Construction – You Need Risk-Based Cost Estimating Contracting Practices Session, June 8, 2015 Philip Sander Alfred Moergeli Technikerstr Innsbruck Austria moergeli consulting, llc (mcllc) Ferdinand Street, P.O. Box 2852 St. Francisville, LA John Reilly 1101 Worchester Road Framingham Massachusetts USA www. johnreilly.us

Slide 2www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Presentation Will Cover Dealing with uncertainty Components of cost estimates Value at Risk (Level) Types of cost estimates a) Deterministic b) Bandwith, square-root approach c) Risk based (probabilistic) Comparison of cost methods Benefits, risk-based approach a) Better, more complete information b) Explicit definition of risks Summary a) Contractor’s advantage / Strategies b) Owner’s advantage / Strategies Example, RIAAT process Questions

Slide 3www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Dealing With Uncertainty  Every cost estimate is uncertain. o Underestimating construction costs can lead to problems for owners in the planning and design phase o Underestimating construction costs – e.g. by contractors in the bidding phase - can lead to loss of profit, disputes, claims, and litigation  A better understanding of potential costs helps: o Owners to budget and get authorization for projects - leading to a reduced chance of “cost overruns” o Contractors to determine base cost and margin plus: o Strategies to secure the work - in low-bid environment o Strategies to maximize profit, avoid loss and recover costs of changes  Consider low probability / high impact “black swan” events

Slide 4www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Risk and Uncertainty  Risk is the combination of the probability of an event and its consequences (if positive = opportunity)

Slide 5www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Components of Cost Estimates  Components of cost which need to be sufficiently addressed in an estimate include: o Base cost – the cost that will result if “all goes according to plan” o Risk costs

Slide 6www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Value at Risk (VaR) = A certain amount, within a distribution, that will not be exceeded according to the corresponding probability. VaR 70 here means that a $5M budget would not be exceeded in 70% of all simulated scenarios (there remains a 30% probability that the $5M budget will be exceeded) Value at Risk (VaR)

Slide 7www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Cost Estimates Must Also Address  Escalation – costs resulting from inflation (with variability) - driven by economic factors.  Effect of competition and market factors  Other uncertain costs – e.g. from events external to the project team’s control, including: o “Unanticipated” events o Management changes / lack of continuity o Politically related changes, and o “Black Swan” events Transition to Alfred

Slide 8www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating 1. Deterministic: Aggregated unit quantities multiplied by unit prices. Usually with some degree of conservatism built in. Plus an added reserve or contingency 2. Bandwidth: Range approach with minimum, most likely, and maximum cost. The total cost is obtained by simply adding these parameters for all line items. 3. Square Root: Delivers one single figure which is the sum of all base costs plus the square root of the sum of the squares of the risk contingencies. 4. Probabilistic: Range approach which characterizes cost information with probability distributions Types of Cost Estimates

Slide 9www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Cost Estimating Methods in Comparison : Tunnel Excavation Category (Base Cost only) 1. Deterministic Approach Most likely quantity x most likely price USD 2. Bandwidth Approach 3. Square Root Approach = USD USD USD USD 4. Probabilistic Approach

Slide Risk-Based, Probabilistic Cost Estimating Methods Min. All Four Cost Estimating Methods in Comparison: Visualized Ml. Max. 223 Bandwidth Approach VaR5 321 VaR VaR95 Probabilistic Approach Deterministic Approach Square Root Approach AB C D A B B B CD DD

Slide 11www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Pro’s & Con’s of the Methods Estimating Method ProCon 1. DeterministicOne single figure Well-known & accepted Quick Can be performed “manually” No probability information - single value No VaR information More often than not on the unsafe side (high, unknown probability of cost overruns) 2. BandwidthThree values - minimum, most likely and maximum, ranged Quick Can be performed “manually” No probability data, range values only No VaR information More often than not on the unsafe side (high, unknown probability of cost overruns) Range maximum and minimum very unlikely 3. Square RootOne single value Quick Can be performed “manually” No probability information for single value Bandwidth information is lost No VaR information Range limits are extreme values and very unlikely 4. ProbabilisticFull probability informationNeeds probabilistic thinking & understanding Needs (a little bit) more time Needs software support

Slide 12www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Tornado Diagram - Risks/Opportunities Transition to John

Slide 13www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Benefits of Risk-based Cost Estimating  Risk-based methods give more detailed and specific information of risk and potential cost impacts – with the following possibilities in the planning & bidding phases: o Allows strategies to protect public funds and interests o Allows the owner to develop better and more equitable contract documents and provisions for risk o Allows a better understanding, by owner and contractor, who will “own” risks – leads to contractual clarity o Allows the contractor to assess risk in bidding vs. the competition – to better evaluate chances of securing the work at a specific price – and to make an informed “go-no go” bid determination o Allows the contractor to determine a risk management strategy for construction in order to best obtain a profit

Slide 14www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Concerns – “Low-Bid” Environment  A concern has been expressed that if an improved risk identification process is used the contractor’s estimate will include higher potential costs, which will mean that their bid will be higher and they are likely not to be successful  This is a valid concern – however, we would argue that more detailed and realistic information about potential risk events is an advantage if:  Appropriate bidding and construction management strategies are used by the owner and contractor and  These strategies are compatible and consistent

Slide 15www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Risk & Risk Registers  If the owner includes a sufficiently comprehensive risk register in the bid documents, and the potential contractor prepares their own detailed risk register, they will better understand the risk environment and can also judge if the owner’s risk register is accurate.  There are several possibilities in this regard: o If the potential contractor thinks that the owner has estimated the consequence or probability of some risks too high, they may see a bidding advantage compared to other bidders. o If the owner has estimated the consequence or probability of some risks too low, it may mean that the potential contractor, using a reasonable assessment of risk, may submit too high a bid and may not win the project over other bidders who have a lower appreciation of risk.

Slide 16www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Summary - Owner’s Strategies  Planning & Design: o A risk-based approach gives a better understanding during design of potential costs and mitigation strategies which help manage the design to meet available budget o Risk definition and characterization allows better contract documents with a more equitable sharing of risks o Sharing of risk registers with contractors can “level the playing field” – more realistic bids with less “contingency” o Owner’s definition of specific risks can clarify who owns the risk as reflected in the owner’s risk management plan o Owner’s definition of specific risks can help avoid “unanticipated” events that can lead to disputes, claims and litigation.

Slide 17www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Summary – Contractor’s Strategies Risk-based cost estimating for construction allows :  A better understanding of potential cost to inform the contractor’s bidding strategy re potential profitability o Whether to bid o What level to bid o What potential profit/loss may be possible  A better understanding of potential risks will allow: o Understanding who “owns” each risk o More specific risk management plans in construction o More specific risk mitigation and claims avoidance procedures

Slide 18www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating How can you do this?  A concern is that the risk-based approach is complex o Requires experienced practitioners o Requires sophisticated software o Some systems are proprietary o Has a significant learning curve  But, benefits outweigh the investment o For owners and contractors  Example of current software (RIAAT) follows Transition to Philip

Slide 19www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating RIAAT Approach, Software Video: Website:

Slide 20www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Where is your project on this curve? How do you know?

Slide 21www.riskcon.atwww.moergeli.com Construction – You Need Risk-Based Cost Estimating Thank you for your attention…… Questions? Philip Sander Alfred Moergeli Technikerstr Innsbruck Austria John Reilly 1101 Worchester Road Framingham Massachusetts USA www. johnreilly.us moergeli consulting, llc (mcllc) Ferdinand Street, P.O. Box 2852 St. Francisville, LA