Pre-Tender Estimate, Contingency IN or OUT?

Think about a construction project that contractors’ bid submissions have an estimated value of 5% above the project’s estimated cost prior tendering process. In most cases, a reasonable difference between estimated project cost versus tender submission value by contractors, it is rated as feasible and as a result, the procurement process is initiated. The infrastructure project delivery process relies heavily on an adequate level of financial management to maintain commercial feasibility and efficient operation of any project owner.

If the tender responses turn out to be 20% than higher that estimated, this can cause many issues for most clients, including:

-     Feasibility of project economical assessment, e.g. its Benefit Cost Ratio (BCR)

-     Availability of required additional fund

-     Additional time pressure to achieve planned milestones

-     Possible cost of redesign

-     Risk of abandonment

-     Reputation and public matters

A Pre-Tender Estimate (PTE) is the cost estimator’s final costing of the Scope of Works (SoW) before tenders are received from contractors. At this stage the SoW can be benchmarked against available cost data to provide comparisons against the provisions on other projects and related to unit values.

The PTE helps in reconciliation of the cost plan with the tender information from which any deviations to be identified, assessed, validated and communicated. Any major differences will be discussed for validation as well as possible design changes of any required implementation of value engineering. PTE also helps to compare the returned tenders for the best value for money (for acceptable risk exposure), particularly when the procurement route is single contractor negotiation.

Over the years I was fortunate enough to be part of a number of independent project reviews and project assurance assessments about the best structure and approach to project pre-tender estimate development, including the inclusions and exclusions – for example, ranges of quantities, rates, contractor’s risks and schedule risk. This article is a summary of discussions and debates on this important topic and hopefully generates further awareness about this topic in our profession.

PTE Objective: the PTE is a base cost contract estimate and therefore allowance for the following items may not be required.

• Client’s costs, including its project management
• Client arranged insurance/s
• Project development costs
• Costs associated with any material/resources provided by Client 
• Detailed design and documentation costs unless specifically included in the contract
• Property acquisition costs unless specifically included in the contract
• Utility costs unless specifically included in the contract
• Finalisation costs unless specifically included in the contract
• Contingency (please keep reading!)

You might be interested to know that different guidelines and estimating manuals, even from key government agencies - NO!, I'm not naming them here! :) - have different views to the inclusion and exclusion of 'contingency' within the pre-tender estimate. But what is the good practice?

When undertaking a pre-tender estimate it is absolutely critical to consider the form of contract that will be reflected in the tender return. Much of this comes down to risk allocation. In my experience, this is the most important factor impacting the accuracy of PTE. Why? Let’s take few steps back at the time of Final Business Case (FBC) development.

In Australia, according to the guide notes of the Department of Infrastructure, Regional Development and Cities (DIRDC) and the 2nd Edition of Contingency Guideline (from Risk Engineering Society – RES), the structure of cost estimate at FBC should have the key elements below.

• Base Estimate, this should have all base numbers for both client and contractor
• Contingency (which can be split, e.g. between P50 and P90 levels), this should be ‘project contingency’ for both client and contractor by assessing all inherent and contingent risks together for optimum contingency.
• Escalation (which can be split, e.g. between P50 and P90 levels), this should be ‘project escalation’ for all relevant items exposed to cost increases from ‘time now’ to the expected procurement date, e.g. 3 years later.

Considering that PTE is a base cost contract estimate, it should not have any client’s costs. Excluding the client cost items from the Base Estimate is not that difficult, however assessing contractor’s portion of ‘Contingency’ and ‘Escalation’ is the tricky step.

In my experience, the notes below can be helpful during extraction of PTE from previously developed detailed estimates, e.g. Final Business Case estimate.

• Client cost items should be excluded from the Base Estimate
• Quantities should be reviewed and updated as per the latest design
• Rates should be escalated, validated and updated to represent the current Time
• Inherent risks: all contractor’s inherent risks should be included. Please note that in most type of contracts, there are still many shared inherent risks, e.g. utilities, wet weather, etc. These should be remained in the PTE. 
• Schedule risks: client’s schedule risks should be excluded from Schedule Risk Analysis (SRA). 
• Contingent risks: all client’s risks should be identified and allocated to the client.
• Costs for contractor’s risk preventions should be included
• Costs for contractor’s risk mitigations should be included
• Costs for contractor’s risk transfer should be included
• Costs associated with the residual risks that are to be allowed as provisional items should be included.

In my experience, a good Pre-Tender Estimate must be based on the proposed contract requirements, expert advice (where needed) and consideration of current market conditions and well as a comprehensive inherent and contingent risk assessment.

I believe an appropriate bottom-up first principles estimate, Quantitative Risk Analysis (QRA), e.g. First Principle Risk Analysis (FPRA), probability estimation and simulation of past estimates, reducing cost engineering skill turnover, incorporating market sentiments into estimates, early involvement of the cost engineers, schedulers and risk engineers at the brief stage, and proper documentation of experience gained in the estimation of projects should help firms improve the accuracy of estimates for new projects. Not an easy task though!

So, all together, what is the right answer for “Pre-Tender Estimate – Contingency IN or OUT?" – The right answer is "Yes and No"! A portion of previously calculated contingency for common contractor’s confidence level (for example P60 for a normal road project in Australia) and costs associated with contract risk prevention, mitigation and transfer must be included in the PTE.

For your free copy of the 2nd Edition of RES Contingency Guideline, send me a note to: PDaneshMand@kpmg.com.au

Your views are welcomed and appreciated, as always.

The views expressed in this article are those of Pedram Danesh-Mand and do not reflect or represent the official policy, position or recommendation of the KPMG Australia, Engineers Australia (EA) or Risk Engineering Society (RES).