Project Management Institute

Wake up! we still do costing wrong

PMCommentary

by Arild Sigurdsen

IN THE SEPTEMBER AND DECEMBER 1996 issues of Project Management Journal, I wrote about “Principle Errors in Capital Cost Estimating Work.” I also touched upon the same subject in “Project Control: Why Do Budget Overruns Occur?” in the April 1995 PM Network. In these articles, I focused on the problem of project cost overrun as a result of a particular malpractice in capital cost estimating. I wrote these articles because I believed a policy change made by the international oil industry in Norway was a step in the wrong direction. I feared large budget overruns would result. For several years I had studied statistics from several hundred contracts and had concluded that the way the construction industry went about doing cost estimates was wrong. I had hoped that the articles would lead to a discussion on capital cost estimating techniques and also to a new approach to project cost control. This did not happen. I did not succeed in stopping a rearrangement of contract strategy that was directly contradictory to what I claim in the articles. The outcome of the arrangement was a tragedy, resulting in billions of dollars of budget overrun and the loss of thousands of jobs.

It now seems evident that this very same malpractice is the main cause for massive budget overruns in recent oil and gas development projects on the Norwegian continental shelf. A government-established committee concluded that the total budget overrun on 13 major oil and gas development projects, commenced after 1994, is in excess of 27 percent. This amounts to nearly 4 billion U.S. dollars. It is, however, clear that the overruns have increased considerably since the committee's report was released in January 1999. Also, the official figures do not include the losses suffered by the construction companies—only losses by the project owners. The real cost overruns are therefore a lot higher. On top of this, numerous layoffs resulted. At Statoil, the state-owned oil company, all members of the board of directors and the company CEO were removed from office. And the public still does not fully know why everything went so terribly wrong.

Arild Sigurdsen, BSc.Eng., CERA Consult, Lier, Norway, is a project management consultant with more than 27 years experience in offshore oil and gas projects. He has been developing cost estimating and cost forecasting systems for use in the international construction industry for over 20 years. Direct comments on this article to editorial@pmi.org.

In my view, the government committee did not establish the real cause for the overruns. It merely described the situation and pointed at the problem. However, in doing so the committee presented data that, in my opinion, validates a crucial point that I make in the previously published articles. (See Exhibit 1.)

Each point or dot on the Exhibit 1 graph represents the total as-built unit cost of one platform deck (the “factory”) in KNOK/tonne. The unit cost of each deck is plotted against the corresponding deck weight. A split has been made for projects completed before 1994 and projects completed after 1994. The continuous curves are the resultant regression lines.

The readers of my previous articles will understand why I like this graph. My point in showing it is, however, not to start a discussion about whether the platform decks built after 1994 cost less than the decks built before 1994—which is the committee's reason for presenting this data. My reason for bringing this to your attention is simply the observation that the regression curves are descending with increasing weight. In other words, the overall unit cost is clearly quantity-dependent, which is analogous to the point I make in my previous articles. I claim that this fact is the source of many tragic budget overruns in projects worldwide!

The descending curves look logical, but the crucial point is this: If historic data show the overall unit costs are dependent on project size rather than contract size, budget cost estimates must also show dependence on project size. Or put another way, the descending historic curves in Exhibit 1 are made up of numbers. It follows that several of the numbers making up a complete cost estimate must comply with the same type of descending behavior. The question is, which numbers?

Depending on how you set up your estimates you may agree that labor-related costs may be calculated by “estimating chains,” such as:

Quantity (Tonnes) x Norm (Whrs/tonne)
x Rate (US$/Whr) = Cost (US$)

Several hundred or several thousand estimating chains make up the total capital cost estimate of a project. My argument is: If it is true that overall or total unit costs decrease with increasing quantity or weight, the source of this downward trend must be one or more of the elements of the above estimating chain. Which one(s)? Referring back to my previous articles, I claim that the descending trend is predominantly caused by the “norm.”

Statistics show that the Unit Costs of offshore oil and gas development projects decrease as the size of the projects increase. This phenomenon is probably the main reason for recent massive cost overruns on the Norwegian continental shelf

Exhibit 1. Statistics show that the Unit Costs of offshore oil and gas development projects decrease as the size of the projects increase. This phenomenon is probably the main reason for recent massive cost overruns on the Norwegian continental shelf.

Now, the reason for the cost overruns on the Norwegian continental shelf: In approximately 1994, new contract policies for the construction of offshore platforms were introduced. To reduce both costs and development time, many new ideas were put into action. The most crucial idea, in our context, was the splitting up of gigantic platform decks into smaller fabrication units—often referred to as Pre-Assembly Units, or PAUs. This was done to make it attractive and possible for smaller companies to bid for the jobs. The idea was that the more bidders, the more competition, the lower the costs. This may sound attractive to most project owners, but it is often a serious trap, because it also means smaller contracts! Also, the historic construction and engineering norms applied at the time stemmed from the construction of much larger units. The decks were not larger in previous years, but they were constructed and designed in larger units. Thus, if contract quantity meant anything at all to the final cost, the meaning was bound to surface now. It did. The budget cost overruns were larger than ever before. Disaster was a reality.

The fact of the matter is that the smaller the object being built, the larger the engineering and construction norms—and vice versa. There are of course many “ifs and buts” involved that I will not discuss here. However, having worked with quantity-related norms in cost estimating for more than two decades and having studied hundreds of as-built contracts comprising thousands of norms and rates, I have no doubt about the tremendous importance of quantity-dependent norms. What amazes me is that very few companies in the construction business, including the shipbuilders and road builders, seem to take this problem seriously.

If you have been involved in projects for a while, you must have experienced several unforeseen or surprise budget overruns. Did you blame the project manager? Well, it is always the project manager to blame, I guess; but could a better and more direct cause have been unfamiliar project sizes or unfamiliar contract strategy? I claim that ignoring the natural quantitative variations in the norms may result in cost overruns exceeding 50–60 percent! Next time your project turns sour and nobody understands what is going on, and everybody is blaming everybody else, see if it might be the “variable norm syndrome” that is the cause of your misery.

Oddly enough, the trend-setters in capital cost estimating work—the publishers of estimating techniques, norms and rates—do not take this problem into consideration either. Look around the bookstores and on the Internet. You will have a hard time finding a publisher of quantity-dependent norms. Most books publishing norms for the purposes of detailed estimating will vary the norms with the variations in pipe diameter, but not with the variations in pipe length! Why is one dimension more important than the other? It's absurd, and we've got to stop this!

I CHALLENGE you to come up with another explanation as to why the curves in the exhibit show such a clear downward trend. Go to the details. Numbers describe these curves, so if you find another explanation please describe your findings with numbers, not words. ■

Reader Service Number 189

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.

PM Network April 2000

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