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Estimating Cost Escalation for Guaranteed Maximum Price (GMP) Budgets

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By Dr. Stephen R. Dunn


"Since December 2003, the overall cost of construction material has climbed 41 percent, not including distribution costs. For comparison, the cost of consumer goods has increased 19 percent." - Ken Simonson, chief economist for the Associated General Contractors of America

While part of the increase in costs since 2003 can be explained as normal cost of living increases, some of the increase is due to the instability of the construction marketplace.  Because of this, estimators are challenged to establish an escalation factor that can be applied to Guaranteed Maximum Price (GMP) budgets, which addresses both Standard and Volatile Market changes.

Main CSI Division – 01210 ALLOWANCES
Subdivisions – Because of the nature of escalation factors, every item in an estimate can be affected by a different escalation factor.  As each item is addressed, the escalation costs are included in the total dollar figure that comprises either Standard Escalation or Volatile Market Escalation.

As an estimator approaches any cost estimate, he should keep in mind what is shown on the documents he’s estimating, along with what’s not shown, that will affect the pricing (an example would be that a door is shown but the door hardware has yet to be selected), and outside influences that could have a financial effect on the estimate value.  The factor causing the most perplexing challenge to estimators is determining the proper project escalation.  This is especially true when developing a GMP budget early in the life of a project.  In some cases, an estimator determines the cost of a project in current market conditions, then has to not only project the cost into the future, but guarantee that cost to his own firm and an owner.

Types of Measurements Used
For the purpose of this paper, only one (1) item will be reviewed:  structural steel.  It is assumed that the project would begin construction 12 months from the date of the estimate.  The reasoning behind selecting structural steel as the sample work item is because both standard escalation and the current volatile conditions surrounding the cost and supply of structural steel can be examined.

Factors That May Affect Take-off, Pricing, etc.
The first step is to decide what is considered standard escalation and what would fall into the category of a volatile marketplace escalation factor.  In looking at items such as labor, there is escalation that would be addressed in an estimate, depending on when the estimate is being prepared, start date, and length of the project, etc.  An estimator can look at labor agreements or labor trends and determine an average labor escalation cost.
There are other, non-standard conditions that will affect pricing that an estimator must also take into account.  These would include items such as:
• The volatility of the oil markets, which could affect would be on any oil-based material.
• The sudden closing of affordable credit, which affects both contractors’ and subcontractors’ ability to obtain short term credit for both payroll and the purchase of materials.
• An overall sudden downturn in the economy, which can cause contractors and subcontractors to go out of business, thereby reducing an owner’s competition pool.

Overview of Labor, Equipment, Material and Indirect Costs
An estimator must have the understanding that construction materials are commodity-based items.  While labor, equipment and indirect costs are locally based, commodity costs are based on an international marketplace.  For construction, these include wood, copper, oil, natural gas, etc.  As other countries (India, China, Dubai, etc.) continue to expand their building programs, the law of supply and demand becomes a large factor in the cost of construction.  Additionally, there are some materials that can only be purchased from foreign suppliers.  The cost and availability of these materials can be affected by changes in the governmental structure of the supplying country or the weakening of the U.S. dollar. 

Special Risk Considerations
One of an estimator’s risks is that he must understand which item(s) should be escalated due to normal market and labor conditions and which must be further analyzed due to volatile markets.  Once an estimate is completed and submitted, the estimator should periodically update and resubmit the estimate, showing any correction or changes made, and include a written narrative explaining the reason for the change.

The estimator runs into another risk if he errs in the amount of increase to a project due to a project escalation, causing the project to no longer be economically viable to an owner.  If this were to occur, an estimator may feel pressure to reduce the escalation financial impact.  The estimator must be sure of his reasoning and resist the temptation to reduce the project cost just to keep the project alive.

Charts
A simple way to calculate standard escalation would be to use a Construction Cost Index for the state where the project will be constructed.  For structural steel, using a worksheet of the basic commodities needed to manufacture structural steel, a historical commodities analysis chart can be developed.  The Structural Steel Commodities Worksheet is located as Appendix Item B.   Using this data, the Structural Steel Commodities History Chart would be:


This chart shows that the cost of the basic commodity materials stayed at an almost even price increase until January 2008 (month 25) at which time the volatility of the commodity markets started having dramatic effect on the production cost of steel.  An estimator must be aware of this volatility, and take into account its effect, as well as trends for escalating the cost of steel materials.

Ratios and Analysis
The CCCI chart shown in Appendix A is based on monthly figures, and encompasses the period from January 1998 through May 2008.  An estimator must determine which period he will use to calculate escalation or, in some cases, de-escalation.  Usually, using a 5-year period provides a reasonable representation period.
The standard escalation can be calculated by using different standard statistical average calculations, either the average of sums during the established period, or more of a means-type method.  The average of sums would be:
1. Average Escalation = [є (% at 2003 … % at 2007) / 5
2. Average Escalation = [(1.0% + 9.1% + 6.3% + 5.6% + 2.3%)] / 5
3. Average Escalation = 4.86% per year (0.405% per month)
The second method would be:
1. Average = (% at 2003 + % at 2007) /2 + % at 2003
2. Average = (1.0% + 1.3%) / 2 + 1%
3. Average = 2.15% per year (0.179 % per year)


These methods calculate a large variance in the average escalation factor. The first method is best, because it provides a more accurate average figure by using all of the known data.


In trying to determine the increase in materials costs, the estimator can use the data from the Structural Steel Commodities History Chart to develop any number of trend analyses.  The three basic charts that could be used are a Linear Trendline Chart, a Polynomial Trendline Chart, or an Exponential Trendline Chart.  The estimator could also use a simple statistical average, if need be.

For the Structural Steel, the charts would look like the following:

 

Each of the charts provides a different value for the projected steel costs.  For example, assuming that the estimator is preparing an estimate for a project that has a projected construction start date 12 months from the date of the estimate, then:
• the Linear Trendline Chart projects a future commodity price of approximately $850
• the Polynomial Trendline Chart projects a future commodity price of approximately $1,375
• the Exponential Trendline Chart projects a future commodity price of approximately $910

An estimator must be aware of this volatility and take into account its effect, as well as trends for escalating the cost of steel materials.

If the estimator decides to use a simple statistical average, he needs to use the data only from the volatile period, which, in this case, is from month 25 to month 30.  There are two different methods that could be used.  The first method averages only the total costs in the first month of the volatile period and the last month of data.  This calculation would be:
1. [[(value at month 30 + value at month 25) / 6]  x  12 months] + value of month 30
2. [[(932.60 + 596.90 / 6]  x  12 ] + 932.60
3. Projected Commodity Cost = $ 3,991.60

The second way would be to use the average sum of the percentage increase, which would then be a compounded increase per year.  This calculation would be:
1. [є (% at month 25 … % at month 30) / 6
2. ( 17.0% + 7.5% + 12.0% + 4.3% + 7.9% + 10.8%) / 6
3. Compound Interest Rate = 9.9 %
4. Projected Commodity Cost = $ 2,397.02
With a spread in values from $850.00 to $3,991.60, the difficulty facing the estimator is which of these values to use, if any.  Some of these can be eliminated immediately.  The value of the commodities in month 30 is $932.60 and does not appear as if it will decrease; therefore, any value under this amount can be eliminated.  This leaves three values to assess:
1. Polynomial Trendline at $1,375.00
2. Total Cost Average at $3,991.60
3. Compounded Interest at $2,397.02
The estimator needs to review the possible values and decide which is the most probable.  In this case, with the value of commodities in month 30 being $932.60, and the projection period being for 12 months, it is not probable that the commodities cost would increase to a value of $3,991.60 or $ 2,397.02.  Therefore, the estimator should use the value of $1,375.00, which would equate to 32%.

The calculated escalation factor would only be added to the commodities cost of the production of structural steel.  The commodity cost of the product of structural steel is just under half of the materials cost.  Assuming that 50% of the cost is labor and 50% of the cost is material, the escalation factor is 16% on the total of the materials cost.

Sample Take-off and Pricing Sheets
To determine the amount of volatile escalation, the estimator needs to determine the amount and cost of the materials that need to have a volatile escalation factor applied.    From this worksheet, a pricing sheet can be created, showing the tonnages of material, material costs, labor costs, equipment, etc. The volatile escalation is only calculated on the material cost.

In this example:
Material Amount = 191.05 tons
Equipment Cost = $152,000.00
Material Cost = $ 688,659.36
Labor Cost = $ 195,264.77
Standard Escalation Factor = 4.84%
Standard Escalation = $32,496.84
Volatile Escalation Factor = 11.14% (calculated Volatile Escalation–Standard Escalation)
Volatile Escalation Cost = $ 74,488.65
Total Structural Steel Cost = $ 1,122,909.62
It is recommended that the Volatile Escalation Costs be kept separate from the Standard Escalation costs for ease of both future modifications (should the market place change) and for a clearer explanation to other shareholders using the estimate.


Dr. Stephen R. Dunn is the Director of Preconstruction Services for gkkworks, an Architecture and Construction Services firm located in Irvine, California.  He has over 30 years of cost estimating, general administration, project management, construction management, and general contracting experience, with 10 years direct accountability for the general administration and supervision of division activities. Management experiences include strategic planning, management reporting, cost control, contract negotiations, claim and claim review, risk management and establishing and implementing policies and procedures.

This article courtesy of The American Society of Professional Estimators, which serves construction estimators by providing education, fellowship, and opportunity for professional development. For more information visit www.aspenational.org

Tags: Costs, Material costs, Estimating Construction



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