Validation — success key in lump-sum projects
Cost is not something that supports business, it is the business. So effective control of it is an absolute necessity for any project success. Cost starts with estimation, so estimation has major significance in the entire project life cycle. On many projects, the first response from an assigned project manager is more than likely to be negative, because of the bid pricing, and the project will be described as one of those potential commercial disasters from day one. However, what these project managers generally fail to understand and appreciate is the necessity of a proper and formal validation exercise, followed by many re-validations in logical intervals to assess and re-assess the project. This paper discusses some important aspects of validation, with strong appreciation for the constraints of the business development or sales department during the preparation of original estimate for the bid.
Cost management is the business. So it is not to be tasted or swallowed. It needs to be chewed and digested. Ultimately, business success is the combination of brain and materials—the more brain you use the less material you need.
There's an evolution underway! Project heads are becoming business leaders or facilitators. Today's project managers do not simply execute what the CEOs dictate. They always see the big picture close, and work towards achieving the strategic objectives of the company. Globally, business managers are appreciating the shift in the way project management contributes to business success.
Cost management starts with estimating, which emphasizes the significance of estimation in project management. This paper emphasizes “validation” with relation to estimating. The base cost estimate and its validation are highly significant to the success of any project. For the owner (client), if the cost estimate is not accurate, financial return from capital investment may not be realized and other deserving projects may not have been funded. For the contractor, the estimation accuracy has different impacts for different contracting situations. On a lump sum project, the profit margin totally depends on the accuracy of the estimate. The loss from an inaccurate estimate, especially on a large project, can potentially put a contractor out of business. On cost-plus projects, the direct economical risk is less, but can severely damage a contractor's reputation. This paper focuses on the contractor's perspective.
Bid Estimate and Limitations on Its Accuracy
The discussion in this paper about the base bid estimate does not intend to cover the concepts and methodologies of estimating. However, limitations faced by the bidding team are well appreciated here. Estimation done during the bidding stage is generally of low accuracy, due to many reasons, such as:
- Limited information from bid package in terms of quality and completeness, leading to many assumptions
- Too much information to comprehend and analyze in short duration
- A small team with limited expertise in all engineering disciplines
- Company business strategies, like winning a client with future business potential
However, the bidding team needs to take all possible measures and care to minimize the errors, using historical data on successful and failed projects in terms of cost and schedule, outcomes of lessons learned exercises on previous projects, pulses in the regional and global economic scenarios, and so forth.
Apart from establishing the project budget, an estimate plays a major role in monitoring the budget during project execution. So the estimate must provide accurate information to allow for scheduling, cost monitoring, and progress measurement during execution.
Benchmarking and reconciliation with past similar projects during estimating will ensure credibility. Major discrepancies need be to be explained in detail or attributed to the peculiarity of the project. Some could even be attributed to the strategic importance of the particular project to the company. Reconciliation can be generally presented at a higher level, with supporting documentation made available for better comprehension by the project team, if required.
With the limitations during bid estimate, a validation of the estimate is essential before commencing the project execution. The validation needs to cover the following aspects of the bid estimate:
- Quality or accuracy of the estimate
- All required information for project controls
- Presentation in an understandable way for the project team members on the client's and contractor's sides
Basis of Estimate
The “Basis of Estimate” (BOE) needs to be unambiguous and comprehendible for all who would be using it in the project execution team.
The BOE document is important, as the dollar value is meaningless without knowing the basis. BOE generally includes the design basis, planning basis, cost basis, and risk basis of the estimate.
Design Basis: This section needs to cover the overall scope of the project in summary. Specific inclusions, and more importantly, specific exclusions of items or facilities need to be clearly documented. Moreover, this section needs to also cover all assumptions made during the bidding stage due to limited information and constraints of time and resources. If not managed carefully, the design/detailed engineering phase has the potential to significantly impact on procurement and construction, which in turn has direct and irreparable impact on cost and schedule. Experienced project managers agree that it's very difficult to win when change control becomes a political battle escalated to upper management. So the success of any project is highly dependant on the clarity of the design basis.
Planning Basis: This section needs to cover specific information about all aspects of the project, including contracting and subcontracting strategies during engineering, procurement, construction, and commissioning phases. It needs to also cover information about resources, length of the workweek, use of overtime, use of shift work, the project schedule, and key milestone dates.
Cost Basis: This section needs to cover the sources of all major equipment and bulk material pricing, labour rates (including engineering, fabrication, construction, and commissioning), allowances included, assumptions on productivity, and so forth. Utmost clarity is required on the pricing strategies used for high-valued capital equipment, and it needs to be well supported with the necessary back-up documentation.
Risk Basis: Every estimate is a prediction of probable costs, and hence involves uncertainty and risk. This section of the BOE document needs to clearly identify key areas of risks and opportunities, and document how the contingency is planned.
Handover to Project Team
As a kick-off for the validation process, the bidding/estimating/business development/marketing team will hand over the bid documentation, right up to job award, to the project team, led by the project manager. This shall be a detailed formal session lasting from 8 to 20 hours, depending on the size and complexity of the project.
The project team must have become initially familiar with the scope before this handover session. This will enable the project team to use the handover meeting to get a clear understanding of the project.
Project Handover on the Client's End
Handover happens on the client's side as well, to the project execution team. It is entirely possible that the client's execution team doesn't have even a single member from the bid handling team. So correspondences during the bidding stage about bid clarifications are very important. In many cases verbal agreements reached during bid stage would not help a situation of a scope ambiguity with commercial impact. Moreover, assumptions made during estimating, along with any verbal commitment on quality or schedule adjustments, need to be documented clearly.
Some experienced project managers use rules of thumb to verify estimates. However, formal validation is the professional approach. Reassessment of the risks and contingencies is essential, as the project manager has to live with and even defend it in subsequent reviews with the upper management. There are many elements of construction projects that add to the pressure to finish a project successfully for the owner and contractor, including:
- Design changes or defects
- Aggressive schedules
- Competitive bidding
- Difficult contracts
- Unrealistic fast-tracking concepts
- Major scope changes
- Late site access
- Unforeseen site conditions
- Environmental issues
- Uncertain labour productivity
- Ineffective project controls
- Differing site conditions
- Budget limitations
- Labour shortage
The validation process should address all applicable elements of the specific project, not limited to the above listing. The validation process at a contractor's end starts when formal or informal information is received from the client about winning the project. The process starts with the assessment of the project as a viable business opportunity meeting the contracting company objectives. It is then followed by a detailed validation exercise leading to no or minimum risk, no blame, pre-construction planning, and a business plan to meet the project objectives.
One of the major early steps in the process is the review of the BOE document for its correctness and completeness. Any ambiguity felt needs to be discussed with the bid estimating team and if necessary, with the client. In some cases, the research on the identified ambiguities can lead to major changes in the project execution, with or without commercial impact.
A quick check of the bid estimate is very important during the early steps of validation. This careful review must verify whether the estimate followed standard guidelines accepted by company norms and procedures. This includes verifying the following:
- Proper estimating methods, techniques, and procedures were used.
- The estimate summary and detail are organized and presented in the proper format.
- Estimates' back-up information is organized properly.
- All allowances and factors are appropriate.
Other major steps in the validation are validating the project from drawings, setting up a cost control system, establishing a realistic project execution plan, determining a revalidation schedule during the project life cycle, and so forth. Moreover, specific focus needs to be given to the following:
- Verification of engineering cost – because engineering decides 80% of overall project cost elements, there should be a realistic approach for engineering cost.
- Agreement with the authorities at the right level about home office-related costs
- Final constructability review
- Construction indirect costs (temporary facilities, construction equipment, tools, services, consumables, and so forth)
- Start-up and commissioning cost elements
- International labour adjustments for productivity, wage rates, working hours, and so forth
- Reduced productivity during regional holidays and festival seasons
- Material cost adjustments for local and globally sourced materials
- Currency fluctuations
Another important step in validation is comparing key matrices from the estimate. Major discrepancies must be explained by the particular circumstances of the estimated project. Some commonly compared matrices are:
- Percentage administration costs
- Percentage engineering/design costs
- Equipment to total field cost ratio
- Equipment to total project cost ratio
- Cost per piece of equipment
- Labour hours per piece of equipment
- Discipline-level ratios (such as cost per diameter inch of piping, cost per cubic yard of concrete)
This exercise will be effective only if accurate historical data is maintained for past projects. The current estimate gains credibility by comparing it with earlier estimates and clearly explaining the differences and reasons for differences. Reconciliation can be presented at a high level without too much detail.
Apart from all the above, strategic reviews of the estimate have to be done at various levels of corporate management, if required. The number of upper management reviews and the level of management they are presented to typically varies with the strategic importance and total estimated cost of a particular project.
As the project validation has to be done during the very beginning of the project, key personnel need to be assembled to handle this task. A typical validation team comprises the following personnel:
- Project manager
- Engineering manager
- Construction manager
- Planning manager
- Procurement manager
- Quality manager
- HSE manager
Generally, no member from the bidding team would be included in the validation team full-time. However, the bidding team has a great role to play in the success of the validation process, with timely clarifications of any ambiguity the validation team finds in the bid estimate.
A new trend gaining importance on the Engineering, Procurement & Construction contractor's side is “Project Team on Shelf,” where a very small group of potential core project management team is involved in the bidding stage of major projects with more than a 60% chance to win. This will ensure effective and seamless handover from the business development team to the project execution team, thereby making the first validation highly accurate and reliable.
It's a prudent management practice to validate at different stages of the project. For any project more than one year long, the first validation needs to be completed within two months. The second validation can happen only after the engineering is fairly advanced. This stage of the validation is extremely important and even critical, as 80% of project cost is controlled through the engineering design.
Opportunities and Risks
Validation should give a very clear picture of the opportunities and risks in these areas:
Opportunities and profit: Opportunities need to be identified at the earliest and handled for timely and effective capitalization. Good examples are achieving client consent for a non-approved vendor for major high-value equipment, or a different subcontracting strategy for a major area of work. Many opportunities can lead to additional business (sales), generally with higher returns than the rate expected from the base bid. Each potential opportunity should be identified, quantified, and valued.
Risks: As we saw earlier, the accuracy of the bid estimate is limited for many reasons, and the contingency plan may not always cover all risks. The validation team needs to highlight any area where the company is exposed to liabilities. Each major risk item should be identified, qualified, and costed.
During validation, if the team comes across a major mistake in the original bid estimate, the project manager needs to have the courage to go back to the client to revise the bid. Most professional clients are likely to absorb such a situation after due evaluation and analysis.
Business plan: The validation team needs to put together a clear business plan, which would be a revised version of the basic plan that the sales or business development team handed over by to the project team. This should include the following, at the minimum:
- Items and issues to be arranged
- Clearly defined ownership
- Timetable for achievement
- A clear-cut plan with ownership from project management team for any outsourced activities like design/detailed engineering, subcontracts, etc.
Effect of Unbalanced Bid
Unbalancing the bid means bidding the cost items that would be completed early in the project at amounts higher than the normal and pricing the items to be completed in later stages at lower than normal. Though front-end loading is mainly practiced in unit price contracts, conceptually it has become a part of the pricing strategy for lump-sum projects as well. Here the contractor does unbalancing on the schedule of values, which is used for determining progress payments. The validation team must closely look at this aspect while finalizing the cost projection system (discussed later in this paper). Front loading in lump-sum projects lead to lower cash inflow towards the end of the project. If the bid estimate was unbalanced for strategic reasons it needs to be formally documented in the handover from the business development/marketing team to the project team.
In today's situation on global investment across various sectors, the world's manufacturing capacities and human resource bank are not able to meet the demand. Aggressive schedules add fuel to this fire. All these contribute to the acceleration cost for meeting or beating the baseline schedule. Major cost elements to address such situations are special shipping (such as air lifting) costs, risk of quality compromises, re-work, shift work, overstaffing, overtime, and so forth. These have to be considered while arriving at contingencies allowed. Overtime, overstaffing, and shift work lead to significant drops in productivity levels. Overtime is often preferred, as it can produce a higher rate of progress without major coordination problems.
Some projects have the potential for productivity loss due to multiple changes arising in between. It can happen due to an unreasonable number of variations issued with or without direct commercial implications. Sometimes these variations together can make a synergetic disruption of the work that will be much more than the impact of individual variations. These disruptions can be very expensive in terms of reduced productivity or increased cost of performance. The validation team needs to consider this possibility.
Project Execution Plan
The validation team needs to revisit the project execution plan. The sequence of major activities can sometimes be changed for easier execution and economic procurement. Moreover, an activity envisaged for subcontracting may be found not the best option during validation, due to many reasons. The project execution plan needs to be analyzed carefully. Many times, experienced project managers come up with better and more logical sequencing and grouping of activities to optimize on equipment and manpower. The plan has to be studied along with the baseline schedule, so that some specific activities do not fall during extreme climatic conditions. Though such situations cannot be fully avoided, all efforts should be made to minimize it. Subcontracting strategies should be carefully analyzed for the best “make or buy” decisions.
Cost Projection for the Project
The validation team needs to put together a realistic cost projection for the project, which can be used during and after the project execution phase for:
- Cost and sales monitoring
- Establishing initial cash flows
- “What ifs” for the project manager to handle specific scenarios
- Bidding of future projects
Cost figures are validated in this document from time to time based on improved clarity on the project deliverables. The cost projection for the project will be refined to a high degree with the approval of various design and detailed engineering deliverables. Big EPC companies have a fairly organized and professional approach to the cost projection system. However, in many companies most of the core project team members are not well exposed to it.
The right people at the right levels should be ensured in the Organization Chart. If the right person is not available for the project, validation should consider budgeting for necessary training and development activities. Companies that are conservative on developing and empowering their human resources often fail to understand that it's more expensive to keep an untrained worker than to lose a trained one. Empowered employees with unambiguous scope can minimize the risks of micro-management, which is a killer on small projects and self-defeating on larger ones.
Human Resource Replacement Cost
For an EPC company, one of the major assets is human resources. In today's global scenario, employee turnover is accepted as a reality and no more considered as a threat. So organizations have started putting effective systems in place to mitigate the damages due to employee turnover. As we say in project management, “you cannot manage what you cannot measure”; it leads us to conclude that we need to measure the cost of human resource replacement in order to effectively manage it. Some major elements of employee turnover are discussed here.
By definition, a project is a “temporary endeavor,” and when key personnel are lost during the short duration of any project, the damage becomes highly expensive to repair. Globally, the supply and demand gap in the EPC sector is highly in the employee's favour, and many organizations are facing “brain drain.”
All organizations may not necessarily be able to develop a system for identifying, quantifying, monitoring, and controlling the “human resource replacement cost.”
Major EPC companies have a large number of educated or skilled personnel and many people occupying similar positions. Such people-intensive organizations invest heavily in their labour force, and qualify for having human resource accounting practices. The validation exercises at any stage have to look at potential human resource replacement costs.
It is not easy to put a value on the loss of efficiency and reduced productivity prior to employees' separation (mainly after they have given notice). A practical approach will be to start, based on standardized norms followed in the project estimate, and subsequently fine tune it during each separation event.
Due consideration should be given to all legal and HSE aspects applicable geographically. Care should also be taken to ensure HSE requirements are considered based on the minimum requirements from local regulations, company standards, or internationally accepted best practices.
Since validation itself is a cost element and calls for specific resources, many times it doesn't receive the priority it deserves. Senior management commitment is crucial to get the best return from validation exercises. At the same time, it is important here to emphasize Pareto's theory that 80% of project's ultimate outcome is result of the higher impact from only 20% of components. So areas of thrust during detailed validation must be identified carefully, and it depends to a great extent on the skills and knowledge of the team.
Chitkara, K.K. (2004). Construction project management. New Delhi, India: Tata McGraw-Hill Publishing Company.
©2008, Madhu P. Pillai
Originally Published as a part of 2008 PMI Congress Proceedings – Sydney, Australia