Escalation

Construction Industry Computer Consultants Ltd.

Project Management’s interest in escalation has heightened considerably in the last few years. This is not only because of the dramatic impact on project costs due to inflation, but also because cost overruns blamed on inflation have been poorly received by Owners. There is the feeling that inflation has been used as an excuse and as a cover-up for poor management. Project managers feel equally frustrated since it has been virtually impossible to identify the effects of escalation with any degree of accuracy.

Recognition of this situation has resulted in the development of a system** that provides analysis of the actual affects of inflation on the project costs to-date and develops cumulative future effects over the remaining duration of the project. Variance from budget due to normal contingent unforeseens are separated from that variance due to schedule changes, estimate revision and inflation rate fluctuations.

The basis of the escalation procedure is the selection of a series of escalation indices applicable for the project. It is important that both the owner and project managers agree on those chosen and that they should be based on published indices that will be readily available throughout the course of the project. The number of indices chosen should not be too great, typically 12 to 15 for a major project, projected annually over its duration. Each index can be assigned variable rates of escalation over varying periods of the project’s duration.

Where some elements of the project cannot be satisfactorily associated with one of the basic indices, a composite index composed of a precisely specified mix of two or more standard indices can be incorporated.

Periodic reviews of the indices should be made to register the actual (published) values and revise future values. It is important to identify as accurately as possible this theoretical actual escalation since determining true escalation is not feasible. The “actual” escalation is compared to the previously forecasted value so that a record can be developed of the cumulative variance. This then becomes a contributory factor to project overrun or underrun that may be segregated from the controllable costs of the project.

ESCALATION CALCULATION

The ingredients of the escalation calculation are:

— the escalation index

— the cost estimate

— the schedule of work

By applying conventional compound interest methods to these data, the provision for escalation can be developed for the items of goods and services required for the project. All three of the above ingredients are variables, therefore a change in any one of them may be cause for recalculating the escalation provision.

The following Figure 1 exhibits the detailed configuration of a typical planned or pre-award status contract package.

At the time the estimate for the items of the contract package are developed, they are calculated by using unit rates and cost data prevalent at a chosen base date. This information is readily available. If, in the example, the base date were 1 JAN 74, the estimates would be developed assuming that all work would be performed precisely on this date. This, of course, is a gross simplification, but convenient and easily manageable.

The appropriate index is either assigned to each item in the estimate, or if left blank, will assume the contract package index to which it is assigned. For example, if a contract is planned for the supply and erection of equipment, the appropriate equipment or material index and the labour index would be assigned to the applicable items.

The calculation of the escalation provision is thus made using the appropriate index, estimate, and schedule for each item of each contract package on the project. This calculation is analagous to the calculation of the eventual value of a single investment P, made now and earning interest at i percent per annum. The compound interest formula is:

S =sum after n periods = P (1 +i)*n

E = the escalation after n periods

    = S-P = P (l + i)n-1

The magnitude of the escalation provision on recent projects that span 6 to 8 years has been as high as 40% of the total project budget — an overall project cost control exercise.

DEVELOPING THE CONCEPTUAL ESTIMATE

Establishing the escalation provision on the project based on the conceptual estimate becomes a simple task. The estimate is usually cast along the code of accounts structure, in which case each item of the escalation is assigned its appropriate index. The project master schedule is used to provide the installation or manufacturing timing.

The acceptance of the project estimate and its escalation provision by the Owner provides the base from which all trends and variances can be monitored and hopefully controlled.

PRE-AWARD ESTIMATE REVISION

The next phase of a project following acceptance by the Owner includes, amongst other tasks, the dividing and recasting of the estimate items into planned contract packages by which the goods and services will be procured. As design progresses and detail becomes available, planned contract packages are often reestimated using cost data prevalent at that time.

In the intervening period, the indices may or may not have been reviewed to reflect the actual economic history.

The task of the program is now two-fold. First, the effect to-date of inflation must be established by deescalating the current estimates to the base date. The second step is to escalate the current estimate to the completion of the installation or manufacturing period of the item. A direct comparison is thus available between the de-escalated estimate and the Authorized Budget base amount. In addition, the indicated escalation can be compared directly with the Authorized budget escalation provision.

CONTRACT AWARD

In the event that the project policy is to incorporate escalation clauses into the contracts, it is helpful to separate the total escalation provision calculation into two parts:

1. Pre-Award Escalation

By determining the amount of the escalation only up to the time the contract is to be awarded, rather than to the completion of the work, that portion of the escalation that will be reflected in the bid price will be identified since all escalation from award point on will be covered by a cost plus reimbursable contractual clause.

2. Post-Award Escalation

The pre-award escalation provision, when subtracted from the total escalation provision to the end of the contract, leaves the indicated post-award escalation provision. This becomes the forecast

value of the contractual escalation clause.

When a contract is awarded without a contractual escalation clause, the cost data associated with the pay items now represents the fully escalated forecast of final cost. The program then determines the de-escalated value of the contract so that the effects of escalation on the final costs can be gauged.

ESCALATION VARIANCE ANALYSIS

It has been previously stated that true future escalation cannot be forecast with precision. The actual escalation at any date can only be theoretically ascertained from a comparison between the published values of the base indices at this chosen date, and the original forecasts. This exercise should be carried out so that the theoretical actual effects can be quantified. Periodic reviews (quarterly, semi-annually or annually) of the indices should be made to record the actual values and revise the forecast values.

Updating of these indices can be handled by the system so that the portion of the escalation variance due solely to indices changes can be isolated from that portion due to schedule and cost changes. This therefore, isolates the one major aspect of the project cost that resides beyond the boundaries of the project management’s total accountability.

Figure 2 exhibits the report format showing the manner in which, contract by contract, the forecast of final cost is de-escalated to the project base date. The difference is developed between the de-escalated forecast of final cost and its indicated escalation with the corresponding Authorized Budget base amount and escalation provision. The total variance represents the total project overrun or underrun and usually represents a direct depletion of the project contingency.

This information, produced on a monthly basis as part of the total cost reporting process, clearly identifies cost trends and their causes. This has been well received by both project management and owners. In fact, one astute owner is responsible for the system’s ability to separate the effects of escalation rate changes from those of schedule and estimate changes for which he is holding the project management responsible.

Figure 2


* Reprinted by permission, Canadian Consulting Engineer

** This system forms part of Construction Industry Computer Consultants Limited (CINCOM) computerized project management system EMSCO. This system supports pre-tender planning, procurement scheduling, cost control, contract administration, finance and project accounting, and is available on several data centers in Canada and in the US.

This material has been reproduced with the permission of the copyright owner. Unauthorized reproduction of this material is strictly prohibited. For permission to reproduce this material, please contact PMI.

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