Budgeting, estimating and contingency management for construction projects

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1 / Leadership Series 4 /01 PROJECT ADVISORY Budgeting, estimating and contingency management for construction projects Leadership Series 4 kpmg.com/nz About the Leadership Series KPMG s Leadership Series is targeted towards owners of major capital programmes, but its content is applicable to all entities or stakeholders involved with major projects. The intent of the Project Leadership Series is to describe a framework for managing and controlling large capital projects based on the experience of our project professionals. Together with our simplified framework, we offer a sound approach to answer the questions most frequently asked by project owners. Introduction Construction projects inherently contain a significant amount of risk to the owner. In many instances, an owners core business does not involve construction activities, and when a company decides to proceed with a construction project, they may not be aware of the resources available to assist them in identifying and minimising their risk exposure. This installment of KPMG s Leadership Series is designed to provide insight related to some of the common challenges identified when assessing construction projects and the resources available to owners to minimise their risks. The process of developing a comprehensive project budget with a reasonable contingency amount is critical for a project to be considered as a success upon completion. According to KPMG s 2012 Global Construction Survey, 54 percent of respondents failed to identify up front the issues that later caused margin erosion. Once an owner decides to proceed from the feasibility or concept phase of a construction project, the next steps are to identify the method of funding based on an estimate of total project costs. Depending on the accuracy of project estimating techniques employed, the development of the overall project budget may or may not include a reasonable contingency amount. If an estimate is too low, the project contingency will most likely be insufficient, leading to budget overruns. On the flip side, an overly conservative estimate can tie up valuable capital that could be used for other capital projects, and the project may be deferred or rejected by senior management.

2 / Leadership Series 4 /02 tip 01: Many companies have an extensive amount of historical project data regarding past projects which often leads some companies to rely solely in internal project estimates as well as architect/engineer or contractor estimates to prepare project budgeting and funding authorisation requests. This lack of independent project estimates often leads to inflated or overly optimistic project estimates as well as missing or unclear scope of work packages. 1. How do I prepare an accurate project estimate during planning and development? The degree of accuracy of a construction cost estimate depends on the phase of the project. In general, the accuracy of the estimate will be proportional to the level of project definition. At the initial feasibility or conceptual stage, parametric, order of magnitude, unit price or other estimating methods for projects of similar type and scale may be used. At this stage, there is a wide range of variability in the estimate, so the estimate should include allowances and design contingencies to address unknowns. Subsequent estimates will be more detailed and comprehensive as the design progresses and as the construction drawings are developed. Following the completion of the construction drawings and specification and prior to bidding, the design team or an outside cost estimator should prepare the detailed estimate based on actual quantity take-offs and current market pricing for labour, equipment, materials and subcontractor services. Appropriate mark-ups for labour, burdens, supervision, indirect field expenses, general and administrative costs, profit, insurance, binds, etc must be added to the direct cost of construction to arrive at a complete detailed estimate. The owner will review the construction bids relative to the detailed estimate prepared by the design team or outside cost consultant. Any significant variation between the values for the individual line items should be investigated. Some differences are usually due to costs being included in different areas of each estimate, so there should always be discussions with the contractor, construction manager or design-builder to understand these differences. If significant differences remain after these discussions, the owner may consider obtaining a third-party cost estimate to validate the construction bids. If the construction bids exceed the budgeted costs, owners must determine id a budget increase is both warranted and possible. Alternatives include providing the bidders with further clarifications, requesting new bids from other sources, or dividing bid packages into smaller packages. 2. How should historical construction costs be used to develop an estimate for a project? Construction cost estimates typically utilise historical cost data in the development of a project estimate. Supplemental information specific to the project maintained by the owner may be combined with this cost data such as: Actual construction project cost information from other completed or ongoing projects. Published cost estimating manuals. Construction cost indexes. Manufacturers catalogue information including price information. 3. What is the benefit of getting third party validation of project costs during budgeting? Depending on the number of variables including the maturity of an owners organisation and controls and the complexity of a given construction project it may be useful for an owner to solicit a third-party validation study of the projected construction costs. Such a study can help to control costs and thereby minimise the risk of exceeding the budget by validating the projected costs for the project. This validation can utilise additional information that my not be available in cost indexes such as data collected from other construction projects. This information can be used for an individual construction project, or, if any owner is embarking on a larger capital programme, it may be useful to incorporate this information into an updateable database. A database of construction cost information allows an owner to incorporate data from previously completed construction projects with the current cost pricing, which may improve the accuracy of the construction estimates.

3 / Leadership Series 4 /03 4. What is the process for developing a comprehensive budget? The project budget should be comprehensive and should include not only the construction contract costs, but also the costs associated with land acquisition, planning and feasibility studies, architectural and engineering design, field supervision and inspection, construction equipment, financing, incentives, insurance and taxes. Project specific variable costs such as weather conditions should be accounted for in the budget as well. While the construction contract may represent the largest cost item, the other project costs are not insignificant and should be carefully estimated and included in the overall budget. The owner is responsible for developing the budget for costs that are not included in the construction contract, while the construction manager or the contractor prepares the construction budget. Before commencing construction, the construction manager or the contractor may engage in a value engineering exercise which involves the review of building systems and major equipment items in an attempt to improve functionality or reduce costs while maintaining the scope of the project. Any proposed value engineering substitutions should be reviewed by the owner and the design team to determine the impact to both construction costs as well as operational costs. 5. How should contingency be established? Most projects include a contingency fund to cover both anticipated costs due to the projects phase and unexpected costs. Project contingency is an amount included in the construction budget to cover the unknown conditions, allowance for design growth, errors in the contract drawings, inaccurate pricing, price escalation and minor changes within the project scope. The optimal amount of project contingency permits the owner to adequately address project risks while not restricting the use of capital funds that can be assigned to other projects. The contingency fund is to absorb additional project costs within the project scope without the necessity of preparing multiple funding requests and obtaining authorisation for every change encountered during the project. Control of the contingency find varies depending on the project delivery method, but the owner s project team should be cautious to avoid using the contingency fund to pay for added scope items. tip 02: Establishing an acceptable and agreed upon contingency for regulated utility projects is extremely challenging due to the extensive scrutiny and often competing objectives of the regulator. By leveraging data from similar past projects as well as acceptable industry standards and resources, utility operators can develop well-supported and justifiable contingencies for their capital projects. Developing the contingency fund is not a one-size fits all approach. Some projects include a percentage of the total construction value as a contingency fund based on experience with previous projects. This approach, however, may not be appropriate for complex construction projects or those without established historical costs. For these situations, the owner should engage all stakeholders during the design phase to identify project risks and develop appropriate risk responses. The risk assessment process should include a review of all high risk budget items with the goal of confirming that the contingency budget is appropriate to cover the costs of all probable risks as well as including contingency for unknown risks. Each item in the risk assessment should include the following: Best and worst case cost and schedule impacts. Potential costs related to the risks. Probability of the risk occurring. Overall probable cost and schedule impact to the project. When the risk is expected to occur. How the risk will be addressed. Individual responsible for developing and implementing the risk management plan for each risk.

4 / Leadership Series 4 /04 6. How do I manage and track contingency once established? The management of the contingency is critical to the success of a project and should be monitored on a continuous basis. It is important to note that the contingency fund is included in the owner s budget to address risks and unforeseen events that may occur during a project. Contingency is risk dependent and therefore, not a budget allowance. Furthermore, contingency should not be used to fund significant changes to scope of the project. The project management team should review the contingency fund balance along with project risks throughout the duration of the project to determine if adjustments to the fund are needed. Managing the contingency fund is as important as developing it and may provide the owner with advance notice of serious financial issues. tip 03: Given the importance of meeting financial projections, recovery targets and loan commitments, the ability to accurately report and track progress against the approved budget is critical for projects. If there is limited visibility or accuracy with regards to budgetary performance, regulatory pressure increases, lending terms get more stringent and investor confidence is eroded. 7. What controls should be in place to avoid budget overruns? The project management team should review the contingency fund balance along with the project risks on a continuous basis throughout the duration of the project to determine project budget variances, including contingency and if adjustments are required. As part of this analysis, individual cost line items and variances are anticipated, to estimate the total cost at project completion. Tools that facilitate budget monitoring include project earned value and a cost to complete analysis. The risk register should be updated to reflect the progress of the project as well as any additional risks or opportunities identified, updating the contingency accordingly. All changes to the contingency forecast should be communicated to all relevant parties by means of a formalised communication process, as this information allows for proactive decisions that may avoid serious financial issues. Conclusion The process of developing a comprehensive project budget with a reasonable contingency amount is critical for the project to be considered a success on completion. The project budget is refined as the project progresses from the conceptual phase to the check estimate or bid phase. The contingency fund should be developed as part of a project risk assessment and should adequately address project risks, while not overly restricting the use of capital funds that can be assigned to other projects. Managing the contingency fund proactively allows the owners project management team to analyse trends and respond to cost pressure relative to the overall budget.

5 / Leadership Series 4 /05 About KPMG KPMG s services are objective, professional approaches to managing the many risks associated with major change: risks that involve complexity, technology, governance, selection and management of vendors and partners, implementation of solutions and acceptance of change throughout the organisation. KPMG applies leading concepts and practices, supported by: Experienced practitioners Recognised best practices Effective tools and templates International standards Built-in knowledge transfer Services can assist organisations to generate significant cost savings by minimising poor selection decisions, costly overruns, misalignment with business needs, poor quality deliverables and failed projects. Our project advisory services include Independent Quality Assurance (IQA) Is your project or programme on track? Are the key risks and issues being effectively managed and addressed? Independent Quality Assurance is KPMG s approach to providing objective, practical and open feedback to senior executives, independently assessing project status, risks and issues. Advice is provided by experienced staff who are not part of the delivery team. Portfolio, Programme and Project Management (P3M) Practices P3M provides services for the purpose of designing or evaluating portfolio, programme, or project management practices. The objective is to assist in implementing or improving P3M practices to reduce project costs, increase project success and create an organisational P3M support environment which is valued by internal and external stakeholders alike. Large Project and Programme Management Assistance This cornerstone service of KPMG s Advisory practice is designed to address the full lifecycle of a project or programme, providing an integrated approach to managing large initiatives the result: significant efficiencies and enhanced outcomes. The methodology incorporates concepts from well-known risk, benefits, project and quality management disciplines to help companies achieve the results they expect during every phase of a large project or programme. Project Risk Assessment and Monitoring These services provide a highly focused, activity-based approach to project risk management. They provide management with an objective and independent assessment of the risks associated with a business initiative, programme or project, and evaluate the effectiveness of planned or implemented controls to mitigate the risks. Benefits Management and Realisation Advisory KPMG professionals help you identify the measurable business changes that you will to see at the successful completion of your project and to tie these into an effective Benefits Management and Realisation strategy which can be referenced in your Business Case. Even for projects where outcomes are enabling or intangible, our Project Advisory team will be able to assist with the identification of proxy indicators and benefit relationships to support the approval of your Business Case and its successful delivery. Portfolio Management Effective portfolio management helps large organisations make sound decisions by prioritising the deployment of scarce resources to change initiatives and maximising their value to help achieve the organisation s strategy. Organisations operate in increasingly dynamic environments, which often make it a struggle to satisfy fluid business requirements. KPMG s Portfolio Management (PfM) Advisory and Assistance services help organisations to develop appropriate processes and capabilities to achieve this aim. We provide practical guidance for conducting capability development, maturity assessments and performance reviews. Our methodology provides a flexible, comprehensive approach that can help our clients achieve their goals. Programme Management Office Assistance Programme Management Office Assistance is intended to help our clients develop the processes to support a Programme Management Office. We assist with the development of a client s programme office processes and facilitate communication across client leadership to help make sure that enterprise programme initiatives are aligned with the organisation s business strategies. The focus of the PMO is to increase project visibility across client leadership in order to help achieve strategic programme performance. Our practitioners know that successful projects are the result of clear vision, careful planning, and meticulous execution. Bottom line: services drive speed and effectiveness of change within your organisation by reducing costs and increasing success.

6 Leadership Series Please look for further important topics covered by our Leadership Series in the coming months: Governance and project controls. Monitoring capital projects and what to do if one is in trouble. Project delivery strategy. Contact us Gina Barlow Director T: (04) E: Chris Dew Director T: (09) E: David Leighton Associate Director T: (03) E: Harriet Dempsey Associate Director T: (04) E: Perry Woolley Director T: (09) E: kpmg.com/nz 2013 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in New Zealand. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 3418