Cost Engineering’s Added Value —Making Better Capital Investment
Decisions
John K. Hollmann PE CCE CEPValidation Estimating LLC
Introduction
• John K. Hollmann PE CCE CEP– Owner – Validation Estimating LLC
• Active in AACE International– Fellow, Award of Merit– Co-Chair: Decision and Risk Management
Professional (DRMP) Certification Task Force– Technical Board– Former Regional Director of ICEC
• Editor/Lead Author of AACE’s Total CostManagement Framework
Cost EngineeringBack to Adding Value
• Investments, Profitability and Cost Engineering• Cost Engineering’s Value Proposition• Total Cost Management (TCM) Process• Decision and Risk Management
Profitability and Cost Engineering• AACE defined Cost Engineering at its founding in
1956 as the application of scientific methods toproblems of “…profitability”; emphasizing cost
• The founders’ main interest was in making bettercapex investment decisions based on better dataand methods centering on engineering economicsand conceptual cost estimating methods
• They recognized that “cost is king” and “time iscost” (in decision analysis, inputs are estimated inmonetary equivalents) with profitability being themain objective
• Today, AACE’s TCM process revolves aroundInvestment Decision Making– i.e., where Cost Engineering adds its value!
*by 1990, profitability was gone from AACE’s CE definition (more on that later)
Profitability and Cost Engineering• AACE defined Cost Engineering at its founding in
1956 as the application of scientific methods toproblems of “…profitability”; emphasizing cost
• The founders’ main interest was in making bettercapex investment decisions based on better dataand methods centering on engineering economicsand conceptual cost estimating methods
• They recognized that “cost is king” and “time iscost” (in decision analysis, inputs are estimated inmonetary equivalents) with profitability being themain objective
• Today, AACE’s TCM process revolves aroundInvestment Decision Making– i.e., where Cost Engineering adds its value!
*by 1990, profitability was gone from AACE’s CE definition (more on that later)
Estimator, Cost Engineering or Decision Maker?
Most of us have heard of Hans Joachim Lang, inventor of the“Lang Factor”
(AACE Award of Merit, 1983)
Did you know he became a CEO and that when he retired toteach he authored “Cost Analysis for Capital Investment
Decisions” and co-authored “The Selection Process for CapitalProjects”: a leading global textbook on engineering economics
and capital investment decision making?
Capital Investmentand Profitability
• “For Profit” companies (most of our employers)have a profitability measure that incorporates theidea of return-on-investments. For example…– Return on assets, return on average capital employed,
return on net assets, etc., etc.
• For discussion, we can simplify this to:Profitability =
This means, minimizing CAPEX is as important asincreasing Revenue and decreasing OPEX
• However, CAPEX “competitiveness” is likely notamong your company’s KPIs (go check)– Why is this?
*CAPEX = Capital Expenditure, OPEX = Operating Expenditure,KPI = Key Performance Indicator in Balance Scorecard (strategy deployment scheme)
Owner Capital Cost Knowledge HasBeen Outsourced
• Started in 1980s; by 1990 signs become clear– Business Process Reengineering (BPR) by Hammer– AACE drops “Profitability” from its definition of Cost
Engineering (puts “manage” and projects” in its place)
• 1993: Outsourcing on a roll– “Today, the (chemical) industry has no dynamic strategy
and constantly shifting structures.... it has adopted thedubious tactic of personnel reduction” 2
• 1997: Mission Accomplished?– “almost half of all projects have substantial contractor
involvement in project definition… Of particular concernis the technical competence to assist the businesses inarriving at the most appropriate project to meet thebusiness need has been lost” 3
1 Wikipedia article on BRP2 “The End of the Chemical Century…?”, JK Smith, 19943 The Business Stake in Effective Project Systems, Business Roundtable , 1997
Cost Engineering’sFocus on Capex and Profitability?• Late 1990s: “Did we go too far?”
– BRT, CII, IPA and other forums and research on “CoreCompetency” all concluded that Owner’s had outsourcedtheir capital cost knowledge and had to reverse this
• 1996: Regaining Cost Engineering at AACE/ICEC– TCM Framework which is Investment Decision-Centric is
outlined (life cycle process for applying Cost Engineering)– Resistance: outsourcing’s beneficiaries succeeded in
equating Cost Engineering with “project control”• 2006: TCM Framework released• We are not back yet
– A generation of lost focus and skills– Cost Engineering vs. Project Control debate rages on– “Management Accounting” takes Capex Decision lead– Finance does not understand Capital Effectiveness (not in KPIs)– Cost Engineers are not key players in the “business case”
• Decision and Risk Management initiatives at AACE
Cost EngineeringBack to Adding Value
• Investments, Profitability and Cost Engineering• Cost Engineering’s Value Proposition• Total Cost Management (TCM) Process• Decision and Risk Management
Selected Terminology
• Profitability – Return on Investment (or similar measures)• Business Case – Analysis justifying a capital investment alternative• Phase-Gate Process – Planned, incremental development of scope
and approval of investment funds (e.g., FEL or Front-End Loading)• Decision Analysis – Quantitative method for analyzing and rating
alternatives (often based on monetary equivalents or “costs”)– Discounted Cash Flow: deals with the time value of monetary streams
• Engineering Economics – The “hard” side of investment analysis(e.g., NPVs, IRR, etc.) looking at the life cycle of the asset
• Behavioral Economics – the “soft” side of investment analysislooking at human factors in decision making under uncertainty
• Capital Effectiveness vs. Predictability – Lower absolute costs vs. atighter range (difficult to have both)
• Balanced Scorecard, KPIs, etc. – Methods to deploy businessstrategy; keep all in alignment with corporate objectives
Value Proposition: Why Investment DecisionMaking is a Key Cost Engineering Focus
• Research by IPA, Inc. shows that the business success of aventure (measured by achievement of NPV) is determinedBEFORE the project is authorized*– “Business FEL” explained 85% of the variation between planned and
actual NPV outcomes
• Further, project control is about “capital conservation”(i.e., predictability)..”not basic venture success”.*
• Therefore, if you are working for an owner, and want toadd value to the business (not just conserve it), onemust focus on Making Better Investment Decisions– At your workplace, are you actively involved in (or just feeding
estimates to) business case development?
*F. Biery:“Improving Construction Project Outcomes and Project Returns”, Northwest ConstructionConsumer Council, May 2002
Value Proposition: Lower Capex Drives ROIfor Commodity Projects
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-7%
-5%
-3%
-1%
1%
3%
5%
7%
From: Hollmann, John K., Best Owner Practices For ProjectControl, 2002 AACE Transactions
Cha
nge
inIR
R
20% 10% -10% -20%
Cost
ScheduleChange in Performance Metric
10% less cost = 2%greater IRR
Corporate Objectives andStrategy Deployment
• Most companies have a strategy deployment method– e.g., Balanced Scorecard: measures are established at each level of
the organization that should align with the higher level objectivesuch as Profitability
• Lets look at a strategy deployment example:
Corporate Goal of Better Profitability =Marketing Goal and KPI: Increase price & revenue 5% (same capacity)Operations Goal and KPI: Decrease opex 5%Capital Goal and KPI: Decrease capex 5%
Capital Goal and KPI: Capex within +/-2% of annual budget(or all projects within +10/-10%, etc.)
This yields Predictability, not Competitiveness or Profitability!
What you want in a strategy:
What you see in strategies:
Competitiveness vs. Predictability
• It is a paradox that the more accurate a company’s projectcost are, the less competitive their capital costs tend to be
• The easiest way to under-run estimates, to hit budgettargets and get tight accuracy is to over-estimate, over-fundand spend all the money approved
• Unfortunately, when companies create “scorecard” metricsfor their processes, they look at accuracy– Why? Because range is easy to measure, cultures are punitive and,
lacking cost engineering knowledge, they have no means tomeasure “should cost”
• Does your company measure capital effectiveness?
Capital ConfusionVery Few Companies Measure Capital Effectiveness
CompanyCategory
Top Level CorporateObjective
Capital Strategy Implied Capital Focus
Major Global Oil “competitive shareholderreturn”
“capital and cost discipline” Predictability
Major EuroChem
“premium on our cost ofcapital” (return)
“disciplined with regard to costs andexpenditures”
Predictability
Major Global Oil “pre-tax profitability” “enhance capital efficiency”(“In particular a Centralised DevelopmentsOrganisation is being established”… rival hasbeen operating under a similar model and isconsidered an industry leader in profitability)
Competitiveness!
Major GlobalPharms
growth and innovation(could not find profit?)
“free up working capital” Get More Capital
Major Euro NGOUtility
“competitive return overtime.”
“organic expansion….combined withacquisitions”
Ambiguous
Major GlobalMining
“best returns” “project delivery” (also low cost overlife of properties; opex focus)
Predictability /Ambiguous
These were all taken from current company website Investor pages or annual report summarizingcorporate “strategy” (i.e., try it yourself; just enter “[company name]” + ”strategy” in Google)
Which is the Path to CapitalCost Competitiveness?
16
Cost
The Wrong Path:Predictable Mediocrity
with Masked Risks•Fat, padded baseestimates (hard to detect)•No measures of absolutecost competitiveness (noidea of “should costs”)•Punish overruns (anddeemphasize control)•“Cresting Wave”distribution of outcomes
The Right Path:Excellence withManaged RiskPredictable +Competitive
•Set Challenging target(will miss some of them)•Measure absolute costcompetitiveness (identify“should cost”)•Only punish “notknowing” cost statusand/or failure to taketimely corrective action
Stat
usQ
uo
Cost EngineeringBack to Adding Value
• Investments, Profitability and Cost Engineering• Cost Engineering’s Value Proposition• Total Cost Management (TCM) Process• Decision and Risk Management
Total Cost Management (TCM) Centers onInvestment Decision Making
Project Control is a Recursive Process Within the Strategic Asset Management Process
If there is no project-there is no Project Control, But Cost Engineering Goes On!
*From the TCM Framework, Chapter 2.2
The Heart of TCM
AssetPerformanceAssessment
(6.1)
AssetPlanning
(3.2)
InvestmentDecision Making
(3.3)
Analysis Basis & Feedback
ProjectImplementation
(4.1)
Decision(ResourceAllocation
forProjects)
Asset CostAccounting
(5.1
AssetPerformanceMeasurement
(5.2)
ProjectControl
(2.4)
Improvement Opportunities(variance from baseline plans)
Require-ments
RequirementsElicitation and
Analysis(3.1)
Asset Performance andValuation Measures
BaselineAsset Management Plans
EnterpriseManagement
BusinessStrategies,
Goals,Objectives
ProjectImplement-
ationBasis
ProjectPerformance
AssetOperation or Use
AssetPerformance
Stakeholdersand Customers
Planning Processes:Scope and Execution Strategy Development
(7.1)Schedule Planning and Development (7.2)
Cost Estimating and Budgeting (7.3)Resource Planning (7.4)
Value Analysis and Engineering (7.5)Risk Management (7.6)
Needsand
Desires
AssetChange
Management(6.2)
Requirements Changes
Asset Historical Database Management(6.3)
All Strategic AssetManagementProcesses(3.1 to 6.4)
ActualData
HistoricalData
ActualData
HistoricalData
OtherEnterprises
Benchmarking Information
Decision(ResourceAllocation
forOperations)
ForensicPerformanceAssessment
(6.4)PerformanceInformation
Strategic Asset Management ProcessDeploys Business Strategy
*From the TCMFramework, Chapter 2.3
AssetPlanning
(3.2)
InvestmentDecision Making
(3.3)
Investment Decision Making ProcessIn TCM (3.3)
Decisions can never be reduced to an equation, butsuccessful decisions must be “informed”
*From the TCM Framework, Chapter 3.3
Key CE Practices That Add Value To andSupport Investment Decision Making
• Engineering Economics *• Cost Models (stochastic at early phases) *• Time Models (stochastic at early phases)• Decision Models• Decision Analysis• Integrated Risk Analysis (incl. Revenue, Opex and Capex)• Value Improving Practices (VIPs: capitalize on opportunities)• Strategic Metrics Analysis: KPIs related to Capex• Historical Data/Knowledge Base (supports all of above)• Soft Skills (e.g., understand Behavioral Economics)
*At AACE’s creation in 1956, these were the primary focuses of Cost Engineering
Typical Organizational ModelsTo Support TCM and Investment Decision Making
Corporate
Finance Business Unit 1
Operations &Maintenance
Technical (someEstimating)
Business Units2,3… Services
Projects (ControlFocus)
Typical:Decisions made by Business Units,biased by internal competition,dominated by finance and operationswith minimal capital cost knowledge orcost analysis capability, and nointegrated opex-capex risk analysis
Corporate
FinanceBusiness Unit
1
Operations &Maintenance Technical
BusinessUnits 2,3… Services
CostEngineering
Projects(Control Focus)
Better:Business biases tempered byindependent Cost Engineering (withQA role) working with finance andoperations (balanced Opex/ Capexview) with empirically-based cost &time knowledge, risk-informed,stochastic capability.Some Flavors:
Business-Development Engineering,Investment Engineering (DuPont), etc.
Cost EngineeringBack to Adding Value
• Investments, Profitability and Cost Engineering• Cost Engineering’s Value Proposition• Total Cost Management (TCM) Process• Decision and Risk Management
Decision Making Under Uncertainty
• Understanding the “base” cost of our capitalasset investments is not enough; we must alsounderstand risk *
• Cost Engineering adds value to Decision Makingunder Uncertainty or Risk.
• AACE effort is being focused on enhancing the“Risk” area of the CE body of knowledge:– Processes: (TCM Chapter 7.6, “Risk Management”)– Methods: e.g., Risk Analysis, Contingency and
Escalation Estimating Recommended Practices– Tools: working Hackney and RAND Excel models– Skills and Knowledge: Decision and Risk Management
Professional Certification (DRMP-beta: 2012) and itsproposed Study Guide
*In TCM (and ISO 31000) risk is uncertainty that could potentially effect objectives. Inother words risk is synonymous with uncertainty (or risk is “uncertainty that matters”)
Some AACE Risk QuantificationRecommended Practices
• 17R-97: Cost Estimate Classification System (Systemic risk driver)• 27R-03: Schedule Classification System (Systemic risk driver)• 40R-08: Contingency Estimating: General Principles• 41R-08: Risk Analysis and Contingency Determination Using Range Estimating• 42R-08: Risk Analysis and Contingency Determination Using Parametric Estimating
– RM-12: Extension of 42R-08 to Schedule Risk (in progress)– 43R-08: Risk Analysis and Contingency Determination Using Parametric Estimating – Example
Models as Applied for the Process Industries (i.e., Hackney and RAND Excel® models)• 44R-08: Risk Analysis and Contingency Determination Using Expected Value• 57R-09: Integrated Cost and Schedule Risk Analysis Using CPM and Monte Carlo
Simulation (exposure draft)• RM-14: Integrated Cost and Schedule Risk Analysis Using Expected Value and
Monte Carlo Simulation (in progress)• 15R-10: Selecting Probability Distribution Functions for Use in Cost and Schedule
Risk Simulation Models (committee draft)• 58R-10: Escalation Estimating Principles and Methods Using Indices• 58R-10 Extension: Escalation Estimating Using Indices and Monte Carlo Simulation
(in progress)• And more on the way…
Value Proposition: Why Risk Management isa Key Cost Engineering Focus
• To repeat, to add value to your business (not justconserve value), one must focus on Making BetterInvestment Decisions; however, to make the rightdecisions, and avoid lost value during execution, onemust also address risk
• Evidence of industry’s failure to address riskadequately is in the news every day
• Cost Engineering adds particular value in terms ofquantification of risks and impacts– Most company “Risk” departments (and books on the topic)
are limited to “qualitative” risk screening because truequantification is difficult (one must understand the asset,project and environment) and controversial (some argue thatmost risk cannot be quantified)
TCM: Risk Management Process
*From the TCM Framework, Chapter 7.6
TCM is the only industry process that explicitly quantifies therisk in a way that supports decisions and control (i.e., recycles
residual risks through Assessment)
How Does Business Management AddressRisk in Investment Decision Making
• First Pass: run DCF on business case model applying a target“hurdle rate” (e.g., 12-15% needed to exceed typical stock return)
• Bounds Testing using Sensitivities/Scenarios: Rerun the modelwith different key “market and financial” driver values (e.g., firstsale date, sale price, interest and tax rates) and run the modelwith rough estimates of impact on return of each driver
• Go/No Go: If scenarios exceed hurdle rate, likely to make the cut
• Analysis is typically led by finance: capital contingency andreserve analysis by the team is largely ignored (engineering noise)and most teams provide little useful schedule risk information
– More sophisticated owners may consider p90 capex or highlighted reserveitems as scenario variables; a Cost Engineering value add!
– Escalation of capex is treated superficially (e.g., CPI on capex and opex) withlittle recognition that rates now vary markedly with each model element
*DCF = Discounted Cash Flow
Quantification Gone Wrong(Traditional “Ranging” Does Not Work)
• Even if business uses “P90” capex and startup date values…They are Wrong
(if you are doing “line-item or activity ranging”)• Findings from empirical research…
– “…contingency estimates are, on average, getting further from theactual contingency required.”… When project scope was poorlydefined, the more sophisticated techniques were “a disaster”
• Why does ranging fail?– Monte Carlo is not the problem, it is the underlying models– Traditional “ranging” models have no direct risk-to-impact link or
consideration of systemic risks (even if one gets the Monte Carlorequirements such as dependencies correct)
* Burroughs Scott E. and Gob Juntima, “ExploringTechniques for Contingency Setting” , 2004
Risk Analysis Must Address Systemic Risks
• Systemic Risks (empirically based methods)– Project or process system attributes such as how well you define the
scope, estimating biases, use of technology, complexity, etc.– Predominate risk in early scope development– Best estimated using Parametric Modeling (models directly link risks
with cost and schedule impacts)
• Project-Specific Risks– Result from attributes, conditions, events, activities, and so on in a
specific project– These risks are generally not readily identifiable until later in project
definition– Best estimated using Expected Value Modeling
• These issues/methods are well covered in AACE literature
Risk Analysis Must Address Systemic Risks
• Systemic Risks (entirely empirical)– Project or process system attributes such as how well you define the
scope, estimating biases, use of technology, complexity, etc.– Predominate risk in early scope development– Best estimated using Parametric Modeling (models directly link risks
with cost and schedule impacts)
• Project-Specific Risks– Result from attributes, conditions, events, activities, and so on in a
specific project– These risks are generally not readily identifiable until later in project
definition– Best estimated using Expected Value Modeling
• These issues/methods are well covered in AACE literature
Estimator, Cost Engineer or Decision Maker?
Many of us have heard of John W. Hackney, the “godfather” ofCost Engineering
(an AACE Founder, Award of Merit 1961)
Before becoming Manager of Cost Engineering at Mobil (and“profitability analysis” with Diamond Shamrock before that), didyou know he conducted research and published the world’s first
parametric risk model linking the level of project scopedevelopment to cost growth? This is a foundation to the phase-
gate (FEL) decision making processes we all use today.
A Big Systemic Risk for Decision Making(Behavioral Economics)
Cost Engineers must move beyond Engineering Economics….Behavioral Economics (part of DRMP body of knowledge)
– 2002 Nobel to Daniel Kahneman for having "integrated insights frompsychological research into…decision-making under uncertainty”
Example derived from above: “Strategic Representation”(i.e., Optimism Bias-or better known as Lying)– American Planning Association endorses Bent Flyvbjerg’s
“Reference Class Forecasting” for public works projects becausecosts overrun >100% and demand underrun >50% not uncommon
– A cynical (but realistic?) approach: just use history for your mostlikely outcome and probability distribution (forget VIPs)
• Less cynically, AACE uses Benchmarking/Validation as a bounds test of models
– He recommends better “Management Accounting” (Unfortunately,he does not recognize Cost Engineering)
Get in the Scenario Game
• In addition to addressing systemic risks (and hence real p90values) realize that business decision makers are looking atsensitivities and scenarios using DCF and EMV (“expectedmonetary value from decision trees)
• Cost Engineers must support these approaches Stochastic cost models that examine multiple options Identify “reserve” risks that cost contingency cannot fund (e.g., low
probability, high impact); considered these in DCF sensitivity runs Identify and highlight schedule completion risks because the “first
sale” date is always a key variable in DCF (finance folks get this) Identify and offer “contingency risk response plans” for the above If you can include portfolio considerations (interaction of projects) in
all of the above, so much the better
Cost EngineeringBack to Adding Value
• Investments, Profitability and Cost Engineering• Cost Engineering’s Value Proposition• Total Cost Management (TCM) Process• Decision and Risk Management
– and Value Management (& VIPs)
35
Value and Risk ManagementProcesses Should Work In Alignment
PlannedValue
AddedValue
ReducedValue
The Risk and Value ManagementShield Protects Investment Value
36
Apply VIPs Early and Often Enough toInfluence Design, Planning and Decisions
Pote
ntia
lto
Influ
ence
Val
ue
Asset Planning Asset Implementation Project Control
Asset OptionSelected
AssetOpportunityIdentified
Project Fully Authorized
Asset Planning and Implementation Phase
37
Example: IPA VIPs
From: The Use and Impact of Value Improving Practices and Best PracticesJim Lozon, P.Eng. and Dr. George Jergeas, P.Eng.AACE Cost Engineering Journal, Vol. 50/No. 6 JUNE 2008
Cost Engineering is CriticalAll VIPs end in Decisions, and most Decisions hinge on Costs
In Conclusion: Cost Engineering HelpsAvoid the Capex Drain
Over Funded Capital/Poor Profitability
Overrun
BecomeRisk Averse
Low RiskPredictable
Projects
Loss ofCredibility
Business Pads Plans
Fails to MeetRequirements
Rework, Debottleneck, Modification Projects
Optimism bias goesuncheckedUnder Funded Capital
GiveRewards
Underdesign
Underrunor Alwayson Budget
GiveRewards
Punish
Weak CostEngineering
PROPOSAL
Overdesign
Value of alternatives not assessed
In Conclusion: Cost EngineeringAdds Value
• Cost Engineering’s added value is in MakingBetter Capital Investment Decision– Profitability is determined before the project– Project Control only conserves value
• AACE’s Total Cost Management FrameworkProcess is centered on the Investment DecisionMaking in consideration of Risk– A current AACE focus is building on Decision and Risk
Management technology, education and certification• Many Cost Engineers need to update their skills
and knowledge so that they are valued by theBusiness Leaders who make decision– Start by being the gurus of Capital Effectiveness and
capital cost and schedule risk– Play in/feed the financial scenario game
40
Questions?
• Contact:– John K. Hollmann PE CCE CEP (…and future DRMP)– [email protected]– www.validest.com– 1-703-945-5483
• Key References:– TCM and RPs
• Free (.pdf format) from AACE at www.aacei.org/technical