions such as high demand, labour shortage, and profit margins. Escalation includes but differs from inflation, caused by the debasement of a currency, and varies for different cost items, regions, and procurement strategies.
Currency Exchange Rates
Most large capital projects like the NLNG project, Ajaokuta-Kaduna-Kano Pipeline project, and Petrochemical refineries must acquire goods or services using multiple currencies. As Estimators and cost engineers, we must apply exchange rate adjustments as needed (Finance and Accounts Department usually provide rates). The future exchange rates are highly uncertain; however, estimators and cost engineers are usually less likely to be involved in currency risk evaluations than they will be for contingency or escalation estimating. It should be noted that escalation and exchange rates have some correlation (e.g., Euro falls relative to the dollar, Euro prices may “escalate” for imported items)
Productivity, Production Rate, and Productivity Adjustment Factors
Another word for productivity is efficiency. Mathematically, Productivity is work accomplished divided by the effort expended or outputs divided by inputs. When the value obtained is greater than 1, it is good; if it is lower than 1, it is bad. It is a measure of output relative to input. Productivity (or efficiency) is improved by increasing output for a given input or decreasing input for a given output. If the input is in work hours, the term commonly used is labour productivity. Productivity is a subject of great interest as far as the construction industry is concerned, and therefore a good grasp of the concept and its drivers is essential for cost estimators and cost engineers. As owners, it is crucial to keep your eyes on the “as-bid” productivity and compare it with “as-being” implemented productivity to know whether the contractor is achieving the productivity he claimed at the bidding stage or not. One major gap for developing nations such as ours is the determination of productivity factors for their respective states or major towns – this is an opportunity for cost professionals to consider.
Job Productivity Adjustment Factors
These are adjustment factors relating to project type, project complexity, quality assurance/quality control, factors relating to the project location, weather factors, labour availability, job site congestion, factors relating to project organization, over time, project management organization, control of project schedule, and other adjustments.
Productivity is the real variable in the labour cost equation – Estimating productivity calls upon an estimator’s best talents since the estimator must evaluate the effect of many interrelated factors such as considerable judgment, gained only through experience and research. Thus, the estimated labour productivity may not be perfectly accurate, but by successively analysing multiple factors individually, estimators focus their analysis methodically.
Production Rate
This is the amount of work accomplished in a given unit of time. Therefore, cost engineers need to be very careful in communications. For example, an operator may say they achieved better “productivity” because they installed three times the number of meters of pipe per day in this job versus their usual. However, if they spent two hours doing so, lower labour productivity (3/2 = 50% more hours/meter than usual). The point being made here is that – Productivity is not the same thing as production rate.
2.4 Costing and pricing
Costing is not pricing. Costing is an outcome of the quantity take-off and information presented in scope documents, assignment of cost values to elements of work, and related items. Pricing is the determination of the amount to be charged to the client (whether lump sum or unit price) to fully include profit and contingency in addition to direct and indirect costs. Price is the amount of money asked or given for a product (exchange value). The chief function of price is to ration the existing supply among prospective buyers, and it incorporates direct costs, indirect costs, general overhead, profit, and contingency. The price of an item may be greater than, equal to, or less than the cost of that item, depending on the motives. Let’s consider the examples on cost and pricing for a good explanation:
JOA Threading firm
Labour = $9.35
Material = $4.37
Factory Overhead = $3.83
Cost of Goods
Manufactured = $17.55
G and A Overhead = $5.45
Total Cost = $23.00 (Cost)
Profit, 20% = $4.60
Price to Distributors = $27.60
AAA Industrial Sales Company (Distributes the threaded pipes)
Cost to AAA = $27.60
Mark-Up and
Profit 66-2/3% = $18.40
Price to Customers = $46.00
In summary,
Price = Cost + X
Where X could be positive or minus depending on the motives of the organization or the person concerned. In an economy like Nigeria, where the price of premium motor spirit is subsidized, the value of X in the equation Price = Cost + X will be negative.
Time Adjustments
In carrying out normalization activities on data, you may have to normalize the data with respect to time, location, and even currency. Time adjustment is derived from inflation and escalation. Inflation results from governmental monetary policy, while Escalation results from economic factors and policy, such as labour, materials supply, and consumer demand. Therefore, escalation is much more variable and more difficult to predict than general inflation.
Open Shop versus Union Shop
At some construction locations, a contractor may or may not have a choice between union or open shop operations. For example, in some areas of the country (say Port Harcourt, Escravos, in Nigeria), virtually all qualified artisans are union members, and essentially, all major construction contract work in that area will be unionized. As a result, the open shops’ work environment will be more cost-competitive and more productive than the union shops’ locality. Usually, a procedure reflects differences between open and union shops by using two Area Productivity.
2.5 What is bid Unbalancing?
Bid unbalancing is a technique used in the pricing process to allocate estimated costs to accounts whose definitions do not fully reflect the nature of the cost being allocated. The purpose of unbalancing is to achieve a desired business result, such as improved cash flow. For example, a disproportionate amount of overhead costs may be allocated in a contract bid to early project activities (or unit price items installed early) to maximize early income. It is an action in which the bidders inflate or deflate the bid item prices by manipulating the item mark-ups – without affecting the total bid price. The purpose of unbalancing a bid by the contractor is to (1) enhance the project cash flow because contractors have a concern for the operation and profitability; (2) because of the lag between the client payments and contractor’s expenditures- which is a risk to their cash flow. Therefore, they use unbalanced bidding as a risk-mitigating strategy.