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Risk-Adjusted Cost: A New Frontier in Construction

Author- Justin Levine

Source- Construction Executive

Original Article- https://www.constructionexec.com/article/risk-adjusted-cost-a-new-frontier-in-construction

Successful general contractors understand that accurate cost estimates are essential to both project and organizational success. For decades, the cost of construction has been a function of marketplaces: labor, materials, insurances and fees. However, given increasing project complexity and greater technological capabilities, this reality is changing. The need to both understand and quantify the risk in performing complex projects will shape the way cost estimates evolve in the very near future.

WHY ACCURATE COST ESTIMATES ARE CRITICAL

It is safe to say that cost overruns have become common across the construction industry. According to a study from KPMG, just 31% of all construction projects from the past three years have been completed within 10% of their initial budget.

Examples of this trend abound. For instance, a recent public works project in Florida beginning with a $91 million cost estimate quickly escalated to a much more expensive project. In order for the project’s engineering firm to adequately complete the required work, costs increased by 53%. 

Overruns are not limited to projects in particular segments or classes, either: Crain’s New York reportedearlier this year that more than half of all New York City construction projects are currently over-budget and delayed.

Additionally, projects today are being scrutinized more than ever given increasing marketplace costs. General contractors cannot afford to accept overruns as the new normal. Given the importance of accurate cost estimates to project and organizational success, why do so many teams still have difficulty getting them just right?

TODAY’S ESTIMATORS MUST CONSIDER RISK DIFFERENTLY

On traditional construction projects, the total budget is built off of the many cost estimates provided by subcontractors and vendors. Thus far, the industry best practice has been to prequalify these subcontractors in parallel in order to understand their abilities and capacity to perform specific types of work. Once the project advances to the bidding phase, however, a disconnect occurs. Despite having assessed risks upfront, general contractors may level bids exclusively based on the cost to provide labor, materials and overhead (such as insurance and management fees). When putting together bids in this way, the additional costs that may be incurred due to a subcontractor or vendor’s risk profile are left out of the cost estimate equation. 

Given the razor-thin margins and depths of planning that go into every project, this pattern of behavior makes sense, especially given how project-scope intensive the bidding process can be. However, new technology solutions can enable a better way to account for the cost of subcontractor and vendor risk during the bidding process, helping estimators understand instances where the lowest bidder may not always be the best choice, or even the cheapest choice. 

By analyzing project-specific risks for subcontractors and vendors, general contractors can select the best possible team for the job and incorporate risk-adjusted costs into their estimates, making them more accurate. 

HOW DOES RISK-ADJUSTED COST WORK?

Risk-adjusted costs quantify uncertainty and lead to more accurate bids because they account for both the probability of an event occurring and the potential cost impacts of those events. 

The most familiar example of risk-adjusted cost is seen when a subcontractor’s prequalification has discovered financial concerns, and the general contractor deems it necessary to implement a risk mitigation action such as lien waivers or joint checks. While effective, these tools also add administrative costs to the subcontractor’s bid. Instead of incurring these costs after the budget has been finalized, a general contractor must factor them into the bid leveling phase.

Additionally, if a subcontractor selected for a project does not have extensive experience with that particular scope of work, the general contractor may need to add costs for additional supervision onsite in order to avoid a quality issue. This cost is quantifiable (general contractors can use known supervision labor rate and hours needed) and should be factored into the bid whenever possible. 

Risk-adjusted costs can also measure uncertainty. What is the probability of an issue occurring, and how can a general contractor budget for it in order to make sure contingencies are in place to keep the project on schedule? For instance, what are the chances that snow will delay the project, and how would that impact budget? With technology, it is possible to see a future where general contractors can easily understand the probability and impact of specific risks to incorporate the costs of risks in to their estimates. 

WHY RISK-ADJUSTED COST IS THE FUTURE 

Developing risk-adjusted cost estimates based on subcontractor data is possible now if a general contractor’s prequalification and bid management tools are in sync. First, a subcontractor’s risks are identified and matched to mitigation tactics within prequalification software. Then, these details are automatically passed on to estimators in their bid management platform, who bake in the cost of the mitigation tactic when leveling bids.

However, achieving a more complex risk-adjusted cost estimate based on uncertainty will require a coordinated effort beyond just prequalification and bid management tools. Risk-adjusted cost requires many different tools to work together, including enterprise resource planning, accounting systems and technology leveraged on the jobsite. To achieve this, prequalification tools need to be connected to the different phases of construction. They need to take data from accounting platforms and from the field to quantify the impact of specific risks.

Technology already exists on the jobsite that measures the likelihood of certain risks. For instance, looking at weather conditions alongside schedules can identify future potential risks. When this data flows back into prequalification software, general contractors can analyze a subcontractor’s application in a different way. In the future, the estimator will have predictive estimates for the cost of risk to use when adjusting bids.

Today, by using effective software tools to anticipate and surface risk insights, general contractors can plan for cost-impacting possibilities earlier on in the project life cycle. As the industry continues to adopt more technology—and deeper integration between tools helps enable connected construction between project phases—a risk-adjusted cost estimating approach will empower general contractors uncover an even wider breadth of risk factors, helping ensure project success time and time again. 

https://www.constructionexec.com/article/risk-adjusted-cost-a-new-frontier-in-construction

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