Revising the cost estimate to support capital investment projects
The COVID-19 pandemic and the global uncertainty it has caused has impacted the supply and demand of all goods, services and commodities. As the natural resources industries look to address these additional challenges, the role of the project estimate is heightened and under even greater scrutiny.
Against the current uncertainty, there are a number of pressures facing the development of robust and reliable estimates. But what can estimators do now to accurately predict the cost of disruption, improve estimate quality and optimise costs?
Current pressures include how to:
- Reasonably estimate the impact of COVID-19 on project costs, business, liquidity, operations and finances?
- Anticipate the market/supply chain impact including changes in capacity, capability and financial stability – can the supply chain survive the underbidding and margin erosion that has occurred since 2014?
- Estimate the cost of delay and disruption caused by COVID-19 related claims or disputes in various global locations?
- Determine the cost of capital and access to funding markets, with variable and volatile currency exchange rates, and the impact this will have on predicting escalation indices.
How the cost estimate is revised in response to these pressures will be key to determining the feasibility of projects.
As in previous downturns, companies are undertaking measures to analyse the cost drivers across projects, and increasing scrutiny on every aspect of expenditure within the capital expenditure (CAPEX) and operating expense budgets.
The immediate response has been to:
- Review asset portfolios in line with commodity prices and viability
- Curtail CAPEX spend to mitigate against the reduction in cash flow (current announcements are between 10 percent and 40 percent),
- Delay final investment decisions
- Suspend, delay or even cancel tenders
- Request rate discounts from the supply chain on both future and existing projects, directly impacting their previous operating margins.
Key factors to consider in re-baselining your project’s estimate
1. Execution strategy – does it still hold up?
Estimates are impacted by the methodology applied to construction activity determined by the project’s execution management team. Estimates will need to be adjusted to deal with short-term changes in execution methodology and safe working practices due to COVID-19, as well as attempting to forecast the future.
For projects currently in execution, social distancing, additional quarantine measures and mobility are impacting performance. The re-baseline estimate will need to factor in the appropriate productivity and associated cost increases along with corresponding schedule extensions. This will challenge the historical benchmarks and data held.
Currently, many operators are considering the execution strategy for projects in development. Going forward, all estimates are likely to be required to factor in changes to the new ways of working. Consideration will be given to cancellation, placing the project on hold, or taking the opportunity to develop better engineering definition.
While cancelling contracts may provide short-term relief, the schedule impacts of doing so could be detrimental. Working through these scenarios requires several factors to be considered simultaneously, which will add to the complexity of this process.
Now is the time to review and work through the opportunities to optimise costs and improve the project’s position.
2. Data from the supply chain – is it going to be accurate?
The issue of leveraging the supply chain to obtain current and future short to medium-term market rates will provide a challenge for the natural resources industry. Most contractors and suppliers will be struggling to develop bids as they can’t get quotes from their sub-contractors and vendors, who may be on furlough, or who are either not able to, or would rather not put the time and effort into developing a price that they know will have no bearing on a changing market. Where they do submit, sub-contractor prices which are used for large parts of most estimates will be caveated or qualified.
It is not uncommon in volatile markets for vendors to limit the information given, making the actual anticipated costs of purchase unclear. A cost risk impact analysis will be required to support accuracy of the estimate.
Given these challenges, it has never been a better time to collaborate with the supply chain to ensure that the data you need is as valid as possible. Relationships with the supply chain can be strengthened through the use of a cost professional who can help determine accurate market knowledge and information as well as assure costs.
3. Consider standardisation options
According to IHS Markit since 2014 there has been an appetite by operators to consider the wider use of supplier technical specifications as opposed to their own, which typically drives a more costly design. For assets with complex technology this type of change could reduce overall costs significantly. It may also have an impact on logistics and storage costs.
Now is the time to assess the benefits of changing technical standards to better reflect safe and adequate operations, rather than the traditional approach of designing facilities to a ‘gold standard’. This may also be a good option for projects that need to respond to cash constraints and reduce scope to continue to be feasible opportunities.
Standardisation can provide an opportunity for savings in both cost and schedule.
4. Contracting models – can a change in risk transfer improve the cost competitiveness?
With the current, significant financial pressures on contractors, vendors and suppliers, a change in contracting strategy at the engineering, procurement and construction (EPC) level may enable all parties to share or transfer aspects of the risk.
Without some form of risk sharing, prices are likely to go up, with contractors contemplating the risk allowance required to win, and sustain their business in the current environment. Additionally, there is potential for the major EPC contractors to become more risk averse, impacting market capacity. Open book or partnering/ alliancing contracts could offer a more transparent way of working.
Any clients looking to account for the current market pressures by changing the existing contract strategy will need to factor in this risk to the project’s assumptions. To determine a more accurate, market sensitive estimate will require an improved budget estimate, or additional cost assurance to prove value for money.
Recommendations for projects re-baselining estimates and preparing forecasts
As we move forward we would recommend:
- Projects build in frequent review meetings to update the estimate and schedule. Consider factors including materials, labour, locations, project duration, productivity, specialist vendors, currency exchange and cost indexation volatility.
- Risks and opportunities are captured, mitigated and/ or monitored and provision made within the estimate. This may take the form of assumptions or allowances, with other items with a lower probability of occurring forming part of the contingency risk modelling.
- Gaining clarity on the data that is critical to your estimate. Engage with the market or an independent cost consultant to determine accurate market knowledge and information to enable the best possible outcome.
- Prioritising the key supply chain elements within current and future projects. Increase engagement and openly discuss data and critical information such as procurement, vendor data, key milestones and critical dates to drive clarity on your re-baselined estimate.
- Run scenarios based on COVID-19 having a range of impacts on future cost levels. Include in these scenarios potential schedule effects.
- Making your assumptions visible in the basis of estimate. These will need to change in line with each review, the market and business expectations.
Please visit our COVID-19 response page for all of our resources relating to the impact of COVID-19 on the construction sector.