![13
AACE INTERNATIONAL INTRODUCTION
LEARNING OBJECTIVES
The objective of this chapter is show how the various skills
and knowledge of cost engineering are integrated or brought
together into a whole. There are three ways to view or model
integration: from a work process or application perspective,
from a human or organizational competency perspective, or
from a physical perspective. This chapter examines the skills
and knowledge of cost engineering from all three perspec-
tives. It also serves as an adjunct to the text index, by show-
ing how the various chapters are integrated in accordance
with the integrative models.
At the end of the chapter, the reader should understand the
following concepts:
• how cost engineering skills and knowledge can be inte-
grated through a work process, specifically the total cost
management (TCM) process;
• how cost engineering skills and knowledge can be inte-
grated within the competency of a cost engineering
professional and the collective competencies of an
organization;
• how cost engineering skills and knowledge about indi-
vidual resource types are integrated through creation of
an asset;
• challenges to successful integration (e.g., bureaucracy,
complacency, and lack of vision); and
• how the chapters of this text come together as a whole.
The reader of this chapter is expected to gain a conceptual
understanding of how the skills and knowledge of cost engi-
neering come together as a whole, not to learn the details of
any particular integration model (e.g., TCM) or any particu-
lar skill or knowledge area.
CONCEPTS
Integration
Integration is broadly defined as bringing things together as a
whole. However, this definition begs the question of a whole
what?. In this chapter, “what” is defined a whole process (the
activities cost engineers do), a whole person and organization
(what cost engineers know and skills they have), and a whole
asset (things that firms that employ cost engineers own). One
author has referred to these three dimensions as the “strategic
resources” of an organization [2].
As an integrative process model, AACE International is
developing the Total Cost Management Framework [3]. The
Framework defines TCM as the sum of the practices and
processes that an enterprise uses to manage the total life cycle
cost investment in its portfolio of strategic assets. The prac-
tices are called cost engineering; the process through which
the practices are applied is called TCM.
By its nature, the TCM process is integrative. However, it is
the people in organizations that make processes work. Only
when an enterprise integrates its process with people that
have the right set of skills and knowledge for the right tasks
at the right time (i.e., the right personal and organizational
competencies) will a process give an enterprise a competitive
advantage.
Furthermore, there is a physical or resource dimension to
integration. The objective of TCM is to manage the invest-
ment of resources through projects or programs in strategic
assets. The asset is the physical end result of the integration
of resources. So, integration can be thought of as the combi-
nation of process plus competency plus resources as brought
together in projects to create competitive strategic assets.
There are factors that impede integration (i.e., that lead to
disintegration). From a process and organizational perspec-
tive, bureaucracy is a major impediment. In a bureaucracy,
INTEGRATION OF THE SKILLS AND KNOWLEDGE
OF COST ENGINEERING
John K. Hollmann, PE CCE](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-14-320.jpg)
![14
INTRODUCTION AACE INTERNATIONAL
the steps of a process are viewed as ends in themselves, and
competency in an organization is viewed as skill in perform-
ing a particular step without regard for skill in facilitating the
process. Bureaucracy works against successful team devel-
opment. On an individual level, complacency is an impedi-
ment because integration requires that individuals renew
their skills and knowledge to match the changes that occur in
the work environment and process. Finally, a lack of vision
of the objective of the TCM process impedes integration
because failure to understand how all the resources come
together in a project or asset risks project performance
and/or asset quality. Lacking vision, the project or asset will
not come together as a “whole” to meet the owner’s needs
and expectations.
Effective integration then is the dynamic combination of
process, competency, and resources with an eye on project
and asset objectives. By “dynamic,” we mean that the people
in an enterprise know when to modify their processes, renew
their skills, and leverage shared resources in a way that
yields projects, programs, and assets that collectively meet
the owner’s changing needs and expectations and give the
enterprise a competitive advantage.
Integration from a TCM Process Perceptive
We will start our discussion of how the skills and knowledge
of cost engineering and the chapters in this text are integrat-
ed by first examining the process perspective. TCM is a
process map that by its nature is integrative. The TCM
process model is based upon the “PDCA” management or
control cycle (also known as the Deming or Shewhart cycle).
The PDCA cycle is a generally accepted, quality driven, con-
tinuous improvement management model. PDCA stands for
plan, do, check, and assess, with the word check being gener-
ally synonymous with measure. The word assess is sometimes
substituted with the word act as in “to take corrective action”.
Figure 1 shows the TCM process map at an abstract level. In
TCM, the PDCA model is applied in a nested manner, where-
by the basic PDCA process is applied for each asset and
group of assets, and then again for each project being per-
formed to create, modify, maintain, or retire those assets.
The two levels of the TCM process in Figure 1 are called the
strategic asset management and project control processes.
Project control is a process nested within the project imple-
mentation step of strategic asset management. An enterprise
will have a portfolio of assets in various stages of their life
cycles, and during each asset’s life cycle, many projects will
be performed (often as a program) to create, modify, or ter-
minate that asset.
Chapter 26 covers how the steps and activities of cost engi-
neering come together in the strategic asset management
process (left side of Figure 1). The four chapters in section 4
(chapters 14 to 17) then describe how various cost engineer-
ing activities, and tools come together in project control (right
side of Figure 1).
Products, in terms of the owner’s technology, design, and
knowledge of the product manufacturing process, are assets
to an enterprise. As such, TCM also applies to the design and
manufacturing of products. Chapters 10 and 11 describe how
various activities and tools of cost engineering come togeth-
er in process product and discrete product manufacturing
applications respectively. Manufacturing applications such
as materials requirement planning (MRP) are covered in
these chapters.
Below the general application level, a more detailed process
map is needed to understand how the individual skills and
knowledge of cost engineering are integrated. The process
maps in Figure 2 and Figure 3 provide the additional detail.
Portfolio of Enterprise Assets
STRATEGIC
ASSET
PLANNING
PROJECTS
IMPLEMENTATION
STRATEGIC
ASSET
PERFORMANCE
MEASUREMENT
STRATEGIC
ASSET
PERFORMANCE
ASSESSMENT
Strategic
Asset
Management
Process
PROJECT
PLANNING
PROJECT
ACTIVITY
IMPLEMENTATION
PROJECT
PERFORMANCE
MEASUREMENT
PROJECT
PERFORMANCE
ASSESSMENT
Project
Control
Process
Portfolio of Projects
Plan
Do
Check
Assess
Plan
Do
Check
Assess
Figure 1—Total Cost Management Process Map [3]](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-15-320.jpg)
![15
AACE INTERNATIONAL INTRODUCTION
Project
Performance
Assessment
Scope
Development
Planning &
Scheduling
WBS
Cost Estimating
& Budgeting
Resource
Planning
Value Engineering
Risk Analysis
& Contingency
Analysis
Basis & Feedback
Analysis Basis & Feedback
Communicate,
Execute
Plans
Schedule
Baseline
(Activities)
Cost
Baseline
(Budget)
Resource
Baseline
(Quantities)
Iterative, concurrent processes
Project
Accounting
Performance
Measurement
Asset,
Project
History &
Learnings
Strategic Asset
Management
Improvement
Opportunities
(variance from baseline plans)
Forecasting,
Corrective Action,
& Change
Management
Project
Requirements
Assessment
Strategic Asset Scope Description,
Project System Requirements,
& Budget
Expenditure and Progress Measures
Baseline
Plans
Strategic
Performance
Assessment
Investment
Options
Development
Estimating,
Parametric
Analysis, ABC
Economic &
Profitability
Analysis
Problem and
Decision
Analysis
Value Engineering
& Management
Risk Analysis
& Management
Analysis
Basis & Feedback
Analysis Basis & Feedback
Project
Implementation
Decision
(Resource
Allocation
for
Selected
Option)
Iterative, concurrent processes
Asset and
Project
Accounting
Asset
Performance
Measurement
Project
Control
Improvement
Opportunities
(variance from
baseline plans)
Strategic
Requirements
Assessment
Asset Performance
and
Valuation Measures
Baseline
Asset
Mgmt
Plans
Enterprise
Management
Business Strategies, Goals,
Objectives, Requirements
Strategic Scope,
Requirements, and
Budget
Project Performance,
History & Learnings
Asset
Life Cycle
Operations
Asset Performance,
History & Learnings
Figure 2. The TCM Strategic Asset Management Process [3]
Figure 3. The TCM Project Control Process [3]](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-16-320.jpg)
![INTRODUCTION
Cost is a basic “yard stick” by which activities and assets are
measured and compared. Because the word cost is so com-
monly used and generally related to monetary value, we may
lose sight of its true meaning and importance as a cost engi-
neering concept. This chapter is strategically located first in
this Skills & Knowledge (S&K) textbook for the very reason
that cost is a fundamental attribute of activities and assets.
Cost is one of the three fundamental attributes associated
with performing an activity or the acquisition of an asset.
These are (1) price (cost), (2) features (performance), and (3)
availability (schedule).
The need to understand and quantify the attribute of cost
spawned the engineering discipline of cost engineering. Cost
engineering is the application of scientific principles and
techniques to problems of estimation, cost control, business
planning and management science, profitability analysis,
project management, and planning and scheduling [3]. While
this definition seemingly addresses non-cost areas, it lists key
engineering activities that either generate cost when they are
performed or define plans and processes that cause (or influ-
ence) cost to be generated in other activities and/or assets.
What are the elements that make up cost? How are these cost
elements categorized and how do they relate to one another?
Why is it important to collect and account for costs as they
relate to specific activities and assets? And, finally, how do
we apply these cost elements and categories to the insight for
managing activities and assets? This chapter will provide
you with a basic understanding of these cost fundamentals
and will give you the insight and background you will need
as you study the following chapters in this S&K textbook.
LEARNING OBJECTIVES
After completing this chapter, the reader should be able to
• understand what makes up cost—i.e. the basic resources
(material, labor, etc.) that are needed to perform an activ-
ity or create an asset;
• understand the distinction between cost elements that
are directly applied to an asset and those that are indi-
rectly applied;
• relate the cost elements to the life cycle of the asset:
acquisition, use, and disposal;
• use the understanding of cost elements to further under-
stand how cost is measured, applied, and recorded to
arrive at the total activity and/or asset cost; and
• apply the knowledge gained to solve problems related to
cost element source and definition.
CONCEPTS
Cost is the value of an activity or asset. Generally, this value is
determined by the cost of the resources that are expended to
complete the activity or produce the asset. Resources utilized
are categorized as material, labor, and “other.” Although money
and time are sometimes thought of as resources, they only
implement and/or constrain the use of the physical resources
just listed. The path by which resources are converted (via a
“project”) to activities and assets is illustrated in Figure 1.1. The
1.1
AACE INTERNATIONAL COST ELEMENTS
Chapter 1
Cost Elements
Franklin D. Postula, PE CCE
Available
Resources
Activity
and/or
Asset
Money
& Time
Cost
Elements
Figure 1.1— Conversion of Resources to Project Results](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-24-320.jpg)
![final activity or asset produced depends on what can be
“afforded” given the money and time allocated to the project.
Normally you think of material as the physical composition
of the asset. However, the value of the asset may also include
the cost elements of scrap material or manufacturing spares,
construction form work and expendable safety items, and the
cost of transporting the material to the work site.
Often, we think of labor as the value of the work needed to
complete the activity or asset; i.e. the worker’s labor in paint-
ing the building or soldering an electrical contact. Labor also
includes the work of the engineer who prepares the design,
the foreman supervising the field work, or the technician that
maintains the wave soldering equipment.
The “other” cost category consists of resources needed to
support the activity and/or asset. An example would be the
facilities needed to produce an activity or asset, which would
include the tooling, electricity, taxes, and maintenance, etc.,
necessary to keep the facility available for use. Other costs
might be office supplies, communication costs, travel costs,
and security costs.
Another important aspect of cost relates to whether one is the
producer or consumer of an activity or asset. The cost cate-
gories just listed are those associated with the producer. The
consumer has additional costs that add to the value of the
activity or asset being acquired. A fundamental addition is
profit for the producer. Generally, profit is established by mar-
ket competition, although the law limits profit on certain gov-
ernment procurements.
The value of an asset or activity also may be related to intan-
gible costs. The value of an art object is often related to the
name of the artist. When evaluating alternatives, the value of
each alternative should be assessed in terms of the benefits
that can be expected if selected and the consequences that
might be suffered if not selected [10]. An intangible benefit
might be an avoided cost if the alternative is selected. For
example, incorporating a spell checker into word processing
software saves (avoids) the labor of manual checking.
An intangible negative consequence might be the cost of
missing an opportunity because resources were invested in
another alternative instead of the more beneficial one.
The following example illustrates the resource cost cate-
gories:
Example 1—John decides to build a deck on the back of his
house. He draws up plans for the project, gets the building
permit from the city, buys the material, hauls it home, and
constructs the deck. The cost elements and categories associ-
ated with building this asset are shown in Table 1.1. Notice
that some of these cost elements are not part of the physical
deck, but are necessary in order to complete the project.
Furthermore, some of the cost elements are not part of the
work activity needed to get the deck built, but are essential
to support the project. In the next section, we will see how
these cost categories are structured.
COST STRUCTURING
It is important to further structure the cost elements within
the material, labor, and other resource categories in order to
understand how they influence the total cost of the activity or
asset and to get a better understanding of how they can be
controlled. This structuring sorts the cost elements into direct
costs, indirect costs, fixed costs, and variable costs. In practice,
some costs may fall in more than one of these groupings. This
will be shown through an extension of the previous example.
Direct Costs
Direct costs are those resources that are expended solely to
complete the activity or asset. In other words, “Any cost that
is specifically identified with a particular final cost objective,
but not necessarily limited to items that are incorporated in
the end product as material or labor” [1]. Thus, the direct cost
of a foundation for a house includes trenching for the foot-
ings, the wooden forms (if not reusable), the concrete, and the
labor to place and finish the concrete. Direct costs for mak-
ing a metal bowl would be the metal sheet stock and the
stamping machine operator labor cost. The material cost for
manufacturing the bowl would include the scrap from the
stamping process less any salvage value.
Indirect Costs
Indirect costs are those resources that need to be expended to
support the activity or asset but that are also associated with
other activities and assets. In other words, “Any cost not
directly identified with a single final cost objective but iden-
tified with two or more final cost objectives …” [1].
Consequently, indirect costs are allocated to an activity or
asset based upon some direct cost element, such as labor
hours, material cost or both. Indirect costs also may be
referred to as “overhead costs” or “burden costs.” Indirect
costs are general administrative activities associated with
operating the business, costs for providing and maintaining
1.2
COST ELEMENTS AACE INTERNATIONAL
Category Cost Elements
Materials drafting paper/pencil, concrete, nails, lumber, deck
screws, paint, brushes, turpentine, drop cloth
Labor draw plans, get permit, get materials, construct footings,
erect deck, paint deck, wife’s support in making lunch
Other building permit fee, use of house to draw plans, shovel,
power saw, power drill, electricity; pickup truck, gasoline
Table 1.1—Costs Associated with John’s Deck](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-25-320.jpg)
![As you consider these groupings of cost elements, you may
realize that the variable direct cost elements are those that
depend on the size of the deck. Although you might think of
them as being “fixed” for this specific project, their value
would change if the deck design were to change. Also, if a
second identical deck were to be built, the value of these cost
elements may go down due to efficiencies (learning) in per-
forming the job.
In the next section, we will investigate the purpose for col-
lecting and reporting cost elements and how these elements
might be organized to provide information for management
decision making.
COST ACCOUNTING
What is the purpose of cost accounting and why is it impor-
tant? Cost accounting is defined as the historical reporting of
disbursements and costs and expenditures on a project.
When used in conjunction with a current working estimate,
cost accounting can assist in giving the precise status of the
project to date [7]. Historical costs can also provide a sound
basis for forecasting and budgeting costs of future activities
and assets.
While detailed methods used for cost accounting may vary
from business to business or from project to project, all
accounting systems include the three basic steps of recording,
classifying, and summarizing cost element data in terms of
money expended with time [5]. The recording of cost infor-
mation is nothing more than the mechanical gathering of
data in a routine manner. There are a variety of methods to
achieve this. Generally, it’s accomplished with time sheets for
labor and invoices for subcontracts and procured items.
Other costs are gathered from utility bills, expense reports,
tax bills, etc.
Every business enterprise has an established approach for clas-
sifying and summarizing costs that is organized around their
business practices. This approach is called a “code of
accounts” by which all recorded cost elements are classified. A
code of accounts (sometimes referred to as a chart of accounts)
is a systematic numeric method of classifying various cate-
gories of costs incurred in the progress of a job; the segregation
of engineering, procurement, fabrication, construction, and
associated project costs for accounting purposes [3].
A company’s code of accounts is configured to support the
recording of cost data in the general ledger. An example of
summary-level accounts is shown in Table 1.4.
While classifying costs in accordance with the general ledger
breakout is a common practice, this approach does not gen-
erally provide the visibility needed to manage the work or to
make informed forecasts of the cost of new jobs. An alternate
method of cost element classification is called activity-based
costing (ABC). In the ABC approach, resources that are used
are assigned to activities that are required to accomplish a
cost objective [9]. ABC makes cost accounts understandable
and logical, and much more useful for the cost engineer [4].
This method of collecting and summarizing cost elements
reveals which resources and activities are the most significant
contributors (drivers) to the cost of the cost objective.
Another approach to classifying costs that is similar to ABC
accounting is using a work breakdown structure (WBS) to
group cost elements. It has become a common practice for a
WBS to be a required project management tool on most con-
tracts. Not only does a WBS provide a framework for plan-
ning and controlling the resources needed to perform the
technical objectives, but it facilitates a summary of project
data regarding the cost and schedule performance. Table 1.5
shows an example WBS for a study project wherein the deliv-
erable item is an intellectual product documented in techni-
cal publications.
When used to classify and record costs, the WBS becomes the
cost element structure (CES), as well. The general format,
however, is applicable for the CES of a manufactured prod-
uct or construction project [8].
1.4
COST ELEMENTS AACE INTERNATIONAL
Direct
Material: drafting paper, concrete, nails, lumber, deck
screws, paint, turpentine
Labor: draw plans, get permit, get materials, construct
footings, erect deck, paint deck
Other: building permit fee
Indirect
Material: pencil, brushes, drop cloth
Labor: wife’s support in making lunch
Other: use of house to draw plans, shovel, power saw,
power drill, electricity, pickup truck, gasoline
Fixed
Direct: get permit
Indirect: use of house to draw plans, shovel, power saw,
power drill, pickup truck, pencil, brushes, drop
cloth
Variable
Direct: drafting paper, building permit fee, concrete,
nails, lumber, deck screws, paint, turpentine,
draw plans, get materials, construct footings,
erect deck, paint deck
Indirect: wife’s support in making lunch, electricity, gaso-
line
Table 1.3—Costs Associated with John’s Deck](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-27-320.jpg)
![While there is no universal WBS/CES
standard, some have been developed
for government acquisition. One
comprehensive example is the U.S.
Army Cost Element Structure [11]
(www.asafm.army.mil/ceac/
ceac.asp). This CES provides a defini-
tion of each cost element within the
structure. It also provides structure
for cost elements in all procurement
phases: development, production,
and operation and support.
Sometimes the code of accounts to be
used is determined by law. For exam-
ple, the Federal Energy Regulatory Commission
(FERC) has established a Uniform System of
Accounts for the electrical power generation industry
(www.ferc.fed.us). The account numbering plan used
consists of a system of three-digit whole numbers as
shown in Table 1.6.
Regardless of how cost elements are classified and
grouped, it is important that this is done in a manner
that is consistent with the way future work is esti-
mated and budgeted. Historical cost records repre-
sent the way a company conducts its business and
can be analyzed to determine whether improve-
ments have been made and how costs may trend in
the future. Therefore, the integrity of the cost
1.5
AACE INTERNATIONAL COST ELEMENTS
2000 Assets
2100 Cash
2200 Accounts Receivable
2300 Notes Receivable
2400 Inventory - materials and supplies
2500 Inventory – finished products
2600 Work-in-progress
2700 Equipment
2800 Buildings and fixtures
2900 Land
3000 Liabilities
3100 Accounts payable
3200 Notes payable
3300 Taxes payable
3400 Accrued liabilities
3500 Reserve accounts
4000 Equity
4100 Capital stock issued and out-
standing
4200 Retained earnings
5000 Revenues
5100 Sales of finished goods
5200 Other revenues
6000 Expenses
6100 Cost of goods sold
6200 Salaries and wages
6300 Heat, light, and power
6400 Communications expense
6500 Reproduction expense
6600 Insurance
6700 Taxes
6800 Depreciation
6900 Interest expense
7000 Construction work in progress
7100 Site preparation
7200 Concrete work
7300 Structural steel
7400 Heavy equipment
7500 Buildings
7600 Electrical systems
7700 Piping systems
8000 Manufactured goods in progress
8100 Direct materials
8200 Direct labor
8300 Overhead
Table 1.4— Typical Code of Accounts (after Jelen [6])
Table 1.5—Typical WBS Format
Level 1
1.0 Research Project
Level 2
1.1 Concept Study
1.2 Mathematical Model
1.3 Deliverable Data
1.4 Project Support
Level 3
1.1.1 State-of-Art Research
1.1.2 Concept Definition
1.1.3 Data Analysis
1.2.1 Equation Formulation
1.2.2 Computer Programming
1.2.3 Test and Evaluation
1.3.1 Technical Documents
1.3.2 Engineering Data
1.3.3 Management Data
1.4.1 Project Management
1.4.2 Review Meetings
Table 1.6— FERC Uniform System of Accounts
100-199 Assets and other debits.
200-299 Liabilities and other credits.
300-399 Plant accounts.
400-432, &
434-435
Income accounts.
433, 436-439 Retained earnings accounts.
440-459 Revenue accounts.
500-599 Production, transmission and distribution expenses.
900-949 Customer accounts, customer service and informational, sales,
and general and administrative expenses.](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-28-320.jpg)
![INTRODUCTION
The goal of this chapter on pricing is to serve as “a guide to
the subject matter in which a cost engineer and a cost man-
ager should be both knowledgeable and competent” [1]. In
the following pages, pricing is established as a set of man-
agement processes (tools and techniques) required to estab-
lish the cost of an endeavor (project, business). These tools
and techniques include the following:
• pricing strategies,
• sales and revenues,
• return on investment (ROI),
• return on sales (ROS), and
• break-even analysis.
With the complexities involved, it should not come as a sur-
prise that pricing is considered to be an art by many cost
managers [2]. Establishing the right information on customer
cost budgets and competitive pricing is an essential element
in this art of pricing. The unreliability of the information base
can lead to wrong or misleading information in many cases.
However a disciplined approach derived from combining the
art of pricing and science is very beneficial.
LEARNING OBJECTIVES
After completing this chapter, the reader should be able to
• differentiate between costing and pricing,
• establish a framework for the comparison of pricing
strategies on projects,
• analyze profitability and establish return on investments
(ROI) and return on analysis (ROA),
• establish the return on sales (ROS) parameters, and
• understand the concept of break-even analysis for any
business situation.
COST AND PRICING—IS THERE
A DIFFERENCE?
Price refers to “the cost at which something is bought or
sold” [5]. Therefore, pricing is the process of establishing the
cost of a project/business. Pricing refers to a set of tools and
techniques used to establish an output-cost. The difference is
subtle, and in real-world applications, it is not incorrect to
use these terms interchangeably, as long as there are terms of
reference. In this chapter the terms of references for pricing
are based on the tools and techniques used to establish cost;
i.e., pricing strategies, sales and revenues, ROI, ROS, and
break-even analysis.
TOOLS AND TECHNIQUES OF PRICING
Analysis of the Pricing Process
In Figure 2.1 on page 2.2, the process of pricing is described in
terms of its inputs, tools and techniques, and output. These are
described separately in this chapter with the focus being on the
tools and techniques. The inputs are the documentable items
that will be acted upon and include, but are not limited to:
work breakdown structure (WBS), historical records, cost esti-
mation and cost management system. The tools and tech-
niques are the mechanisms applied to the inputs to produce
the outputs and include pricing strategies, sales and revenues,
ROI, ROS, and break-even analysis. Tools and techniques of
the pricing process is the focus of this section.
Pricing Strategies
Pricing Strategies must be developed for each individual
situation. Essentially two situations frequently appear
when one is pursuing a project. These situations that often
occur in competitive acquisitions are referred to as Types I
and II [2]. In each case there are specific but different busi-
ness objectives.
2.1
Chapter 2
Pricing
Rohit Singh, PEng CCE
AACE INTERNATIONAL PRICING](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-34-320.jpg)
![(including marketing programs, recruiting programs, and
training programs), and to more traditional investment deci-
sions (such as the management of stock portfolios or the use
of venture capital).
Simple ROI
ROI is frequently derived as the return (incremental gain)
from an action divided by the cost of that action—that is sim-
ple ROI. For example, what would be the ROI for a new mar-
keting program that is expected to cost $500,000 over the next
five years and deliver an additional $700,000 in increased
profits during the same time?
Simple ROI = (Gains – Investment Costs)/Investment
Costs = ($700,000 – 500,000)/$500,000 = 40%
Simple ROI works well in situations where both the gains
and the costs of an investment are easily known and where
they clearly result from the action. Other things being equal,
the investment with the higher ROI is the better investment.
The return on investment metric itself, however, says nothing
about the magnitude of returns or risks in the investment.
Complex ROI
In complex business settings, ROI, also called the Dupont or
engineer’s method, is the percentage relationship of the aver-
age annual profit to the original investment, including non-
depreciable items such as working capital:
ROI = (average yearly profit during earning life)/(orig-
inal fixed investment + working capital) expressed as
a percentage.
Let’s look at an example. Based on Table 2.1 below calculate
the ROI.
The average profit = (275 + 200 + 130 + 70 + 0)/5 = 135
k$/year
By the equation above, the ROI = (135)/(1000+0) = 13.5%.
Return on Average Investment (RAI)
On the other hand, return on average investment (RAI) is
similar to ROI except that the divisor is the average out-
standing investment.
RAI = (average yearly profit during earning life)/(aver-
age Outstanding investment ) expressed as a percentage.
Other ROI Metrics
Other “financial ratios” are sometimes treated as ROI figures,
including return on capital, return on total assets, return on
equity, and return on net worth. In still other cases, the term
refers simply to the cumulative cash flow results of an invest-
ment over time.
In brief, several different ROI metrics are in common use and
the term itself does not have a single, universally understood
definition. When reviewing ROI figures, or when asked to
produce one, it is a good idea to be sure that everyone
involved does the following:
• defines ROI the same way, and
• understands the limits of the concept when used to sup-
port business decisions
Return on Sales (ROS)
What it is—This ratio compares after tax profit to sales. It can
help you determine if you are making enough of a return on
your sales effort.
When to use it—If your company is experiencing a cash flow
crunch, it could be because its mark-up is not enough to
cover expenses. Return on sales can help point this out and
allow you to adjust prices for an adequate profit. Also, be
sure to look for trends in this figure. If it appears to be drop-
ping over time, it could be a signal that you will soon be
experiencing financial problems.
The formula—Net profit divided by sales.
Return on Assets (ROA)
What it is—This number tells you how effective your busi-
ness has been at putting its assets to work. The ROA is a test
of capital utilization—how much profit (before interest and
2.3
AACE INTERNATIONAL PRICING
Table 2.1-Project Cash Flow [4]
GLOSSARY TERMS IN THIS CHAPTER
capital ◆ cash flow ◆ competitive advantage
cost ◆ inputs ◆ opportunity ◆ price
production ◆ work breakdown structure (WBS)
Time, end year After Tax Profit, K$ Depreciation, K$ Cash Flow, K$
0 -1,000 0 -1,000
1 275 200 475
2 200 200 400
3 130 200 330
4 70 200 270
5 0 200 200](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-36-320.jpg)
![space. Moreover, excess material quantities can lead to dam-
age and theft.
Materials Quality
Materials procurement must focus on the proper quality of
the required materials. This implies the existence of prede-
termined standards and specifications to measure materials
acceptance. Over-specifying on higher-quality materials in
excess of requirements will lead to excessive costs and cus-
tomers may not appreciate these benefits. Similarly, the usage
of poor quality materials can result in product defects lead-
ing to increased costs and potential litigation problems.
Materials Vendor Surveillance and Materials
Traceability
In certain situations, the criticality of materials in a given
application is such that vendor surveillance is an important
requirement. Vendor surveillance may require periodic
inspection by purchasers at the vendors’ location(s) to ensure
conformance with performance standards and specifications.
Depending on volume and criticality, this periodic inspection
may need to be conducted on a full-time basis at the subject
vendor facility. Materials traceability is accomplished by
means of mill certifications. Before a material is utilized in a
given application, mill certifications ensure that the material
used meets the purchasing specifications. Thus, a mill certifi-
cation will verify that a material, such as cross-linked poly-
ethylene tubing, is in fact as it has been represented before
incorporation into a finished product.
Materials traceability is a key issue, because the improper
substitution of one improper type of material for the speci-
fied material can lead to significant in-service problems and
defects. A railroad car manufacturer that utilizes the improp-
er lower grade of steel of mixed steel in fabricating railroad
car axles will witness a significant number of service failures
resulting in expensive call-backs and repairs.
Materials Quantity
Funds spent to acquire materials are a cost to the firm until
these same materials can be sold as part of the completed
product. Firms in industries where materials obsolescence is
a factor encounter special problems in holding excess materi-
al quantities. As an example, a large inventory of printed cir-
cuit boards may have to be discarded or drastically discount-
ed as technology changes thus creating obsolescence.
Materials storage is a further burden that can sometimes
exceed the value of the materials. The simple example of stor-
ing some bags of cement proves this point. If the inside stor-
age space costs $100 per square meter per year, and the stor-
age of an excess of 20 bags of cement valued at $5 per bag
takes up 1 square meter of space, any storage beyond one
year, therefore, exceeds the actual value of the stored cement.
On the other hand, maintaining insufficient materials inven-
tories may create dangers of “stock-outs” interrupting the
production process. Ordering too-small materials quantities
may create higher costs through missing the economies of
volume discounts. The organization needs to balance these
competing issues involving materials quantity.
Economic Order Quantity
As aforementioned, there must be sufficient materials invento-
ry to meet production requirements while still avoiding exces-
sive inventory carrying costs and storage costs. In order to bal-
ance these competing demands, the firm must determine its
economic order quantity (EOQ) number. This EOQ number is
determined based upon materials costs, storage costs, order
costs, and annual demand. A garden tractor manufacturer has
a requirement for 15,000 engines per year. The engines each
cost $75. The order cost for a purchase order is $250. The stor-
age costs for the engine are $12 per year which includes space
costs and financing costs. The standard formula for EOQ is
_____________
EOQ = [√ (2 x D x O) / S]
where
D = annual demand,
P = purchase order costs, and
S = storage/carrying costs.
Thus, in this example:
_____________________
EOQ = [√(2 x 15,000 x $250) / $12] = 790
Therefore, in this case, the manufacturer should order 790
engines at a time which is the EOQ value.
The formula for computing reorder point (RP) is:
RP = (O x R) + I
where
RP = reorder point,
O = order time,
R = production rate, and
I = minimum inventory level or safety stock.
Assume that the production process uses 60 engines per day for
the 60 garden tractors produced per day. If the lead time for an
order is 5 days, and the safety stock level is 180 engines (mini-
mum level), then the reorder formula in this example yields:
RP = (5 days x 60 units/day) + 180 units = 480 units
Thus the EOQ value of 790 engines should be ordered when-
ever inventory drops to 480 units. Cycle stock levels main-
tained at very low levels can almost ensure the potential for
production delays.
3.4
MATERIALS AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-43-320.jpg)
![INTRODUCTION
As an owner, employer, project manager, and estimator, I
have a given set of work tasks that I need a worker to com-
plete. As such, I need to know how much this will cost me. I
also need to know how to set up and monitor the effort, so
that I can be assured that I am getting the desired work prod-
uct in the timeframe required and for a price that I can afford.
In order to do this, I need to understand the cost factors that
go into this work and the techniques to monitor progress to
ensure that I will achieve my goals.
LEARNING OBJECTIVES
After completing this chapter, the reader should be able to
• identify different classifications of labor and how each
contributes to the final completed project;
• develop labor rates for estimating, and develop and use
weighted average rates/composite crew rates;
• include indirect and overhead labor and other costs;
• estimate work hours for a given work scope at a given
location; and
• use labor hours to monitor work progress.
LABOR CLASSIFICATIONS
The following definitions were taken or adapted from AACE
International’s Cost Engineer’s Notebook [1].
• Direct Labor—The labor involved in the work activities
that directly produce the product or complete the instal-
lation being built.
• Indirect Labor—The labor needed for activities that do
not become part of the final installation, product, or
goods produced, but that are required to complete the
project.
• Overhead Labor—The labor portion of costs inherent in
the performing of a task (such as engineering, construction,
operating, or manufacturing), which cannot be charged to
or identified with a part of the work, and, therefore, must
be allocated on some arbitrary basis believed to be equi-
table, or handled as a business expense independent of the
volume of production.
Table 4.1 provides examples of different labor classifications
and costs. The examples are not all-inclusive and only serve
to illustrate the elements of each type of labor.
4.1
AACE INTERNATIONAL LABOR
Chapter 4
Labor
Morris E. Fleishman, PE CCE
Cost Type Direct Labor Indirect Labor Overhead labor
Construction Carpenters,
Electricians,
Ironworkers, etc.
and Foremen
working on the
project
General Foremen, Construction
Management, Field Purchasing,
Field Warehouse personnel,
Payroll Personnel, Jobsite
Computer Support, Project Cost
Engineers and Schedulers etc.
Home Office Support such as;
Legal Assistance, Procurement,
Human Resources, Senior
Management review, Corporate
Computer Support, Estimating
and Business Development, etc.
Manufacturing Plant Equipment
Operators, First
Line Foreman,
and Supervisors,
etc.
Plant Accountants,
Maintenance Personnel,
Purchasing Personnel, Security,
Plant Supervision, Warehouse
Personnel, Production Planning
and Cost Personnel, On-site
Computer Support
Corporate support: Legal,
Human Resources, Computer
Support, Corporate Finance and
Accounting Support, Sales, etc.
Engineering Civil,
Mechanical,
Electrical,
Instrumentation
and Controls
Engineering and
first line
supervision
Documentation Support –
duplicating and record keeping,
Engineering Cost and
Scheduling Personnel, Project
Supervision
Corporate Support: Human
Resources, Computer Support,
Corporate Accounting Support,
Estimating, Business
Development, etc.
Table 4.1—Examples of Labor Costs](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-48-320.jpg)
![The difference between indirect and overhead labor appears
to be somewhat vague. Depending upon the size of a project,
plant, or office and its location, some elements could shift
from indirects to overheads, and there may be instances
where direct labor moves to indirects and overheads as well.
For example, if the construction project is small, payroll and
accounting may be located offsite and may be composed of
personnel who are splitting their time between several proj-
ects at different locations. In this instance, this function could
be an indirect or an overhead. Therefore, it is imperative that
the estimator and/or cost engineer understand where within
his project, industry, and company each of these costs are
included, so that they can be correctly estimated and includ-
ed in the estimate and budget.
DEVELOPING LABOR RATES
Base Wages
The base wage is the amount that will go directly to the
employee. The source of these wage structures can be found
in databases from previous projects, labor contracts, unit
rates supplied by contracting and engineering firms, local
chamber of commerce data, government labor statistics, pub-
lished labor databases, and standardized estimating publica-
tions, such as Means and Richardson [2–5].
Base wages are usually calculated on a per hour basis.
However, it can also be a breakdown of weekly or monthly
base salary prorated to a daily or hourly rate. The reason for
an hourly breakdown is that estimates are usually based
upon the amount of work hours to complete. Therefore, the
labor cost rates need to be developed on a comparable basis.
If one is costing out craft labor, their pay rate is usually given
in hourly increments. Supervision, support staff, and engi-
neering, etc., often are paid on a weekly, bi-weekly, or month-
ly rate. This rate can also be broken down to an hourly rate
for estimating and payroll purposes.
The following are examples of base wages:
• craft personnel—$25.00 per hour,
• supervision—$1,200 per week divided by 40 hours per
week = $30.00 per hour, and
• engineering—$ 60,000 per year divided by 2,080 hours
per year = $ 28.85 per hour (2,080 hours = 5 days per
week at 8 hours per day for 52 weeks).
The examples above can be used to calculate the direct
amount that each employee will earn and be paid for each
hour that they work.
Fringe Benefits
Paid time off (PTO)—Most employees have additional ben-
efits of time off for local and national holidays, vacation, and
sick time. Therefore, in developing a unit cost for labor, a fac-
tor is added to increase the estimated and booked cost per
hour worked each week to cover PTO. Most companies trans-
fer this money to special fund to be used when an employee
takes paid time off.
In the case of construction craft that may work for many
employers during a given period, wages are usually paid
into a fund managed by their union or trade organization
who distributes the salary for PTO.
For example, an engineer gets 5 days of sick time, 10 days of
vacation, and 10 holidays per year. His base salary is $28.85
per hour. Adders are
• sick time: 5 days at 8 hours /day @ $28.85 =
$1,154 per year
• vacation: 10 days at 8 hours /day @ $28.85 =
$2,308 per year
• holiday: 10 days at 8 hours /day @ $28.85 =
$2,308 per year
• total: $5,770 per year
This Engineer is now working 2,080 hours (52 weeks x 40
hours per week) less 25 days at 8 hours or 200 hours for PTO.
So his productive time is 1,880 hours.
His hourly cost is
$28.85 base wage + 3.07 PTO adder ($5,770
divided by 1,880 hours) = $31.92 total.
Medical & Life Insurance Benefits—Some firms and labor
contracts include contributions to a medical and life insur-
ance program. These costs are usually can be calculated on an
hourly, weekly, or monthly cost basis and added to the per
hour work cost.
If the firm that employs the engineer in the previous example
contributes $400 per month for medical and other insurances,
the following should be added to the hourly costs:
$400/month x 12 months = $4,800/year divided
by 1,880 hours = $2.55 per hour
If the company contributes to 401ks and other retirement-
plans for the engineer, the following should be added:
$300/month x 12 months = $ 3,600/year divided by
1,880 hours = $1.91 per hour
4.2
LABOR AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-49-320.jpg)
![Government Mandated Benefits
These benefits include such items as government retirement
funds, unemployment insurance, retirement healthcare
insurance, etc. In the United States, these funds are federal
old age insurance (Social Security), Medicare, state unem-
ployment insurance, etc.
These costs are usually calculated on a straight percent of the
worked hours. Continuing with our example engineer, we
will add the following:
• retirement (6.2%) = .062 x $28.85 =$ 1.79
• retirement medical (1.35%) = .0135 x $28.85 =$ 0.39
• state unemployment (1.0%) = .01 x $28.85 =$0.29
total government mandated benefits = $ 2.47
Summary of Engineer’s Wages Example
The cost basis for an engineer who makes $60,000 is summa-
rized in Table 4.2:
Engineer/Contractor Overhead and Profit
The above calculations will apply for the direct hire of indi-
vidual workers. When hiring contract employees, or estimat-
ing an engineer or contractor’s costs, labor rates are usually
broken down differently:
• base wages including fringes,
• worker’s compensation (if applicable),
• overhead, and
• profit (if applicable for time and material situations).
In these instances, the vacation, sick time, retirement contri-
butions, and medical contributions are included in the
fringes. Worker’s compensation is a direct government rate.
Overhead will apply to the home office cost of administra-
tion, payroll, and billing, etc. Profit usually only applies to
approved time and material changes. All of these costs are
dependent upon what type of contract is negotiated.
R.S. Means, for example, includes a table of average rates for
various types of contractor personnel including overhead
and profit in their manual Concrete & Masonry Cost Data 2001
[5]. These labor rates are based upon a survey of union rates
in 30 cities.
Fully-Loaded or Billing Rate
A fully-loaded rate is the base salary plus adders that will be
paid for an hours work on the job. An owner employing a con-
tractor on time and material basis only pays for the workers
time when he is on the job. If he is sick, on vacation, or holiday,
the contractor cannot bill the owner. However, the payment
rate charged usually includes funds to cover this paid time off.
The contractor either places the funds in a separate account for
use when the worker is off or, if the worker is in a union, the
union may get the funds to disburse when the worker is off.
All estimates relating cost of labor to work performed are usu-
ally calculated using the fully-loaded rates.
Overtime Wages
There are many different overtime wage situations and there
are several aspects that need to be evaluated in developing
an overtime wage structure. Overtime can range from
straight time pay for the additional hours beyond the stan-
dard workweek of 40 hours or 8 hours per day, to 1.5 and 2.0
times the regular pay.
When developing the overtime formula the estimator needs
to take into account that some benefits are calculated on an 8-
hour day or 40-hour week and are not added to overtime
hours. Benefits such as PTO, some insurance, and some gov-
ernment funding programs may be included in this category.
Government funded retirements, such as Social Security and
Medicare, are calculated as a percentage of the wage and are
usually added to the overtime rate. The estimator needs to
confirm what needs to be added for the specific work area
that the project is located in order to develop the correct rate.
For example, a craft worker earning $25.00 per hours is work-
ing overtime at 1.5 times his base rate at $ 37.50. PTO adders,
company insurance adders, and state unemployment are not
included. Federal retirement and medical is included at 7.55
percent, which equals $2.83. The total cost per hour for 1.5
overtime is $40.33.
4.3
AACE INTERNATIONAL LABOR
GLOSSARY TERMS IN THIS CHAPTER
base wages ◆ direct labor
indirect labor ◆ overhead labor
Per Hour
Base Salary Working 1,880 hrs/yr = $28.85
Fringe Benefits:
company retirement contributions = $1.91
PTO (holidays, vacation, sick time) = $3.07
company medical and life insurance = $2.55
government mandadted benefits
(retirement, etc.) = $2.47
Total Cost Per Hour
Benefits Adder = ($38.85 - $28.85) = $10.00
= $10.00/28.85 =$34.7%
Table 4.2—Example Labor Costs for Engineer](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-50-320.jpg)
![Work Packaging/Work Breakdown Structure (WBS)
The first step is to review the project and develop meaning-
ful work packages. Often several summary level estimates
are completed before enough of the project is designed to
provide the estimator with detailed quantities of material so
that a detailed labor estimate can be developed. An example
of a WBS is shown below for a small manufacturing facility
consisting of a main building, warehouse and office building,
site work area including entrance roads and utilities.
The WBS for this project is shown in Table 4.5:
In the above example, the work hour estimates will be done
at the level 3. We will use the main building concrete foun-
dation as an example [5, p. 89]:
• the building is 300 ft/m x 100 ft/m;
• the concrete foundation consists of wall footings, foun-
dation walls, and a slab;
• the slab will be our example, and it is 1 foot/meter thick;
and
• the quantity of concrete in the slab is; 200 ft/m x 100
ft/m x 1 ft/m = 20,000 cubic ft/cubic meters = 741
CY/CM.
Determination of the work hours required is done by con-
sulting a reference database to determine how many hours it
has taken historically to complete a foundation slab of this
type. There are multiple places to obtain this data including
company historical data for projects on this site or in the area,
a commercial estimating database, Means, Richardson, etc.
For example, using Means2 to place this slab will take
.026 labor hours per sf/sm. This equals
20,000 sf/sm x .026 = 520 labor hours.
Costs to Support the Worker
The costs above include only the direct work required to
place the slab. The assumption is that all of the material is on
hand, the site is prepared, and the crew is ready to start work.
The reality is that the costs need to include many items and
support personnel that allow the worker to perform his/her
task. In addition to indirect and overhead labor, the following
examples further illustrate indirect and overhead costs.
Construction indirects and overheads can include items, such
as storage and fabrication facilities, lunch and restroom facil-
ities, and tool rooms, etc. Manufacturing indirects could
include warehouse space, administrative offices, rest rooms,
lunchrooms, locker rooms, and raw material loading and
unloading facilities. Engineering indirects could include
duplicating facilities, computer facilities, administrative
offices, and personnel. When doing a conceptual or Level 1
estimate, these will normally be added as a percentage or
allowance. When doing a definitive or Level 5 estimate, these
costs will be estimated in detail. If you are doing a less
detailed estimate, often these support costs are estimated by
adding a historical factor to the direct work estimate to pro-
vide for these necessary personnel and activities.
Factors Affecting Productivity
Most estimates are developed from a common database that
equates so much work done for so many work hours expend-
ed. In the petrochemical industry, common indices are based
upon “Houston-Gulf Coast“ production. These rates are then
adjusted for conditions at the jobsite. The following is a typi-
cal, but not all-inclusive, list of items that each estimator
needs to review to determine if they affect the job and the
estimate:
• Will union or non-union craft labor be used?
• Is sufficient labor available locally, or will workers have
to come from a long distance away?
• If the area is remote, do workers have to be bused in?
• What will the weather conditions be like (hot, cold, rainy,
etc.)?
• Are there any local holidays?
• Are temporary living quarters needed?
• Is overtime necessary to attract workers?
• What are the standard work hours and work days?
2 In this example, measurements are in feet or meters and are designated by
ft/m (feet/meters), sf/sm (square feet/square meters), etc.
4.6
LABOR AACE INTERNATIONAL
Level 1 - ABC Manufacturing Plant
Level 2 - Site Development Main Building Warehouse
Roads Foundation Foundation
Utilities Excavation Excavation
Water Base Fill (gravel) Base fill (gravel)
Gas/Electrical Concrete Concrete
Sewerage Structural Steel Structural Steel
Lighting Building walls Building walls
Parking Lot Building roof Building roof
Building interior Building interior
Building lighting Building lighting
Building utilities Building utilities
Equipment Office furniture
(installation)
Equipment (cost) Warehouse
equipment
Electrical
Piping
Table 4.5—Example WBS for Small Facility](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-53-320.jpg)
![The Richardson Estimating System suggests adjustments to
their rates for the following [3, p. 1–2]:
Jobsite Conditions
Good + 3% to 5%
Average + 6% to 8%
Poor + 9% to 15%
Worker Skill Level
High + 2% to 5%
Average + 6% to 10%
Poor + 11% to 20%
Temperature
Below 40 degrees or above 85 degrees add 1%
per degree of variance
Work Weeks in excess of 40 hours
40 to 48 hours + 5%b to 10%
49 to 50 hours + 11% to 15%
51 to 54 hours + 16% to 20%
55 to 59 hours + 21% to 25%
60 to 65 hours + 26% to 30%
66 to 72 Hours + 31% to 40%
Example Calculation:
The standard labor cost for 100 LF of footing
8 inches by 12 inches = $130.90 [3, p. 3–1].
The jobsite conditions are as follows
Adders
Jobsite conditions Good + 4%
Worker Skill Average + 8%
Temperature 95 degrees +10%
Work week = 40 hours + 0 %
Total adders = +22%
Unit Rate = $130.90 x 1.22 =$159.70
Productivity Improvements
The discussion above was meant to make the reader aware of
various conditions that affected both the cost and schedule of
the project.
Learning Curve—One of the most important items affecting
learning curve is the productivity improvement that results
from a crew performing repetitive type operations. In a man-
ufacturing environment or a construction project where sim-
ilar kinds of work are done, the more the crew does the work,
the faster and more efficient they become as they become
familiar with working together, using the tools, possibly fab-
ricating special tooling to make the work easier and faster,
etc. This needs to be encouraged and factored into any budg-
et or estimate made.
Examples of other types of productivity improvements—
While it is one thing to recognize existing factors, there is also
the opportunity to put in place procedures or make changes to
improve productivity and minimize the cost of some of these
factors. For example, to shorten waiting time for a crew, mate-
rial may be prestaged at the work location, stored on trailers
which can be easily moved to the work site, fabricated in sec-
tions, and assembled at the work site. To minimize the impact
of adverse weather, temporary shelters can be built which pro-
vide shelter from the elements. Using portable tool sheds,
which can be moved around to various locations as the work
progresses, can shorten the time required to pick up tools. In
addition to these physical actions, there is a whole series of
actions, including training and team building, which can be
used to improve communications and working relations
between the various crews and personnel on a site. A manufac-
turing plant has the added benefit of more permanent person-
nel and the same physical location at which all of these ideas
can be used to improve the worker’s efficiency. There are many
books and programs dealing with ways to improve productiv-
ity, and these should be consulted for a complete list of options
available. The cost of these types of programs can more than
offset by the savings.
Using Commercially Available Data for Location
Estimating and Comparisons
In addition to your own company database, sources for com-
parison data include R.S. Means and Richardson Estimating
Systems [2–5].
R.S. Means publishes a city-by-city comparison that is also
broken down by material and installation costs as by cost
division (concrete, masonry, etc.). Their system involves com-
paring the ratio of the different city indices to develop a mul-
tiplier to apply to your labor cost estimates. Since they also
publish unit rates, they offer comparison factors by states by
zip code, which can then be adjusted to determine a factor to
apply to their unit rate extensions.
An example of R.S. Means comparison data for two cities is
given in Table 4.6 on page 4.8.
The comparisons listed in Means are comparisons to a
national average. Therefore, in order to compare one city to
another, you need to calculate the ratio difference, not the
numerical difference.
The city index number = Specific City Cost x 100
National Average Cost
4.7
AACE INTERNATIONAL LABOR](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-54-320.jpg)
![For example, a building in Chicago was erected for
$1,540,000. I want to estimate the cost of the same building in
Los Angeles.
Index of LA
Index of Chicago
108.5
111.4
Note: Explanation from R.S. Means Concrete & Masonry Cost
Data 2001 [5, p. 430].
PERFORMANCE MONITORING
Work Packaging/Work Breakdown Structure (WBS)
An estimate is usually assembled in work packages. Work
packages should be clearly identified. Items that determine
what makes up a work package include portions of the job that
complete a specific portion, building, or area, or are assigned to
one subcontractor, can clearly be designed and scheduled, etc.
Construction activity has been fairly standard for years.
However, manufacturing, power plants, and other portions of
industry also utilize labor estimating and control. In their situ-
ations, work output and their organizations are more compli-
cated than the labor craft versus work activities on the con-
struction site. In order to better address their situations, activi-
ty-based cost (ABC) methodology has been developed to aid in
organizing, analyzing, and setting up labor monitoring systems
within these industries. This methodology gives some guide-
lines and suggests procedures that can be used to clearly define
appropriate work packages. While there is not sufficient time to
discuss this methodology here, a discussion of ABC is included
in Chapter 8.
For purposes of this presentation, we will start with a simple
construction-related WBS for a project to install a new boiler
at an existing manufacturing facility.
1. mobilization
2. excavation
3. subfoundation
4. slab placement
5. support steel
6. piping
7. boiler installation
8. utilities
9. startup
10. cleanup
11. demobilization
The labor estimate is usually the basis for project perform-
ance monitoring. The comparison of actual work hours
expended, versus the estimated work hours and the devel-
opment of a relationship between milestone goals, is a key
tool in determining how much of the project is completed,
how much effort has been expended to get to the current
point, if there are problems, what has to be worked on to
overcome these problems, and how this will affect the com-
pletion date and final costs.
The estimate is shown in Table 4.8:
4.8
LABOR AACE INTERNATIONAL
Chicago, Illinois1 Los Angeles, California2
Matl Inst Total Matl Inst Total
02 Site Construction 86.0 91.0 89.8 89.5 109.0 104.5
03 Concrete (Summary) 100.6 134.6 117.6 108.2 115.6 111.9
04 Masonry 93.9 131.5 117.0 97.8 116.5 109.3
05 Metals 96.4 123.7 106.3 111.2 99.3 106
06 Woods & Plastics 103.3 128.9 116.5 99.6 117.3 108.7
07 Thermal & Moisture Protection 99.3 128.7 113.3 114.2 114.6 114.4
08 Doors & Windows 104.1 136.4 111.9 99.1 114.8 102.9
09 Finishes 89.4 129.9 110.1 108.5 116.6 112.7
Total (10-14) (Define) 100.0 123.7 105.0 100.0 114.5 103.1
15 Mechanical 100.0 124.5 111.3 100.2 114.0 106.6
16 Electrical 101.1 130.7 121.4 109.8 113.6 112.4
Weighted Average 98.2 125.4 111.4 104.3 112.9 108.5
1. R.S. Means 2001, Concrete & Masonry Cost Data, page 436
2. R.S. Means 2001, Concrete & Masonry Cost Data, page 433
Table 4.6—Comparison Data for Two Cities as per R.S. Means 2001[4].
x cost of Chicago = Cost in LA
x $1,540,000 = $1,500,000 (rounded)](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-55-320.jpg)
![flaws can be costly from a repair/recall standpoint in addition
to harming the organizations’ overall image and reputation.
Process Selection
Part and parcel of product engineering design will be process
selection. Process selection relates to the production methods
chosen to produce the product. There are two basic types of
production methods:
• continuous production, and
• discrete production.
Examples of continuous production methods would be
petrochemical plants, power plants and manufacturers with
assembly-line methods, such as wire/cable manufacturers
and automotive manufacturers. Examples of discrete pro-
duction would be manufacturers of any type of custom prod-
uct, such as a pre-cast concrete plant, structural steel fabrica-
tion shop, or machine shop. Some products will envelope
both methods sometimes by the same firm. A structural steel
fabrication shop will take basic steel products from a steel
manufacturer engaged in a continuous process method, such
as continuous casting, and turn them into customized “one-
off” structural steel fabrications for a particular project.
Continuous production method systems are less expensive
in the long run because the high fixed costs of extensive pro-
duction machinery can be amortized over many units of pro-
duction. The determining factor in deciding in favor of con-
tinuous production is whether demand is such that produc-
tion volumes can justify the investments required for this
method. In general, continuous production methods use
specialized equipment including conveyor lines and special-
ized machinery.
Discrete production methods use general-purpose equip-
ment. Production equipment, such as forklifts, welders, fab-
rication tables, and machining centers can be utilized for a
wide variety of items. Discrete production methods will have
a higher labor factor versus continuous methods. In regions
of the world where labor costs are less expensive relative to
capital equipment, discrete methods may be favored due to
their more favorable capital/labor tradeoff ratios.
Manufacturability
Engineering design methods must focus not only on issues of
product design, but also on issues of manufacturing the
design [3]. A design may work perfectly in terms of function,
but if it is unnecessarily complicated to produce, problems
may ensue. Design tolerances may be specified that are
unnecessary for product function yet create substantial prob-
lems in production.
Designs, where possible, should be
• forgiving of minor inaccuracies,
• easy to fabricate, and
• based on efficient utilization of labor, materials, and
equipment.
Slight changes or modifications in a design that don’t affect
the product but instead promote ease of assembly of the
product are referred to as manufacturability. During the
design and development process, experienced manufactur-
ing personnel should view products from the manufactura-
bility perspective. These reviews can pinpoint problems
before designs are developed to the point where changes cre-
ate significant delays and associated costs.
Constructability
Constructability is the counterpart of manufacturability
applied to constructed projects and their elements. The same
issues apply to the realm of constructability. Designs can be
developed on paper and in the computer that may make
sense from the designer’s viewpoint but present significant
problems in their construction. The Construction Industry
Institute has defined constructability as the optimum use of
construction knowledge and experience in planning, design,
procurement, and field operations to achieve overall project
objectives [1]. The same precepts of manufacturability apply
to constructability. Early preconstruction implementation of
these techniques can pinpoint problems before designs are
developed to the point where changes create significant
delays and associated costs.
Make or Buy Decisions
Product, project, and process development must concern
decision-makers with “make” or “buy” decisions. That is to
say, which items should be subcontracted out to others and
which should be made in-house. Decision-makers must
question whether their organization’s quality and cost on an
item can compete with outside suppliers. If trade secrets are
involved, the decision will typically be to make the item,
unless the trade secret is the result of certain combinations of
widely-sourced ingredients. For example, if a commodity
such as sugar is part of a fermentation trade secret process,
the organization will not find it practical to produce its own
sugar unless it is already in that line of business.
The overarching goal with make or buy decisions is making
the best selections to enhance overall quality at a lower cost. If
a manufacturer is producing 100,000 units of a piece of equip-
ment on an annual basis, it will usually make far more sense to
purchase motors from another manufacturer specializing in
motors. The motor manufacturer may be making 1,000,000 of
these motors for their own use and as OEM-sourced equip-
ment for others. There is no practical way to achieve these
kinds of economies-of-scale benefits at the relatively low
5.4
ENGINEERING AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-65-320.jpg)
![100,000 units per year. Therefore, the motor selection will be
a buy decision.
ENGINEERING
PRODUCTION/CONSTRUCTION
Numerous decisions must be made with regards to engineer-
ing production/construction. These decisions will naturally
occur based on decisions reached in other areas as discussed
previously.
Production Health And Safety
Personnel health and safety is paramount in any production
situation. Health and safety is important from both a human-
itarian and an economic standpoint. Advanced civilizations
place a premium on human health and safety. From the eco-
nomic viewpoint, health and safety lapses are expensive. An
accident, for example, results in the loss of a trained worker
and an interruption in the process.
Systems must be selected that reduce and/or eliminate the
potential of accidents. Health issues are more difficult to
ascertain because usually they are not immediate as opposed
to a safety-related accident. Health issues include exposures
to fumes, dust, noise, and heat. Fumes from a production
process may cause long-term health problems for personnel.
The exposure risk may require a change to eliminate fumes or
robotic operation so that human exposure is unnecessary.
Facility Layout
Facility layout involves decisions as to arrangement, includ-
ing equipment location, labor location, and services location.
The facility may be existing requiring renovation or one that
is being built from the ground up on a “greenfield” basis.
Layout decisions should always consider the potential
impact of additional demand therefore considering future
expansion and additions to the base layout.
Assembly And Flow Process Charts
Assembly and flow process charts assist in planning the facil-
ity layout. They help to analyze production operations in
terms of operations sequences performed, distances between
operations, and operation time require-
ments [4].
Process charts are developed based on
standard symbols for studying operations.
The symbol O represents an operation. An
operation occurs when any change takes
place whether of a physical nature or
when new information is received. The
symbol ∇ represents storage of an item.
Storage is when any item is kept or held in
the process. The symbol ⇒ represents
transportation or movement in the process
as when items are moved from one location to another. The
symbol represents inspection. An inspection occurs when
an object is examined for conformance as to quality or quan-
tity. The symbol D represents delay. Delays occur with inter-
ruptions to the process that prohibit the next operation or
item from taking place.
A production operation might entail the cutting of steel
beams to length and drilling holes in the beams. Flow chart-
ing of this operation would be as shown in Table 5.1 below:
Flow charts offer the advantage of mapping product flow,
which helps in spotting inefficiencies in the production
process. Steps can be changed and rearranged to promote
higher productivity and lower costs. Therefore, these charts
can be a powerful tool.
Quantitative Analysis In Facility Layout
Techniques such as linear programming and Monte Carlo can
significantly assist in facility layout and production deci-
sions.
Linear programming is a mathematical technique that is
widely used in finding optimal solutions to problems. Linear
programming techniques are designed to either minimize or
maximize some objective function. Thus, material distances
in a facility can be minimized or space available may be max-
imized. These linear programming decisions are also bound-
ed by parameters, which are limitations or restraints. There
may only be a limited amount of space available or limited
milling machines available for a certain production opera-
tion. Detailed linear programming techniques are beyond the
scope of this chapter since entire books have been written on
these topics.
Monte Carlo techniques provide for simulation. Queuing
problems, such as wait time for a crane in a plant, can be ana-
lyzed with Monte Carlo techniques. Data can be generated
via computer programs with random number generators.
Information, such as wait time costs, are factored into the
5.5
AACE INTERNATIONAL ENGINEERING
Symbol Operation
∇ Beams In Storage
⇒ Transport Beam To Saw
Ο Cut Beam To Length At Saw
∇ Place On Pallet
⇒ Transport By Forklift To Vertical Drill
Ο Drill Beam
Inspect Beam To Verify Quality
D Store On Pallet Until Needed
⇒ Transport To Paint Booth
Ο Prime Beam
Table 5.1—Flow Chart of Steel Beam Production](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-66-320.jpg)
![Sum-of-Years Digits Depreciation
Sum-of-years digits (SOYD) method allows depreciation to
be taken at a faster rate than SL. This SOYD method takes
depreciation in any one year as the product of a fractional
value times the total original depreciable value. The fraction-
al value for any given year has as numerator the years of
asset life remaining, while the denominator is the sum of dig-
its including 1 through the last year of the asset’s life. The
SOYD formula is:
Dr = (C – S)*[(2(N-r+1))/(N(N + 1)]
Where:
Dr = depreciation charge for the rth year
C = asset original cost
S = salvage value
N = remaining asset depreciable life (years)
r = rth year
From the SL and DDB examples above, the similar SOYD
amounts would be as follows in Table 7.2 for an asset with a
$5,000 original cost, 5-year life, and $1,000 residual salvage
value:
SOYD = [(N/2)(N + 1)] = [(5/2)(5 + 1)] = 15
In the comparison between SL and SOYD methods, SOYD is
similar to DDB in that it allows faster write-offs of the asset
value in the early years. Again, as noted above, a general eco-
nomic cost principle given the time value of money is that
early money is of greater importance.
Modified Accelerated Cost Recovery
System Depreciation
The modified accelerated cost recovery system (MACRS)
method is unique to the United States Tax Code.
Depreciation under this MACRS method is based on original
asset cost, asset class, asset recovery period, and asset in-
service date. Asset classes are differentiated based on 3-year,
5-year, 7-year, 10-year and other property lives, depending
on asset type. Depreciation rates are set by percentages
allowed under the U.S. Tax Code.
Units of Production Depreciation
The units of production (UOP) Method is utilized when
depreciation more accurately based on usage instead of time.
The UOP Method is particularly useful when an asset
encounters variable demand. A piece of construction equip-
ment may be utilized 1,200 hours in one year, 1,600 hours the
next, and 900 hours the third year. The UOP method recog-
nizes that the equipment wears out based on use and, there-
fore, is a more accurate barometer than years.
ECONOMIC ANALYSIS TECHNIQUES
There are a variety of economic analysis techniques available
to enable accurate choices between competing alternatives.
The general principle is that there are competing alternatives
and the goal is to choose the alternative with the highest
return. In order to analyze returns from alternative choices,
there are a number of techniques including
• net present worth,
• capitalized cost,
• annual cash flow analysis,
• rate of return analysis,
• benefit-cost ratio analysis, and
• payback period.
7.5
AACE INTERNATIONAL ECONOMIC COSTS
Table 7.1—DDB Amounts for an Asset with a $5,000
Original Cost, 5-Year Life, and $1,000 Residual
Salvage Value
Year DDB Formula DDB
Calculated
Amount
DDB
Allowable
Depreciation
1 (2/5)($5,000 – 0) = $2,000 $2,000
2 (2/5)($5,000 – $2,000) = $1,200 $1,200
3 (2/5)($5,000 – $3,200) = $720 $720
4 (2/5)($5,000 – $3,920) = $432 $80*
5 (2/5)($5,000 – $4,352) = $259.20 $0*
Total = $4,611.20 $4,000
Year SOYD Formula SOYD
Calculated
Amount
1 (5/15)($5,000 - $1,000) = $1,333
2 (4/15)($5,000 - $1,000) = $1,067
3 (3/15)($5,000 - $1,000) = $800
4 (2/15)($5,000 - $1,000) = $533
5 (1/15)($5,000 - $1,000) = $267
Total = $4,000
*Note: An asset cannot be depreciated below its salvage value thus
depreciation totals under the DDB method for Years 4 and 5
total $80. In the comparison between SL and DDB methods,
DDB allows faster write-offs of the asset value. A general eco-
nomic cost principle given the time value of money is that early
money is of greater importance.
Table 7.2—SOYD Amounts for an Asset with a $5,000
Original Cost, 5-Year Life, and $1,000 Residual
Salvage Value](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-86-320.jpg)
![Except for the payback period method, these analysis tech-
niques deal with a concept commonly referred to as the time
value of money.
Time Value of Money
The time value of money is a key area in economic cost analy-
sis. Different alternatives will have differing amounts of cash
income and cash expenses over their lifetime. In order to
compare these different alternatives on the same basis, these
cash amounts of income and expenditure must be set to
equivalent terms.
There is a common unit of measure set in a currency whether
it be dollars, euros, pesos, yen or some other measure. There
will also be an interest rate set that provides the common
basis for calculations. In order to perform this analysis, cer-
tain information will be available with other information
requiring calculation. The problem must be expressed in
quantitative terms. A problem of whether it is best to paint a
building blue or green cannot be judged on a quantitative
basis. But if one type of building paint has a life of 10 years
with its own cost structure, and another paint type has a life
of 7 years with a separate cost structure, this is a problem
suitable for quantitative analysis.
Common language terms and their symbols for time value of
money problems are as follows:
P = present value or present worth
F = future value or future worth
A = annual amount or annuity
G = uniform gradient amount
n = number of compounding periods or asset life
I = interest rate
S = salvage value
The standard formulas for economic analysis are shown in
Table 7.3.
Net Present Worth Method
A common basis is needed when comparing alternatives.
Alternatives typically will have different costs and benefits
over the analysis period. The net present worth (NPW)
method provides the platform to resolve alternatives into
equivalent present consequences.
Example NPW Problem: A firm is evaluating the potential
purchase of one of two pieces of equipment. Unit A has a pur-
chase price of $10,000 with a four-year life and zero salvage
value. Annual maintenance costs are $500 per year. Unit B has
a purchase price of $20,000 with a twelve-year life and $5,000
salvage value. In Year 1, maintenance costs are zero. In Year 2
maintenance costs are $100 and increase by $100 per year there-
after. The firm’s cost of capital is 8 percent.
Example NPW Problem Solution: This problem illustrates
two common issues faced in comparison of alternatives.
Units A and B have unequal lives of four years and twelve
years respectively. Therefore, a common multiple of the
respective unit lives must be selected, which, in this case, will
be twelve years. Economic analysis problems view repur-
chase of the same unit at four-year intervals at original cost
unless there is concrete information to the contrary. The sec-
ond issue this problem illustrates is that of a gradient where
maintenance costs for Unit B are increasing on a year-to-year
basis as opposed to steady costs.
NPW Unit A:
NPW = $10,000 + $10,000(P/F,8%,4) +$10,000(P/F,8%,8) +
$500(P/A,8%,12)
= $10,000 = + $10,000(0.7350) + $10,000(0.5403) +
$500(7.536)
= $26,521
NPW Unit B:
NPW = $20,000 + $100(P/G,8%,12) - $5000(P/F,8%,12)-$100
= $20,000 + $100(34.634) - $5000(0.3971)-$100
= $21,347
Since in this example problem we are analyzing costs and not
benefits, the unit with the lower NPW cost structure is prefer-
able, which is Unit B since $21,478 < $26,521. If the calculation
involved benefits greater than costs, then Unit A with the
higher benefit NPW would be preferable.
7.6
ECONOMIC COSTS AACE INTERNATIONAL
Formula Name Operation Symbol Formula
Single-Payment
Compound
Amount
P to F (F/P, I%, n) F=P (1+I)n
Present Worth F to P (P/F,I%, n) P=F(1+I)-n
Uniform Series
Sinking Fund
F to A (A/F,I%, n) A=F[I/((1+I)n - 1)]
Capital
Recovery
P to A (A/P,I%, n) A = P[(I(1 + I)n))/
(1 + I)n - 1]
Compound
Amount
A to F (F/A,I%, n) F = A[((1 + I)n - 1)/ I]
Equal Series
Present Worth
A to P (P/A,I%, n) P = A[((1 + I)n - 1) /
I(1 + I)n]
Arithmetic
Uniform
Gradient Present
Worth
G to P (P/G,I%, n) P = G[((1 + I)n - In -
1)/ (I2(1+I)n]
Table 7.3—Standard Formulas for Economic Analysis](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-87-320.jpg)
![estimate on a lump-sum bid can potentially put a contractor
out of business. For cost-plus projects, the contractor will face
less direct economic risk from an inaccurate estimate, but the
damage to the contractor’s reputation can be severe.
The cost estimate, however, serves other purposes besides
establishing the budget for a project. It also serves as a tool or
resource used for both scheduling and cost control of projects.
The estimate not only establishes a project budget, but plays an
equally important role in monitoring the budget during project
execution. It is the relationship between estimating, scheduling,
and cost control, which is typically identified by the term “cost
engineering” that serves as a driver for successful and cost-
effective projects. Thus, an effective estimate must not only
establish a realistic budget, but must also provide accurate
information to allow for scheduling, cost monitoring, and
progress measurement of a project during execution.
ESTIMATE CLASSIFICATIONS
Estimate classifications are commonly used to indicate the
overall maturity and quality for the various types of esti-
mates that may be prepared; and most organizations will use
some form of classification system to identify and categorize
the various types of project estimates that they may prepare
during the life cycle of a project. Unfortunately, there is often
a lack of consistency and understanding of the terminology
used to classify estimates, both across industries as well as
within single companies or organizations.
AACE International (AACE)
developed the “Recommend-
ed Practice for Cost Estimate
Classification” (AACE 17R-97,
see appendices) to provide
generic guidelines for the gen-
eral principles of estimate clas-
sification that may be applied
across a wide variety of indus-
tries. This document has been
developed to
• provide a common
understanding of the
concepts involved in
classifying project cost
estimates;
• fully define and correlate
the major characteristics
used in classifying cost
estimates so that differ-
ent organizations may
clearly determine how
their particular practices
compare to the AACE
guidelines;
• use degree of project definition as the primary charac-
teristic in categorizing estimate classes; and
• reflect generally accepted practices in the cost engineer-
ing profession.
AACE 17R-97 maps the phases and stages of project estimat-
ing with a maturity and quality matrix; providing a common
reference point to describe and differentiate various types of
cost estimates. The matrix defines the specific input informa-
tion (i.e., design and project deliverables) that is required to
produce the desired estimating quality at each phase of the
estimating process. The matrix defines the requirements for
scope definition and indicates estimating methodologies
appropriate for each class of estimate. Table 9.1 shows the
generic AACE cost estimate classification matrix.
AACE identifies five classes of estimates. A Class 5 Estimate is
associated with the lowest level of project definition (or project
maturity), and a Class 1 Estimate is associated with the highest
level of project definition. Five characteristics are used to dis-
tinguish each class of estimate from another. The five charac-
teristics used in the AACE recommended practice are
• degree of project definition;
• end usage of the estimate;
• estimating methodology;
• estimating accuracy; and
• effort required to produce the estimate.
9.2
ESTIMATING AACE INTERNATIONAL
Table 9.1—Generic Cost Estimate Classification Matrix
Notes:
[a] If the range index value of “1” represents +10/-5%, then an index value of 10 represents +100/-50%.
[b] If the cost index value of “1” represents 0.005% of project costs, then an index value of 100 represents 0.5%.](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-103-320.jpg)
![Degree of project definition is the primary (or driving) char-
acteristic used to identify an estimate class. The other charac-
teristics are “secondary,” with their value typically deter-
mined by the level of project definition.
In addition to the generic estimate classification system, a
more specific version has been created for the process indus-
tries (Table 9.2). The term “process industries” is intended to
include firms involved with the manufacturing and produc-
tion of chemicals, petrochemicals, pulp/paper and hydrocar-
bon processing. The commonality among this industry (for
the purpose of estimate classification) is their reliance on
process flow diagrams (PFDs) and piping and instrument
diagrams (P&IDs) as primary scope defining documents.
These documents are key deliverables in determining the
level of project definition, and thus the extent and maturity of
estimate input information, and subsequently the estimate
class for an estimate for a process industry project.
This estimate classification system for the process industries is
meant to supplement the generic standard. Over time, addi-
tional matrices will be developed which are specific to other
industries (such as general construction, highway construction,
software development, etc.).
Included with the supplemental guideline for the process
industries is a chart that maps the maturity of estimate input
information (project definition deliverables) against the class-
es of estimates (Table 9.3 on page 9.4).
9.3
AACE INTERNATIONAL ESTIMATING
GLOSSARY TERMS IN THIS CHAPTER
allowance ◆ battery limits ◆ basis ◆ basis of estimate
budget ◆ budgeting ◆ code of accounts (COA)
contingency ◆ cost ◆ cost estimate
cost estimating relationship (CER) ◆ direct cost
price variation ◆ profitability ◆ sunk cost
taxation ◆ taxes ◆ time value of money
Table 9.2—Cost Estimate Classification Matrix for the Process Industries
Notes:
[a] The state of process technology and availability of applicable reference cost data affect the range markedly. The +/-
value represents typical percentage variation of actual costs from the cost estimate after application of contingency
(typically at a 50% level of confidence) for given scope.
[b] If the range index value of “1” represents 0.005% of project costs, then an index value of 100 represents 0.5%.
Estimate preparation effort is highly dependent upon the size of the project and the quality of estimating data and tools.](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-104-320.jpg)
![In contrast, a deterministic (or detailed) estimate requires a
large effort during the actual preparation of the estimate. The
evaluation and quantification of the project scope can take a
substantial amount of time, sometimes weeks or even
months for extremely large projects. Research and applica-
tion of accurate detailed pricing information, and application
of specific estimating adjustments to the quantified scope,
can also take considerable time.
The estimating method used for any particular estimate will
depend on many factors: the end use of the estimate, the
amount of time and money that is available to prepare the
estimate, the estimating tools and data available, and, of
course, the level of project definition and design information
on hand [1].
Conceptual Estimating Methodologies
Conceptual estimating methods are typically used for Class 5
and Class 4 (and sometimes Class 3) estimates. They are often
referred to as “order-of-magnitude” (OOM) estimates in ref-
erence to their typically wide range of estimate accuracy (as
previously defined in the estimate classification matrices). They
provide a relatively quick method of determining the approxi-
mate probable cost of a project without the benefit of detailed
scope definition. As indicated in the estimate classification
matrices, these estimates may be used for the following:
• establishing an early screening estimate for a proposed
project or program,
• evaluating the general feasibility of a project,
• screening project alternatives (such as different locations,
technologies, capacities, etc.),
• evaluating the cost impacts of design alternatives, and
• establishing a preliminary budget for control purposes
during the design phase of a project.
Conceptual estimates are generally based on little project def-
inition (i.e., engineering deliverables), thus subjecting them to
a wide range of estimate accuracy. Their accuracy can depend
on several factors, including the level of project definition, the
quality of the past historical cost data used in development of
the factors and algorithms, as well as the judgment and expe-
rience of the estimator. These limitations should, of course, be
recognized in using conceptual estimating methods.
Nonetheless, there are many cases where conceptual esti-
mates can be very reliable, especially in estimating repeat
projects. Generally, the emphasis with conceptual estimating
is not on detailed accuracy, but on obtaining a reasonable cost
estimate of sufficient accuracy to insure that the results are
meaningful for management to make the decision at hand.
There are a wide variety of conceptual or OOM estimating
methodologies. Several of the more commonly used methods
are end-product units, physical dimensions, capacity factor,
various ratio or factor methods, and parametric modeling.
Most conceptual estimating methods rely on relationships of
one form or another.
End-Product Units Method
This conceptual estimating method is used when the estima-
tor has enough historical data available from similar projects
to relate the end-product units (capacity units) of a project to
its construction costs. This allows an estimate to be prepared
relatively quickly, knowing only the end-product unit capac-
ity of the proposed project. Examples of the relationship
between construction costs and end-product units are
• the construction cost of an electric generating plant and
the plant’s capacity in kilowatts,
• the construction cost of a hotel and the number of guest
rooms,
• the construction cost of a hospital and the number of
patient beds, and
• the construction cost of a parking garage and the num-
ber of available parking spaces.
To illustrate, consider a client that is contemplating building
a 1,500 luxury hotel in a resort area. The client needs an
approximate cost estimate for the proposed hotel as part of
the feasibility study. Assume that a similar luxury hotel has
been recently completed at a nearby resort and the following
information is available:
The hotel just completed included 1,000 guest rooms, as well
as a lobby, restaurants, meeting rooms, parking garage,
swimming pool, and nightclub. The total construction cost
for the 1,000 room hotel was $67,500,000. The resulting cost
per room is thus calculated as $67,500,000/1000 = $67,500 per
room.
Therefore, we can use this information to determine the cost
of the 1,500 room hotel of comparable design and a nearby
location as $101,250,000 ($67,500/room x 1,500 rooms).
While this cost estimate may serve to meet the needs of the
feasibility study, it has ignored several factors that may
impact costs.
For example, it has ignored any economies-of-scale that may
be generated from constructing a larger hotel and has
assumed that the cost of the common facilities (lobby, restau-
rants, pool, etc.) vary directly with the increase in the number
of rooms. If the data exists to understand the cost impact of
these differences, then adjustments may be made to the ini-
tial cost estimate. Similarly, if the location or timing of the
proposed hotel had differed significantly from the known
cost data point, then cost indices can be used to adjust for
these differences.
9.5
AACE INTERNATIONAL ESTIMATING](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-106-320.jpg)
![The key steps in preparing a capacity factor estimate, there-
fore, are the following:
• Deduct costs from the known base case that are not
applicable in the new plant being estimated.
• Apply location and escalation adjustments to normalize
costs. (This now determines what the adjusted scope for
the base case will cost in the new location and time
frame.)
• Apply the capacity factor algorithm to adjust for plant
size.
• Add any additional costs which are required for the new
plant but which were not included in the known plant.
The capacity factor estimating method provides a relatively
quick and sufficiently accurate means to prepare early esti-
mates during the concept screening stage of a project. The
method requires historical cost and capacity data for similar
plants and processes. Although published data on capacity
factors exists, the best data would be from your own organi-
zation and requires a level of commitment to maintain. When
using this method, the new and existing known plant should
be near duplicates, and reasonably close in size. You must
account for differences in scope, location, and time. Each of
the adjustments that you make adds additional uncertainty
and potential error to the estimate. Despite this, capacity fac-
tor estimates can be quite accurate and are often used to sup-
port decision-making at the pre-design stage of a project.
Ratio or Factor Methods
Ratio or factored estimating methods are used in situations
where the total cost of an item or facility can be reliably esti-
mated from the cost of a primary component. For example, this
method is commonly used in estimating the cost of process and
chemical plants, where the cost of the specialized process
equipment makes up a significant portion of the total project
cost. This is often referred to as “equipment factor” estimating.
Equipment factored estimates are used to develop costs for
process and utility units for which the behavior of the costs
of the direct labor and bulk materials used to construct the
facilities is correlated with the costs (or the design parame-
ters) of the major equipment. Typically, this estimating
methodology relies on the principle that a ratio or factor
exists between the cost of an equipment item and costs for
the associated nonequipment items (foundations, piping,
electrical, etc.) needed to complete the installation.
An equipment factored estimate can typically be generated
when project definition (engineering complete) is approxi-
mately 1 percent to 15 percent complete (Class 4). An equip-
ment list should be available at this point in the project. This
estimate is often a feasibility estimate used to determine
whether there is a sufficient business case to pursue the proj-
ect. If so, then this estimate may be used to justify the funding
required to complete the engineering and design required to
produce a funding or budget estimate (Class 3).
Depending on the particular factoring techniques and data
used, the factors may estimate Total Installed Costs (TIC) or
Direct Field Cost (DFC) for the facility. Usually, the factors
generate costs only for the Inside Battery Limits (ISBL) facili-
ties, and require the Outside Battery Limit Facilities (OSBL)
costs to be estimated separately; however sometimes appro-
priate factors are used to estimate the costs of the complete
facilities. Therefore, it is extremely important to understand
the basis of the particular factors being used in an equipment
factored estimate.
In 1947, Hans Lang first published an article [11] in Chemical
Engineering introducing the concept of using the total cost of
equipment to factor the total estimated cost of a plant:
Total plant $ = total equipment $ x equipment factor
Lang proposed three separate factors based on the type of
process plant (Table 9.4). Lang’s factors were meant to cover
all the costs associated with the total installed cost of a plant
including the Battery Limits Process Units (ISBL Costs) and
all Offsites Units (OSBL Costs).
The following is an example of a Lang Factor estimate for a
fluid process plant:
Total estimated equipment cost = $1.5M
Total plant cost = $1.5M X 4.74
Total plant cost = $7.11M
Lang’s approach was rather simple, utilizing a factor that var-
ied only by the type of process. Since that first publication,
many different methods of equipment factoring have been pro-
posed, and some methods have become very sophisticated. The
term “Lang Factor,” however, is often used generically to refer
to all the different types of equipment factors.
In 1958, W. E. Hand [10] elaborated on Lang’s work by pro-
posing different factors for each type of equipment (columns,
vessels, heat exchangers, etc.), rather than process type.
9.8
ESTIMATING AACE INTERNATIONAL
Type of Plant Factor
Solid Process Plant 3.10
Solid-Fluid Process Plant 3.63
Fluid Process Plant 4.74
Table 9.4—Lang Factors](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-109-320.jpg)
![Hand’s factors estimated DFCs, excluding instrumentation.
Hand’s published equipment factors ranged from 2.0 to 3.5
(which might correlate to approximately 2.4 to 4.3 including
instrumentation). Hand’s factors excluded indirect field costs
(IFC), home office costs (HOC), and the costs for offsite or
outside battery limit (OSBL) facilities. These costs would
need to be estimated separately.
An example of an estimate prepared for a fluid processing
plant using Hand’s equipment factoring techniques appears
in Table 9.5. In this example, the total cost of all equipment
items for each type of equipment was multiplied by a factor
for that specific type of equipment to derive the DFC for that
equipment type. For instance, the total cost of all vertical ves-
sels ($540K) was multiplied by an equipment factor of 3.2 to
obtain an installed DFC of $1,728K. The DFC costs for all
equipment types totals $7,753K. Direct Field Labor (DFL)
was estimated at 25 percent of DFC or $1,938K. The IFC were
then estimated at 115 percent of the DFL costs, totaling
$2,229K. The sum of the DFC and IFC costs make up the total
field costs (TFC) of $9,982K. HOC are factored as 30 percent
of DFC, which totals $2,326K. For this estimate, the project
commissioning costs were factored as 3 percent of DFC, and
contingency was factored as 15 percent. The total installed
cost (TIC) for this estimate thus totals $14,422K.
Note the various equipment factors displayed in this exam-
ple. Total equipment cost to DFC is a factor of 2.8 (a typical
range would be 2.4 to 3.5). Total equipment cost to TFC is a
factor of 3.6 (with a typical range being 3.0 to 4.2). Total
equipment cost to total project cost, including contingency, is
a factor of 5.1 (a typical range would be 4.2 to 5.5). This cor-
relates closely with Lang’s original overall equipment factor
of 4.74 for fluid plants.
Arthur Miller proposed another enhancement to the concept
of equipment factors in 1965 [13]. Miller recognized the
impact of three specific variables that affect the equipment
9.9
AACE INTERNATIONAL ESTIMATING
Table 9.5—Equipment Factored Estimate Example
Adj Eqmt %
Acct No Item Description Factor Labor $ Eqmt $ Eqmt Factor Total Mult Total
51 Columns 650,000 2.1 1,365,000
52 Vertical Vessels 540,000 3.2 1,728,000
53 Horizontal Vessels 110,000 2.4 264,000
54 Shell & Tube Heat Exchangers 630,000 2.5 1,575,000
55 Plate Heat Exchangers 110,000 2.0 220,000
56 Pumps, Motor Driven 765,000 3.4 2,601,000
2,805,000
DIRECT FIELD COSTS 25% 1,938,000 7,753,000 2.8 53.8%
Of DFC
10 Temporary Construction Facilities
11 Construction Services/Supplies/Consumables
12 Field Staff/Subsistence/Expense
13 Payroll Burdens/Benefits/Insurance
14 Construction Equipment/Tools
15 International Expense
INDIRECT FIELD COSTS 115% 2,229,000 15.5%
Of DFL
TOTAL FIELD COSTS 9,982,000 3.6 69.2%
20 Project Management
21 Project Controls/Estimating
22 Project Procurement
23 Project Construction Management
24 Engineering/Design
25 Home Office Expenses
HOME OFFICE COSTS 30% 2,326,000 16.1%
Of DFC
TOTAL FIELD and HOME OFFICE COSTS 12,308,000 4.4 85.3%
30 Owner's Costs
31 Project Commissioning Costs 3% Of DFC 233,000
32 Escalation
33 Other Non-Assignable Costs
34 Contingency 15% Of Above 1,881,000
35 Fee
OTHER PROJECT COSTS 2,114,000 14.7%
TOTAL PROJECT COSTS $14,422,000 5.1 100.0%
Costs](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-110-320.jpg)
![material cost to a greater degree than they affect the cost of
the associated bulk materials and installation. These three
factors are: the size of the major equipment, the materials of
construction (metallurgy) of the equipment, and the operat-
ing pressure. Miller noted that as the size of a piece of major
equipment gets larger, the amount of corresponding bulk
materials (foundation, support steel, piping, instruments,
etc.) required for installation does not increase at the same
rate. Thus, as the equipment increases in size, the value of the
equipment factor decreases.
A similar tendency exists for metallurgy and operating pres-
sure. If the equipment is made from more expensive materi-
als (stainless steel, titanium, monel, etc.), the equipment fac-
tor will become smaller. If the operating pressure increases,
the equipment factor gets smaller. Again, as the equipment
becomes more costly due to expensive materials of construc-
tion or higher operating pressures, the costs for the associat-
ed bulk materials required for installation increase at a lower
proportion or rate, and the resulting equipment factor
becomes smaller.
Miller suggested that these three variables could be summa-
rized into a single attribute known as the “average unit cost”
of equipment. The average unit cost of equipment is
Total cost of process equipment/number of
equipment items
If the average unit cost of equipment increases, then the
equipment factor is scaled smaller. The correlation between
increasing average unit cost of equipment and decreasing
equipment factors was statistically validated in subsequent
studies [16, 18].
Thus far, the equipment factors we have discussed have been
used to generate all in DFC or TIC costs. Another method of
using equipment factors is to generate separate costs for each of
the disciplines associated with the installation of equipment.
Using this methodology, each type of equipment is associated
with several discipline-specific equipment factors. For exam-
ple, one discipline equipment factor will generate costs for con-
crete, another factor will generate costs for support structural
steel, another generates the cost for piping, etc. An advantage
to this approach is that it provides the estimator with the capa-
bility to adjust the costs for the individual disciplines based on
specific knowledge of the project conditions, and improves the
accuracy of the equipment factoring method. It also allows the
costs for each specific discipline to be summed and compared
to other similar projects. Miller, and later, Guthrie [9] described
this methodology.
An example of using discipline specific equipment factors is
shown in Table 9.6 on page 9.11. The example shows disci-
pline equipment factors for a 316SS shell & tube heat
exchanger with a size range of 350 to 700 m2. In this example,
the equipment cost of $10,000 is multiplied by each of the
indicated factors to generate the DFC costs for that discipline.
For example, the equipment installation labor is factored as
$10,000 x 0.05 = $500; piping material and labor is factored as
$10,000 x 1.18 = $11,800; etc. The total DFC costs for installa-
tion of this heat exchanger is $28,600 (including the equip-
ment purchase cost of $10,000). This equates to an overall
DFC equipment factor of 2.86. These costs do not include IFC,
HOC, or OSBL Costs.
Development of the actual equipment factors to be used in
preparing process plant estimates is a tedious and time-con-
suming affair. Although some published data exists on
equipment factors (see the articles included in the refer-
ences), much of this data is old, and some of the assumptions
in normalizing the data for time, location, and scope are
incomplete or unavailable. A clear explanation of what is or
what is not covered by the factors is sometimes missing.
Lacking anything better, the published data provides a start-
ing point for your database of equipment factors; however
the best information will be data that comes from your own
organization’s project history and cost databases and that
matches your engineering and construction techniques.
Overall equipment factors from total equipment cost to
DFC/TIC (true “Lang” factors) are the easiest to generate.
Historical data from completed projects should be normal-
ized to a common time and location/labor productivity base-
line. The total equipment costs, direct field costs, and total
installed costs should be very easy to derive from the histor-
ical data. The results can then be analyzed, plotted, and test-
ed to establish overall equipment “Lang” factors.
Developing individual equipment factors that vary based on
the type of equipment, or separate factors for each discipline,
is much more complicated. Generally, it is difficult to derive
the required data from the actual cost histories for completed
projects. Project accounting and cost coding typically does
not collect actual cost data in the necessary format. Instead,
these types of equipment factors are typically developed by
generating detailed estimates for a matrix of equipment
types, size ranges, metallurgies, operating pressures, etc. The
estimates are then carefully analyzed to develop individual
equipment and adjustment factors so that equipment size,
metallurgy, and operating pressure can be accounted for.
The factors developed in this manner can then be tested and
calibrated against actual project histories. The proposed
equipment factors (and adjustment factors, if necessary) are
applied to the actual equipment costs for completed projects,
and the results from the factoring exercise are compared to
the actual project costs to determine if a reasonable degree of
accuracy has been obtained. If the factoring results vary
widely from the actual costs, or are consistently low or con-
sistently high, then an analysis to determine the reasons will
need to be performed, and development of the factors will
continue until sufficient accuracy can be obtained.
9.10
ESTIMATING AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-111-320.jpg)
![system) and its resultant cost [NASA]. A parametric estimate
comprises cost estimating relationships and other parametric
estimating functions that provide logical and repeatable rela-
tionships between independent variables, such as design
parameters or physical characteristics and the dependent
variable, cost.
Capacity factor and equipment factor estimates are simple
examples of parametric estimates; however sophisticated
parametric models typically involve several independent
variables or cost drivers. Yet similar to those estimating
methods, parametric estimating is reliant on the collection
and analysis of previous project cost data in order to develop
the cost estimating relationships (CER’s).
The development of a parametric estimating model can
appear to be a daunting task; however, the use of modern
computer technology (including popular spreadsheet pro-
grams) can make the process tolerable, and much easier than
it would have been years ago. The process of developing a
parametric model should generally involve the following
steps [3, 7]:
1. cost model scope determination,
2. data collection,
3. data normalization,
4. data analysis,
5. data application,
6. testing, and
7. documentation.
The first step in developing a parametric model is to establish
its scope. This includes defining the end use of the model, the
physical characteristics of the model, the cost basis of the
model, and the critical components and cost drivers. The end
use of the model is typically to prepare conceptual estimates
for a process plant or system. The type of process to be cov-
ered by the model, the type of costs to be estimated by the
model (TIC, TFC, etc.), the intended accuracy range of the
model, etc. should all be determined as part of the end-use
definition. The model should be based on actual costs from
complete projects, and reflect your organization’s engineering
practices and technology. The model should generate current
year costs or have the ability to escalate to current year costs.
The model should be based on key design parameters that
can be defined with reasonable accuracy early in the project
scope development, and provide the capability for the esti-
mator to easily adjust the derived costs for specific complex-
ity or other factors affecting a particular project.
Data collection and development for a parametric estimating
model requires a significant effort. The quality of the result-
ing model can be no better than the quality of the data it is
based upon. Both cost and scope information must be identi-
fied and collected. The level at which the cost data is collect-
ed will affect the level at which the model can generate costs,
and may affect the derivation of the CERs. It is best to collect
cost data at a fairly low level of detail [19]. The cost data can
always be summarized later if an aggregate level of cost
information provides a better model. It is obviously impor-
tant to include the year for the cost data in order to normal-
ize costs later. The scope information should include all pro-
posed design parameters or key cost drivers for the model, as
well as any other information that may affect costs.
The type of data to be collected is usually decided upon in
cooperation with the engineering and project control com-
munities. It is usually best to create a formal data collection
form that can be consistently used, and revised if necessary.
After the data has been collected, the next step in the process
of developing a parametric model is to normalize the data
before the data analysis stage. Normalizing the data refers to
making adjustments to the data to account for the differences
between the actual basis of the data for each project, and a
desired standard basis of data to be used for the parametric
model. Typically, data normalization implies making adjust-
ments for escalation, location, site conditions, system specifi-
cations, and cost scope.
Data analysis is the next step in the development of a para-
metric model. There are many diverse methods and tech-
niques that can be employed in data analysis, and are too
complex to delve into in this chapter. Typically, data analysis
consists or performing regression analysis of costs versus
selected design parameters to determine the key drivers for
the model. Most spreadsheet applications now provide
regression analysis and simulation functions that are reason-
ably simple to use. The more advanced statistical and regres-
sion programs have goal-seeking capabilities, which can also
make the process easier.
Generally, a series of regression analysis cases (linear and non-
linear) will be run against the data to determine the best algo-
rithms that will eventually compose the parametric model. The
algorithms will usually take one of the following forms:
Linear Relationship
$ = a + bV1 + cV2 + …
Nonlinear Relationship
$ = a + bV1
x + cV2
y + …
where
V1 and V2 are input variables;
a, b, and c are constants derived from regression; and
x and y are exponents derived from regression.
9.12
ESTIMATING AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-113-320.jpg)
![where
n = decimal fraction of semivariable costs incurred at 0
production (usually about 0.3)
Similarly, the total cost line can be expressed as
Cp = [V + (1 - n)R]p + F + nR (equation 10.3)
where
Cp = total cost at production rate p
p = actual annual production rate as a fraction of plant
capacity
Since total annual sales are proportional to production
(assuming no stock-piling of production), and, therefore,
have no value at zero output, the equation for the sales line is
Sp = (S x p) (equation 10.4)
where
Sp = sales income at production rate p.
The point at which the sales and total cost lines cross is the
breakeven point for the plant and is equal to the level of out-
put at which sales is equal to total cost.
RAW MATERIALS COSTS
Depending upon the particular process, raw materials costs
can constitute a major portion of operating costs. For this rea-
son, a complete list of all raw materials must be developed
using the process flowsheet as a guide. In developing the raw
materials list, the following information must be obtained for
each raw material:
• units of purchase (tons, pounds, etc),
• unit cost,
• available sources of the material,
• quantity required per unit of time and/or unit of pro-
duction, and
• quality of raw materials (concentration, acceptable
impurity levels, etc.).
In estimating the quantity of each raw material, appropriate
allowance must be made for losses in handling and storage,
process waste, and process yield.
Price data for purchased raw materials are generally available
to a high level of accuracy from many sources. Purchased price
information can generally be obtained from the suppliers.
Alternatively, supplier catalogs and price lists can be used, as
can published data. The Wall Street Journal, European Chemical
News, and similar trade and business publications are all good
sources of spot data.
In estimating the cost of any raw material it must be remem-
bered that, in general, raw material costs vary with quality
(concentration, surface finish of metals, impurities, etc) and
generally decrease in unit cost as quantity increases. There is
little sense, for example, in relying on a cost figure for
reagent-grade hydrochloric acid in 5-lb bottles when the
process can utilize much lower cost commercial-grade
hydrochloric acid (muriatic) in tank car or tank truck lots.
Another major factor to be considered is availability of the
raw material. Does sufficient productive capacity exist such
that the market can supply the demands of the proposed
process? A sudden large new demand for a raw material can,
and often does, cause substantial price increases, particularly
if the material is available only in small quantities or as a by-
product of another process.
In pricing raw materials, it must also be remembered that the
prices are generally negotiated and that the discounts obtained
can result in prices substantially less than quoted or published
data. Where available, company experience in negotiating
supply orders for the same or similar materials should be used
to estimate the amount of any such probable discounts.
A common pitfall in operating and manufacturing cost esti-
mates is to neglect the cost of raw materials manufactured or
obtained in-house or from another company division because
they are not purchased. Such raw materials, however, do rep-
resent a cost to the company and do have value. In the estimate,
therefore, they should be included as a cost at their market
value or company book value. The market value to be used is
the going market price corrected for any direct sales costs
which are not incurred due to internal use. In addition, internal
company freight, handling, and transfer costs must be added.
If the captive raw material is an intermediate product that
has no established market price, the cost should be based
upon the value of the nearest downstream product or mate-
rial for which an established market price exists. The cost is
equal to the value of the downstream product less direct sales
costs not incurred plus internal company transfer costs less
manufacturing costs for operations avoided by using the
intermediate product instead of processing it further.
Other raw materials cost items that are easily overlooked are
fuels that are used as raw materials (eg, natural gas in
methane conversion processes) and periodic makeup of loss-
es to catalysts and other processing materials. In the case of
catalysts and similar materials, the initial fill of such items is
usually treated as a capital expense if its useful life exceeds
one year. Otherwise it is considered as a start-up expense.
Fuels that are used as a raw material should be treated in the
same manner as any other raw material. Those which are
used for utility purposes should be treated as a utility cost.
10.5
AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-142-320.jpg)
![Electric power charges are usually based upon a demand fac-
tor—the maximum power draw during a 15- to 30-min peri-
od in any given month. A load factor is computed as the ratio
of average usage to the demand factor and rates are estab-
lished to give preference to high load factors (i.e., steady con-
sumption). The rate schedules also generally include an esca-
lation factor, which is tied to increases in fuel costs.
Electric rates in the past were remarkably stable for many,
many years, and it was common estimating practice to arbi-
trarily assume a cost of the order of a cent or two per kW-hr
for preliminary estimating purposes. This is no longer true,
and no generalization can be made about electric rates. The
estimator must obtain current rates from the utility compa-
nies serving the proposed plant and can no longer safely
assume any “rule-of-thumb” figure for power costs. If the
power is not purchased and instead is obtained from a cap-
tive company-owned generating system, utility costs must be
based upon a study of the system itself.
Natural gas prices depend on quantity required. Steam costs
are dependent upon many factors, including pressure, cost of
fuel, temperature, credit for heating value of condensate, etc.
If company data are not available on steam cost, it must be
estimated taking into account fuel cost, boiler water treat-
ment, operating labor, depreciation on investment, mainte-
nance, and other related costs of steam production. Black [1]
has suggested that steam costs can be approximated as 2 to 3
times the cost of fuel.
Water costs are highly variable depending upon the water
quality needed and the quantity required. Purification costs,
if contamination occurs before disposal, must also be includ-
ed, as must cooling costs if the process results in heating of
process water. In most jurisdictions, water may not be dis-
charged into streams or the natural water table unless it is
equal or better in quality and temperature as when it was
withdrawn from the stream.
Fuel costs vary with the type of fuel used, the Btu value of the
fuel, and the source of supply. Careful consideration should
be given in the estimate not only to fuel cost but to the type
of firing equipment required and to required fuel storage
facilities. Often these factors can rule out what would other-
wise be the least expensive available fuel.
Another factor to be considered is that, as mentioned earlier
in this chapter, certain fuels, although lower in cost than alter-
native fuels, may not be available in sufficient quantities, if at
all. In some cases, a fuel may be abundant in warm weather
but in short supply during the heating season, necessitating
use of alternate fuel supplies or planned production cutbacks
or stoppages during periods of severe winter weather.
In estimating utility requirements, equipment, efficiency
losses, and contingencies must be considered. Utility con-
sumption generally is not proportional to production due to
economies of scale and reduced energy losses per unit of vol-
ume or production on larger process units. Black [1] has sug-
gested that utility consumption varies to the 0.9 power of
capacity, rather than in direct proportion to capacity.
Last, while not normally thought of as a utility, cost of motor
fuels and greases for all mobile equipment must be estimated.
Fuel costs are based upon annual operating hours for each
piece of equipment times fuel consumption per hour, times the
10.7
AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING
Table 10.1—Typical Utility Summary
Power
(kWh/hr)
1,830
1,920
18,550
4,050
26,350
400
300
150
150
150
27,500
Water
required
(gpm)
1,000
38,650
1,330
40,980
500
300
520
42,300
Mine
Crushing plant
Concentrating plant
Pelletizing plant
Subtotal:
Utilities:
Makeup water
Plant lighting
Sanitary water
General facilities
Miscellaneous and contingencies
Total:
Water
recovery
and
makeup
(gpm)
36,720
36,720
5,580
42,300](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-144-320.jpg)
![prevailing cost for the fuel to be used. Greases and lubricant
costs are directly related to fuel costs, and amount to approxi-
mately 16 percent of the fuel cost for most types of equipment.
LABOR COSTS
Labor costs, particularly in a labor-intensive process, may be
the dominant cost factor in an operating or manufacturing
cost estimate. To properly estimate these costs, a staffing
table must be established in as detailed a manner as possible.
This table should indicate the following:
1. the particular skill or craft required in each operation,
2. labor rates for the various types of operations,
3. supervision required for each process step, and
4. overhead personnel required.
It is not always possible to determine the extent of supervi-
sion and overhead personnel required. In such cases, alter-
nate methods of estimating these costs may be used as dis-
cussed later in this book. However, if sufficient data are avail-
able, these factors should be included in the staffing table for
maximum estimate accuracy.
Table 10.2 is a typical staffing table for a complete estimate.
This table illustrates the detail required in a complete staffing
table. Note that the table includes general and administrative
personnel, production workers, maintenance workers, and
direct supervision.
Once the staffing table is developed (at a minimum including
all direct production labor), labor costs can readily be esti-
mated from company records of wages and salaries by posi-
tion, union wage scales, salary surveys of various crafts and
professions, or other published sources. Because labor rates
are prone to rapid inflation, often at rates sharply different
from general inflation rates, care must be taken to obtain cur-
rent figures and to properly project future wage rates.
Generally, data on wage rates includes shift differentials and
overtime premiums. If not, these factors must be added to the
extent applicable.
Further, when estimating around-the-clock, 168-hr/wk oper-
ations, allowance must be made for the fact that a week
includes 4.2 standard 40-hr weeks. Even with four work
crews on “swing shift,” one crew must work 8 hr/week of
overtime to keep the plant in steady operation. Depending
upon local custom, laws, and union contracts, this overtime
is generally payable at 1.5 to 3 times the normal hourly rate.
An alternate method of calculating labor requirements, if suf-
ficient data are not available to establish a staffing table, is to
consider a correlation of labor in workhours per ton of prod-
uct per processing step. This relationship, which was devel-
oped by Wessell [6], relates labor requirements to plant
capacity by the following equation:
(equation 10.5)
where
t = 23 for batch operations with a maximum of labor,
t = 17 for operations with average labor requirements, and
t = 10 for well-instrumented continuous process opera-
tions.
As pointed out previously, the relationship between labor
requirements and production rate is not usually a direct one.
The Wessell equation recognizes that labor productivity gen-
erally improves as plant throughput increases. It can also be
used to extrapolate known workhour requirements from one
plant to another of different capacity.
Another shortcut method of estimating labor requirements,
when requirements at one capacity are known, is to project
labor requirements for other capacities to the 0.2 to 0.25
power of the capacity ratio.
A significant factor to be considered in estimating labor costs is
overtime. As mentioned earlier, around-the-clock, 24-hr/day, 7-
day/week operations have an inherent overtime penalty of 8
hr/week. With this exception, and occasional overtime to cover
for absent workers, overtime is usually not a major considera-
tion in manufacturing and production operations.
However, in estimates involving construction projects, or
those which anticipate regular scheduled overtime, these
costs can be substantial and must be carefully evaluated.
Scheduled overtime over an extended period can result in
substantial decreases in worker productivity resulting in a
major cost penalty for productivity losses in addition to the
higher direct costs of premium pay at 1.5, 2, or even 3 times
normal hourly rates.
Scheduled overtime involves a planned, continuing schedule
for extended working hours for individual workers or even
entire crews. It is not occasional overtime caused on an irreg-
ular basis by absenteeism, equipment malfunctions, etc.
Unfortunately, scheduled overtime rarely saves money or
accelerates production. Two articles which appeared in the
AACE Bulletin in 1973 [2, 5] amply illustrated this point.
These articles, prepared by representatives of the
Construction Users Anti-Inflation Roundtable (now the
10.8
PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL
Operating workhours
tons of product
= t
number of
processing steps
(capacity, tons/day)0.76](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-145-320.jpg)
![Business Roundtable), clearly demonstrated that scheduled
overtime rarely, if ever, is beneficial, and that overtime
should be avoided in favor of additional employees working
normal shifts or partial shifts.
Quoting from one article [5]:
Studies indicate that when a job is placed on overtime
there is a sharp drop in productivity during the first
week with a substantial recovery which holds for
about two weeks and is followed by a fairly steady
decline. At the end of seven to nine weeks the produc-
tivity on an overtime basis is no greater than the pro-
ductivity would be on a 40-hour week. In this period
there is an increase in work accomplished of about 12
percent. After seven to nine weeks of operation, pro-
ductivity continues to decline and the work accom-
plished is less than would have been accomplished on
a 40 hour per week schedule. After 18 to 20 weeks
there is no gain in total work accomplished . . . .
SUPERVISION AND MAINTENANCE COSTS
As discussed above, supervision costs should be established,
if at all possible, through a staffing table and tabulation of
associated costs.
Unfortunately, for most preliminary estimates, particularly
those for proposed new processes, this is not possible.
In such cases, costs of supervision can be roughly estimated
by taking a fixed percentage of direct labor costs based upon
company experience. In the absence of prior data on similar
operations, a factor of 15 to 20 percent is generally satisfactory.
The validity of the latter factor can readily be seen when con-
sidering the fact that one front-line supervisor can effectively
manage no more than 8 to 10 workers, i.e., supervision work-
hours of 0.100 to 0.125 per direct labor workhour. With front-
line supervision (i.e., foremen or forewomen) at labor rates
approximately 50 to 60 percent above general labor rates, 15
to 20 percent supervision factor is evident.
Maintenance labor costs, like supervision costs, should be
delineated in the labor staffing table if at all possible. However,
other than company records of existing similar plants, reliable
data on maintenance costs are generally not available, and the
staffing table approach is usually not feasible. For this reason,
maintenance costs are often estimated as a fixed percentage of
depreciable capital investment per year. For complex plants
and severe corrosive conditions, this factor can be 10 to 12 per-
cent or higher. For simple plants with relatively mild, noncor-
rosive conditions, 3 to 5 percent should be adequate.
Maintenance costs are a semivariable category, which is gen-
erally distributed about 50 percent to labor and 50 percent of
materials. For a preliminary estimate, the various factors
making up plant maintenance can be back calculated from
the total maintenance number using the following approxi-
mate percentages:
• direct maintenance labor, 35 to 40 percent;
• direct maintenance labor, supervision, 7 to 8 percent;
• maintenance materials, 35 to 40 percent; and
• contract maintenance, 18 to 20 percent.
Then as the project evolves toward a final staffing plan, the
factors can be improved and are finally replaced with num-
bers generated from the staffing table. The back calculation
allows one to estimate the number of people required early in
10.12
PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL
Table 10.2—Typical Complete Staffing Table (continued)](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-149-320.jpg)
![is based upon royalties levied by the unions on production
rather than being a function of labor costs. Such royalties are
variable production costs and must be treated as such.
The expense of operating company testing and research labo-
ratories is another overhead expense which must be included
in the estimate. Generally, such costs are indirect costs,
although in the case of product laboratories they may be direct
semivariable costs.
Laboratory overhead is best estimated based upon company
experience. Lacking suitable data, these costs can be estimat-
ed as follows:
• from workhours required plus associated overhead,
• from literature sources, and
• as a percentage of direct labor costs.
If the last is used, laboratory overhead costs may range from
3 to 20 percent or more for complex processes. A suitable fig-
ure for average situations might be 5 to 10 percent.
ROYALTIES AND RENTALS
As was discussed earlier in this chapter, royalties may be
variable, semivariable, fixed, or capital costs (or a combina-
tion of these), depending upon the conditions of the royalty
agreement. The same is true of rental costs.
Single-sum royalty, rental, or license payments are properly
considered as capital investment items, whereas payments in
proportion to production or fixed payments per annum are
treated as direct operating costs.
Royalty expenses, in the absence of data to the contrary, are
treated as a direct expense and may be estimted at 1 to 5 per-
cent of the product sales price.
Due to the complexity of agreements for royalty payments
and to variations in tax laws and accounting methods,
extreme care should be exercised to be sure that such costs
are properly included in the appropriate expense category.
CONTINGENCIES
As is true with a capital cost estimate, any operating or man-
ufacturing cost estimate should include a contingency
allowance to account for those costs that cannot readily be
determined or defined or that are too small to estimate indi-
vidually but may be significant in the aggregate. The contin-
gency allowance applies both to direct and indirect costs and
ranges from 1 to 5 percent (and more in some cases), depend-
ing upon the uncertainty in the data used to prepare the esti-
mate and the risk associated with the venture.
Hackney [3] has suggested the following guidelines for con-
tingency allowances in operating and manufacturing cost
estimates:
1. installations similar to those currently used by the com-
pany, for which standard costs are available—1 percent;
2. installations common to the industry, for which reliable
data are available—2 percent;
3. novel installations that have been completely developed
and tested—3 percent; and
4. novel installations that are in the development stage—5
percent.
GENERAL WORKS EXPENSE
General works expense or factory overhead represents the
indirect cost of operating a plant or factory and is dependent
upon both investment and labor. Black [1] suggested that fac-
tory overhead be estimated by the sum of investment times
an investment factor and labor times a labor factor. In this
case, labor is defined as total annual cost of labor, including
direct operating labor, repair and maintenance, and supervi-
sion; and labor for loading, packaging, and shipping.
Black’s suggested labor and investment factors for various
industries are as follows:
Alternately, for preliminary estimates, indirect overhead may
be approximated at 40 to 60 percent of labor costs or 15 to 30
percent of direct costs. Humphreys [4] has suggested 55 per-
cent of operating labor, supervision, and maintenance labor
for the mineral industries. Again, these factors may be some-
what higher outside the U.S. depending upon local customs
and laws.
It is important to note that indirect or factory overhead (gener-
al works expense) does not include so-called general expense
(i.e., marketing or sales cost) and administrative expense.
10.14
PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL
Investment
factor Labor factor
Industry (% per year) (% per year)
Heavy chemical
plants
(large-capacity) 1.5 45
Power plants 1.8 75
Electrochemical
plants 2.5 45
Cement plants 3.0 50
Heavy chemical
plants
(small capacity) 4.0 45](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-151-320.jpg)
![approaches to CAPP are (1) the variant approach, which
searches a database for similar parts and modifies the
closest similar component plan for the new component;
and (2) the generative approach, which designs the
process plan starting from “scratch,” that is, generating a
completely original approach.
• Concurrent Engineering—Concurrent engineering as
defined by the Institute for Defense Analysis [9] is a sys-
tematic approach to the integrated, concurrent design of
products and their related processes, including manufac-
turing and support. This approach is intended to cause
the developer (designers), from the outset, to consider all
elements of the product life cycle from conception
through disposal, including quality, cost, schedule, and
user requirements.
• Group Technology—Group technology is a manufactur-
ing philosophy that identifies and exploits the underlying
sameness of component parts and manufacturing process
[2]. There are two primary approaches, which are (1) clas-
sifying parts into families that have similar design features
and (2) classifying parts into families that have similar pro-
cessing operations. This permits the standardization of
parts in the design process and, in the second case, pro-
duction of parts as families by permitting cell formation
and reducing the set-up times via fewer set-up changes.
• Just-in-Time—Just-in-time is the manufacturing philos-
ophy that requires that the supplies (raw materials) are
delivered when required, and, thus, inventory costs are
theoretically driven to zero as there is no inventory. This
is not only for external suppliers but also for internal use
as parts go from one operation to the next, so the work-
in-process inventory is a minimum. This is closely relat-
ed to the “Kanban” system or “pull” system in which
parts are not produced until ordered.
• Lean Manufacturing—Lean manufacturing is a manufac-
turing philosophy to shorten lead times, reduce costs, and
reduce waste. This philosophy is implemented by (1)
reducing waste through scrap reduction, improving yields,
and developing new products from waste stream materi-
als; (2) improving employee performance, skills, and satis-
faction via training, recognition, and employee involve-
ment and empowerment; and (3) investing capital to
improve processes, process rates, and capabilities. Lean
manufacturing is not “mean” manufacturing, and it is not
a short-term process. Rather, it is a continuous improve-
ment process.
11.2
DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL
Table 11.1—Component Operation Classification for Discrete Manufacturing [6, 7, 10]
Major Component Group Illustrative Manufacturing Operations of Major Component Group
1. Metal Component Manufacturing
Casting sand casting, investment casting, die casting, permanent mold casting, squeeze
casting, full mold casting, slush casting, etc.
Forming and Shaping rolling, open-die forging, impression die forging, impact extrusion, drawing,
shearing, bending, powder processing, etc.
Machining turning, drilling, milling, sawing, planning, shaping, grinding, water-jet machining,
electrical discharge machining, etc.
2. Plastic Component Manufacturing injection molding, extrusion, blow molding, pultrusion, thermoforming, compres-
sion molding, filament winding, etc. and many of the machining operations
3. Ceramic and Glass Component Manufacturing
Ceramic slip casting, extrusion, pressing, injection molding, hot pressing, drying, firing,
drawing, etc.
Glass rolling, float forming, pressing, blowing, etc.
4. Component Surface Modification case hardening, hot dipping, porcelain enameling, electroplating, thermal spraying,
vapor deposition, anodizing, painting, cleaning, peening, etc.
5. Assembly and Joining arc welding, resistance welding, laser welding, brazing, soldering, adhesive
bonding, mechanical fasteners, etc.
6. Micro-Electronic Component crystal growth, wafer slicing and polishing, photolithography, doping, sputtering,
Manufacturing chemical vapor deposition, etching, adhesive bonding, wave soldering, etc.](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-163-320.jpg)
![• Material Requirements Planning (MRP)*—MRP is a
system that uses bills of material, inventory and open
order data, and master production schedule information
to calculate requirements for materials. It makes recom-
mendations to release replenishment orders for materi-
als. Further, since it is time-phased, it makes recommen-
dations to reschedule open orders when due dates and
need dates are not in phase.
• Supply Chain Management—The production of com-
plex products require the integration of many different
components from a variety of suppliers. Supply chain
management involves the assurance that the parts will
arrive from the suppliers when required to avoid large
inventories or production stoppages from a lack of parts.
Supply chain management also requires the involvement
of suppliers in the design process to eliminate unneces-
sary operations and inefficient designs of components or
even unnecessary components. Although the focus is on
the movement of materials, it also involves the transfer
of information on the status of delivery and financial
flow of credit, terms and conditions, and payment sched-
ules as the materials move through the various stages of
the supply chain. The goals are to reduce inventory,
time-to-market, and costs, and improve quality.
• Total Quality Management—Total quality management
is a leadership philosophy, organizational structure, and
working environment that fosters and nourishes a per-
sonal accountability and responsibility for the quality
and a quest for continuous improvement in products,
services, and processes [8].
BASIC COST RELATIONSHIPS
The basic relationships between the various manufacturing
cost terms are illustrated in Figures 11.1 and 11.2 on pages
11.4 and 11.5. Figure 11.1 shows the relationships between the
various cost terms in a flow chart form [3], and Figure 11.2
illustrates the terms in a stepwise fashion referred to as the
“ladder of costs.” The sum of direct material, direct labor,
direct engineering, and direct expense is the prime cost.
However, many companies do not keep adequate records of
direct engineering and direct expenses, and, in many
instances, the prime cost is the sum of the direct material and
direct labor costs. Usually the design engineering and direct
expense are included as overhead costs and not allocated to
the specific product. This is partly because only 10 percent of
new products make it into the production stage, and most of
the design work cannot be assigned to the specific products.
The relationships between the cost terms can also be illus-
trated by equations such as the following:
*prime cost = direct material cost + direct labor cost +
direct engineering cost + direct expense
(equation 11.1)
**manufacturing cost = prime cost + factory expense
(equation 11.2)
production cost = manufacturing cost + administrative
expense
(equation 11.3)
total cost = production cost + marketing, selling, and dis-
tribution expense
(equation 11.4)
selling price = total cost + mark-up (profit and taxes)
(equation 11.5)
*prime cost is also called direct cost
**manufacturing cost is also called factory cost
The profit should be related to the value to the customer.
Some items will generate more profit than others; parts that
one is skilled at producing should yield more profit than new
items or those that one does not have the ideal equipment to
produce. Equal profits indicate your prices will be too high
for items that you have difficulty making and too low for
items that are your specialty area.
Profit is usually meant to imply net profit; that is, the profit
after all expenses have been incurred and after taxes have
been paid. The other profit terms, that is gross profit and
operating profit, do not include all the expenses and thus are
larger than the net profit term.
COST ESTIMATING FOR DISCRETE PART
MANUFACTURING
Direct and Indirect Costs
Direct costs are those costs that can be directly related to a
specific part and these most commonly are direct materials
and direct labor. There can be other direct costs, such as direct
engineering or direct burden expenses, but these are often
11.3
AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING
GLOSSARY TERMS IN THIS CHAPTER
administrative expense ◆ break-even analysis
contingency ◆ cost ◆ cost estimating
costing/cost accounting ◆ discrete manufacturing
direct cost ◆ direct labor
indirect cost ◆ indirect labor ◆](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-164-320.jpg)
![Other indirect costs are those which cannot be directly tied to
the product such as supervision, administrative salaries,
maintenance, janitorial, material handling, and legal, etc.
These costs have different degrees of indirectness. For exam-
ple, the immediate supervisor may have five people working
for him, whereas the plant superintendent may have 500.
More of the immediate supervisors cost must be allocated in
the overhead burden than the plant superintendents over-
head for particular component part, but the plant superin-
tendents overhead will be applied over many more compo-
nent parts. In large companies, indirect costs also include
items such as basic and applied research and development,
which must be done to develop future products. However,
the costs of such activities must be recovered on the current
products being produced and these research and develop-
ment costs for future products are indirect burden costs for
the current products.
Cost Estimating Guide Form
There are so many different types of operations and items
that can be included on a cost estimating form, that only a
general guide can be given. A form particular to the particu-
lar products produced must be designed to obtain good cost
estimates. The general form is illustrated in Table 11.2 on
page 11.6. The mark-up amount is calculated as follows:
mark-up (amount) = total cost x [% MU /[1 - % MU]]
(equation 11.6)
where
total cost = total costs
% MU = decimal percent of mark-up for profits and taxes
For example, if the total costs are $10,000, and the mark up is
20 percent, the mark-up amount would be:
mark-up (amount) = 10,000 x [0.20 /[1.00 – 0.20]] =
$2,500
The selling price would be $10,000 plus $2,500 mark-up or
$12,500.
To illustrate the use of the form, an illustrative example is
presented in Table 11.3 on page 11. 7. The values presented
are for illustrative purposes and not specific values or rates to
be used. These values must be evaluated for each individual
company.
An order has been received for 100 units of a component,
which will require 240 lbs of material 1 at $0.75 per pound
and 5 lbs of material 2, which is $ 4.00 per pound for each
unit. The product requires two operations, operation 1,
11.5
AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING
Direct
Cost
or
Prime
Cost
Factory
Cost
or
Manufacturing
Cost
Production
Cost
Total
Cost
Selling
Price
Factory
Expenses
Selling and
Distribution
Expenses
Mark Up
Direct
Expenses
Direct
Engineering
Direct
Labor
Direct
Materials
Figure 11.2—Ladder of Costs for Discrete Part Manufacturing
Administrative
Expenses](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-166-320.jpg)
![which takes 0.20hrs/unit at $ 20/hr, and operation 2, which
takes 0.40hrs/unit at $25/hr. The special tooling for the job is
$ 3,600. The mark-up for profits and taxes is 20 percent of the
selling price. The example costs and selling price are present-
ed in Table 11.3, with the unit selling price of $596.38 and a
unit cost of $477.10. With a tax rate of 40 percent, one must
charge $1.67 for every $1.00 of after-tax profit desired, and
this is one reason why businesses dislike the taxes so much.
The contingency costs are primarily for new products and
processes, and would be low for standard products. The con-
tingency costs are for expected tooling changes and process
changes that would be required from expected design errors
or incorrect process parameters.
The form is illustrative to indicate the various items that
must be tracked to determine the total and unit costs. A form
must be designed to the particular operations and materials
of the particular company, and, as illustrated in Table 11.1,
there are a wide variety of possible operations. It is not prac-
tical to design a form to include all types of operations and
materials. The costs in the form follow the ladder of costs,
and the percentages of the total cost can be included in the
form as illustrated in Table 11.3
BREAK-EVEN ANALYSIS
4.1 Introduction
There are two critical issues in break-even analysis [9, 10] that
must be considered and they are (a) the cost base and (b) the
various break-even points. The two different cost bases are
the time base and the quantity base. The quantity-based
break-even analysis determines the production quantity at
the specific break-even point, and this has worked for mar-
keting, sales, and top management for forecasting yearly
sales and other long-range planning activities. However, it
provides little assistance at the plant management level
where the production quantity is not a variable, but is a
quantity specified by the customer.
Time-based break-even analysis focuses on the time to pro-
duce the order, which is something under the control of the
plant supervision. Time-based break-even analysis deter-
mines the production time for the specific break-even point,
and this is what can be controlled at the plant level. The same
break-even points can be used in either system, but the costs
must be considered carefully as the different bases—time and
quantity—result in different conclusions with respect to the
variability of the costs.
Costs are generally classified as fixed costs, variable costs,
and semivariable costs, but whether a cost is fixed, variable
or semivariable depends upon the cost base used. One of the
difficulties in promoting the time-based system is that what
has been treated as a variable cost in the quantity-based sys-
tem is often fixed in the time-based system and vice-versa.
The second issue with break-even points is that increased
quantities are desired in the quantity-based system, whereas
decreased times are desired in the time-based system.
Cost Bases
Costs are generally classified into three major groups: (1)
fixed, (2) variable, and (3) semivariable. How the costs are
assigned to a group depends upon the cost base; that is,
whether the cost base is the quantity base or the time base.
Since production quantity has been the standard base, this
base will be considered first. Costs that do not vary with
respect to production quantity are considered as fixed costs,
and some of the commonly designated fixed costs are prop-
erty taxes, administrative salaries, research and development
expenses, and insurance. Variable costs are those that vary
linearly with production quantity, and the most common
variable cost items in the production quantity base are direct
material costs and direct labor costs. The costs that do not fit
into either of the fixed or variable costs are classified as semi-
variable costs, and an example of semivariable cost is main-
tenance cost.
When a time-based system is used, many of the cost compo-
nents in the fixed and variable categories change when com-
pared to the quantity-based system. Costs that do not vary
with respect to time are considered as fixed costs, and these
would be items such as the direct material costs. For as the
production quantity is fixed, the material costs would be
fixed. On the other hand, costs such as property taxes,
administrative salaries, research and development expenses,
and insurance would be considered as variable as they must
be recovered over time. Direct labor may be a fixed or vari-
able quantity depending upon the policies used. If the direct
labor does not vary per unit of production, then with a fixed
quantity, the direct labor cost would be a fixed cost on the
time basis. If the labor force were fixed, such as when man-
agement does not layoff employees, then it would be similar
to a fixed salary and the cost would be variable with respect
to the time to do the work.
Break-Even Points
The four break-even points that are considered in the prof-
itability evaluation of products or operations are the shut-
down point, the cost point, the required return point, and the
required return after taxes point. These points can be evalu-
ated on either the time based or quantity based system. The
points can be defined as follows:
• Shutdown Point (SD)—The shutdown point is the
quantity or time where the manufacturing costs equals
the revenues. In the production quantity system, it is the
production quantity at which the revenues equal the
manufacturing costs. In the production time system, it is
the production time at which the revenues equals the
11.8
DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-169-320.jpg)
![INTRODUCTION
The work tasks needed to complete a construction project
range from designing the foundations to clearing and grad-
ing a site, to startup and turnover of the completed facility.
During the course of the project, the individuals executing it
must periodically report their progress on each task. Since
the nature of each task varies, no single reporting method is
suitable, and several methods of measuring progress are
required. The six most common methods are presented in
this chapter. Other topics discussed include earned value,
how to evaluate worker productivity, and the use of fixed
budget systems.
LEARNING OBJECTIVES
After completing this chapter, readers should be able to
• identify the six methods used for measuring work
progress,
• understand the concept of earned value and how to use
it in fixed budgets to analyze cost and schedule per-
formance, and
• understand how to evaluate worker productivity.
MEASURING WORK PROGRESS
Method 1—Units Completed—This method is applicable to
tasks that involve repeated production of easily measured
pieces of work, when each piece requires approximately the
same level of effort. In most cases, subtasks are not mixed,
but if so, they are accomplished simultaneously, and one of
the subtasks can be used as the reference task.
Wire pulling is a task where accomplishment is easily meas-
ured in terms of linear meters of wire pulled. If the work for
pulling a certain type of wire is contained in a single control
account, the units completed method can be applied. For
example, if 10,000 linear meters (LM) of wire is to be pulled,
and 4000 LM have been pulled, the percent complete is
found by dividing 4000 LM by 10000 LM to show 40 percent
complete.
Placing and finishing a reinforced concrete slab is a type of
work with multiple tasks handled simultaneously (placing
and finishing), but progress would normally be reported on
the basis of cubic meters (or yards) of concrete placed and
finished, or on the number of square meters (or feet) of fin-
ished surface.
Method 2—Incremental Milestone—This method is applica-
ble to any control account that includes subtasks that must be
handled in sequence. For example, installing a major vessel
in an industrial facility includes the sequential tasks or oper-
ations listed in Table 14.1. Segmenting a task into subtasks
and assigning each an increment of progress for the entire
task is called developing “rules of credit [1].” Completing
any subtask or operation is considered to be the achievement
of a milestone, and each incremental milestone completed
represents a certain percentage of the total installation. The
percentage chosen to represent each milestone is normally
based on the number of workhours estimated to be required
to that point in relation to the total.
14.1
AACE INTERNATIONAL PROGRESS MEASUREMENT AND EARNED VALUE
Chapter 14
Progress Measurement and Earned Value
Dr. Joseph J. Orczyk, PE CCE
TASK
Received/inspected
Setting complete
Alignment complete
Internals installed
Testing complete
Accepted by owner
INCREMENTAL
PROGRESS
15%
20%
15%
25%
15%
10%
CUMULATIVE
PROGRESS
15%
35%
50%
75%
90%
100%
Table 14.1—Rules of Credit for Drums and Tanks](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-206-320.jpg)
![is traditionally estimated and controlled in terms of tons
of steel. The process is illustrated in Table 17.1.
Productivity Measurement of Individual Work Tasks
Owners and contractors are always interested in comparing
actual field productivity to that estimated and budgeted.
When dealing with a single work activity, the calculation of
productivity is very simple:
productivity = (number of units completed) ÷ (work-
hours consumed)
What is more difficult is the calculation of productivity at a
summary level or for an entire project.
Productivity Analysis at a Summary Level
While a comparison of earned to actual workhours is used by
some practitioners to provide an evaluation of productivity
at a summary level, that approach is valid only if actual
quantities of work are exactly equal to those budgeted. This
is not always true, particularly on fixed-price, lump-sum con-
tracts, so another tool is needed to evaluate productivity.
That tool is credit work-hours.
Credit workhours (CWH) are derived quantities and are
found using this formula for work items completed:
CWH = (budgeted unit rate*) x (units completed to date)
* budgeted unit rate = budgeted hours per unit of work
For individual work packages in progress (not yet complete),
this formula is appropriate:
CWH = (percent complete) x (budgeted unit rate)
The productivity index (PI) for a single work package is
found by this formula:
productivity index = (CWH to date) ÷ (actual WH to date)
The productivity index (PI) for a
combination of work packages or
for a total project uses this formula:
productivity index = (∑ CWH ÷
∑ actual workhours).
The format of these equations is
such that an index of less than 1.0
is unfavorable, while one equal to
or greater than 1.0 is favorable.
Use of Productivity Data
It is a waste of time to collect data
that is not used for the benefit of the
project or the company. Recalling
that project estimates include pro-
ductivity assumptions for the vari-
ous work tasks, a very important
use of the field data is to compare
estimated with actual productivi-
ties. It is unlikely that estimated
and actual productivities associated
with a single work task will ever be
exactly equal, but significant varia-
tions should be cause for concern—
the difference may be attributable
to a poor estimate and/or it may be
attributable to field performance.
In any event, significant variations
should be investigated and the
results shared with the estimators,
since their databases may need
updating.
17.10
PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL
Wt.
0.02
0.02
0.05
0.06
0.10
0.11
0.20
0.09
0.30
0.05
1.00
Subtask
Run fdn bolts
Shim
Shakeout
Columns
Beams
Cross braces
Girts/sag rods
Plumb and align
Connections
Punch list
STEEL
UM
each
percent
percent
each
each
each
bay
percent
each
percent
TON
Quantity
Total
200
100
.100
84
859
837
38
100
2977
100
Equiv.
Steel TN*
10.4
10.4
26.0
31.2
52.0
57.2
104.0
46.8
156.0
26.0
520.0
Quantity
To Date
200
100
100
74
0
0
0
5
74
0
Earned
Tons **
10.4
10.4
26.0
27.5
0.0
0.0
0.0
2.3
3.9
0.0
80.5
Table 17.1—Steel Erection as Traditionally Estimated and Controlled in Terms of
Tons of Steel
* Equiv. Steel TN = (Wt.) (520 Ton)
** Earned Tons = (% complete) (Equiv. Steel Tons)
percent complete = (earned tons) ÷ (total tons)
= (80.5 tons) ÷ (520.0 tons) = 15.5 percent
Notice in this example how tons of steel is the account's unit of measure, and all subtasks
are converted to equivalent tons. It also may be noted that percent complete could have
been calculated by this formula:
percent complete = ∑ [ (weight) x (percent complete each subtask) ]](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-237-320.jpg)
![mit to, and work to the agreed execution plan. There would
be unanimous support from all and all would be working to
the same “plan.”
With a strong project management culture and effective com-
pany leadership, it was anticipated that the “matrix” would
be effective. Initially it was, but as time passed, the “matrix”
failed and the research carried out by Peters and Waterman
(in their book, In Search of Excellence [1]) and many other man-
agement experts, has clearly demonstrated this failure. The
answer, agreed by all, was a new approach, called quality
management. This new approach was spearheaded by Dr.
Edward Deming, working in Japan, in the 1960s and1970s.
Demingism and Total Quality Management (TQM)
This made its debut in the US in 1981, at the Ford Motor
Corporation. Yet the transformation of the US industry to
Demingism has been slow, even though there is wide accept-
ance that his quality management approach is essential.
TQM, a version of Demingism, has been implemented in the
manufacturing industries since the late 1980s and in the engi-
neering/construction industry in the early 1990s. Dr. Deming
has developed 14-key sets of criteria for developing a quality
management program. This criteria is referred to as
“Demingism” and is summarized as follows.
• Client Satisfaction—For the services provided or for the
product sold.
• Understanding and Reducing Variation—Every manage-
ment process, practice, procedure, policy must be evalu-
ated for its effectiveness in allowing the company’s indi-
viduals to work at maximum effectiveness.
• “Top-Down” Management Leadership and
Commitment—Improvement cannot come merely from
middle managers and workers “trying harder.” There
must be full understanding of, and total commitment to,
the necessary systematic change and the planned
improvements.
• Change and Improvement Must Be Continuous—It must
be all-encompassing, involving every “process,” individ-
ual and outside services and suppliers.
• Ongoing Training and Education is Essential for all
employees, and it must be of a high technical quality so
that high standards of skills and practices can be imple-
mented by all personnel.
• A Culture of Personnel Pride and Job Satisfaction—At all
levels; this requires leadership, program champions, the
development of trust and loyalty, personnel empower-
ment, and the elimination of inadequate performance
measurement schemes that can create more losers than
winners, resulting in lowering of morale. Such schemes,
says Deming, do not account for the “variations” and
weaknesses in the company process and can be inaccu-
rate and unfair; and are perceived as such by the
employees. Performance measurement is essential, but it
should be of the system or process, and individuals
should be paid for their experience and responsibilities.
Not all personnel will be “star” performers, and the con-
tribution of the company janitor can be equal to that of
the chief engineer, when there is a commitment to excel-
lence from both. However, most companies do not agree
with Deming on this particular issue and use a “person-
nel performance” awards program that gives individuals
recognition and awards for superior performance. Such
a program is Fluor Corporation’s “MVP” (most valuable
player) program, which was developed through an
extensive personnel survey where the staff stated that
the company salary program did not properly reward
superior performance and that individual awards would
be a viable program. Thus the practice of employee
empowerment showed a major “need,” and Fluor insti-
tuted the program in 1994. They currently report that the
program is successful and is a key feature of their con-
tinuous improvement program (CIP). Fluor Corporation
is an international contractor, with headquarters located
in Annaheim, CA.
GENERAL
It is an obvious, but not well-understood fact, that it is peo-
ple in single, medium, or large size groups who design and
build projects, not companies. If there are people available, if
they have the required skills, if they have a positive working
environment, then success is possible. If none of these condi-
tions pertain or only partially, then success is very question-
able. Therefore, there must be a consistent and long-term
interest in people needs, their development and their train-
ing. When there is little interest, or the interest is not genuine,
the long term success of the company is unlikely. The entire
total quality management (TQM) program is built around the
needs and development of people, and there is unanimous
acceptance by industry that total quality management is the
key to success. In essence, develop the people, and in turn,
the people will develop the profits.
IS THE OWNER COMPANY QUALIFIED TO BE
ITS OWN PROJECT MANAGER?
A very fundamental consideration in today’s world of com-
pany reengineering is the question of the owner functioning
as its own project manager. Too often, owners arrive at an
affirmative answer through poor analysis. It is a matter of
previous experience of the specific project (particularly size),
having adequate in-house or consulting resources (skills and
numbers), a good project management program and costs.
This is, currently, a major consideration with many operating
companies as they downsize their operations. Many companies
19.2
PROJECT ORGANIZATION STRUCTURE AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-255-320.jpg)
![• rework due to design, fabrication, and field errors;
• site layout;
• weather; and
• constructability.
Implementing the labor cost control methods included in this
chapter can be costly. A cardinal rule of cost control is that the
cost of the control techniques be less than the money saved
by using the cost control techniques. Cost control should be
approached as an application of Pareto’s Law, which essen-
tially states that 80 percent of the outcome of a project is
determined by only 20 percent of the included elements.
Thus, in establishing a cost control system, the idea is to iso-
late and control in detail those elements with the greatest
potential impact on final cost, with only summary-level con-
trol on the remaining elements.
The methods presented in this chapter utilize two-dimen-
sional tables or spreadsheets to present data. These spread-
sheets lend themselves to computerization. In fact, many job
cost control and project management software will perform
the calculations described in this chapter.
MEASURING INPUTS AND OUTPUTS
In the example of a home heating system, only one measure-
ment, temperature, is required to control the system.
Controlling construction labor costs requires many measure-
ments. The ultimate goal of labor cost control is to expend the
fewest dollars to complete the project. In order to achieve this
goal, project management must measure the efficiency or
cost-effectiveness of each dollar spent. This requires hun-
dreds of measurements of labor dollars and workhours
expended and quantities produced. Labor cost efficiencies
are measured as a ratio of inputs (workhours or dollars) and
outputs (quantities produced).
A construction project is complex and must be broken into
controllable parts. This is accomplished using a work break-
down structure (WBS). The WBS is the classification of each
project element along activity levels where the activity out-
puts can be measured and then compared to the resources
expended for that activity. Each classification is assigned a
cost code for identification. A construction project has hun-
dreds of cost codes. A study of 30 building contractors in
Atlanta showed that for a two-million-dollar project, the
median number of line items was 400 [2]. This translates into
approximately the same number of cost accounts. The WBS
must be carefully constructed and documented so that all
members of the project team consistently use the correct cost
codes for inputs and outputs.
Labor input is measured by workhours expended
or by labor dollars spent. Workhours are measured
directly using cost codes and time cards. Dollars
are calculated by multiplying each workhour
expended by the appropriate wage rate (i.e., dol-
lars per workhour). Unlike construction inputs
that have the common unit of measurement (i.e.,
dollars and workhours), the output cannot be
measured with a common unit of measure.
Consequently, a large number of measures are
used for construction outputs. Examples of these
measures include cubic yards of excavation,
square feet of concrete formwork, tons of structur-
al steel, lineal feet of pipe, and number of electri-
cal terminations.
Cost control requires matching each unit of output
to the input (resources) that was required to produce
it. Each category of output requires a separate cost
account. The input is separated into the appropriate
cost account in order to match each unit of output to
the resources (inputs) that produced the output. The
breakdown of the inputs into the individual cost
accounts is accomplished by observing and record-
ing the number of workhours expended each day by
cost account. If workhours are not accurately
21.2
PROJECT LABOR COST CONTROL AACE INTERNATIONAL
Table 21.1—Original Estimate](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-265-320.jpg)
![recorded in the correct cost account, the cost control system
will be ineffective. The accuracy of cost coding workhours is
improved by the following:
• training all personnel in the use of company cost
accounts to correctly code time cards;
• checking time cards for correct cost codes before record-
ing in the cost control system; and
• developing and maintaining a well documented WBS.
A major consideration for measuring construction quantities
is to determine if an item (such as cubic yards of concrete
placed or lineal feet of wire pulled) is installed in one step or
several steps. Quantities installed in one step are the easiest
to measure. The item is either installed or it is not installed.
The project management team can physically measure the
output for the reporting period. It is more difficult to meas-
ure progress when quantities are installed in several steps.
One method to measure progress is to assign each sequential
step its own cost account. However, this would burden the
labor cost control system with too many cost accounts. A bet-
ter way to handle this situation is to use the equivalent units
method to report the partially completed units as equivalent
units completed. In the equivalent units method, each step is
assigned a weight based upon the percentage of the activity’s
budget dollars or workhours required to complete that step.
The breakdown of the effort that is required for each step is
called the “rules of credit.” Following is an example of piping
rules of credit [3].
• pipe placed in the permanent location—60 percent of the
work;
• pipe end connections are welded or bolted—20 percent
of the work:
• pipe trim installed and pipe is ready for hydrotest—20
percent of the work.
An example of a daily production report that measures work
progress by cost account using the equivalent units (rules of
credit) method can be found in Table 21.2. The detailed
description of each field in the daily production report for
cost account 03140 appears below.
The description column lists all subtasks for account 03140.
The field engineer or superintendent records the quantity
completed each day for each of the following subtasks: erect
forms, wreck forms, and clean and oil forms. The subtask
quantities are totaled through the report cut-off date.
Each subtask is weighted according to the estimated level of
effort required for that subtask. These weights are the “rules
of credit” and are listed for each subtask.
The actual quantity for the subtask is multiplied by the sub-
task’s weight in order to obtain the subtotal of quantity
21.3
AACE INTERNATIONAL PROJECT LABOR COST CONTROL
Table 21.2–Daily Production Report.
GLOSSARY TERMS IN THIS CHAPTER
earned value ◆ schedule variance
work breakdown structure (WBS)](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-266-320.jpg)
![completed for the account. For this example, 767 linear feet
(LF) of edge form was erected by day 30. This amount is mul-
tiplied by 0.6, the weight for erecting edge forms, to obtain
the equivalent completed units for the account of 460 LF.
The subtotal for each subtask is totaled to obtain the equiva-
lent actual quantity for the account. The total of 608 lf is the
sum of 460 LF (erect form) plus 111 LF (wreck forms) plus 37
lf (clean and oil forms).
Earned Value Method
Once the actual inputs and outputs are measured, the project
management team compares the actual inputs and outputs to
the project budget inputs and outputs. This comparison
occurs at both the cost code and project levels (or at any level
in the WBS). The dollars and workhours cost cannot be com-
pared directly to the budget dollars and workhours because
the actual is only for completed work, whereas the budget
dollars and workhours are for the entire project.
In the earned value labor cost control system, the budget dol-
lars or workhours is multiplied by the percent of work com-
pleted to calculate the earned value. The percent complete for
the cost account is the actual quantity divided by the fore-
casted total quantity (see equation 1). The forecasted total
quantity is the project management team’s current assess-
ment of the total quantity included in the cost account. The
earned value is compared directly to the actual cost to evalu-
ate project cost performance. Earned value is measured by
either workhours or labor dollars. Earned value is also
referred to as the budgeted cost of work performed (BCWP).
(equation 1)
Percent complete (single account) = (actual quantity)
(forecasted total quantity)
The relationship between the earned value and the budget is
expressed in equation 2:
(equation 2)
Earned value (BCWP) = (actual percent complete) x
(budget for the account)
As can be seen from this equation, a portion of the budget
dollars or workhours is earned as a task is completed up to
the total budget in that account. One cannot earn more than
has been budgeted. If an account has a budget of $3,200 and
100 workhours and the account is now 25 percent complete,
then $800 and 25 workhours have been earned. Cost per-
formance is measured by comparing the earned value to the
actual cost. Earned value and actual cost can be measured in
either dollars or workhours. Also, earned value and actual
cost can be for a period or the total to-date. The actual cost
comparison can be a ratio or a variance as illustrated in equa-
tions 3 and 4.
(equation 3)
Cost Variance (CV) = (earned value) - (actual cost)
(equation 4)
Cost Performance Index (CPI) = (earned value)
(actual cost)
Note that a positive variance and an index of 1.0 or greater
indicate a favorable performance.
Since progress in all accounts can be reduced to earned work-
hours and dollars as illustrated, then multiple accounts can
be summarized and overall progress calculated as shown in
equation 5.
(equation 5)
Percent Complete (multiple accounts) = (earned value all accounts)
(budget cost all accounts)
The estimated total dollars or workhours at completion
(EAC) is determined by predicting the overall cost perform-
ance index at the completion of the cost account. There are
several sophisticated forecasting techniques that are
explained in management science texts, but few constructors
are comfortable with them and their reliability appear no bet-
ter than utilizing a few simple approaches. One fact is certain.
No two methods, sophisticated or otherwise, produce the
same answer. Three basic approaches are provided here [1].
Method 1: assumes that work from this point forward will
progress at the budget (CPI = 1) whether or not this perform-
ance has prevailed to this point. (See Equation 6.)
(equation 6)
Estimate at Completion (EAC) = (actual cost to-date) +
(budget - earned value)
Method 2: assumes that the performance to-date will contin-
ue. (See Equation 7.)
(equation 7)
Estimate at Completion (EAC) =(budget) / (CPI)
Method 3: Utilizes historical curves that show the normal vari-
ation in the CPI as the cost account progresses. The forecaster
simply makes the best extrapolation possible using the typical
shapes of such curves and whatever other information may be
available to the forecaster to make the projection.
21.4
PROJECT LABOR COST CONTROL AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-267-320.jpg)
![It is recommended that no single forecasting method be used.
Rather, include a forecast by each of the above methods in
order to provide a range of possibilities.
Both the quantities installed and the labor unit rate deter-
mine labor dollars or workhours. The labor unit rate is
expressed in either dollars per unit or in workhours per unit.
Multiplying the workhours per unit yields the dollars per
unit. Overall cost performance depends on both quantity
variances and unit rate variances.
As can be seen from the calculation of earned value, cost
overruns occur when actual quantities installed total more
than the budget quantities. This occurs when the budget
quantities is based upon an inadequate scope, when there are
mistakes in the estimate takeoff, when scope creep occurs
after the budget is prepared, when the field force installs
more quantities than what was required, and when there is
rework due to poor workmanship. Cost overruns also occur
when the actual unit rate (dollars per unit or workhours per
unit) is greater than the budget unit rates.
The credit value is the budget unit rate multiplied by the actu-
al quantities of work installed [1, p. 11-4]. The credit value rep-
resents what the cost would have been if the actual quantities
were installed at the budget unit rate. The credit value is
computed using equation 8a or 8b, and the unit of measure
can be dollars or workhours. Comparing the credit value to
the actual cost measures the performance of the unit rate
alone without the confounding effect of changes in quanti-
ties. Use the unit cost (dollars per unit) for the budget unit
rate to calculate credit dollars (C$). For an analysis by work-
hours, use the production rate (workhours per unit) to calcu-
late credit workhours (CWH). The unit cost index is the ratio
of the credit dollars (C$) to the actual dollars. (See equation
9.) The productivity index is the ratio of the credit work-
hours (CWH) to the actual workhours. (See equation 10.)
(equation 8a)
Credit dollars = (actual quantity) x (budget unit cost)
(equation 8b)
Credit workhours = (actual quantity) x (budget
production rate)
(equation 9)
Unit Cost Index (UCI) = (credit dollars)
(actual dollars)
(equation 10)
Productivity Index (PI) = (credit workhours)
(actual workhours)
A significant feature of an earned value analysis is that the cal-
culated earned value can be compared to the scheduled value
to measure schedule performance. The scheduled value is the
value in dollars or workhours of work scheduled. It is also
known as the budgeted cost of work scheduled (BCWS). The
BCWS is computed using either equation 11 or 12.
(equation 11)
Scheduled value (BCWS) = (scheduled percent complete) x
(budget dollars or workhours)
(equation 12)
Scheduled value (BCWS) = (quantity scheduled) x
(budget unit cost or production rate)
Schedule performance is measured by comparing the earned
value to the scheduled value. This comparison can be a vari-
ance, as in equation 13, or a ratio, as in equation 14.
(equation 13)
Schedule Variance (SV) = (earned value) - (scheduled
value)
(equation 14)
Schedule Performance Index (SPI) = (earned value)
(scheduled value)
Note that a positive variance and an index of one or greater
is a favorable performance.
In Table 3, the scheduled value (BCWS) is calculated at the
end of day 30 of the project. Day 30 is the cut-off date for the
example used in this chapter.
The detailed description of each field in the schedule report
for cost account 03140 appears below.
• The budget labor dollars are listed for each account. This
is $1,440 for account 03140.
• The start date is expressed as the beginning of the day.
The slab edge forms are scheduled to start at the begin-
ning of day 26.
• The number of workdays scheduled by the cut-off date,
day 30, is 5 for account 03140. The five days are days 26
through 30 inclusive (26, 27, 28, 29, and 30).
• The BCWS is calculated by multiplying the budget labor
dollars or workhours by the percentage of work that
should have been accomplished by the cut-off date. For
this example, the assumption is that an equal amount of
work is scheduled for each day. Therefore, the scheduled
percentage complete is equal to the scheduled days at
day 30 divided by the total duration. The scheduled per-
21.5
AACE INTERNATIONAL PROJECT LABOR COST CONTROL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-268-320.jpg)
![• The actual cost of work performed (ACWP) is gathered
from the daily time cards. For cost account 03140, the
ACWP is $288.
• The budgeted cost of work performed (BCWP) is also
known as the earned value. The BCWP is calculated by
multiplying the budget labor
dollars by the percentage of work actually completed. The
actual percent complete is the actual quantity divided by
the forecast quantity. For account 03140, the actual percent
complete is 608 lf divided by 2,880 LF, or 21.11 percent. The
BCWP is $1,440 multiplied by 21.11 percent, or $304.
• The credit dollar (C$) is equal to the budgeted unit cost
multiplied by the actual quantity. This is the amount that
would have been spent to produce the actual quantity at
the budget unit cost. The budget unit cost is the budget
dollars divided by the budget quantity. For cost account
03140, the budget unit cost is $1,440 divided by 2,880 LF,
or $0.50 per LF. The C$ is $0.50 per lf multiplied by 608
LF, or $304. Note that the C$ is equal to the BCWP. This
will always be the case when the forecast quantity is
equal to the budget quantity.
• The cost performance index (CPI) is a measure of the cost
performance. It is calculated by dividing the BCWP by
the ACWP. Indexes greater than one indicate good cost
performance. Indexes of less than one point towards
poor cost performance. For cost account 03410, the CPI is
equal to $304 divided by $288, or 1.056, which indicates
good performance.
• In Table 4, the estimated total dollars or workhours at
completion (EAC) is computed assuming that the cost
performance to-date will continue until the cost account is
completed. The EAC is calculated by dividing the budget
labor dollars by the CPI. The CPI is equal to 1.00 for
accounts that have no actual data. For cost account 03410,
the EAC is equal to $1,440 divided by 1.056, or $1,364.
• The schedule performance index (SPI) is a measure of
schedule performance. The SPI is the ratio of the BCWP
to the BCWS. Indexes greater than one indicate good
schedule performance and indexes of less than one point
towards poor schedule performance. For cost account
03410, the SPI is equal to $304 divided by $360, or 0.844,
which indicates poor schedule performances; i.e., the
edge forms are behind schedule.
• The unit cost index (UCI) is a measure of unit cost per-
formance. The labor unit cost is a combination of both
labor productivity and wage rates. Variances between the
budget unit cost and actual unit cost are generally caused
by differences in productivity. Therefore, the UCI is an
indirect measure of labor productivity. The UCI is the ratio
of the C$ to the ACWP. Indexes greater than one indicate
good unit cost performance and indexes of less than one
point towards poor unit cost performance. For cost
account 03410, the UCI is equal to $304 divided by $288, or
1.056. Note that the UCI is equal to the CPI for this account.
Since there is no variance between the budget quantities
and actual quantities, the overall cost performance is deter-
mined solely by the unit cost variance.
UNIT RATES METHOD
The unit rates labor cost control system is another method for
the project management team to compare the actual inputs
and outputs to the project budget inputs and outputs. This
method makes comparisons at the cost code level, total proj-
ect level, or at any level in the WBS. In the unit rates labor
cost control system, actual dollars or workhours to-date are
used to calculate actual unit rates (dollars per unit or work-
hours per unit). The actual unit rates are then analyzed to
forecast the unit rates at the completion of the account. The
estimated total dollars or workhours at completion (EAC) is
calculated by multiplying the estimate at completion unit
rates by the forecasted quantities. The EAC is then compared
to the budget dollars or workhours to determine cost per-
formance. Note that at the account level, to-date unit rates
can be compared directly to the budget unit rates to deter-
mine performance.
The estimated total dollars or workhours at completion
(EAC) is analogous to finding the EAC in the earned value
method. It is determined by predicting the overall unit rates
at the completion of the cost account. The three basic
approaches for determining EAC are restated here for the
unit rates method.
Method 1: assumes that work from this point forward will
progress at budget unit rates whether or not these rates have
prevailed to this point. (See Equation 15.)
(equation 15)
Estimate at Completion (EAC) = (actual dollars or work-
hours to-date) + [(to go quantity) (budget unit rate)]
Method 2: assumes that the unit rate prevailing to-date will
continue to prevail. (See Equation 16.)
Estimate at Completion (EAC) = (total quantity) x
(actual unit rate)
Method 3: utilizes historical curves that show the normal
variation in unit rates as the cost account progresses. The
21.7
AACE INTERNATIONAL PROJECT LABOR COST CONTROL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-270-320.jpg)
![INTRODUCTION
It has been recognized for some time that cost professionals,
and other professionals, are faced with an unprecedented
rate of technological change and growing competitiveness in
the marketplace. However, it also is recognized that technol-
ogy and competition can be more easily managed than the
human element of the enterprise. Some have noted that the
managing change would present few problems if it were not
for the people who create and are affected by the change
(Conference Board, 1969). This presents even greater chal-
lenges for today’s leaders. This chapter examines different
approaches to leadership—one of the most important aspects
of project management.
LEARNING OBJECTIVES
After completing this chapter, readers should be able to
• recognize some of the key contributions to the field of
leadership and management,
• describe the challenges of working with multicultural
teams and identify advantages they afford,
• recognize some theories of motivation and some critical
motivation mistakes to avoid, and
• appreciate the challenges associated with business ethics
at the individual and organizational levels.
LEADERSHIP STYLES
Today’s leaders must work to promote a team culture and
establish partnerships with customers and suppliers. This is
done through communication and information sharing among
all stakeholders. Leaders now are considered team players.
The leader does not work to control team members, but
instead works to obtain commitment from them to support
goals and objectives by fostering open communication,
increased productivity through group efforts, and participato-
ry decision making. The leader may not be necessarily a tech-
nical expert, as his or her expertise is in leading the team to
reach success on each endeavor as measured by its goals and
objectives. A number of theories and writings of behavioral
scientists have influenced the development of leadership
styles. Five key contributions are discussed in this section.
Douglas McGregor
In The Human Side of Enterprise [19], Douglas McGregor was an
early proponent of management as a profession. McGregor
stated that management demands a scientific base of research
and application to make it a successful profession. He said that
to develop the professional manager, first the manager should
examine how he or she saw himself or herself in relation to the
job of managing human resources. The starting point is a set of
fundamental beliefs or assumptions of what people are like. He
developed two theoretical constructs of the nature of man in
relation to his work, known as Theory X and Theory Y. Theory
X includes the following assumptions:
• The average person has an inherent dislike of work and
will avoid it if possible.
• The average person must be coerced, controlled, direct-
ed, or threatened with punishment to put forth adequate
effort toward achievement of organizational objectives.
• The average person prefers to be directed, wishes to
avoid responsibility, has relatively little ambition, and
wants security.
• Control should be externally imposed.
Theory Y assumptions include the following:
• People are self-motivated and will exercise self-direction
and self-control toward achieving objectives to which
they are committed.
22.1
Chapter 22
Leadership and Management of Project People1
Dr. Ginger Levin
AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE
1This chapter includes modified excerpts from Flannes, Steven W., and
Ginger Levin. 2001. People Skills for Project Managers. 2001. Management
Concepts, Inc. Reprinted with permission.](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-276-320.jpg)
![• Average people learn to not only accept but also seek
responsibility.
• People are capable of a high degree of imagination, inge-
nuity, and creativity in solving organizational problems.
• The average person’s intellectual potential is only par-
tially used.
Central to a discussion of McGregor’s two theories is the
matter of control. Under Theory X, control is externally
imposed, while Theory Y emphasizes self-control or an inter-
nal control. Theory Y implies that within a climate of trust
and respect, the employee is capable of putting forth willing
effort and controlling work habits. Theory Y presented a flex-
ible view and opened up a wide range of possibilities for new
managerial policies and practices.
Frederick Herzberg
Frederick Herzberg [12] studied the relationship between the
role of work and working conditions. He developed a moti-
vation-hygiene theory based on the concepts of satisfiers and
dissatisfiers. He found that real motivation resulted from the
worker’s involvement in accomplishing an interesting task,
not from the working conditions or environmental factors
that are peripheral to the job. The hygiene factors, though,
must be adequately provided if a person is to rise above them
and be able to involve oneself in meaningful tasks. Managers
need to recognize the disparate nature of hygiene factors and
motivators and increase the challenging content of the job.
Herzberg’s emphasis on job enrichment stated that increas-
ing the challenging content of the job would cause the
employee to grow both in skill and in a feeling of accom-
plishment.
Chris Argyris
Chris Argyris [2] advanced some of McGregor’s theories
and said that the organization may be the source and cause
of human problems. He felt that individual needs and orga-
nizational needs were not met effectively in most organiza-
tions, as he described the dichotomy between these two sets
of needs. Part of the problem, Argyris noted, was due to the
bureaucratic nature of organizations and their hierarchical
structures; he was an early proponent of the concept of ad
hoc work groups, or project teams, that cross-cut organiza-
tional lines. Argyris felt that the organization must change
to conform to human needs, and that the organization
should offer meaningful challenges and opportunities for
responsibilities. A climate of open communication and trust
is needed in all interpersonal relationships. Argyris advo-
cated the development of interpersonal competence and
authenticity in relationships as the first step in dealing with
any personal differences that may block information flow
and understanding of objectives at the individual, unit, and
organizational levels.
Rensis Likert
Well-known for the development of an attitude measurement
approach known as the Likert-type scale, Rensis Likert [15] also
developed the concept of the linking pin—a person who
belongs to two groups in the organization. The linking pin
shows that the entire organization is viewed as a set of over-
lapping and interacting groups. Likert advocated open com-
munication within groups, development of mutual trust, con-
sensus decision-making, group goal setting, definition of roles,
and shared responsibility. He said that real authority is not just
official or formal authority, but is dependent on how much
authority a manager’s subordinates allow the manager to exert
over them, regardless of formal authority position. As Likert
stated, the amount of influence a manager exerts over subordi-
nates is determined by how the manager allows himself or her-
self to be influenced by them. The degree of group commitment
and involvement is based on the extent to which the manager
considers the opinions of subordinates in reaching a decision
whose outcome has impact upon the group. Likert [16] further
developed four basic styles of leadership related to a wide
range of organizational variables:
• exploitive-authoritative,
• benevolent-authoritative,
• consultative, and
• participative group.
These four styles exist in everyday practice, but he directed
his attention toward the participative group, which he felt
was ideal for a human-concerned organization.
Robert Blake and Jane Mouton
In 1962, Dr. Robert Blake and Dr. Jane Mouton developed a con-
cept called the managerial grid [4]. They felt there was an
unnecessary dichotomy in the minds of most managers
between concern for people problems and concern for produc-
tion problems. These concerns are complementary. They said
that each manager has a discernible style of management based
on the degree of concern for production and people. At one end
is the manager who is only concerned with production; at the
other end is the manager who coddles people at the cost of lost
production. There are 81 possible positions on their manageri-
al grid representing leadership styles; of these, though, there
are five key styles. Ideally, on the grid, a manager should be a
9,9. This manager stresses team management. Concern for peo-
ple and production are interdependent. The manager’s job is
one of a coach, an advisor, or a consultant.
TEAMS
It has long been recognized that teams out-perform individ-
uals acting alone, especially when performance involves
multiple skills and areas of expertise. However, groups of
people do not become a team merely because they are
22.2
LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-277-320.jpg)
![assigned to one. They must be collectively committed to each
other and mutually accountable. As noted by Katzenbach
and Smith [13], “the wisdom of teams comes with a focus on
collective work products, personal growth, and performance
results. However meaningful, ‘team’ is always a result of
pursing a demanding performance challenge.”
A team begins as a group of individuals with different moti-
vations and expectations. Some people are pleased to be part
of the team; others are not. Some people want to have signif-
icant responsibility on the team and want to lead it, while
others want to follow. People also bring views as to how
teams should operate and stereotypes that reflect one’s views
and attributes toward members of various groups. Not
everyone will view the project with the same attitudes.
These conditions create an environment in which individuals
determine the conditions on the team. Individual accountabili-
ty must be merged with mutual accountability. Team members
must be committed to a common approach as to how they
might best work together. Performance challenges should ener-
gize teams, as a team’s performance goals must always relate to
its overall purpose [13]. Clear goals can help reduce the poten-
tial for future disruptive conflicts and minimize any past dif-
ferences among the various people represented on the team. As
Parker [22] notes, the people who come together to be part of
the team will be effective to the extent that they agree on a com-
mon goal, set aside their individual priorities and agendas,
develop a plan to reach that goal, and then commit to work
together to attain it.
CROSS-CULTURAL CONCERNS
Culture, as defined by the American Heritage Dictionary [1],
is “The totality of socially transmitted behavior patterns, arts,
beliefs, institutions, and all other products of human work
and thought.” It includes political, economic, demographic,
educational, ethical, ethnic, religious, and other areas, includ-
ing practices, beliefs, and attitudes, that affect the way people
and organizations interact [24].
All organizations are becoming more culturally diverse with
each passing business day. People working on teams in the
field of cost management, for example, often consist of mem-
bers representing many different nationalities, languages,
and cultures. This cultural richness brings many advantages
to a team in the form of different backgrounds, values,
norms, and perspectives. However, the characteristics that
add richness to a team also increase its complexity. With mul-
ticultural teams, the team leader must create vehicles to
bridge the cultural gap and bring the team together. A man-
ager working with a multicultural team needs to be aware of
these cultural differences and take special care to avoid the
potential risks associated with them.
Culture affects our work in many ways. Research has shown
that birth culture has a greater effect on a worker’s frame of
mind than does organizational culture. A worker, no matter
how well he or she adopts the organization’s culture, is still
motivated primarily by the cultural environment in which he
or she was raised.
In such a multicultural world, the manager or team leader
faces a variety of issues, such as managing the team member
who may be bicultural and dealing with a culture that may
be different from that of the organization. This includes a
wide range of challenges from language barriers and time
differences to religious diversity and differences in food pref-
erences. For example, in some cultures that value harmony,
indirectness, and shared identify, conflict is seen as a loss of
face. Open discussion and resolution of conflict is viewed as
negative, and a direct approach to conflict resolution, such as
a confrontational style, is considered threatening. Here, con-
flict is best handled behind the scenes, using a smoothing or
compromising method. Other cultures that value confronta-
tion see conflict as a positive force as it allows ideas to be
aired and insights to be shared in an open fashion. As anoth-
er example, some cultures view risks as only the responsibil-
ity of the executives in the organization, while others view it
as the team’s responsibility.
For a manager working in settings that involve multicultural
issues, it is important to recognize the effect of cultural fac-
tors. In the area of communications, the manager must be
aware of verbal and nonverbal differences, and recognize
that cultural differences can result in misunderstandings.
The manager should remain conscious of the fact that cultur-
al differences do exist and try to accommodate these differ-
ences if possible. Diversity itself, although a challenge, is also
the source of many creative issues. A multicultural team does
have greater potential for higher productivity and innova-
tion. Cultural differences should not be ignored or mini-
mized, and if a cultural difference does cause a problem, it
should be addressed. Awareness of cultural differences
among team members may even make the difference
between success and failure.
22.3
AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE
GLOSSARY TERMS IN THIS CHAPTER
culture ◆ empowerment ◆ ethics
hierarchy of needs ◆ leadership ◆ management
motivation ◆ motivation-hygiene theory ◆ team
Theory X management ◆ Theory Y management](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-278-320.jpg)
![LEADING, MANAGING, FACILITATING,
AND MENTORING
Similar to many leaders, cost engineers and other profession-
als are often promoted into leadership roles for reasons relat-
ed to technical competency, not demonstrated leadership and
management skills. This technical professional then must
acquire functional knowledge of basic leadership and man-
agement skills, because ultimately the success and failure of
all projects can be traced to the “people” component. Carr,
Hard, and Trahant [6] and Fitz-Enz [8] offer resources related
to generic managerial and leadership skills. The importance
of this elusive, people component remains constant in
today’s complex world in which sophisticated technology
and software resources are available to manage the intricate
processes of any project.
Working with a team of people, the manager faces many
challenges. These include the following:
• uncertain organizational resource support for the project,
• extreme time pressures,
• first-time challenges to solve unique and complicated
problems,
• a wide variety of personnel and other resource interde-
pendencies, and
• challenges of obtaining resources from senior managers
who may not totally support the project.
As a result, the successful manager must bring special skills
and abilities to the organization. He or she must be able to
• apply both technical and managerial skills in addition to
operating as a generalist;
• motivate the team toward the goals and objectives of the
project while still attempting to meet each individual’s
professional goals;
• create group cohesion without succumbing to “group
think;”
• think and thrive under pressure while integrating and
resolving conflicting priorities and goals of other stake-
holders;
• drive the team toward excellence;
• work with the emotional, intellectual, and physical chal-
lenges in the start-up and close-out phases of the project;
• think in terms of three dimensions– timely delivery, cost
compliance, and task performance; and
• create mechanisms within the team that encourage the
discussion of conflict and balance the process through
methods that motivate the team toward decisive action.
The role of the project manager is multifaceted. During a proj-
ect, the project manager then must be able to assume four dif-
ferent roles: that of leader, manager, facilitator, and mentor.
Leadership
Being a leader of a project is a more subtle, complicated role
than simply being the person who is in charge of the project
and is supposed to deliver it on time and within budget.
True leadership involves the ability to conceptualize the
vision and direction of the project and then be able to com-
municate and sell this vision to the team members and other
stakeholders. In this context, vision is not an idealistic, amor-
phous concept of the project, but involves identifying the
purpose of the project. This involves listening to the cus-
tomer to determine the added value the project will bring
and recognizing what the customer is not saying.
Once the project manager has discussed the purpose of the
project, the next step is to create a personal vision of its pur-
pose. The key point is to create a personal representation of
the true purpose of the project, noting subtle goals and the
customer’s true requirements. This then enables the project
manager to be confident and motivated to begin the project
and to determine how to best sell this process to the team and
required stakeholders.
The next step is to begin a dialogue with the team members on
the subject of the project’s purpose. The project manager must
create an atmosphere in which all team members are encour-
aged to ask questions about the purpose of the project and to
offer opinions and clarification. Additionally, the project man-
ager must gain credibility and must demonstrate managerial
actions and behaviors that are consistent with verbally
espoused values. Congruence in actions and stated values is
crucial because it creates a state of comfort and trust for team
members that enables the person to take the leader at face
value and become involved in the task without holding any
reservations, doubts, or hesitation. Leadership also involves
an active role in being the team’s voice to the outside world.
The leader needs to communicate actively with outside partic-
ipants who affect the success of the project to address stake-
holders in terms of supporting and buying into the project
goals, obtaining needed project resources, providing updates
and progress reports, and addressing conflict in a productive
and forthright manner. Active communication between the
project manager and various stakeholders maintains sponsor
support, creates needed ongoing liaisons, and helps reduce the
risk of unexpected obstacles hindering the project.
Management
The manager role ensures the project is completed on time,
within budget, and at acceptable levels of performance. It
involves creating the administrative procedures and structure
to monitor completion of the work. The manager role, viewed
from the perspective of people challenges, involves creating an
administrative system with enough structure and discipline to
complete the project without the structure stretching into the
realm of excessive bureaucracy. It is important to balance the
need for structure and the need for autonomy and flexibility.
22.4
LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-279-320.jpg)
![Facilitation
Facilitation is one of the more subtle, yet profound roles for
the project manager. Facilitation is those behaviors and atti-
tudes that help others get their work done and is often
achieved through the art of influencing others. It involves
communication abilities, conflict resolution, the ability to
actively procure necessary supplies and resources for the
team as a hole, and the ability to motivate both individual
team members and the team ass a unit. Team-focused moti-
vation involves the creation of strategies that unite the team
in common action and rewards that are realistic. The goal is
to provide team members with choices, options, and a con-
ductive setting and then trust that the team members will cre-
ate the desired outcome. A project manager who is adept at
helping team members address and resolve conflict in a pro-
ductive manner promotes facilitation.
Mentor or Coach
The roles of mentoring and coaching are becoming increas-
ingly important areas in the workplace. They can be defined
as those processes in which one person (the mentor or coach)
assists another person, either formally or informally, in vari-
ous tasks related to the general purposes of professional
growth and development. This assistance takes the form of
guidance and encouragement, which may or may not be
directly tied to an actual project issue being faced by the indi-
vidual but instead may be directed at assisting the individual
in attaining a broader view of future career directions or
advancement. The role of mentoring and coaching involves
the following:
• being a role model who demonstrates desired skills,
behavior, and attitudes whose adoption may benefit
team members;
• demonstrating a genuine, personal interest in the welfare
and professional growth of team members;
• offering suggestions, possibilities, resources, problem-
solving approaches, and opportunities to think-out-loud
with team members regarding current or future issues;
• providing feedback that is supportive and also frank and
accurate; and
• offering motivation directed toward assisting team
members in identifying and achieving long-term profes-
sional goals.
The Four Key Roles
Thus, the most effective project manager is able to assume
these four roles—leader, manager, facilitator and mentor—
throughout the project and has competency in each of the
four areas. Additionally, the project manager needs the skill
of timing to determine when to move from one role to anoth-
er, since projects have different needs at different times.
MOTIVATORS AND DEMOTIVATORS
What is Motivation?
Used in the context of this chapter, motivation is defined as
“That process, action, or intervention that serves as an incen-
tive for a project team member to take the necessary action to
complete a task within the appropriate confines and scope of
performance, time, and cost”[10].
The impetus for taking action may come from either intrinsic or
extrinsic sources of motivation. Intrinsic motivation is that
which arises from a source within a team member, such as a
desire to obtain new skills or the need to confront a stimulating
personal challenge. Extrinsic sources of motivation involve a
force outside of the individual, such as recognition from one’s
peers in a professional association or at a conference or a man-
ager providing a sizeable pay increase for a job well done.
Members of a high-performance team tend to be motivated by
both sources. The manager or leader, working with his or her
team, should strive to search for both intrinsic and extrinsic
sources of motivation when working with each team member.
Motivational Challenges
Motivation is particularly difficult because of three strong
forces and trends: the continuing ongoing reductions in force;
the unspoken contract between the employee and employer,
which has changed dramatically over the past 20 years; and
the increase in the number of team members that are from
different backgrounds and viewpoints.
Organizations in both the public and private sectors continue
to downsize. Even organizations that are experiencing
growth in one sector of their operations may downsize in
other sectors. Nearly all downsizing results in situations in
which those who survive are required to do more with less.
Frequently, the survivors have experienced feelings of anger
and guilt that clearly decrease motivation [21]. It is not
unusual to find pervasive cynicism and skepticism among
the surviving employees, which creates an environment that
makes motivation difficult at best.
The contract between the employer and the employee in
today’s operating environment primarily focuses on the
organization owning the job with the employee owning the
career. This differs from the era before the 1970s, in which
employees often perceived an unspoken contract between
themselves and their employer, grounded in the belief that
quality job performance and loyalty would be in turn
rewarded by job security. In today’s environment, the man-
ager must instead be creative in developing motivational
approaches and processes that are part of the current reality.
The richness of team members from different backgrounds, as
noted in the previous section, brings many positive contribu-
tions to the work environment. However, it can be a richness
22.5
AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-280-320.jpg)
![that also complicates the process of motivating team mem-
bers, since the “norms” for what is viewed as motivating can
be so different across the different cultural groups and loca-
tions involved. Greater sensitivity is required of the manager
who is responsible for motivating people from different cul-
tural backgrounds. Knowledge must be acquired as to what
is motivating for each individual, while at the same time
avoiding the pitfall of generalizing as to what will be moti-
vating for specific cultural groups.
Other Motivational Considerations
It is important to recognize that people bring with them a cer-
tain amount of “baggage” that will affect their motivation.
This baggage can be feelings, attitudes, or expectations that
have a negative tone and are the result of previous negative
personal or professional experiences of the individual
involved. The baggage then becomes an impediment to the
person’s positive engagement with the work to be done.
Sources of such baggage include the following:
• previous or ongoing organizational problems,
• industry changes,
• health issues,
• career stalling, and
• personal problems.
It is also important to be aware of some motivational mis-
takes. The following are some examples:
• what motivates me will probably motivate others,
• people are primarily motivated by money,
• everyone wants to receive a formal award,
• team members are motivated by quotas,
• each person needs a rally slogan,
• the best leader is a strong cheerleader,
• people who are professionals do not need motivating,
• people only need to be motivated if there is a problem,
• everyone should be treated the same, and
• just find one thing that motivates each person and then
stay with it.
Motivation of project team members is one of the most chal-
lenging tasks of managers. It must address individual issues
as well as organizational issues. Sources of motivation are
both fluid and dynamic. As a manager, a good practice to fol-
low is to ask each person what he or she finds to be particu-
larly motivating. This practice, although simplistic, will pro-
vide the manager with a wealth of current and specific infor-
mation that cannot be obtained through any other method.
Theories of Motivation
Traditionally, theories of motivation have characterized the
subject from the perspective of evolution, biology, drives,
needs, and social influence. Each of these perspectives is in
agreement that individuals display a wide range of motives.
An overview of these theories of motivation begins with the
premise that motivation involves goal-directed behavior.
• Biological perspective is considered an evolutionary
approach. It asserts that actions or behaviors that con-
tribute favorably to the preservation and expansion of
the species will produce motivation. It is appropriate
when confined to the more basic aspects of human
behavior, such as hunger and thirst, reproduction, and
the need for affiliation for the goal of basic survival.
• Drive theories state that certain behaviors are the result
of individuals meeting the requirements of specific
drives. Drives are considered complex combinations of
internal stages of tension that cause the individual to
take action to reduce the level of tension. The goal of
reducing tension is to achieve an internal state of equi-
librium or balance or “homeostasis.” Individuals in this
model are believed to desire homeostatic states in their
lives, and behavior is motivated because of attempts to
maintain this balance. Similar to evolutionary theories,
these drive theories work best when applied to the most
basic human behaviors. They are often insufficient when
trying to explain the complex behavior and skills
involved in management.
• Incentive theories state that individual behavior is
pulled in certain directions based on the external condi-
tions in the specific setting. Much of the field of learning
theory and instrumental learning work conducted by the
noted psychologist, B.F. Skinner, is based on the incen-
tive type of motivation. These approaches can work in
settings when the manager and team member have the
ability and the resources to identify a desired behavior
that can be awarded by providing the identified incen-
tive. The incentives must be valued by the group and
may need to come directly from the group members.
The incentives also need to be appropriate to the culture
of the organization.
• Theory of needs is another approach to motivation pri-
marily based on work done by David McClelland [18],
who developed the concept that people who value the
need for achievement are often those people who are the
leaders in the areas of creativity and economic growth.
This approach is based on premises that, as humans,
challenging environments provide us with an opportu-
nity to achieve excellence, or to compete against others
successfully will provide motivation. The need to
achieve and compete within one’s own professional dis-
cipline can self-motivate many individuals.
• Fear of failure can describe another motivational basis to
act and succeed. This approach can be a strong motiva-
tor in situations when the consequences for failure are
22.6
LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-281-320.jpg)
![especially distasteful or catastrophic. However, it should
be employed only in unusual circumstances, such as if a
project is headed for crisis, and immediate action is
required. If it is employed too frequently, it may create a
crisis management, disaster-avoiding environment, which
will easily lead to employee burn out and dissatisfaction.
• Hierarchical theory of motivation was set forth by
Abraham Maslow [17]. It adopts the premise that the
basic physical needs and more subtle social or psycho-
logical needs will motivate people. Maslow states that
people are motivated by the desire to satisfy these vari-
ous needs according to a hierarchy, with the most basic
needs placed at the bottom of a “needs pyramid.” When
one need is satisfied, the individual will then move
upward to the next need. Maslow’s hierarchy of needs
can be described as follows:
-Level 1—physiological needs (food, thirst),
-Level 2—security and safety needs (stability, survival),
-Level 3—belonging needs (affiliation, love),
-Level 4—esteem needs (achievement and the acquisi-
tion of recognition),
-Level 5—cognitive needs (knowledge),
-Level 6—aesthetic needs (beauty, order), and
-Level 7—self-actualization needs (the realization of
one’s personal potential).
• Career stages is a different approach presented by Schein
[25] through a model that describes major stages in a per-
son’s career. An understanding of an individual’s current
career stage by the leader can be used in developing tan-
gible approaches to individual motivation. This model
has 10 career stages.
-Stage one and stage two occur in the person’s life before
entering the world of work and involve early years of
career exploration followed by formalized career prepa-
ration, such as higher education and specialized train-
ing.
-Stage three is the first formal entry into the workplace
where real world sills of the profession are acquired.
-Stage four refers to training in the concrete application of
skills and professional socialization, which occur as the
identity of being a professional is becoming established.
-Stage five occurs when the individual is observed as
having gained full admission into the profession based
on competency and performance.
-Stage six is the point at which the individual gains a
more permanent membership in the profession.
-Stage seven is the natural mid-career assessment or cri-
sis period during which questions are asked as to the
value of the career and what has been accomplished.
-Stage eight is the challenge of maintaining momentum
as the career starts to move into its final chapters.
-Stage nine is when the individual beginning to disen-
gage from the profession and the world of work.
-Stage ten is the retirement stage in which the individual
must come to some form of closure of employment with a
specific organization or membership in a certain profession.
Schein also stated that our personal values affect our
enjoyment and pursuit of various tasks in the workplace,
and, as a result, the more we understand our own values
in specific areas, the better we are able to achieve work
satisfaction. Therefore, our motivation will be greatest
when we pursue tasks and functions consistent with our
values. Schein identified eight of these values, which he
describes as career anchors; the word anchor suggesting
a person’s self-image of what is important for them as
they consider the aggregate of their skills, motives, and
values. These eight values are as follows:
-technical-functional,
-general managerial,
-autonomy and independence,
-security and stability,
-entrepreneurial creativity,
-service and dedication to a cause,
-pure challenge, and
-lifestyle.
• Empowerment is another approach suggested by
Meredith and Mantel [20] in which a team environment
be established in which the members experience a strong
sense of empowerment through the use of participatory
management methods. Empowerment is defined as an
approach that stresses individual initiative, solution cre-
ation, and accountability. The team is then motivated by
the opportunity to be self-determinative in creating the
structure and methods to achieve its goals.
ETHICAL THEORIES AND APPLICATIONS
For any professional, in any discipline, ethics is an emotion-
ally and intellectually charged word. It prompts images of
moral responsibility and obligation, scholars debating the
intricacies of profound issues, and arguments between pro-
fessionals and social commentators about right and wrong
behavior. Other images are those such as a professional over-
sight board ruling on professional conduct or misconduct;
discussions about financial or corporate malfeasance, and the
like [9].
Business ethics is considered a management discipline
because of the social responsibility movement that began in
the 1960s. During the 1960s, social awareness movements
emphasized the expectations of businesses to use their influ-
ence to address social problems. People asserted that since
22.7
AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-282-320.jpg)
![businesses were making profits, it was also their responsibil-
ity to work to improve society. Many replaced the word
“stockholder” with “stakeholder,” including employees, cus-
tomers, suppliers, and the wider community. By the 21st cen-
tury, 90 percent of business schools provide some type of
training in business ethics. However, philosophers, academ-
ics, and social critics traditionally have handled the field of
business ethics. Much of the literature that is available is not
geared to the practical requirements for the behavior of lead-
ers and managers. And, while there is no shortage of differ-
ing opinions about what businesses should do in various sit-
uations, there is little information on ways to actually imple-
ment ethical practices.
One definition is that ethics “is the science of judging specif-
ically human ends and the relationship of means to those
ends” or “the art of controlling means so that they will serve
specifically human ends.” It, therefore, involves techniques
of judging and decision making, as well as tools of social con-
trol and personal development. Accordingly, it is or should
be involved in all human activities. In terms of business,
ethics is concerned with the relationship of business goals
and techniques to human ends. It studies the impacts of acts
on the good of the individual, the organization, the business
community, and society as a whole [11]. Another definition is
that it is “the guidelines or rules of conduct by which we aim
to live” [5]. As Cadbury explains, while it is difficult enough
to resolve dilemmas when one’s personal rules of conduct
conflict, the real difficulties arise when one must make deci-
sions affecting the interests of others. Often it is necessary to
balance the interests of employees against those of share-
holders and the differing views that exist among the share-
holders. What matters most is how one behaves when faced
with decisions that involve combining ethical and commer-
cial judgments.
Most organizations have ethics programs, but many are
unaware of them. These ethics programs typically are com-
posed of values, policies, and activities that affect the propri-
ety of organization behavior. Ethics is a matter of values and
associated behavior. Several principles have been set forth for
highly ethical organizations:
• They easily interact with diverse internal and external
stakeholder groups. The ground rules of these firms
make the good of the stakeholder groups part of the
organizations’ own good.
• They are obsessed with fairness. The ground rules
emphasize that other peoples’ interests count as much as
their own.
• Responsibility is individual, not collective; individuals
assume personal responsibility for the actions of the
organization. The ground rules state that individuals are
responsible to themselves.
• Activities are viewed in terms of purpose; this purpose is
a way of operating that members of the organization
value highly. The purpose ties the organization to its
environment [23].
There are few, if any, ethical truths or standards that can be
memorized and applied in a concrete fashion in all settings
applicable to cost and project management. Ethical behavior
is difficult to qualify and operationalize. It can be viewed as
a process that one goes through, a method to consider the
conflicting and often contentious agendas of those involved.
It is not an action taken after the consideration of memorized
rules of conduct. It is, instead, the actions that are taken as a
result of the individual having engaged in a process of con-
sidering the needs of the various stakeholders, thinking
through the consequences of various actions, and arriving at
an action that is grounded in a good faith approach to respect
the rights of those involved [10].
The difficulty of establishing sound ethical norms for an
organization cannot be underestimated, as the ethical climate
of an organization is extremely fragile. The task requires
unremitting effort, and ethical codes can be helpful, although
not decisive [3]. In the end, society sets the ethical framework
within which those who run companies must work out their
own codes of conduct. Business must take into account its
responsibilities to society in reaching its decisions, but socie-
ty must accept its responsibilities for setting the standards
against which decisions are made [5].
SUMMARY
The challenges associated with management of project peo-
ple are numerous and complex. But as a leader or manager,
one must establish direction, communicate this direction to
others, and motivate and inspire people to achieve goals and
objectives. This involves the necessity of developing a lead-
ership style that is appropriate to the specific organizational
situation, working more frequently with diverse groups of
people representing many different cultures, using the most
appropriate motivational approaches, and also taking profes-
sional responsibility for one’s actions.
REFERENCES
1. American Heritage Dictionary of the English Language.
Third Edition. 1992. Boston: Houghton Mifflin.
2. Argyris, C. 1964. Integrating the Individual and the
Organization. New York: Wiley.
3. Badaracco, J. L., and A. P. Webb. 1995. Business Ethics: A
View from the Trenches. California Management Review.
Winter.
22.8
LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-283-320.jpg)
![PRODUCTIVITY PARADOX
To complicate matters, some companies that have been
“reengineered” may have become leaner and smaller from
downsizing, but not necessarily fitter. It may have helped
them to survive, but they may still not have a distinct com-
petitive or quality advantage. In many cases, you cannot sim-
ply remove bodies if you do not also reduce the work; other-
wise, service levels erode and deteriorate. In addition, the old
methods and old systems usually remain in place.
Management may have met some short-term objectives, but
the surviving workforce is hopefully operating with the long
term in mind.
As a result of these types of changes, so-called improvements
in productivity do not always translate into a more profitable
business. This has been referred to as the productivity paradox.
Some organizations have invested in improving processes that
were not critical to their strategic success. Such processes may
have been improved, sometimes dramatically, but they did not
turn out to be sufficiently relevant to the organization’s long-
term performance and success. Process performance improve-
ment, cost reduction, and the like are managerial terms, but
they are not necessarily indicative of value added. Value is an
economic concept. However, with an advanced managerial
accounting system, increases or decreases to shareholder
wealth can be traced to the changes in features, functions, and
processes aimed at altering customer satisfaction.
In addition, simply being lean and agile will no longer be suf-
ficient for success. Companies’ success will depend on all the
trading partners in their supply chains behaving similarly.
Waste and redundancy created by interorganizational mis-
trust must be removed via collaboration. Ideally quality man-
agement can be a shared experience among trading partners
and a basis for communications.
THE ROLE OF CONTINUOUS IMPROVEMENT
PROGRAMS
Quality management encompasses many tools and tech-
niques under the umbrella of what is popularly referred to as
continuous improvement, including statistical process con-
trol (SPC), quality control, quality improvement, quality
assurance, and benchmarking. The emphasis in this chapter
is on measuring the financial accounting aspects, because Six
Sigma’s key differentiator is its emphasis on financial returns
justification (in contrast to its predecessor quality manage-
ment programs) and because AACE International is an
organization that approaches problem solving and manage-
ment from a cost viewpoint. There are substantial materials
about continuous improvement tools and techniques at the
Web site of the American Society for Quality at www.asq.org.
WHY IS TRADITIONAL ACCOUNTING
FAILING QUALITY MANAGEMENT?
One of the obstacles affecting quality management initia-
tives, and other initiatives as well, has been the shortcomings
of the financial accounting field. Part of the problem is the
traditional emphasis of accounting on external reporting.
A significant reason why traditional accounting fails quality
managers is that the initial way in which the financial data
are captured is not in a format that lends itself to decision
making. It is always risky to invest in improving processes
for which the true cost is not well established, because man-
agement lacks a valid cost base against which to compare the
expected benefits of improving or reengineering the process.
Gabe Pall, in The Process-Centered Enterprise, states:
Historically, process management has always suf-
fered from the lack of an obvious and reliable
method of measurement that consistently indicates
the level of resource consumption (expenses) by the
business processes at any given time—an indicator
which always interests executive management and
is easily understood. The bottom line is that most
businesses have no clue about the costs of their
processes nor their processes various outputs [5].
Another part of the problem involves attitudes. For some qual-
ity professionals, using quality to connect with the bottom line
or with executive thinking may seem irrelevant or, worse yet,
destructive. These quality professionals fear the danger of
managers who myopically focus on short-term results.
In short, understanding the economic contribution toward
increasing shareholder wealth from individual business
processes is a significant concern for management. When the
costs of processes and their outputs can be adequately meas-
ured financially, two things can happen:
1. The data can gain management’s attention and confi-
dence that they can depend on these managerial account-
ing data as reliable business indicators.
2. Management can more reliably assess the different worth
of processes and how they contribute to the overall per-
formance of the business.
Finally, another part of the problem is accountants and defi-
ciencies with their financial accounting system. The account-
ants’ traditional general ledger is a wonderful instrument for
what it is designed to do: post and bucketize (i.e., categorize)
transactions into their specific account balances. But the cost
data in this format (e.g., salaries, supplies, depreciation) are
structurally deficient for decision support, including measur-
ing cost of quality (COQ). The accounting community has
been slow to understand and accept this problem.
23.4
QUALITY MANAGEMENT AACE INTERNATIONAL](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-289-320.jpg)
![The quality professional’s focus should be on the quality of
cost as well as the COQ. That is, focusing on the quality of
cost ensures that any money spent on the business produces
its equivalent in value for the customer and the supplier’s
employees and shareholders. The COQ measures how much
cost is caused by poor quality. Both are important. This is a
before-investment view in contrast to an after-the-fact view.
The next section discusses the issues related to measuring the
financial dimensions of quality.
BRING FACTS, NOT HUNCHES
To some people, it is obvious that better management of qual-
ity ultimately leads to goodness that, in turn, should lead to
improved financial health of an organization. Perhaps some
of these same people have difficulty imagining a bridge of
linkages that can equate quality improvements with exactly
measured costs or profits. However, for them this does not
matter very much. These types of people operate under the
belief that if you simply improve quality, good things, such
as happier customers and higher profits, will automatically
fall into place.
Other types of people prefer having fact-based data and rea-
sonable estimates with which to evaluate decisions and pri-
oritize spending. These types of people do believe in quality
programs, but in complex organizations with scarce idle
resources, they prefer to be more certain they know where it
is best to spend the organization’s discretionary money.
Some quality managers have become skeptical about measur-
ing the COQ. They have seen increasing regulations and stan-
dards, such as the ISO 9000 series, where installing any form of
COQ measurement was perceived as more of a compliance
exercise to satisfy documentation requirements to become “reg-
istered” rather than a benefit to improve performance.
Some perceive quality and cost as an investment choice,
implying that there is a trade-off decision. This thinking
assumes that achieving better quality somehow costs more
and requires more effort. This is not necessarily true. If qual-
ity programs are properly installed, productivity can be
improved while also raising customer satisfaction. These two
combined eventually lead to increased sales, market penetra-
tion, and higher profits and returns.
Managers in the quality field have seen a number of quality
programs and tools come along. Some have fallen short of
their initial promise. The ISO 9000 series is the popular inter-
national standard. It addresses not only products and service
lines but also the processes and policies of an organization.
The benefits of the ISO 9000 accreditation included relieving
buyers of redundant supplier assessments, expansion of
assessments to the suppliers’ suppliers, protection against
product liability litigation, and a firm foundation upon which
organizations could potentially further develop their quality
development. However, a disadvantage of ISO 9000 is that it
represents only a minimum standard, perhaps insufficient to
induce competitive-advantage behavior. Also, due to its being
written in general terms, with a manufacturing origin, it is open
to interpretation with ambiguities for service sector organiza-
tions. Some complain that ISO 9000 serves as a documentation
tool with little extension to apply as a managerial tool.
Now, Six Sigma is vying to exhibit staying power as a quality
management program. Will it succeed, or is there an inherent
flaw? Six Sigma is viewed as a paradigm shift in the quality
arena. Veterans of quality management believe that quality
just for quality’s sake—meaning conformance to standard—is
not good. This sounds paradoxical. Quality is obviously need-
ed to capture and retain customers, but quality must also be
applied to the business itself. Six Sigma ensures that there is
emphasis on the conversion and the paperwork-related trans-
action processes as well. But Six Sigma goes much farther and
also suggests consideration of the business’ financial health.
A popular definition of quality preferred by Six Sigma advo-
cates is quality is a state in which value entitlement is real-
ized for the customer and the supplier (i.e., employees and
shareholders) in every aspect of the relationship. It is pre-
dictable that there will be debates about trade-offs among
shareholders, customers, employees, taxpayers, and the envi-
ronment. The methods of COQ measurement will be useful
to convert debates into agreements [3].
This new perspective acknowledges that investing addition-
al capital intended to reduce defect rates will not be sus-
tained unless shareholders and lenders feel assured of high-
quality financial returns to them. In Six Sigma, financial data
to support manager proposals for projects are absolutely
required. So, just like customers who demand utility-value,
owners, investors, and lenders have a rightful expectation of
profit-value and wealth creation.
This broader notion of quality is well beyond the more narrow
TQM of the 1990s. For producers, it is no longer enough to just
make and deliver quality goods and services. A quality busi-
ness must exist as well. The intent of Six Sigma is to refocus on
business economics as the driver of quality improvements.
WHAT IS QUALITY?
Before discussing the various costs of quality and how to
measure them, one should have a definition of quality itself.
To some the term quality might mean durability or richness in
a product or a pleasurable experience. This is a “fitness for
use” definition that relates to a customer’s needs. In the
1980s, a predominant supplier-oriented view defined quality
23.5
AACE INTERNATIONAL QUALITY MANAGEMENT](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-290-320.jpg)
![as being a high conformance to the buyer’s requirements or
specifications, usually measured at the time of final product
test. One of the risks of limiting the definition of quality to a
supplier “doing things right” is that it can miss the cus-
tomers’ real needs and preferences.
More recently, quality has been considered from a customer
satisfaction orientation to meet or exceed customer require-
ments and expectations. This shifts the view from the sell side
to the buy side. There has been substantial research about cus-
tomer preferences, both stated and subconscious, with elabo-
rate survey questionnaires, diagnostics, and conjoint statisti-
cal analysis. For example, “food” may be a customer’s stated
need, but “nourishment” or a “pleasant taste” are the real pri-
mary needs. A customer’s ultimate perception of quality
involves many factors. In short, the universally accepted goals
of quality management are lower costs, higher revenues,
delighted customers, and empowered employees.
IMPACT OF POOR QUALITY
Almost every organization now realizes that not having the
highest quality is not even an option. High quality is simply
an entry ticket for the opportunity to compete. Attaining high
quality is now a must. Anything less than high quality will
lead to an organization’s terminal collapse. In short, high
quality is now a prerequisite for an organization to continue
to exist. The stakes are much higher.
The quality techniques that have been applied in the past,
however, are still relevant. One of leaders in the quality
movement, Joseph M. Juran, has described managing for
quality by using three managerial steps, called the Juran
Trilogy [4, p. 2–7]:
1. Quality planning—translating customer needs into
characteristics of products and service lines (e.g., quality
function deployment analysis).
2. Quality control: measuring quality levels and compar-
ing them against desired levels (i.e., removing sporadic
deficiencies).
3. Quality improvement: implementing incremental
improvements to attain better levels of control (i.e.,
removing chronic deficiencies).
Figure 23.2 shows that each step leads to a result used in the
next step.
In the figure, sporadic problems are those that periodically
occur and are dealt with shortly after they happen. In effect,
the problem is quickly corrected until the process or off-spec
output is returned to an acceptable level. Sporadic problems
will likely continue to recur because the solution is usually
more a bandage than a real cure.
Chronic problems, in contrast, have usually existed for an
extended period of time and may be accepted or tolerated by
23.6
QUALITY MANAGEMENT AACE INTERNATIONAL
Figure 23.2—Juran’s Trilogy](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-291-320.jpg)
![the organization as known but unresolvable.
Examples include poor communications or inad-
equate tools for workers. Employees are often
resigned to the existence of chronic problems.
They are undesirable but expected to persist
because they have been subconsciously designed
and planned into the processes and procedures.
Organizations tend to concentrate on sporadic
problems because when they occur there is usu-
ally an adverse consequence, such as a customer
complaint or a missed delivery date. But the fix
may not necessarily be lasting. In contrast, the
elimination of chronic problems requires greater
effort. The solution may be the result of forming
a project team that produces an innovative solu-
tion. The problem analysis will likely be more
intent on truly understanding the root cause.
When root causes of chronic problems are
removed, improvements in performance and
costs can be substantial.
In Figure 23.2, sporadic problems can spike from an
unplanned event, such as a power failure. Immediately fol-
lowing these events teams troubleshoot and “put out the
fire,” which restores the error level back to the status quo—
the planned chronic level. The figure also reveals that after a
quality improvement initiative addresses the process, the
level of error is driven downward.
Another leader in the quality movement, W. Edwards
Deming, advocated a similar and now well-accepted set of
steps with his “Plan-Do-Check-Act” (PDCA) cycle, an itera-
tive approach to achieving preventive and corrective solu-
tions [4, p. 41.3–41.5]. Some now have reduced PDCA to a
more simple “Do-and-Reflect.” Regardless of the quality
techniques applied, financial measures will be increasingly
relevant as organizations move from decisions based on
instinct and intuition toward fact-based decisions.
CATEGORIZING QUALITY COSTS
To some people quality costs are very visible and obvious.
To others, quality costs are understated; and they believe
that much of the quality-related costs are hidden and go
unreported.
There are several levels of non-error-free quality costs, as
illustrated in Figure 23.3. The following discussion of scope is
restricted to the inner concentric circles, although there are
additional quality costs.
Figure 23.3 begins to reveal that there are other hidden finan-
cial costs and lost income opportunities beyond those associ-
ated with traditional obvious quality costs. Examples of obvi-
ous quality-related costs are rework costs, excess scrap mate-
rial costs, warranty costs, and field repair expenses. These
typically result from errors. Error-related costs are easily
measured directly from the financial system. Spending
amounts are recorded in the accountant’s general ledger sys-
tem using the “chart-of-accounts.” Sometimes the quality-
related costs include the expenses of an entire department,
such as an inspection department that arguably exists solely
as being quality-related. However, as organizations flatten
and de-layer, and employees multitask more, it is rare that an
entire department will focus exclusively on quality.
The hidden poor quality costs, represented in the figure’s
outer circle, are less obvious and are more difficult to meas-
ure. For example, a hidden cost would be those hours of a
few employees’ time sorting through paperwork resulting
from a billing error. Although these employees do not work
in a quality department that is dedicated to quality-related
activities, such as inspection or rework, that portion of their
workday was definitely quality-related. These costs are not
reflected in the chart-of-accounts of the accounting system.
That is why they are referred to hidden costs.
The lack of widespread tracking of the COQ in practice is
surprising because the tools, methods, and technologies exist
to accomplish reporting COQ. A research study [6] investi-
gating the maturity of COQ revealed that the major reason for
not tracking COQ was lack of management interest and sup-
port in tracking COQ and their belief that quality costing is
“paperwork” that does not have enough value to do. Other
major reasons for not tracking COQ were a lack of knowledge
23.7
AACE INTERNATIONAL QUALITY MANAGEMENT
Figure 23.3—Levels and Scope of Quality Costs](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-292-320.jpg)
![inclusion. This invites debate about arbitrariness or
ambiguity. However, when 100 percent of expenditures
are included, the COQ plus error-free costs exactly rec-
oncile with the same data used by executive manage-
ment and the board of directors. There is no longer any
suspicion that some COQ has been left out or that the
COQ data are not anchored in reality. By starting with
100 percent expenditures, the only debate can be about
misclassification, not omission.
The capture of COQ can be further refined if it is worthwhile
for the organization.
When making decisions, the universally popular costs-ver-
sus-benefits test can be applied with COQ data. If either sub-
category of COQ is excessive, it draws down profits for com-
mercial companies or draws down resources in government
agencies that could have been better deployed on higher-
value-added activities elsewhere.
GOALS AND USES FOR THE COQ
INFORMATION
If an organization makes the effort to collect data, validate
the information, and report it, it might as well use the infor-
mation. In fact, to state the obvious, the amount of use of and
utility in the information will be proportional to the length of
life of the COQ measurement system. In short, the uses of a
COQ measurement system can range from favorably influ-
encing employee attitudes toward quality management by
quantifying the financial impact of changes to assisting in
prioritizing improvement opportunities.
The rationale for implementing COQ is based on the follow-
ing logic:
• For any failure, there is a root cause.
• Causes for failure are preventable.
• Prevention is cheaper than fixing problems after they
occur.
If you accept the logic that it is always less expensive to do the
job right the first time than to do it over, the rationale and goal
for quality management and using COQ to provide a quality
program with concrete and fact-based data should be apparent.
Implementation involves the following steps:
• Directly attack failure costs with the goal to drive them to
zero.
• Invest in the appropriate prevention activities, not fads,
to effect improvements.
• Reduce appraisal costs according to results that are
achieved.
• Continuously evaluate and redirect prevention efforts to
gain further improvement.
Figure 23.8 on page 23.12 illustrates the direction in which qual-
ity-related costs can ideally be managed. Ideally, all four COQ
cost categories should be reduced, but one may initially need to
prudently increase the cost of prevention to dramatically
decrease the costs of and reduced penalties paid for nonconfor-
mance. This makes COQ more than just an accounting scheme;
it becomes a financial investment justification tool.
A general corrective operating principle is that as failures are
revealed, for example via customer complaints, the root caus-
es should be eliminated with corrective actions. A general
rule-of-thumb is that the nearer the failure is to it being used
by the customer, the more expensive it is to correct. The flip
side is that it is less expensive—overall—to fix problems ear-
lier in the business process. As failure costs are reduced,
appraisal efforts can also be reduced in a rationale manner.
QUANTIFYING THE MAGNITUDE OF THE
COSTS OF QUALITY
The formal COQ measurement system provides continuous
results. In contrast to a one-time assessment, it requires
involvement by employees who participate in the business
processes. More important, these employees must be moti-
vated to spend the energy and time, apart from their regular
responsibilities, to submit and use the data.
Commercial ABC/M software products were designed for
frequent repeated updating. For such a COQ system to be
sustained longer-term, the system requires senior manage-
ment’s support and interest as well as genuinely perceived
utility by users of the data to solve problems.
Regardless of the collection system selected, it is imperative
to focus analytical and corrective time and energy on the area
of failure costs. As Dr. Joseph Juran discussed in his highly
popular article, “Gold in the Mine,” there is still much “min-
ing” that can be performed [4, p. 8.1–8.11]. This mining
should be considered a long-term investment, because failure
costs, when starting a quality management program, usually
constitute 65 to 70 percent of a corporation’s quality costs.
Appraisal costs are normally 20 to 25 percent, and prevention
costs are 5 percent.
CONTINUOUS IMPROVEMENT WITH
BENCHMARKING AND UNIT COSTS
Tagging attributes onto costs is obviously a secondary pur-
pose for measuring costs. The primary purpose for costing is
to simply know what something costs. This data allows you
23.11
AACE INTERNATIONAL QUALITY MANAGEMENT](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-296-320.jpg)
![figure reveals how each of these subcategories can be tagged
against the ABC/M costs. This provides far greater and reli-
able visibility of COQ without the great effort required by
traditional cost accounting methods.
The quality movement has been a loud advocate for measur-
ing things rather than relying on opinions. It would make
sense that measuring the financial implications of quality
will become an increasingly larger part of the quality man-
agement domain.
SUMMARY
The reputation of quality management movement has expe-
rienced a few waves of ups and downs. It has become almost
religious-like for some years and then ridiculed. Hopefully,
the addition of valid costing data will give the quality move-
ment more legitimacy. In a recent publication from one of the
key sanctioning quality societies, The American Society for
Quality (ASQ), there was a key definition. ANSI/ISO/ASQ
Q9004-2000 suggests financial measurement as an appropri-
ate way to assess “the organization’s performance in order to
determine whether planned objectives have been achieved
[1]. Hopefully there will be increased coordination amongst
the quality, managerial accounting, and operations system.
REFERENCES
1. American Society for Quality. 2000. ANSI/ISO/ASQ
9004-2000. Milwaukee, Wisconsin: ASQ Quality Press.
2. Cokins, Gary. 2001. Activity-Based Cost Management: An
Executive’s Guide. New York: John Wiley & Sons.
3. Harry, Mickel J. 2000. New Definition Aims to Connect
Quality with Financial Performance. Quality Progress.
January. p. 65.
4. Juran, Joseph M. 1999. Juran’s Quality Handbook. New
York: McGraw-Hill.
5. Pall, Gabe. 2000. The Process-Centered Enterprise. New
York: St. Lucie Press. p. 40.
6. Sower, Victor E., and Ross Quarles. 2002. Cost of Quality
Usage and Its Relationship to Quality Systems Maturity.
Working Paper series. Center for Business and Economic
Development at Sam Houston State University. Lucie
Press, 2000), p. 40.
23.13
AACE INTERNATIONAL QUALITY MANAGEMENT
Figure 23.9—Typical Cost-of-Quality Components](https://image.slidesharecdn.com/01-skillsandknowledgeofcostengineering-231026110234-a7a70625/85/01-Skills-and-knowledge-of-cost-engineering-pdf-298-320.jpg)
01-Skills and knowledge of cost engineering.pdf
- 2. Skills & Knowledge of Cost Engineering Fifth Edition With New Appendix Listings Edited by Dr. Scott J. Amos, PE 2004
- 3. A Special Publication of AACE International – the Association for the Advancement of Cost Engineering SKILLS & KNOWLEDGE OF COST ENGINEERING Fifth Edition With New Appendix Listings Edited by Dr. Scott Amos, PE A continuing project of the AACE International Education Board Current Education Board Members: Mark T. Chen, PE CCE, Chair Dr. Scott J. Amos, PE, Co-Chair and Editor William R. Barry, CCE Lawrence J. Bloch, ECCE Brian D. Dunfield M. Steven Franklin, CCE Donald F. McDonald, Jr. PE CCE Franklin D. Postula, PE CCE Dr. Parviz F. Rad, PE CCE Rohit Singh, CCE Dr. George Stukhart, PE Michael B. Pritchett, CCE Sean T. Regan, CCE Harry W. Jarnagan, PE CCE Technical Production Staff: Charla Miller, Staff Director Education and Administration Marvin Gelhausen, Managing Editor Cathie Falvey, Production Editor Noah Kinderknecht, Graphic Designer
- 4. Support the AACE Education Fund Net proceeds from the sale of this book go to the AACE Education Fund and support scholarship grants at many colleges and universities in the U.S. and Canada. Your tax-deductible donations to the AACE Education Fund are also welcome in any amount. Donations are tax deductible in both the U.S. and Canada. Please make your checks payable to AACE and mail them to: AACE Education Fund 209 Prairie Avenue Suite 100 Morgantown, WV 26501 USA SKILLS & KNOWLEDGE OF COST ENGINEERING 5th Edition Copyright © 1987, 1988, 1992, 1993, 1999, 2002, 2004 by AACE International 209 Prairie Avenue, Suite 100, Morgantown, WV 26501 USA Printed in the United States of America ISBN: 1-885517-49-1
- 5. CONTENTS Preface Dr. Scott J. Amos, PE Dedication Donald F. McDonald, Jr PE CCE Acknowledgements INTRODUCTION Integration of Skills & Knowledge of Cost Engineering John K. Hollmann, PE CCE SECTION 1—COST 1. Cost Elements Franklin D. Postula, PE CCE 2. Pricing Rohit Singh, PEng CCE 3. Materials Neil D. Opfer, CCE 4. Labor Morris E. Fleishman, PE CCE 5. Engineering Neil D. Opfer, CCE 6. Equipment, Parts, and Tools Dr. Carl C. Chrappa 7. Economic Costs Neil D. Opfer, CCE 8. Activity-Based Cost Management Gary Cokins SECTION 2—COST ESTIMATING 9. Estimating Larry R. Dysert, CCC 10 Process Product Manufacturing Dr. Kenneth K. Humphreys, PE CCE 11. Discrete Product Manufacturing Dr. Robert C. Creese, PE CCE SECTION 3—PLANNING & SCHEDULING 12. Planning Jennifer Bates, CCE 13. Scheduling Anthony J. Werderitsch, PE CCE SECTION 4—PROGRESS & COST CONTROL 14. Progress Measurement and Earned Value Dr. Joseph J. Orczyk, PE CCE 15. Earned Value for Variable Budgets Dr. Joseph J. Orczyk, PE CCE 16. Tracking Cost and Schedule Performance Dr. Joseph J. Orczyk, PE CCE
- 6. 17. Performance and Productivity Management Dr. James M. Neil, PE CCE SECTION 5—PROJECT MANAGEMENT 18. Project Management Fundamentals James A. Bent, CCC 19. Project Organization Structure James A. Bent, CCC 20. Project Planning James A. Bent, CCC 21. Project Labor Cost Control Dr. Joseph J. Orczyk, PE CCE 22. Leadership and Management of Project People Dr. Ginger Levin 23. Quality Management Gary Cokins 24. Value Analysis Del L. Younker, CCC 25. Contracting for Capital Projects James G. Zack, Jr. 26. Strategic Asset Management John K. Hollmann, PE CCE SECTION 6—ECONOMIC ANALYSIS 27. Basic Engineering Economics Dr. Scott J. Amos, PE 28. Applied Engineering Economics Dr. Scott J. Amos, PE SECTION 7—STATISTICS, PROBABILITY, & RISK 29. Statistics & Probability Dr. Elizabeth Y. Chen and Mark T. Chen, PE CCE 30. Basic Concepts in Descriptive Statistics Dr. Frederick B. Muehlhausen 31. Risk Management Allen C. Hamilton, CCE APPENDICES A. Glossary of Terms B. International System of Units C. Estimating Reference Material D. RP 11R-88—Required Skills and Knowledge of a Cost Engineer E. RP 17R-97—Cost Estimate Classification System F. RP 18R-97—Cost Estimate Classification System—As Applied in Engineering, Procurement, and Construction for the Process Industries G. RP 21R-98—Project Code of Accounts—As Applied in Engineering, Procurement, and Construction for the Process Industries H. Proposed Scope Graphic for PSP I. Membership Information (Introduction, Application, Canon of Ethics) AUTHOR INDEX
- 7. PREFACE Cost Engineers: Who are they and what do they do? So just what is cost engineering and who are the people we call cost engineers? The first place to seek an answer is the AACE International Constitution and Bylaws, which states the following: Section 2. The Association is dedicated to the tenets of furthering the concepts of Total Cost Management and Cost Engineering. Total Cost Management is the effective application of professional and technical expertise to plan and control resources, costs, profitability and risk. Simply stated, it is a systematic approach to man- aging cost throughout the life cycle of any enterprise, program, facility, project, product or service. This is accomplished through the application of cost engineering and cost management principles, proven method- ologies and the latest technology in support of the management process. Section 3. Total Cost Management is that area of engineering practice where engineering judgment and expe- rience are utilized in the application of scientific principles and techniques to problems of business and pro- gram planning; cost estimating; economic and financial analysis; cost engineering; program and project man- agement; planning and scheduling; and cost and schedule performance measurement and change control. What this says is that the list of practice areas in Section 3 are collectively called cost engineering; while the “process” through which these practices are applied is called total cost management or TCM. Let’s elaborate a bit more. TCM and its subprocesses (strategic asset management and project control) are defined in the “integration” chapter that follows this preface. However, we can summarize that chapter by saying that TCM is a management process focused on coming up with ideas for creating things (i.e., a strategic assets), analyzing and deciding upon the best idea, and finally planning and creating the selected thing (i.e., by doing projects) in a controlled way (i.e., project control). So, that’s the process; but who performs the process? Many people would say that “engineers” and engineering are most often responsible for creating functional things (or strate- gic assets as we call them). They are correct. However, there are multiple elements to engineering. Most look at engineering and see the element of physical “design” and the calculation and analysis tasks that are done to support that physical design (e.g., design a bridge). Again they are correct. However, many people don’t see that beyond the physical dimension of the design (e.g., the bridge structure), there are less tangible dimensions of money, time, and other resources that are invested in the creation of the asset. We refer to these investments collectively as “costs”. Someone needs to estimate what the bridge might cost, determine the activities needed to design and build it, estimate how long these activities will take, and so on. Furthermore, someone needs to continually monitor and assess the progress of the bridge design and construction (in relation to the expenditure of money and time) to ensure that the completed bridge meets the owner’s objectives. This is a lot of work. It requires special skills and knowledge. The cost dimension requires calculation, analysis, planning, and control. No bridge has ever been built without dealing with both the physical and cost dimensions. However, the engineering skills and knowledge required to deal with “costs” are quite different from those required to deal with the physical design dimension. From that difference, the field of cost engineering was born. So, cost engineers work alongside of and are peers with engineers (or software analysts, play producers, architects, and other creative fields) to handle the cost dimension. And, returning to the Constitution and Bylaws definition, the skills and knowledge needed by that dimension are “business and program planning; cost estimating; economic and financial analy- sis; cost engineering; program and project management; planning and scheduling; and cost and schedule performance meas- urement and change control.” All these functions are performed in an integrated way through the process of TCM. Cost engineers often specialize in one function with a focus on one side of the asset and project business. They may have titles such as cost estimator, parametric analyst, strategic planner, scheduler, cost/schedule engineer, project manager, or project con- trol lead. They may work for the business that owns and operates the asset (emphasis on economics and analysis), or they may 6
- 8. work for the contractor that executes the projects (emphasis on planning and control). But, no matter what their job title or busi- ness environment, a general knowledge of, and skills in, all areas of cost engineering are required to perform their job effectively. The History of this Publication This AACE International publication had its beginnings in 1985, when the Education Board started work on the AACE Recommended Practice: Required Skills & Knowledge of a Cost Engineer. Board members included Brian D. Dunfield (Chair), Dr. Brisbane H. Brown Jr., Frank J. Kelly Jr., CCE, James M. Neil, PE CCE, and Gord Zwaigenbaum, CCE. The AACE staff admin- istrator supporting the Education Board was Barry G. McMillan, our current AACE International executive director. The document Required Skills & Knowledge of a Cost Engineer was published in August 1986 in Cost Engineering magazine. Then in 1987, a 13-session workshop was organized and presented at the AACE Annual Meeting in Atlanta. The presenters prepared instructional materials for the workshop, and Dr. James M. Neil, PE CCE, served as editor for a new AACE publication con- taining all of the instructional materials. The publication, Special Supplement-1987 Transactions, was the 1st edition of this publication. Similar sessions have been presented at AACE annual meetings every year since that first effort in 1987. The following year (1987), the 2nd edition was published with its present title, Skills & Knowledge of Cost Engineering. Dr. James M. Neil, PE CCE, again served as editor. The content was increased to 17 chapters, and a consistent style was adopted. Five years later (1992), the 3rd edition was published with Donald F. McDonald Jr., PE CCE, and Dr. James M. Neil, PE CCE, serving as co-editors. A large number of AACE International members became involved in the updating and revising of the published materials. The 18 chapters in this edition were presented as the basis of a system for teaching the basic skills and knowledge any cost engineer should possess. The 4th edition—published in 1999 with Dr. Richard E. Larew, PE, CCE serving as editor—added new chapters, problems, and solutions, while grouping closely-related chapters into eight parts. The AACE International Canon of Ethics was also includ- ed as an appendix. This Edition The 5th edition, with 31 Chapters organized into seven sections, is the first step in aligning the content of educational materi- als within the Association to improve their value in the certification preparation process. Special attention is given to the need to have a good match between materials in this Skills & Knowledge of Cost Engineering and the AACE International Certification Study Guide. New chapters include: As in past editions, all new materials have been subjected to independent reviews by professional cost engineers and other sub- ject area experts. Introduction – Integration of Skills and Knowledge of Cost Engineering Chapter 1 – Cost Elements Chapter 2 - Pricing Chapter 3 - Materials Chapter 4 - Labor Chapter 5 – Engineering Chapter 6 – Equipment, Parts, Tools Chapter 7 – Economic Costs Chapter 8 – Activity Based Cost Management Chapter 9 – Estimating Chapter 21 – Project Labor Cost Control Chapter 22 – Managing Project People Chapter 23 – Quality Management Chapter 24 – Value Analysis Chapter 25 – Contracts Chapter 26 – Strategic Asset Management Chapter 29 – Statistics and Probability Chapter 31 - Risk 7
- 9. The Next Edition The Education Board will begin to review this 5th edition a short time after it has been published. It will begin to ask: What technical corrections are needed? Which chapters need to be updated or rewritten? Which chapters need to be converted to SI units? How can chapters best be grouped? Are there chapters that should be eliminated or combined with others? Should more multiproject and enterprise level chapters be included? In addition, the Education Board will be considering needed changes in other AACE International publications. You, the read- er and user of this publication, can be of great help to the Education Board and AACE International. You can make note of changes you believe should be made in the next edition. You can offer to help write or edit the next edition. Please take the time to send your suggestions to the Education Board chair. If your present objective is to become certified as a CCE or CCC, we hope this publication will be helpful to you. A final reminder: net income from this publication goes into the fund for competitive scholarships offered by AACE International. A special thanks to John Hollman and Dr. Richard E. Larew who contributed significantly to this preface. Dr. Scott J. Amos, PE Springfield, MO January 2004 8
- 10. Dedication to Dr. James M. Neil, PE 1927 - 2003 AACE International Education Board Member 1982 – 1990 This 5th edition of the Skills & Knowledge of Cost Engineering is dedicated to the memory of Dr. James M. Neil, PE who was the editor of the first and second editions of this Education Board publication. Jim was much more than an editor and contributor to the early edi- tions. He was an accomplished author, teacher, leader, and mentor to many AACE mem- bers and countless others in the profession. It is through Jim’s collective works and mentoring efforts that the first edition of the “S&K” text was an instant success that allowed future expanded editions to build on that success. This is the most popular book that AACE International has ever produced. The original scope of cost engineering skills was a product of a survey developed by Jim Neil to ascertain what was important to working professionals. It listed hundreds of topics of relevant areas of technical expertise. Jim compiled an index of the most important and most used technical areas and, based on the response from AACE’s membership, deter- mined what was relevant and what was not. This led to the identification of the skills and knowledge of cost engineering standard criteria, and subsequently to the publication of the book, Skills and Knowledge of Cost Engineering, of which he was editor and author of nearly 50 percent of the material included in the first edition. While Jim’s mentoring and quiet advice has led many AACE members to become polished cost engineers, Jim and his wife Delores, became a part of the Association’s extended family. Jim and Delores have helped many members learn how to com- bine and balance our social and professional lives. The editor and authors of the 5th edition, along with AACE’s Education Board, are dedicated to continually improving on Jim Neil’s great start to the Skills & Knowledge series. We would encourage you to embrace the positive spirit Jim Neil embodied and use it to improve your knowledge of cost engineering. by Donald F. McDonald, Jr. PE CCE – Education Board Member 9
- 11. Introduction John K. Hollmann, PE CCE Cost Elements Franklin D. Postula, PE CCE Pricing Rohit Singh, PEng CCE Materials Neil D. Opfer, CCE Labor Morris E. Fleishman, PE CCE Engineering Neil D. Opfer, CCE Equipment, Parts and Tools Dr. Carl C. Chrappa Economic Costs Neil D. Opfer, CCE Activity-Based Cost Management Gary Cokins Estimating Larry R. Dysert, CCC Process Product Manufacturing Dr. Kenneth K. Humphreys, PE CCE Discrete Product Manufacturing Dr. Robert C. Creese, PE CCE Planning Jennifer Bates, CCE Scheduling Anthony J. Werderitsch, PE CCE Progress Measurement and Earned Value Dr. Joseph J. Orczyk, PE Earned Value for Variable Budgets Dr. Joseph J. Orczyk, PE Tracking Cost & Schedule Performance Dr. Joseph J. Orczyk, PE Performance and Productivity Management Dr. James M. Neil, PE CCE Project Management Fundamentals James A. Bent, CCC Project Organization Structure James A. Bent, CCC Project Planning James A. Bent, CCC Project Labor Cost Control Dr. Joseph J. Orczyk, PE Leadership and Management of Project People Dr. Ginger Levin Quality Management Gary Cokins Value Analysis Del L. Younker, CCC Contracting for Capital Projects James G. Zack, Jr. Strategic Asset Management John K. Hollmann, PE CCE Basic Engineering Economics Dr. Scott J. Amos, PE Applied Engineering Economics Dr. Scott J. Amos, PE Statistics and Probability Mark T. Chen, PE CCE Dr. Elizabeth Y. Chen Basic Concepts in Descriptive Statistics Dr. Frederick B. Muehlhausen Risk Management Allen C. Hamilton, CCE Editor Dr. Scott J. Amos, PE Production of Skills & Knowledge, 5th Edition Charla Miller Marvin Gelhausen Cathie Falvey Noah Kinderknecht These individuals contributed to the development of the first four editions: Introduction Dr. Richard E. Larew, PE CCE Donald F. McDonald, Jr. PE CCE Brian D. Dunfield Cost Estimating Basics Charles P. Woodward, PE CCE Mark T. Chen, PE CCE Duane R. Meyer, PE CCE Donald F. McDonald, Jr. PE CCE Dr. Kweku K. Bentil Franklin D. Postula, PE CCE Raymond A. Cobb Order-of-Magnitude Estimating Charles P. Woodward, PE CCE Mark T. Chen, PE CCE Duane R. Meyer, PE CCE Donald F. McDonald, Jr. PE CCE Dr. Kweku K. Bentil Franklin D. Postula, PE CCE Raymond A. Cobb Definitive Estimates Charles P. Woodward, PE CCE Mark T. Chen, PE CCE Duane R. Meyer, PE CCE Donald F. McDonald, Jr. PE CCE Dr. Kweku K. Bentil Franklin D. Postula, PE CCE Raymond A. Cobb ACKNOWLEDGEMENTS AACE International wishes to thank all contributors to the publication and to thank their employers for their support in mak- ing this most important project possible. Special thanks to AACE International staff members: Barry G. McMillan, Executive Director; Charla Miller, Staff Director Education and Administration; Marvin Gelhausen, Managing Editor; and Noah Kinderknecht, Graphic Designer. Thanks also to the Production Editor, Cathie Falvey. The following are persons who con- tributed to the development of this edition: 10
- 12. Manufacturing & Operating Costs Dr. Robert C. Creese, PE CCE Dr. Kenneth K. Humphreys, PE CCE Cost Estimating Methods for Machining Operations Dr. Robert C. Creese, PE CCE Planning Jennifer Bates, CCE Remo J. Silvestrini, PE Dr. James M. Neil, PE CCE David L. Freidl, PE CCE Scheduling Basics Jennifer Bates, CCE Dr. James M. Neil, PE CCE Dr. Brisbane H. Brown, Jr. David L. Freidl, PE CCE James A. Bent, CCC Dr. Gui Ponce de Leon, PE Donald J. Fredlund, Jr. Project Management Fundamentals James A. Bent, CCC Project Organization Structure James A. Bent, CCC Project Planning James A. Bent, CCC Contract Packages; Contracting Arrangements James A. Bent, CCC Basic Concepts in Descriptive Statistics Dr. Frederick B. Muehlhausen The International System of Units (SI) Kurt G. R. Heinze, CCE Communication Dr. George Stukhart, PE Change Control and Risk Analysis James A. Bent, CCC Word Processing & Graphics LaQuita Caraway Consulting Technical Editor Judith Harris Bart Editor Dr. Richard E. Larew, PE CCE Donald F. McDonald, Jr. PE CCE Dr. James M. Neil, PE CCE Scheduling Techniques Jennifer Bates, CCE Dr. James M. Neil, PE CCE Dr. Brisbane H. Brown, Jr. David L. Freidl, PE CCE Progress & Cost Control I Dr. Joseph J. Orczyk, PE Dr. James M. Neil, PE CCE F. Fred Rahbar Project & Cost Control II Dr. Joseph J. Orczyk, PE T. Lynn Hyvonen Dr. James M. Neil, PE CCE F. Fred Rahbar Project & Cost Control II Dr. Joseph J. Orczyk, PE Dr. James M. Neil, PE CCE F. Fred Rahbar Progress Measurement and Earned Value Dr. Joseph J. Orczyk, PE Earned Value for Variable Budgets Dr. Joseph J. Orczyk, PE Tracking Cost and Schedule Performance Dr. Joseph J. Orczyk, PE Basic Engineering Economics Dr. Scott J. Amos, PE Julian Piekarski, PE CCE Applied Engineering Economics Dr. Scott J. Amos, PE Julian Piekarski, PE CCE Performance & Productivity Management Dr. James M. Neil, PE CCE Dorothy J. Burton Constructability Dr. James M. Neil, PE CCE Dorothy J. Burton Value Engineering Dr. James M. Neil, PE CCE Dr. Brisbane H. Brown, Jr. Dorothy J. Burton Managing Contracts James A. Bent, CCC Dr. Gui Ponce de Leon, PE Donald J. Fredlund, Jr. Project Management Fundamentals James A. Bent, CCC Project Organization Structure James A. Bent, CCC Project Planning James A. Bent, CCC Contract Packages; Contracting Arrangements James A. Bent, CCC Basic Concepts in Descriptive Statistics Dr. Frederick B. Muehlhausen The International System of Units (SI) Kurt G. R. Heinze, CCE Communication Dr. George Stukhart, PE Change Control and Risk Analysis James A. Bent, CCC Word Processing & Graphics LaQuita Caraway Consulting Technical Editor Judith Harris Bart Editor Dr. Richard E. Larew, PE CCE Donald F. McDonald, Jr. PE CCE Dr. James M. Neil, PE CCE 11
- 14. 13 AACE INTERNATIONAL INTRODUCTION LEARNING OBJECTIVES The objective of this chapter is show how the various skills and knowledge of cost engineering are integrated or brought together into a whole. There are three ways to view or model integration: from a work process or application perspective, from a human or organizational competency perspective, or from a physical perspective. This chapter examines the skills and knowledge of cost engineering from all three perspec- tives. It also serves as an adjunct to the text index, by show- ing how the various chapters are integrated in accordance with the integrative models. At the end of the chapter, the reader should understand the following concepts: • how cost engineering skills and knowledge can be inte- grated through a work process, specifically the total cost management (TCM) process; • how cost engineering skills and knowledge can be inte- grated within the competency of a cost engineering professional and the collective competencies of an organization; • how cost engineering skills and knowledge about indi- vidual resource types are integrated through creation of an asset; • challenges to successful integration (e.g., bureaucracy, complacency, and lack of vision); and • how the chapters of this text come together as a whole. The reader of this chapter is expected to gain a conceptual understanding of how the skills and knowledge of cost engi- neering come together as a whole, not to learn the details of any particular integration model (e.g., TCM) or any particu- lar skill or knowledge area. CONCEPTS Integration Integration is broadly defined as bringing things together as a whole. However, this definition begs the question of a whole what?. In this chapter, “what” is defined a whole process (the activities cost engineers do), a whole person and organization (what cost engineers know and skills they have), and a whole asset (things that firms that employ cost engineers own). One author has referred to these three dimensions as the “strategic resources” of an organization [2]. As an integrative process model, AACE International is developing the Total Cost Management Framework [3]. The Framework defines TCM as the sum of the practices and processes that an enterprise uses to manage the total life cycle cost investment in its portfolio of strategic assets. The prac- tices are called cost engineering; the process through which the practices are applied is called TCM. By its nature, the TCM process is integrative. However, it is the people in organizations that make processes work. Only when an enterprise integrates its process with people that have the right set of skills and knowledge for the right tasks at the right time (i.e., the right personal and organizational competencies) will a process give an enterprise a competitive advantage. Furthermore, there is a physical or resource dimension to integration. The objective of TCM is to manage the invest- ment of resources through projects or programs in strategic assets. The asset is the physical end result of the integration of resources. So, integration can be thought of as the combi- nation of process plus competency plus resources as brought together in projects to create competitive strategic assets. There are factors that impede integration (i.e., that lead to disintegration). From a process and organizational perspec- tive, bureaucracy is a major impediment. In a bureaucracy, INTEGRATION OF THE SKILLS AND KNOWLEDGE OF COST ENGINEERING John K. Hollmann, PE CCE
- 15. 14 INTRODUCTION AACE INTERNATIONAL the steps of a process are viewed as ends in themselves, and competency in an organization is viewed as skill in perform- ing a particular step without regard for skill in facilitating the process. Bureaucracy works against successful team devel- opment. On an individual level, complacency is an impedi- ment because integration requires that individuals renew their skills and knowledge to match the changes that occur in the work environment and process. Finally, a lack of vision of the objective of the TCM process impedes integration because failure to understand how all the resources come together in a project or asset risks project performance and/or asset quality. Lacking vision, the project or asset will not come together as a “whole” to meet the owner’s needs and expectations. Effective integration then is the dynamic combination of process, competency, and resources with an eye on project and asset objectives. By “dynamic,” we mean that the people in an enterprise know when to modify their processes, renew their skills, and leverage shared resources in a way that yields projects, programs, and assets that collectively meet the owner’s changing needs and expectations and give the enterprise a competitive advantage. Integration from a TCM Process Perceptive We will start our discussion of how the skills and knowledge of cost engineering and the chapters in this text are integrat- ed by first examining the process perspective. TCM is a process map that by its nature is integrative. The TCM process model is based upon the “PDCA” management or control cycle (also known as the Deming or Shewhart cycle). The PDCA cycle is a generally accepted, quality driven, con- tinuous improvement management model. PDCA stands for plan, do, check, and assess, with the word check being gener- ally synonymous with measure. The word assess is sometimes substituted with the word act as in “to take corrective action”. Figure 1 shows the TCM process map at an abstract level. In TCM, the PDCA model is applied in a nested manner, where- by the basic PDCA process is applied for each asset and group of assets, and then again for each project being per- formed to create, modify, maintain, or retire those assets. The two levels of the TCM process in Figure 1 are called the strategic asset management and project control processes. Project control is a process nested within the project imple- mentation step of strategic asset management. An enterprise will have a portfolio of assets in various stages of their life cycles, and during each asset’s life cycle, many projects will be performed (often as a program) to create, modify, or ter- minate that asset. Chapter 26 covers how the steps and activities of cost engi- neering come together in the strategic asset management process (left side of Figure 1). The four chapters in section 4 (chapters 14 to 17) then describe how various cost engineer- ing activities, and tools come together in project control (right side of Figure 1). Products, in terms of the owner’s technology, design, and knowledge of the product manufacturing process, are assets to an enterprise. As such, TCM also applies to the design and manufacturing of products. Chapters 10 and 11 describe how various activities and tools of cost engineering come togeth- er in process product and discrete product manufacturing applications respectively. Manufacturing applications such as materials requirement planning (MRP) are covered in these chapters. Below the general application level, a more detailed process map is needed to understand how the individual skills and knowledge of cost engineering are integrated. The process maps in Figure 2 and Figure 3 provide the additional detail. Portfolio of Enterprise Assets STRATEGIC ASSET PLANNING PROJECTS IMPLEMENTATION STRATEGIC ASSET PERFORMANCE MEASUREMENT STRATEGIC ASSET PERFORMANCE ASSESSMENT Strategic Asset Management Process PROJECT PLANNING PROJECT ACTIVITY IMPLEMENTATION PROJECT PERFORMANCE MEASUREMENT PROJECT PERFORMANCE ASSESSMENT Project Control Process Portfolio of Projects Plan Do Check Assess Plan Do Check Assess Figure 1—Total Cost Management Process Map [3]
- 16. 15 AACE INTERNATIONAL INTRODUCTION Project Performance Assessment Scope Development Planning & Scheduling WBS Cost Estimating & Budgeting Resource Planning Value Engineering Risk Analysis & Contingency Analysis Basis & Feedback Analysis Basis & Feedback Communicate, Execute Plans Schedule Baseline (Activities) Cost Baseline (Budget) Resource Baseline (Quantities) Iterative, concurrent processes Project Accounting Performance Measurement Asset, Project History & Learnings Strategic Asset Management Improvement Opportunities (variance from baseline plans) Forecasting, Corrective Action, & Change Management Project Requirements Assessment Strategic Asset Scope Description, Project System Requirements, & Budget Expenditure and Progress Measures Baseline Plans Strategic Performance Assessment Investment Options Development Estimating, Parametric Analysis, ABC Economic & Profitability Analysis Problem and Decision Analysis Value Engineering & Management Risk Analysis & Management Analysis Basis & Feedback Analysis Basis & Feedback Project Implementation Decision (Resource Allocation for Selected Option) Iterative, concurrent processes Asset and Project Accounting Asset Performance Measurement Project Control Improvement Opportunities (variance from baseline plans) Strategic Requirements Assessment Asset Performance and Valuation Measures Baseline Asset Mgmt Plans Enterprise Management Business Strategies, Goals, Objectives, Requirements Strategic Scope, Requirements, and Budget Project Performance, History & Learnings Asset Life Cycle Operations Asset Performance, History & Learnings Figure 2. The TCM Strategic Asset Management Process [3] Figure 3. The TCM Project Control Process [3]
- 17. 16 INTRODUCTION AACE INTERNATIONAL The next few paragraphs briefly describe the TCM sub-process maps shown in these two figures, and then show how the other text chapters are linked using these process maps. The strategic asset management process is detailed in Figure 2. This subprocess starts on the left with assessing the enter- prise’s objectives, requirements, and resource constraints. Benchmarking and other methods are also used to identify performance improvement opportunities for new or existing assets. The information from these steps is used in formulat- ing strategic asset performance requirements. Considering the requirements and opportunities (and moving towards the center of the figure), asset investment options are identified and developed, and then evaluated and decided upon using a wide variety of asset planning and decision making tech- niques that should be familiar to cost engineers. The invest- ment decisions that are made become part of the enterprise’s integrated asset portfolio management plan. Asset invest- ment plans and requirements are then communicated to and executed by project teams. The project teams return complet- ed assets to the owner. Moving to the right side of Figure 2, performance of assets and the project system that creates those assets are measured. A key measure is profitability, but there are many other meas- ures such as quality. Coming back around to the left of the figure, asset performance is assessed to determine if the prof- itability, quality, and other measures vary from asset man- agement plans and objectives. Also, trends or changes in per- formance are evaluated. If everything is according to plan, the strategic management process continues its cycle. If there are performance deviations noted, action should be taken to correct or improve the trend. If performance correc- tions will affect asset portfolio investment plans, or changes to enterprise requirements or resource availability occur, then asset portfolio investment plans must be managed to incorpo- rate the changes. On the right of Figure 2, there is project implementation step. The project control process is nested within that project imple- mentation step. Project control, as detailed in Figure 3, is a process for controlling the investment of resources in an asset. On the left side of Figure 3, a project starts with assessing the enterprise’s strategic asset requirements and aligning them with project performance requirements. Based upon the proj- ect requirements, the project technical scope and integrated plans for cost, schedule, and resource management are devel- oped. The various planning steps in the middle of Figure 3 should again be familiar to cost engineers. Project perform- ance is measured against these plan baselines. Moving to the right side of Figure 3, the project plans are communicated to and executed by the project team. Teams usually include both owner and contractor personnel; there- fore, contracting is integral to this step. The performance of project activities is then measured. Measurement steps include accounting for cost expenditures and commitments, as well as physical progressing that includes measures of the work and resource quantities that have been completed. Moving back around to the left of Figure 3, activity perform- ance is assessed. Assessment determines if the expenditures and progress vary from the plans and if there are trends in performance. If everything is according to plan, the project control process cycle continues on with more measurements. If performance deviations or trends are noted in assessments, action is taken to correct or improve the performance trend. Forecasting techniques (scheduling, estimating, and resource planning) are used to determine if corrective actions will achieve plan targets. If performance corrections will affect the project scope (or changes to the requirements or scope are initiated by the owner), the project baseline plans must be managed to incorporate the changes. The process maps in Figures 2 and 3 give a general idea of how the various skills and knowledge areas come together as a whole. However, the figures fail to show how truly inte- grated the process steps are. For example, the project plan- ning and scheduling, estimating, and resource steps are closely tied. Estimators help determine activities for the schedule; schedulers determine activity duration that affects the estimated productivity; estimators provide resource quantities, that when loaded in a schedule, support resource planning, and so on. It is beyond the scope of this chapter to describe the myriad interconnections—however, readers must not view each step of the process map as independent (i.e., the bureaucratic view). Having laid out the more detailed process maps, the follow- ing paragraphs describe how some of the text chapters are integrated from a process perspective. Chapters 12 and 20 deal with planning both from a strategic and a project perspective. Chapter 12 describes high level activities and tools that roughly correspond to the asset plan- ning process steps in Figure 2 (i.e., from requirements assess- ment through project plan implementation). Chapter 20 cov- ers the corresponding project planning steps in Figure 3 (i.e., from requirements assessment through executing plans). GLOSSARY TERMS IN THIS CHAPTER competency (also core competency) ◆ strategic asset ◆ total cost management (TCM)
- 18. 17 AACE INTERNATIONAL INTRODUCTION Chapter 2 and 7 on price and economic costs respectively delve into the basic concepts of the strategic economic and profitability analysis step shown in Figure 2 (e.g., discount rates, present value, and so on). These chapters also touch on the strategic assessment step (e.g., competition, markets, and so on) that precedes economic analysis. Chapters 27 and 28 cover the practices of engineering economics where the basic concepts of price and economic costs are pulled together into techniques for analyzing asset and project investment deci- sion options. Chapter 8 on activity-based costing (ABC) covers cost analy- sis methods that ensure that “activities” are properly recog- nized and addressed as causal drivers of cost. In other words, ABC helps ensure that when a decision is made to pursue or eliminate an activity, you truly know what the decision is going to cost because the causal link has been established. Chapter 9 on estimating covers the specific activities and tools of this critical cost engineering planning step shown in both Figure 2 and Figure 3. It covers topics such as the vari- ous types of estimates, estimating techniques, contingency, and so on. Chapter 13 on scheduling covers the specific activities and tools of this planning process step as shown in Figure 3. It covers topics such as work breakdown, scheduling tech- niques, and so on. Chapter 21 on project labor cost control covers tools for analyz- ing labor cost performance, which is part of the “performance assessment” step in Figure 3. Labor costs are typically a major cost element of asset and project investments. Labor costs are also often the most variable (i.e., risky) element of cost. A number of the text’s chapters cover cost engineering “tools” that can also be viewed from a process integration perspective. Chapter 31 on risk covers the specific activities and tools of this planning step shown in both Figure 2 and Figure 3. It covers topics such as the risk analysis process steps, risk analysis tech- niques, and contingency for both cost and schedule. Chapter 23 on quality management covers topics such as the quality assurance and control, continuous improvement, and benchmarking. As was discussed, the TCM process map itself is based on a quality management model (i.e., the PDCA model). As such, Chapter 23 touches on all activities and tools in TCM. Chapter 24 on value analysis covers the specific activities and tools of the value engineering and value management steps shown in both Figure 2 and Figure 3. It covers general topics such objective setting and team development, but also spe- cific value engineering steps such as functional analysis. Finally, Chapter 25 on contracts recognizes that there are multiple parties involved in implementing assets and proj- ects. The roles and relationships of these parties are legally defined by contracts. Done well, contracting contributes to strong process and organizational integration and team development. Done poorly, contracting is a disintegrating factor. From a process perspective, contracting can be viewed as helping to define the links between any activity or step in the TCM process when parties other than the asset owner are involved. Contracting plays a very significant role in the “project implementation step” shown in Figure 2 and the “communicate and execute plans” step in Figure 3. These steps often involve a hand-off in roles and responsibilities for the asset or project. There are other text chapters that cover basic concepts and knowledge areas that are more appropriately viewed from a competency integration perspective. Integration from a Competency Perspective As an integrated whole, the cost engineering skills and knowledge competency of an enterprise resides in the organ- ization of the enterprise, not in any single individual. However, for an organization or team to function effectively, each individual needs to understand what the skills and knowledge competency of other individuals are and when to bring these personal competencies to bear in the asset or proj- ect life cycle. This text includes chapters that cover aspects of both personal as well as organizational competency. Depending on its mission and scope, and enterprise will have a set of “core” competencies that are retained and fostered in- house. Other competencies will be considered non-core (i.e., not contributing to competitive advantage) and these will typically be out-sourced or contracted to other parties with strengths in those areas. One cost engineering competency that owners should never outsource is the basic cost knowl- edge of their asset base. Some competencies are brought to bear in, or are central to, most if not all of the cost engineering skill areas and TCM process steps. For example, the concepts of statistics and probabilities are applied in cost estimating, scheduling, risk assessment, economic analysis, contract strategy develop- ment, forecasting, and many other areas. Much of cost engi- neering (as opposed to accounting) is predictive in nature; therefore, it is important that every cost engineer be compe- tent in basic statistics and probabilities. However, some com- petencies are not as generically applicable. For example, a cost engineer whose role and responsibility is to perform strategic economic analysis is unlikely to make use of project scheduling tools (though understanding the concept of the critical path is useful in understanding project drivers and risks that affect economic analysis).
- 19. 18 INTRODUCTION AACE INTERNATIONAL Figures 4 and 5 provide examples of how the importance of various skills and knowledge or competency areas of cost engineering increase and decrease over the course of asset and project life cycles respectively. The figures are only exam- ples; the relative importance of each com- petency will be different for each enter- prise, asset, or project. However, the point of the examples is to show that the competency of an enterprise cannot reside in any single individual. No one person can be the best at every skill and as asset and project life cycles progress, cost engineers with different competen- cies will be included on the team. Only with assets of the most limited scope or projects of the smallest size can one per- son do all the cost engineering tasks. For example, Figure 4 shows that concep- tual cost estimating competency is very important early in asset planning stages as asset options are evaluated. Later, as the asset is implemented (and assuming no changes in scope), the importance of conceptual cost estimating diminishes while the importance of cost/schedule control increases. The competency related chapters of the text can be categorized in one of two groups; either general competencies or functional competencies. The importance of general competencies does not increase and decrease much over the course of asset or project life cycles. Each cost engi- neer needs excellent skills and knowledge in the general competencies. On the other hand, the importance of various function- al competencies does change, and it is less important that each individual be strong in every functional competency. The general competency areas start with Chapter 1 on cost elements. This chapter describes all the different types of cost. Topics such as fixed and variable costs, capital and expense, life cycle costs and other cost element concepts are covered. Understanding the concept of cost ele- ments is critical to the competency of every cost engineer. MAJOR MODERATE MINOR IMPORTANCE OF ROLES Asset Planning Investment Options Development Strategic Requirements Assessment Asset Performance Assessment Asset/Project Implementation CONCEPTUAL COST ESTIMATING AND SCHEDULING PROJECT CONTROL AND CONTRACT MANAGEMENT FINANCIAL AND ECONOMIC ANALYSIS RISK AND VALUE MANAGEMENT QUALITY MANAGEMENT ASSUMES NO MAJOR CHANGES OR RISKS Project Planning Project Definition Project Execution Strategic Asset Management Turnover & Start-up Close-Out FRONT END LOADING MAJOR MODERATE MINOR IMPORTANCE OF ROLES PROJECT COST ESTIMATING AND SCHEDULING PROJECT (COST/SCHEDULE) CONTROL FINANCIAL AND ECONOMIC ANALYSIS RISK AND VALUE MANAGEMENT ASSUMES NO MAJOR CHANGES OR RISKS CONTRACT AND QUALITY MANAGEMENT Figure 4—Skills and Knowledge Importance in the Asset Life Cycle Figure 5—Skills and Knowledge Importance in the Project Life Cycle
- 20. 19 AACE INTERNATIONAL INTRODUCTION Chapters 18 and 19 cover project management fundamentals and project organization structure, respectively. The “funda- mentals” chapter covers management knowledge that is crit- ical to a cost engineer’s personal competency in managing projects, while the “structure” chapter covers the organiza- tional competencies needed for project management. Chapter 22 on management of project people describes how people and organizations work together. It also covers topics such as leadership and ethical considerations. Whether or not a cost engineer is a manager, understanding management concepts is critical to their competency. Chapters 29 and 30 on statistics and probability and descriptive statistics cover concepts such as distributions, confidence, accu- racy, and simulation and modeling. As was discussed the con- cepts of statistics and probabilities are applied in cost estimat- ing, scheduling, risk assessment, economic analysis, contract strategy development, and many other areas. Many of thechapters described earlier from a “process inte- gration” perspectivecan also be viewed from a competency perspective. For example, chapter 31 on risk covers a process step (risk management), general competency (risk concepts), and functional competency (quantitative risk analysis). . Integration from a Resource Perspective In this last section, we examine how some skills and knowledge of cost engineering and the chapters in this text are integrated from a resource or physical perspective. As was discussed, the objective of TCM is to manage the investment of resources through projects in strategic assets. The resources are integrat- ed as a whole in the form of an asset. The primary resources that go into most assets are materials and labor. Equipment and tools are resources used by labor to manipulate the materi- al resources. Labor includes labor to evaluate, design and man- age an asset or project (e.g., engineering labor), as well as labor to build or create the asset (e.g., construction or fabrication labor), and later to operate or maintain the asset. The chapters of the resources section of the text are best viewed from a resource integration perspective. Chapter 3 on materials covers material types such as bulk, fabricated, and engineered materials, as well as practices for managing materials such as purchasing, expediting, and inventory management. Chapter 4 on labor covers labor types such as direct and indi- rect labor, but also labor issues such as productivity and the learning curve. Chapter 5 on engineering focuses on one particular type of labor. Cost engineers often work as partners with other engi- neering discipline leads; the cost engineer’s strong cost man- agement competency compliments the design competency of the other engineers. Topics in this chapter include system and product design, engineering tools (CAD/CAM), and other engineering issues. Chapter 6 on equipment parts and tools covers the resources that are used by labor to manipulate materials. Topics include the use, rental and lease of equipment are covered, as well as testing, operating and maintenance, and other issues. PRACTICE PROBLEMS AND QUESTIONS 1. What does AACE International call the integrative process through which cost engineering skills and knowledge are practiced? Answer: Total Cost Management 2. What distinguishes competencies that an enterprise will keep in-house versus those that are typically out- sourced? Answer: Something along the lines of competencies kept in house are those that do not contribute to competitive advantage. 3. When might it be reasonable to expect that one individ- ual can do most of the cost engineering activities on a project? Answer: Something along the lines of only when an asset or project is of limited size and or scope. DISCUSSION CASES 1. Assume you are responsible for cost estimating on a project. Discuss why it is important that you understand project scheduling practices. Answer: Along the lines of how cost/schedule integra- tion supports resource planning, how you need to know durations and activity logic in order to understand crew- ing, supervision, and equipment needs, how time and money are related, how the cost and schedule work breakdown should be related to support resource load- ing and progressing, etc, etc . 2. Assume you are assigned cost engineering responsibili- ties on an ongoing project that has a bureaucratic project organization in place and poor cost and schedule per- formance. From various integration perspectives, dis- cuss some actions you might recommend to project man- agement to improve project performance.
- 21. 20 INTRODUCTION AACE INTERNATIONAL Answer: Along the lines of establishing an integrative project process or system, consider cross-training, ensure asset and project mission and objectives (vision) are communicated in a workshop, etc. REFERENCES 1. AACE International. Cost Engineering Terminology. Recommended Practice No. 10S-90, 2. Hamel, Gary. Leading the Revolution. Harvard Business School Press. 3. AACE International. Total Cost Management Framework. www.aacei.org/technical.
- 22. Section 1 Cost
- 24. INTRODUCTION Cost is a basic “yard stick” by which activities and assets are measured and compared. Because the word cost is so com- monly used and generally related to monetary value, we may lose sight of its true meaning and importance as a cost engi- neering concept. This chapter is strategically located first in this Skills & Knowledge (S&K) textbook for the very reason that cost is a fundamental attribute of activities and assets. Cost is one of the three fundamental attributes associated with performing an activity or the acquisition of an asset. These are (1) price (cost), (2) features (performance), and (3) availability (schedule). The need to understand and quantify the attribute of cost spawned the engineering discipline of cost engineering. Cost engineering is the application of scientific principles and techniques to problems of estimation, cost control, business planning and management science, profitability analysis, project management, and planning and scheduling [3]. While this definition seemingly addresses non-cost areas, it lists key engineering activities that either generate cost when they are performed or define plans and processes that cause (or influ- ence) cost to be generated in other activities and/or assets. What are the elements that make up cost? How are these cost elements categorized and how do they relate to one another? Why is it important to collect and account for costs as they relate to specific activities and assets? And, finally, how do we apply these cost elements and categories to the insight for managing activities and assets? This chapter will provide you with a basic understanding of these cost fundamentals and will give you the insight and background you will need as you study the following chapters in this S&K textbook. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • understand what makes up cost—i.e. the basic resources (material, labor, etc.) that are needed to perform an activ- ity or create an asset; • understand the distinction between cost elements that are directly applied to an asset and those that are indi- rectly applied; • relate the cost elements to the life cycle of the asset: acquisition, use, and disposal; • use the understanding of cost elements to further under- stand how cost is measured, applied, and recorded to arrive at the total activity and/or asset cost; and • apply the knowledge gained to solve problems related to cost element source and definition. CONCEPTS Cost is the value of an activity or asset. Generally, this value is determined by the cost of the resources that are expended to complete the activity or produce the asset. Resources utilized are categorized as material, labor, and “other.” Although money and time are sometimes thought of as resources, they only implement and/or constrain the use of the physical resources just listed. The path by which resources are converted (via a “project”) to activities and assets is illustrated in Figure 1.1. The 1.1 AACE INTERNATIONAL COST ELEMENTS Chapter 1 Cost Elements Franklin D. Postula, PE CCE Available Resources Activity and/or Asset Money & Time Cost Elements Figure 1.1— Conversion of Resources to Project Results
- 25. final activity or asset produced depends on what can be “afforded” given the money and time allocated to the project. Normally you think of material as the physical composition of the asset. However, the value of the asset may also include the cost elements of scrap material or manufacturing spares, construction form work and expendable safety items, and the cost of transporting the material to the work site. Often, we think of labor as the value of the work needed to complete the activity or asset; i.e. the worker’s labor in paint- ing the building or soldering an electrical contact. Labor also includes the work of the engineer who prepares the design, the foreman supervising the field work, or the technician that maintains the wave soldering equipment. The “other” cost category consists of resources needed to support the activity and/or asset. An example would be the facilities needed to produce an activity or asset, which would include the tooling, electricity, taxes, and maintenance, etc., necessary to keep the facility available for use. Other costs might be office supplies, communication costs, travel costs, and security costs. Another important aspect of cost relates to whether one is the producer or consumer of an activity or asset. The cost cate- gories just listed are those associated with the producer. The consumer has additional costs that add to the value of the activity or asset being acquired. A fundamental addition is profit for the producer. Generally, profit is established by mar- ket competition, although the law limits profit on certain gov- ernment procurements. The value of an asset or activity also may be related to intan- gible costs. The value of an art object is often related to the name of the artist. When evaluating alternatives, the value of each alternative should be assessed in terms of the benefits that can be expected if selected and the consequences that might be suffered if not selected [10]. An intangible benefit might be an avoided cost if the alternative is selected. For example, incorporating a spell checker into word processing software saves (avoids) the labor of manual checking. An intangible negative consequence might be the cost of missing an opportunity because resources were invested in another alternative instead of the more beneficial one. The following example illustrates the resource cost cate- gories: Example 1—John decides to build a deck on the back of his house. He draws up plans for the project, gets the building permit from the city, buys the material, hauls it home, and constructs the deck. The cost elements and categories associ- ated with building this asset are shown in Table 1.1. Notice that some of these cost elements are not part of the physical deck, but are necessary in order to complete the project. Furthermore, some of the cost elements are not part of the work activity needed to get the deck built, but are essential to support the project. In the next section, we will see how these cost categories are structured. COST STRUCTURING It is important to further structure the cost elements within the material, labor, and other resource categories in order to understand how they influence the total cost of the activity or asset and to get a better understanding of how they can be controlled. This structuring sorts the cost elements into direct costs, indirect costs, fixed costs, and variable costs. In practice, some costs may fall in more than one of these groupings. This will be shown through an extension of the previous example. Direct Costs Direct costs are those resources that are expended solely to complete the activity or asset. In other words, “Any cost that is specifically identified with a particular final cost objective, but not necessarily limited to items that are incorporated in the end product as material or labor” [1]. Thus, the direct cost of a foundation for a house includes trenching for the foot- ings, the wooden forms (if not reusable), the concrete, and the labor to place and finish the concrete. Direct costs for mak- ing a metal bowl would be the metal sheet stock and the stamping machine operator labor cost. The material cost for manufacturing the bowl would include the scrap from the stamping process less any salvage value. Indirect Costs Indirect costs are those resources that need to be expended to support the activity or asset but that are also associated with other activities and assets. In other words, “Any cost not directly identified with a single final cost objective but iden- tified with two or more final cost objectives …” [1]. Consequently, indirect costs are allocated to an activity or asset based upon some direct cost element, such as labor hours, material cost or both. Indirect costs also may be referred to as “overhead costs” or “burden costs.” Indirect costs are general administrative activities associated with operating the business, costs for providing and maintaining 1.2 COST ELEMENTS AACE INTERNATIONAL Category Cost Elements Materials drafting paper/pencil, concrete, nails, lumber, deck screws, paint, brushes, turpentine, drop cloth Labor draw plans, get permit, get materials, construct footings, erect deck, paint deck, wife’s support in making lunch Other building permit fee, use of house to draw plans, shovel, power saw, power drill, electricity; pickup truck, gasoline Table 1.1—Costs Associated with John’s Deck
- 26. field equipment or a manufacturing facility, and expenses for utilities, taxes, legal services, etc. Fixed Costs Fixed costs are those cost elements that must be provided independent of the volume of work activity or asset produc- tion that they support. These can be either direct or indirect costs. The tool used to stamp the metal bowl is a direct fixed cost that is incurred whether 100 or 1,000 items are produced. The tools used to finish the concrete foundation are an indi- rect fixed cost since they can be reused on other concrete fin- ishing work. Variable Costs Variable costs are those cost elements that must be provided and are dependent on the volume of work activity or asset production that they support. Again, these can be either direct or indirect costs. An example of a direct variable cost is the material used to form the metal bowl since the amount varies with the quantity produced. An indirect variable cost would be the electricity used to operate the stamping machine since it also varies with the quantity produced but is considered to be an overhead cost. In business practice, cost element information may be grouped in a variety of ways to provide the basis for manage- ment decisions. Some of these groupings are listed in Table 1- 2. Bear in mind that this table only shows a representative list of cost groupings. Any set of cost groupings should be tai- lored to the individual company’s method of doing business. Let’s see how the cost elements of Example 1 can be struc- tured. Example 2—John tries to better understand the costs asso- ciate with building the deck. He structures the costs as shown in Table 1.3 on page 1.4. 1.3 AACE INTERNATIONAL COST ELEMENTS Table 1.2—Example Cost Element Groupings Cost Center Cost centers are groups of activities within a project that provide a convenient point for collecting and measuring costs. This could be a department in an engineering organization such as a structural design group. Or it could be process related such as a metal stamping operation. Labor Craft It may be convenient to group types of labor such as electricians, plumbers, etc. on a construction site. Or machinists, tool & die technicians, etc. in a manufacturing operation. Material Type These groups could be raw material, purchased parts, etc. in a manufacturing company. Or could be concrete, 1.5-inch and smaller pipe, etc. for a construction project. Inventory This could be the value of purchased material and equipment waiting to be used in manufacturing or installed in a facili- ty under construction. This could also be the cost of finished goods waiting to be sold. Overhead As discussed previously, these are indirect costs that are allocated to labor and material cost elements. Examples are the cost of maintaining a manufacturing facility or the cost of the home office of a construction company that has sever- al projects underway. Equipment This is the value of all machines, tools, and other equipment needed to support a manufacturing operation or a con- struction project. Subcontracts It is important to separately collect and report work that is contracted out to others in support of the project. This could be labor or material, direct or indirect work. Other Direct Costs Sometimes it is convenient to charge directly a cost that may also be treated as an indirect cost. Examples are travel expenses, start-up costs, plant protection, etc. Commitments This is a group of future costs that are represented by obligations to obtain subcontracted/purchased material and serv- ices. It’s extremely important to have this information available when changes to production or construction plans occur. GLOSSARY TERMS IN THIS CHAPTER activity ◆ assets ◆ cost ◆ cost categories cost elements ◆ cost objectives ◆ direct costs fixed costs ◆ indirect costs ◆ project project ◆ resources variable costs ◆ work breakdown structure (WBS)
- 27. As you consider these groupings of cost elements, you may realize that the variable direct cost elements are those that depend on the size of the deck. Although you might think of them as being “fixed” for this specific project, their value would change if the deck design were to change. Also, if a second identical deck were to be built, the value of these cost elements may go down due to efficiencies (learning) in per- forming the job. In the next section, we will investigate the purpose for col- lecting and reporting cost elements and how these elements might be organized to provide information for management decision making. COST ACCOUNTING What is the purpose of cost accounting and why is it impor- tant? Cost accounting is defined as the historical reporting of disbursements and costs and expenditures on a project. When used in conjunction with a current working estimate, cost accounting can assist in giving the precise status of the project to date [7]. Historical costs can also provide a sound basis for forecasting and budgeting costs of future activities and assets. While detailed methods used for cost accounting may vary from business to business or from project to project, all accounting systems include the three basic steps of recording, classifying, and summarizing cost element data in terms of money expended with time [5]. The recording of cost infor- mation is nothing more than the mechanical gathering of data in a routine manner. There are a variety of methods to achieve this. Generally, it’s accomplished with time sheets for labor and invoices for subcontracts and procured items. Other costs are gathered from utility bills, expense reports, tax bills, etc. Every business enterprise has an established approach for clas- sifying and summarizing costs that is organized around their business practices. This approach is called a “code of accounts” by which all recorded cost elements are classified. A code of accounts (sometimes referred to as a chart of accounts) is a systematic numeric method of classifying various cate- gories of costs incurred in the progress of a job; the segregation of engineering, procurement, fabrication, construction, and associated project costs for accounting purposes [3]. A company’s code of accounts is configured to support the recording of cost data in the general ledger. An example of summary-level accounts is shown in Table 1.4. While classifying costs in accordance with the general ledger breakout is a common practice, this approach does not gen- erally provide the visibility needed to manage the work or to make informed forecasts of the cost of new jobs. An alternate method of cost element classification is called activity-based costing (ABC). In the ABC approach, resources that are used are assigned to activities that are required to accomplish a cost objective [9]. ABC makes cost accounts understandable and logical, and much more useful for the cost engineer [4]. This method of collecting and summarizing cost elements reveals which resources and activities are the most significant contributors (drivers) to the cost of the cost objective. Another approach to classifying costs that is similar to ABC accounting is using a work breakdown structure (WBS) to group cost elements. It has become a common practice for a WBS to be a required project management tool on most con- tracts. Not only does a WBS provide a framework for plan- ning and controlling the resources needed to perform the technical objectives, but it facilitates a summary of project data regarding the cost and schedule performance. Table 1.5 shows an example WBS for a study project wherein the deliv- erable item is an intellectual product documented in techni- cal publications. When used to classify and record costs, the WBS becomes the cost element structure (CES), as well. The general format, however, is applicable for the CES of a manufactured prod- uct or construction project [8]. 1.4 COST ELEMENTS AACE INTERNATIONAL Direct Material: drafting paper, concrete, nails, lumber, deck screws, paint, turpentine Labor: draw plans, get permit, get materials, construct footings, erect deck, paint deck Other: building permit fee Indirect Material: pencil, brushes, drop cloth Labor: wife’s support in making lunch Other: use of house to draw plans, shovel, power saw, power drill, electricity, pickup truck, gasoline Fixed Direct: get permit Indirect: use of house to draw plans, shovel, power saw, power drill, pickup truck, pencil, brushes, drop cloth Variable Direct: drafting paper, building permit fee, concrete, nails, lumber, deck screws, paint, turpentine, draw plans, get materials, construct footings, erect deck, paint deck Indirect: wife’s support in making lunch, electricity, gaso- line Table 1.3—Costs Associated with John’s Deck
- 28. While there is no universal WBS/CES standard, some have been developed for government acquisition. One comprehensive example is the U.S. Army Cost Element Structure [11] (www.asafm.army.mil/ceac/ ceac.asp). This CES provides a defini- tion of each cost element within the structure. It also provides structure for cost elements in all procurement phases: development, production, and operation and support. Sometimes the code of accounts to be used is determined by law. For exam- ple, the Federal Energy Regulatory Commission (FERC) has established a Uniform System of Accounts for the electrical power generation industry (www.ferc.fed.us). The account numbering plan used consists of a system of three-digit whole numbers as shown in Table 1.6. Regardless of how cost elements are classified and grouped, it is important that this is done in a manner that is consistent with the way future work is esti- mated and budgeted. Historical cost records repre- sent the way a company conducts its business and can be analyzed to determine whether improve- ments have been made and how costs may trend in the future. Therefore, the integrity of the cost 1.5 AACE INTERNATIONAL COST ELEMENTS 2000 Assets 2100 Cash 2200 Accounts Receivable 2300 Notes Receivable 2400 Inventory - materials and supplies 2500 Inventory – finished products 2600 Work-in-progress 2700 Equipment 2800 Buildings and fixtures 2900 Land 3000 Liabilities 3100 Accounts payable 3200 Notes payable 3300 Taxes payable 3400 Accrued liabilities 3500 Reserve accounts 4000 Equity 4100 Capital stock issued and out- standing 4200 Retained earnings 5000 Revenues 5100 Sales of finished goods 5200 Other revenues 6000 Expenses 6100 Cost of goods sold 6200 Salaries and wages 6300 Heat, light, and power 6400 Communications expense 6500 Reproduction expense 6600 Insurance 6700 Taxes 6800 Depreciation 6900 Interest expense 7000 Construction work in progress 7100 Site preparation 7200 Concrete work 7300 Structural steel 7400 Heavy equipment 7500 Buildings 7600 Electrical systems 7700 Piping systems 8000 Manufactured goods in progress 8100 Direct materials 8200 Direct labor 8300 Overhead Table 1.4— Typical Code of Accounts (after Jelen [6]) Table 1.5—Typical WBS Format Level 1 1.0 Research Project Level 2 1.1 Concept Study 1.2 Mathematical Model 1.3 Deliverable Data 1.4 Project Support Level 3 1.1.1 State-of-Art Research 1.1.2 Concept Definition 1.1.3 Data Analysis 1.2.1 Equation Formulation 1.2.2 Computer Programming 1.2.3 Test and Evaluation 1.3.1 Technical Documents 1.3.2 Engineering Data 1.3.3 Management Data 1.4.1 Project Management 1.4.2 Review Meetings Table 1.6— FERC Uniform System of Accounts 100-199 Assets and other debits. 200-299 Liabilities and other credits. 300-399 Plant accounts. 400-432, & 434-435 Income accounts. 433, 436-439 Retained earnings accounts. 440-459 Revenue accounts. 500-599 Production, transmission and distribution expenses. 900-949 Customer accounts, customer service and informational, sales, and general and administrative expenses.
- 29. accounting system is essential to developing a project cost baseline. Example 3—John recognizes that the deck he is building is an improvement to his home that would be considered a cap- ital investment. He decides that he needs to structure his cost accounts to provide data for future maintenance estimates. Here is the code of accounts he develops: Notice that John hired some of the labor and has cost records (invoices) for the work. For the labor he performed, John might use a fair market value to account for the cost of these activities. Also, values of indirect cost elements are not shown in this list. For, example, John could have included the rental value of the tools used in the construction. This val- uation approach would have allowed him to get a better understanding of the total value of the deck. John’s code of accounts allows him to group material and labor costs to find the total cost of the footings, deck struc- ture, and painting. Table 1.8 shows how he rearranges the cost elements to get this visibility: Cost element allocation would be ratioed to the cost of the material and labor in each component of the asset. This arrangement of cost elements is similar to the ABC or WBS approach. COST MANAGEMENT There are many ways that cost elements and cost structure can be displayed to provide information for cost manage- ment. We will consider four of the most common methods of how cost information is applied to cost management. These are: cost estimating, cost trending, cost forecasting, and life- cycle costing. Although these methods will be discussed in more detail in later chapters, it is important to see how they relate to cost elements and structure. Cost Estimating Cost Estimating predicts the quantity and cost of resources needed to accomplish an activity or create an asset. The building blocks of a cost estimate are • a well-defined scope (what we are trying to estimate), • a cost element structure (how we organize the informa- tion), and • historical cost data (data from cost accounting records and/or “experience” of knowledgeable people). Key questions to ask regarding a cost estimate always include “What cost data was used?” and “How can we reduce the cost of x?” Therefore, cost element data and its structure are paramount ingredients of a sound cost estimate. Cost Trending Cost trends are established from historical cost accounting information. Cost management questions may focus on how expenditures are trending relative to physical accomplish- ments. “How much are we spending for pipe fitters and how much piping has been installed during the last six months?” or “What has been our monthly cost for steel this last year and how many bowls have we produced?” Again, having 1.6 COST ELEMENTS AACE INTERNATIONAL 1.0 Material 1.1 Footing form lumber, nails, and concrete 1.2 Deck lumber and screws 1.3 Paint and turpentine 2.0 Labor 2.1 Draw plans (self) 2.2 Get permit (self) 2.3 Get materials (self) 2.4 Construct footings—Sam’s Handyman Service 2.5 Erect deck—Sam’s Handyman Service 2.6 Paint deck - Sam’s Handyman Service 3.0 Other 3.1 Permit fee Table 1.7—John’s New Code of Accounts 1.0 Footings 1.1 Allocation, in part, of: • Draw plans (self) • Get permit (self) • Permit fee • Get material (self) 1.2 Form lumber, nails, and concrete 1.3 Construct footings—Sam’s Handyman Service 2.0 Deck Structure 2.1 Allocation, in part, of: • Draw plans (self) • Get permit (self) • Permit fee • Get material (self) 2.2 Lumber and screws 2.3 Erect deck—Sam’s Handyman Service 3.0 Painting 3.1 Allocation, in part, of: • Draw plans • Get permit • Permit fee • Get material 3.2 Paint and Turpentine 3.3 Paint deck—Sam’s Handyman Service Table 1.8—Cost Elements of John’s Deck Project
- 30. access to cost history in the structure needed is key to pro- viding the required information. Cost Forecasting Forecasts are much like estimates. Whereas an estimate is always for future activities and assets, forecasts are predic- tions of the cost at completion for cost elements in progress. Therefore, a sound cost forecast will be based on cost element data from inception of the work to the date of the forecast, the cost trend of that data compared to accomplishments, and a cost estimate of the work remaining to be completed. Cost element history in the proper activity structure is essential for realistic cost forecasts. Life-Cycle Costing Life-cycle costs (LCC) are associated with an asset and extend the cost management information beyond the acquisition (cre- ation) of the asset to the use and disposal of the asset. Asset acquisition consists of the design/development phase and the production/construction phase. Generally, cost elements are segregated into these phases because design/development costs are often recovered over more than one asset. For exam- ple, design and development cost of a new airplane is amor- tized over the production. The design of a housing project is recovered through sales of the houses built. Once the asset is created, it enters the operation and support (O&S) phase, sometimes called operations and maintenance (O&M). A new set of cost elements and CES is applicable to this phase and cost data must be collected to support cost management efforts. The final phase is disposal of the asset with another unique set of cost elements. Refer to Table 1.9 to see how John might group cost elements of the deck project to reflect its LCC. Example 4—John rearranges the project cost elements to understand what it cost to design and construct the deck and to get a perspective on what it might cost to maintain and eventually remove the deck. If John wants to, he can develop a cost estimates for the maintenance and disposal phases. As a first cut at the estimate, he can refer to the construction cost element history for most of the information and add esti- mates for termite inspection and replanting the grass. SUMMARY In this chapter, we have studied some of the fundamental aspects of cost. We started with an understanding of resources and cost elements and how they relate to the per- formance of activities and the creation of an asset. Money and time we introduced as both enablers of and constraints on the execution of a project. Cost elements were illustrated by an example of building a wood deck at a house. Next we considered how cost elements are structured into direct, indirect, fixed, and variable cost groups. The purpose for organizing costs into groups is to determine which cost elements are used in performing the activity or creating the asset and which are in support of the work. Other possible groupings were introduced to illustrate how cost elements can be arranged to provide visibility on the cost of specific activities or resources. The deck example was extended by structuring the cost elements into cost groups. The importance of cost accounting in establishing a database for cost management was discussed. Several methods of clas- sifying and summarizing cost elements were introduced: code of accounts, activity based costing, and work break- down structure (WBS). The cost elements of the deck exam- ple were organized into a code of accounts and WBS to illus- trate these methods. Finally, the topic of cost management was introduced. Four common methods for providing cost information were dis- cussed as they apply to cost management. This illustrated the importance of having sound cost history that is structured in a usable format. The deck example was extended further to demonstrate the four phases of life-cycle costing. 1.7 AACE INTERNATIONAL COST ELEMENTS 1.0 Design 1.1 Draw plans 1.2 Get permit 1.3 Permit fee 2.0 Construction 2.1 Get materials 2.2 Form lumber, nails, concrete 2.3 Construct footings 2.4 Deck lumber and screws 2.5 Erect deck 2.6 Paint and turpentine 2.7 Paint deck 3.0 Maintenance 3.1 Repaint deck every 5 years 3.2 Termite inspection every 2 years 4.0 Disposal 4.1 Tear-down deck after 25 years 4.2 Remove footings 4.3 Haul demolition material to dump 4.4 Replant grass Table 1.9—Life-Cycle Cost Elements of John’s Deck
- 31. PRACTICE PROBLEMS AND QUESTIONS Questions: Is the returned material a manufacturing cost ele- ment? How about the scrap? Would these be direct, indirect, fixed, or variable costs? Answers: The returned material is not a cost to the manufac- turer but would be a handling cost to the supplier that could show up in the price of the hardwood. The scrap is a direct manufacturing cost that is also a variable cost since it depends on the number of units produced. Questions: Is the crane rental a direct cost or indirect cost? How about the equipment that is owned by the contractor? Answers: The crane rental is a direct cost to the project. However, the use of the equipment that is owned would be part of the overhead and considered an indirect cost. Questions: What are some of the direct cost elements in the CD? How is the cost to develop the game software recov- ered? Answers: The direct costs associated with the production of the CD are the raw material, the operators labor, the label, crystal case, and packaging. Game software development costs would be amortized to production and recovered in the CD price. Questions: Does the company’s code of accounts (refer to Table 1.4) provide the information Mary needs? What type of accounting would have provided better cost visibility. Answers: There is not much detail available, however, an approximation can be made of the proportion of material, labor, and overhead by looking at the Manufactured goods in progress accounts. Better visibility would result from appli- cation of activity based cost accounting. Questions: The asset is now in what life-cycle phase? Are the station operating costs part of the cost elements in this phase? How do the operating and maintenance costs relate to the cost of the electricity produced? Answers: The asset is in the O&S phase. Yes, the operating costs and maintenance costs are part of the O&S phase costs. In addition, there would be some indirect costs. Since this asset is used to produce a product, electricity, all the O&S costs along with the cost of the natural gas make up the cost of the electricity produced. 1.8 COST ELEMENTS AACE INTERNATIONAL Problem 1: A manufacturing company is producing fur- niture and buys the hardwood lumber from a supplier who make daily deliveries. Consequently, when the wood is inspected some is not useable and is returned to the supplier. Of the wood used, some ends up as chips and scrap pieces. Problem 2 : A shopping mall is under construction. The general contractor owns some construction equipment but needs to rent a crane for the steel placement. Problem 3 : A company develops computer programs for children’s game machines. The product (the game software) is an intellectual property that is transferred to CDs and marketed. Consider the cost elements that make up the CDs. Problem 4 : Mary has been assigned the task of estimat- ing the cost of a new product that is a redesign of one cur- rently in production. She needs to get historical costs records from the company’s accounting system. Problem 5 : An electric utility operates a natural gas-fired turbine generating station. It is necessary to shut down operation for one week each year for preventive mainte- nance. During this time, extra work crews are assigned and repair parts are purchased.
- 32. REFERENCES 1. U.S. Dept. of Defense. Armed Services Pricing Manual. Commerce Clearing House, Inc. (latest revision). 2. Merriam-Webster On-Line Dictionary. www.merriam- webster.com 3. AACE International. Standard Cost Engineering Terminology. Recommended Practice No. 10S-90. Morgantown, WV. 4. Cokins, Gary. 2002. Activity-Based Costing: Optional or Required.; 2002 AACE International Transactions. RISK.03.1 5. Humphreys, K. K. 1984. Project and Cost Engineers’ Handbook. Marcel Dekker, Inc. 6. Jelen, Frederic C. and James H. Black. 1983. Cost and Optimization Engineering. McGraw-Hill, Inc. 1983. 7. Meigs, Walter B., Charles E. Johnson, and Robert F. Meigs. 1977. Accounting: The Basis for Business Decisions. McGraw-Hill, Inc. 8. Postula, Frank D. 1991. WBS Criteria for Effective Project Control. AACE International Transactions. I.6.1 9. Player, Steve, and David Keys. 1995. Activity-Based Management: Arthur Andersen’s Lessons from the ABM Battlefield. MasterMedia Limited. 10. Souder, William E. 1980. Management Decision Methods for Managers of Engineering and Research.Van Nostrand Reinhold Company. 11. U.S. Army. 2001. Army Cost Analysis Manual. Appendix E. 1.9 AACE INTERNATIONAL COST ELEMENTS
- 34. INTRODUCTION The goal of this chapter on pricing is to serve as “a guide to the subject matter in which a cost engineer and a cost man- ager should be both knowledgeable and competent” [1]. In the following pages, pricing is established as a set of man- agement processes (tools and techniques) required to estab- lish the cost of an endeavor (project, business). These tools and techniques include the following: • pricing strategies, • sales and revenues, • return on investment (ROI), • return on sales (ROS), and • break-even analysis. With the complexities involved, it should not come as a sur- prise that pricing is considered to be an art by many cost managers [2]. Establishing the right information on customer cost budgets and competitive pricing is an essential element in this art of pricing. The unreliability of the information base can lead to wrong or misleading information in many cases. However a disciplined approach derived from combining the art of pricing and science is very beneficial. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • differentiate between costing and pricing, • establish a framework for the comparison of pricing strategies on projects, • analyze profitability and establish return on investments (ROI) and return on analysis (ROA), • establish the return on sales (ROS) parameters, and • understand the concept of break-even analysis for any business situation. COST AND PRICING—IS THERE A DIFFERENCE? Price refers to “the cost at which something is bought or sold” [5]. Therefore, pricing is the process of establishing the cost of a project/business. Pricing refers to a set of tools and techniques used to establish an output-cost. The difference is subtle, and in real-world applications, it is not incorrect to use these terms interchangeably, as long as there are terms of reference. In this chapter the terms of references for pricing are based on the tools and techniques used to establish cost; i.e., pricing strategies, sales and revenues, ROI, ROS, and break-even analysis. TOOLS AND TECHNIQUES OF PRICING Analysis of the Pricing Process In Figure 2.1 on page 2.2, the process of pricing is described in terms of its inputs, tools and techniques, and output. These are described separately in this chapter with the focus being on the tools and techniques. The inputs are the documentable items that will be acted upon and include, but are not limited to: work breakdown structure (WBS), historical records, cost esti- mation and cost management system. The tools and tech- niques are the mechanisms applied to the inputs to produce the outputs and include pricing strategies, sales and revenues, ROI, ROS, and break-even analysis. Tools and techniques of the pricing process is the focus of this section. Pricing Strategies Pricing Strategies must be developed for each individual situation. Essentially two situations frequently appear when one is pursuing a project. These situations that often occur in competitive acquisitions are referred to as Types I and II [2]. In each case there are specific but different busi- ness objectives. 2.1 Chapter 2 Pricing Rohit Singh, PEng CCE AACE INTERNATIONAL PRICING
- 35. The objective for Type I acquisitions is to win the project and execute it profitably and satisfactorily according to contrac- tual agreements. The same applies to Type II acquisitions; however, Type II refers to a new industry that a company is trying to get a foothold into. In such cases, the profit may not be as important as obtaining the new business acquisition. A Type II acquistion is an example of a “must win” situation where the price is determined by the market forces. Thus the fundamental difference is that for a Type I profitable new business acquisition, the bid price is determined according to the actual project cost; whereas in a “must-win” Type II situ- ation, the price is determined by the market forces. This is the basis of pricing strategies as applied in cost management. BUSINESS AND ECONOMIC RATIOS: AN OVERVIEW A business can normally forecast its outgoings, but incom- ings can be more difficult to predict. Even a business that appears to be successful can flounder if it does not generate enough cash to pay its obligations. The following ratios provide the necessary guidance to assist in the successful planning of a business: • ROI, • ROS, and • break-even analysis. A business begins with a the following set of inputs or resources: • Natural resources—These form the basic ingredients of the product or assist in its manufacture. This includes such resources as coal and steel, which one day will be exhausted, and assets, such as buildings, that help in the production process. • Capital—This includes the assets through which busi- ness is done or the cash that makes this possible. Therefore, a shop is capital, as is an oil refinery. • People—Normally referred to as the most important assets a business has, the abilities of its employees are vital to the success of any business. The attitudes shown by both employees and managers will shape much of what happens within any business. Managers or entre- preneurs will be called upon to lead, and workers/employees will be responsible for making the goods/services that the customers want. If any member of this process gets it seriously wrong, then the liveli- hoods of all can be threatened. Obviously, these inputs vary in nature and importance from one business to another. However they offer a background to understanding these business economic ratios. All ratios must be taken in context. The reason to look at them on a monthly basis is to make sure that you spot trends as they develop, not afterward. If you are doing something exceed- ingly well, you need to know it. And if something is wrong, it’s better to find out sooner than later. ROI is one of several approaches to building a financial busi- ness case. The term means that decision makers evaluate the investment potential by comparing the magnitude and tim- ing of expected gains to the investment costs. In the last few decades, this approach has been applied to asset purchase decisions (computer systems or maintenance vehicles, for example), “go/no-go” decisions for programs of all kinds 2.2 PRICING AACE INTERNATIONAL Figure 2.1—Analysis of the Pricing Process Pricing Outputs Project Acquisition Business Decision Lessons Learned Tools and Techniques Pricing strategies Sales and Revenues Return on Investment Return on Sales Break-Even Analysis Inputs WBS Historical Records Cost Estimation Cost Management System
- 36. (including marketing programs, recruiting programs, and training programs), and to more traditional investment deci- sions (such as the management of stock portfolios or the use of venture capital). Simple ROI ROI is frequently derived as the return (incremental gain) from an action divided by the cost of that action—that is sim- ple ROI. For example, what would be the ROI for a new mar- keting program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time? Simple ROI = (Gains – Investment Costs)/Investment Costs = ($700,000 – 500,000)/$500,000 = 40% Simple ROI works well in situations where both the gains and the costs of an investment are easily known and where they clearly result from the action. Other things being equal, the investment with the higher ROI is the better investment. The return on investment metric itself, however, says nothing about the magnitude of returns or risks in the investment. Complex ROI In complex business settings, ROI, also called the Dupont or engineer’s method, is the percentage relationship of the aver- age annual profit to the original investment, including non- depreciable items such as working capital: ROI = (average yearly profit during earning life)/(orig- inal fixed investment + working capital) expressed as a percentage. Let’s look at an example. Based on Table 2.1 below calculate the ROI. The average profit = (275 + 200 + 130 + 70 + 0)/5 = 135 k$/year By the equation above, the ROI = (135)/(1000+0) = 13.5%. Return on Average Investment (RAI) On the other hand, return on average investment (RAI) is similar to ROI except that the divisor is the average out- standing investment. RAI = (average yearly profit during earning life)/(aver- age Outstanding investment ) expressed as a percentage. Other ROI Metrics Other “financial ratios” are sometimes treated as ROI figures, including return on capital, return on total assets, return on equity, and return on net worth. In still other cases, the term refers simply to the cumulative cash flow results of an invest- ment over time. In brief, several different ROI metrics are in common use and the term itself does not have a single, universally understood definition. When reviewing ROI figures, or when asked to produce one, it is a good idea to be sure that everyone involved does the following: • defines ROI the same way, and • understands the limits of the concept when used to sup- port business decisions Return on Sales (ROS) What it is—This ratio compares after tax profit to sales. It can help you determine if you are making enough of a return on your sales effort. When to use it—If your company is experiencing a cash flow crunch, it could be because its mark-up is not enough to cover expenses. Return on sales can help point this out and allow you to adjust prices for an adequate profit. Also, be sure to look for trends in this figure. If it appears to be drop- ping over time, it could be a signal that you will soon be experiencing financial problems. The formula—Net profit divided by sales. Return on Assets (ROA) What it is—This number tells you how effective your busi- ness has been at putting its assets to work. The ROA is a test of capital utilization—how much profit (before interest and 2.3 AACE INTERNATIONAL PRICING Table 2.1-Project Cash Flow [4] GLOSSARY TERMS IN THIS CHAPTER capital ◆ cash flow ◆ competitive advantage cost ◆ inputs ◆ opportunity ◆ price production ◆ work breakdown structure (WBS) Time, end year After Tax Profit, K$ Depreciation, K$ Cash Flow, K$ 0 -1,000 0 -1,000 1 275 200 475 2 200 200 400 3 130 200 330 4 70 200 270 5 0 200 200
- 37. income tax) a business earned on the total capital used to make that profit. This ratio is most useful when compared with the interest rate paid on the company’s debt. For exam- ple, if the ROA is 15 percent and the interest rate paid on its debt was 10 percent, the business’s profit is 5 percentage points more than it paid in interest. When to use it—Return on assets is an indicator of how prof- itable a company is. Use this ratio annually to compare your business’ performance to your industry’s norms. The formula—Earnings before interest and taxes (EBIT) divided by net operating assets. Gross Profit Margin Ratio What it is—The gross profit margin ratio indicates how effi- ciently a business is using its materials and labor in the pro- duction process. It shows the percentage of net sales remain- ing after subtracting cost of goods sold. A high gross profit margin indicates that a business can make a reasonable prof- it on sales, as long as it keeps overhead costs in control. When to use it—This figure answers the question, “Am I pricing my goods or services properly?” A low margin— especially in relation to industry norms— could indicate you are underpricing. A high margin could indicate overpricing if business is slow and profits are weak. The formula—Gross profit divided by total sales. Break-Even Analysis Break-even analysis involves finding the level of sales neces- sary to operate a business on a break-even basis. At break- even, total costs equal total revenue; i.e., you don’t make any money, but you don’t lose any money either. If you produce more units than at the break-even level, you will be generat- ing a profit. Conversely, if you produce less than the break- even level, you will be losing money. The following are typical terms that are used in performing a break-even analysis: • Selling Price (SP)—This is the price that each unit will sell or retail for. The SP is generally expressed as revenue in dollars per unit. • Variable Costs (VC)—These consist of costs that vary in proportion to sales levels. They can include direct mate- rial and labor costs, the variable part of manufacturing overhead, and transportation and sales commission expenses. The VC are usually expressed as a cost in dol- lars per unit. • Contribution Margin (CM)—This is equal to sales rev- enues less variable costs or SP – VC. • Fixed Costs (FC)—These costs remain constant (or near- ly so) within the projected range of sales levels. These can include facilities costs, certain general and adminis- trative costs, and interest and depreciation expenses. The FC are usually expressed as a lump-sum cost in dollars. • Units (X)—The unit is another way to say number of items sold or produced. For the purpose of a break-even calculation, it is assumed that the number of units pro- duced during a period is equal to the number of units sold during the same period. The following steps are involved in calculating the break-even point for a business. Remember, at break-even, the total sales revenue is equal to total costs (fixed and variable). Determine the variables: FC, SP, and VC. Occasionally, the selling price and variable costs are not identified separately; instead, a contribution margin (CM) is given. The CM can still be used in the break-even calculation, replacing the SP and VC. Calculate the number of units produced or sold at break-even. SP(X) = VC(X) + FC Rearranging the formula to solve for X, the number of units at break-even will give you: X = FC / (SP - VC) or X = FC / CM Calculate the break-even revenue in dollars as follows: break-even revenue ($) = (break-even units) x (selling price) For example, let’s say you manufacture widgets. Each unit retails at $5. It costs you $2 to make each one, and the fixed costs for the period are $750. What is the break-even point in units and in sales revenue? SP = $5 VC = $2 FC = $750 Break-even units: X = FC / (SP - VC) = $750 / ($5 - $2) = $750 / $3 = 250 units Break-even sales revenue = break-even units x SP = 250 x $5 = $1,250 In other words, you would have to manufacture 250 widg- ets to break-even, which results in a revenue of $1,250. 2.4 PRICING AACE INTERNATIONAL
- 38. OUTPUTS These are the documentable items that result from the pricing process and include • project acquisition, • business decision, and • lessons-learned. A project is acquired as a result of the application of a finan- cial analysis on the scope and work breakdown structure (WBS) on the preliminary information. A decision is made on a business proposition based on the tools and techniques (financial ratios) being applied to the information in order to make a decision on the business. Lessons are learned from any process and the pricing process is no exception. SUMMARY In reviewing the following tools and techniques, it is obvious why pricing is considered to be an art by many cost man- agers: • differentiating between costing and pricing; • establishing a framework for the comparison of pricing strategies on projects; • analyzing profitability and establishing ROI, RAI, and ROA; • establishing ROS parameters; and • understanding the concept of break-even analysis for any business situation. However, the pricing tools, techniques, and processes present- ed in this chapter combine art and science will result in a disci- plined process when properly applied. Finally, it must be remembered that in reviewing all financial ratio figures, it is a good idea to be sure that everyone involved does the following: • defines the ratios the same way, and • understands the limits of the concept when used to sup- port business/project decisions PRACTICE PROBLEMS AND QUESTIONS 1. Why is it correct to use cost and pricing interchangeably in the real world? 2. How does cost and price differ? 3. Explain the differences between Type I and II objectives for the acquisition of a business/project. 4. Based on the table below, calculate the cash flow and ROI. 5. Let’s say you manufacture widgets. Each unit retails at $5. It costs you $2 to make each one, and the fixed costs for the period are $750. What is the break-even point in units and in sales revenue? 6. Define ROS, and RAI. REFERENCES 1. AACE International. 2002. Skills and Knowledge of Cost Engineering. 4th ed. Morgantown, West Virginia. 2. Kerzner, Harold. 1998. Project Management: A systems Approach to Planning, Scheduling and Controlling. New York: John Wiley and Sons. 3. Project Management Institute (PMI). 2000. The Project Management Body of Knowledge. (PMBOK 2000) 4. Jelen, F. C. and J. H. Black. 1983. Cost and Optimization Engineering. New York: McGraw Hill. 5. Funk and Wagnalls. 1975. Standard Encyclopedic Dictionary. Funk and Wagnall Publishing Co. 2.5 AACE INTERNATIONAL PRICING Time, end year After Tax Profit, K$ Depreciation, K$ Cash Flow, K$ 0 -5,000 0 1 750 400 2 500 400 3 300 400 4 200 400 5 0 400
- 40. INTRODUCTION Materials are a key element in most projects and production endeavors. There may be isolated instances, such as a service call for the adjustment of a component, where no materials are required. However, in most cases, materials and their related issues must be addressed by those responsible for the project. Materials have the quality of being purchased by those uti- lizing them, rather than being manufactured by the subject entity. Thus a tree log is material to the lumber mill that man- ufactures it into dimension lumber (product), which is mate- rial to the roof truss plant that fabricates it into a roof truss (product), which is material to the home builder that incor- porates the roof trusses into a finished house. Materials are a key resource in almost any economic endeav- or. Materials range from the simplest of raw materials to the most complex fabricated materials with a large range in between. The simplest of raw materials may be silica sand from a pit that is mined in order to manufacture glass. On the other end of the spectrum, an electronic components manu- facturer may require complex fabricated materials such as a printed circuit board containing millions of transistors. While both the glass and the printed circuit boards rely on a form of silica, there are vast differences in the degree of com- plexity between the two. Besides the issues of materials type, materials must be pro- cured in proper amounts at the right time and at the right cost in order to lead to an efficient production process. In addition to materials shaped in the particular production process, those machines and related equipment that perform the work also need maintenance materials, again, ranging from the simple to the complex. Simple materials may consist of grease and oil whereas complex materials may again con- sist of fabricated items. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • identify types of project materials; • understand the issues involved in selecting and handling materials; • understand the principles of materials purchasing and management, including maintaining the proper amount of stock to save money and avoid waste and production delays; and • understand possible safety hazards associated with materials and be aware of regulations governing worker and materials safety. MATERIALS COMPETITION Practical selection of materials for a given application must always take into account materials competition issues. Materials compete on a number of characteristics including cost, availability, service life, weight, corrosion/wear resist- ance, machinability, weldability, and other ease-of-fabrica- tion criteria. A standard phrase used in industry is “there are no bad materials just bad applications of materials.” The strong performance of materials in one application does not guarantee success in a differing application and sometimes the differences may be difficult to ascertain. The automotive industry is a prime example of continued competition among materials due to various factors, such as weight with its attendant impact on fuel economy. Steel has been replaced in numerous applications in autos by the advent of high performance plastics and aluminum. At first, targets were nonstructural auto applications, such as interior panels and interior trim items. These plastic and aluminum components through further engineering have migrated into structural auto components, such as tanks and body parts. Steel auto applications have also witnessed significant 3.1 AACE INTERNATIONAL MATERIALS Chapter 3 Materials Neil D. Opfer, CCE
- 41. changes through the advent and improvements of high- strength, low-alloy steels. Galvanized steels in auto body fab- rication have seen increased use through the advent of two- sided galvanized steels, with a mini-spangle spray applica- tion of zinc galvanizing that permits smooth-finish painting. MATERIALS HANDLING In the materials area, the materials handling issue is a signif- icant concern regarding cost structure and system efficien- cies. Materials handling is a requirement of the production process, but inefficiencies in this area create plant-wide prob- lems. Poor materials handling can result in damage to either raw materials or the finished product. An inefficient materi- als handling system can slow production operations creating other excessive costs due to production delays. Materials Handling Principles All materials manufacturing situations are somewhat differ- ent. However, there are some basic principles in this area that find wide application. These basic principles include • material movement should be over the shortest distance possible; • terminal time should be in the shortest time possible, since the objective is to move materials; • eliminate manual material handling when mechanized methods are feasible; • avoid partial transport loads since full loads are more economical; and, finally, • materials should be readily identifiable and retrievable. Some of these above principles always apply whereas others are situation specific. Mechanized material handling meth- ods are most cost-effective in high wage countries. In a less- er-developed country, the capital/labor trade-off given low wages will tend to emphasize manual methods as compared to equipment-intensive operations. In virtually all situations, it is uneconomical to delay material handling equipment at terminal points for materials loading and unloading. Thus, materials can be loaded onto containers or pallets that are quickly transferred on and off materials handling platforms. Materials Handling Decision Factors There are four basic decision factors that affect materials han- dling. These four factors are 1. material to be handled, 2. production system type, 3. facility type; and 4. materials handling system costs. The material to be handled will impact numerous other deci- sions. A brick manufacturing plant will be dependent upon a source of clay material. In part, this clay can be handled much as other earthen products are handled with similar equipment, including front-end loaders and conveyors. A paint production facility will handle numerous raw materials through pipelines, thus requiring other criteria. Such materi- als as pipe or structural steel in a fabrication facility will require overhead cranes and forklifts for their movement. The production system type will be divided into job shop or batch process and continuous process types. Continuous processes, such as seen in a petrochemical plant or a steel mill, will find fixed-path equipment, including conveyor lines and pipelines. Job shop or batch processes need more flexibility in their material handling requirements. Many job shops perform unique jobs, and large investments in single- application equipment are often not economical. The facility type will govern materials handling decisions. A facility with low-ceiling heights and barely adequate struc- tural system will not be a candidate for installation of over- head cranes. Rectangular facilities versus other facility shapes will govern production layout and hence material handling decisions. Material handling system costs and their economic feasibili- ty will be dependent on labor costs in the capital/labor trade- off equation. Predicted demand for a facility can help in the economic and practical evaluation of alternatives. Facilities with high levels of demand over several years can better jus- tify more expensive materials handling systems. Comparisons between alternative materials handling sys- tems is difficult and must include not only initial costs but life-cycle costs as well, such as labor, maintenance, repair, energy, and disposal costs. TYPES OF MATERIALS AND RELATED INFORMATION Materials, for purposes of differentiation, can be segregated into four basic categories: 1. raw materials, 2. bulk materials, 3. fabricated materials, and 4. engineered or designed materials. These categories are differentiated on the criteria of the amount of processing required for the material to be useful for its intended purpose. Raw Materials Raw materials are those materials utilized in a production or fabrication process that require a minimum amount of pro- cessing to be useful. The most basic example of this might be 3.2 MATERIALS AACE INTERNATIONAL
- 42. natural gravel from a river deposit that, combined with some screening for size separation, is then used as a subbase mate- rial for a roadway or foundation slab. The gravel can further be processed into materials for a concrete mix. In the steel- making process, certain raw materials such as coal, lime- stone, and iron ore are mined for eventual combination and utilization for producing steel. Bulk Materials The steel product can be considered to be a bulk material in all of its various forms, including sheet steel, steel bars, steel pipe, and structural steel shapes, such as wide-flange beams and angles. The bulk materials category is distinguished by its availability. A customer desiring a bulk material such as steel pipe can call a distributor and achieve delivery of this pipe as soon as the next day, depending on transport dis- tance. Bulk materials in common sizes are typically readily available with minimal lead times for order and delivery. Fabricated Materials Fabricated materials are bulk materials transformed into cus- tom-fit items for a particular product or project. As an exam- ple, the bulk material of steel pipe is transformed by fabrica- tion operations into custom dimensions for a particular use, such as in a petroleum refinery. If the particular use is a weld- ed piping system with flanged fittings, the pipe will be cut to dimension with welded flanges added where necessary based on shop drawings. In the shop drawing phase, data from design drawings, which have been prepared by the project’s or product’s design professionals, is used to develop detailed shop draw- ings. These shop drawings need to convey all information necessary for the fabrication of the given item. In some cases, the shop drawings will also provide information for field assembly and erection of the fabricated items. The design professionals typically require review shop drawings prior to fabrication for acceptance. The design professional’s review of shop drawings is undertaken to ensure conformance with original design intent. The historical separation between design drawings and shop drawings is due to the fact that fabricators are more familiar with economies of fabrication. Therefore, as long as design intent is met, the fabricator has a significant degree of flexibility, thus leading to lower costs in the fabrication process. Engineered/Designed Materials Engineered or designed materials constitute a category requiring substantial working in order to attain their final form. Design or engineered materials are also based on shop drawings. These engineered materials may consist of many components and subcomponents that end with a completed product. They consist of such diverse items as pumps, motors, boilers, chillers, fans, compressors, transformers, and motor control centers. The engineered materials producer, in some cases, will be producing these items as off-the-shelf products, and in other instances as custom products. An engineered item, such as a fan, will consist of such compo- nents as a fan housing, impeller, shaft, bearings, motor, and support base. Items such as the impeller, shaft, and fan hous- ing may be manufactured directly by the subject vendor from various materials. Bearings and motor may come from other manufacturers to be added as components of the final prod- uct. The degree of capabilities possessed by the particular manufacturer will often be the deciding factor concerning what items in the final product are self-performed and which are subcontracted out. The issue of custom or off-the-shelf products will have an impact to the potential customer on availability. The manu- facturer will often produce standard sizes and maintain these in inventory. Unusual sizes will require special designs and often lengthy lead times. In materials procurement and selec- tion, those responsible will want to analyze these issues for value-added benefits. In certain cases, the cost- and time- effective alternatives may be to attempt to standardize as much as possible to allow purchase of off-the-shelf compo- nents rather than custom items. PRODUCTION MATERIALS PURCHASE AND MANAGEMENT Materials procurement is an important business function because it has a key role on the organization’s ability to offer products at a competitive price. Purchasing can be defined as the acquisition of necessary materials of the correct quality at the correct time for a competitive price, from the selected ven- dor or supplier. Sufficient stocks of materials must be acquired to prevent delays in production operations. Thus the concept of safety stocks are important whereby ensuring the critical amount on hand when a replenishment quantity is received. The safety stock’s purpose is to protect against the uncertainty in demand and in the length of the replenishment lead time. On the other hand excessive materials supplies create addi- tional costs and problems for the organization. Excess materials beyond reasonable quantities require an investment in oper- ating capital to finance this inventory and require storage 3.3 AACE INTERNATIONAL MATERIALS GLOSSARY TERMS IN THIS CHAPTER bill of materials ◆ bulk materials ◆ cycle stock engineered or designed materials ◆ expiditing fabricated materials ◆ inventory ◆ production purchasing ◆ raw materials ◆ safety stock ◆ surplus
- 43. space. Moreover, excess material quantities can lead to dam- age and theft. Materials Quality Materials procurement must focus on the proper quality of the required materials. This implies the existence of prede- termined standards and specifications to measure materials acceptance. Over-specifying on higher-quality materials in excess of requirements will lead to excessive costs and cus- tomers may not appreciate these benefits. Similarly, the usage of poor quality materials can result in product defects lead- ing to increased costs and potential litigation problems. Materials Vendor Surveillance and Materials Traceability In certain situations, the criticality of materials in a given application is such that vendor surveillance is an important requirement. Vendor surveillance may require periodic inspection by purchasers at the vendors’ location(s) to ensure conformance with performance standards and specifications. Depending on volume and criticality, this periodic inspection may need to be conducted on a full-time basis at the subject vendor facility. Materials traceability is accomplished by means of mill certifications. Before a material is utilized in a given application, mill certifications ensure that the material used meets the purchasing specifications. Thus, a mill certifi- cation will verify that a material, such as cross-linked poly- ethylene tubing, is in fact as it has been represented before incorporation into a finished product. Materials traceability is a key issue, because the improper substitution of one improper type of material for the speci- fied material can lead to significant in-service problems and defects. A railroad car manufacturer that utilizes the improp- er lower grade of steel of mixed steel in fabricating railroad car axles will witness a significant number of service failures resulting in expensive call-backs and repairs. Materials Quantity Funds spent to acquire materials are a cost to the firm until these same materials can be sold as part of the completed product. Firms in industries where materials obsolescence is a factor encounter special problems in holding excess materi- al quantities. As an example, a large inventory of printed cir- cuit boards may have to be discarded or drastically discount- ed as technology changes thus creating obsolescence. Materials storage is a further burden that can sometimes exceed the value of the materials. The simple example of stor- ing some bags of cement proves this point. If the inside stor- age space costs $100 per square meter per year, and the stor- age of an excess of 20 bags of cement valued at $5 per bag takes up 1 square meter of space, any storage beyond one year, therefore, exceeds the actual value of the stored cement. On the other hand, maintaining insufficient materials inven- tories may create dangers of “stock-outs” interrupting the production process. Ordering too-small materials quantities may create higher costs through missing the economies of volume discounts. The organization needs to balance these competing issues involving materials quantity. Economic Order Quantity As aforementioned, there must be sufficient materials invento- ry to meet production requirements while still avoiding exces- sive inventory carrying costs and storage costs. In order to bal- ance these competing demands, the firm must determine its economic order quantity (EOQ) number. This EOQ number is determined based upon materials costs, storage costs, order costs, and annual demand. A garden tractor manufacturer has a requirement for 15,000 engines per year. The engines each cost $75. The order cost for a purchase order is $250. The stor- age costs for the engine are $12 per year which includes space costs and financing costs. The standard formula for EOQ is _____________ EOQ = [√ (2 x D x O) / S] where D = annual demand, P = purchase order costs, and S = storage/carrying costs. Thus, in this example: _____________________ EOQ = [√(2 x 15,000 x $250) / $12] = 790 Therefore, in this case, the manufacturer should order 790 engines at a time which is the EOQ value. The formula for computing reorder point (RP) is: RP = (O x R) + I where RP = reorder point, O = order time, R = production rate, and I = minimum inventory level or safety stock. Assume that the production process uses 60 engines per day for the 60 garden tractors produced per day. If the lead time for an order is 5 days, and the safety stock level is 180 engines (mini- mum level), then the reorder formula in this example yields: RP = (5 days x 60 units/day) + 180 units = 480 units Thus the EOQ value of 790 engines should be ordered when- ever inventory drops to 480 units. Cycle stock levels main- tained at very low levels can almost ensure the potential for production delays. 3.4 MATERIALS AACE INTERNATIONAL
- 44. Just-In-Time Inventory Techniques Recent years have seen the widespread introduction of just- in-time techniques for materials procurement across various industries. The just-in-time concept implies that the exact materials quantities needed are delivered at the exact time needed. The goal is to reduce inventories. Traditional prac- tices that focus on safety stocks can mask unprofitable varia- tions in the production process. By removing these safety stocks, the goal of just-in-time systems is a lean production process and an enhanced competitive position. Individual Purchasing Orders and Systems Contracts Nonstandard and costly items may be procured by the pur- chasing function through a system of plans/specifications requirements and competitive bidding. For items that the organization utilizes on a continual basis, a systems contract may be the best solution. At the start of every year, the organ- ization estimates potential quantities of required materials and places these out for bid on a systems contract. Thus, a fabricator during a year may require x thousand pounds of various types of welding wire and welding rod for their operations. This is bid on a systems contract with periodic deliveries throughout the year as usage demands based on actual production. If quantities vary significantly higher or lower, there may be additional provisions for price adjust- ments in the systems contract or for inflationary upstream price increases not controllable by the vendor. The advantage of the systems contract is reduced purchasing work load and improved pricing based on economies of scale. Expediting Expediting involves the monitoring of all steps in the pro- curement cycle to ensure on-time delivery of the necessary materials. This monitoring includes checking design status, material status, production status, and shipping status. Analysis of potential delays is a key element in the expedit- ing process. If shipping delays take place, alternative forms of delivery may be necessary to avoid production delays. By continually reviewing status, the expediting process helps to avoid unpleasant interruptions of the production process. Expediting communication is conducted through telephone, fax, and e-mail methods. Personal visits to vendors as part and parcel of vendor surveillance efforts can also be helpful. The author remembers one site visit to a manufacturer of motor control centers for a wastewater treatment plant. The week before surprise site visit, the manufacturer had prom- ised over the telephone that the motor control centers were almost ready to ship. Instead, it was found upon a site visit that this manufacturer had not even started construction on these units. Global Materials Decisions Materials fabrication decisions as to locations and methods are being made on a global basis. An example may assist in illustrating this concept. A large East-coast hotel in the United States wanted a series of simulated trees and canopies created inside the hotel areas with beads simulating the tree and canopy cover. These beads would be strung such that there were 9,000 beads per square meter, and there were almost 200 square meters of area to cover. A West-coast interior theming firm won the contract. The quantities meant that nearly 1.8 million beads would need to be strung on the canopies and trees at a com- petitive price. The trees and canopies were fabricated out of structural steel at the firm’s West-coast fabrication shop. To be cost-competitive, the beads and the bead stringing work were subcontracted to a firm in India. In India, skilled crafts- people strung the beads. The steel frames were shipped to India, strung with beads, and then transshipped to the U.S. East-coast hotel for final installation. PLANT MATERIALS MANAGEMENT Plant materials are a special category of materials. These are materials that are not associated with incorporation into any particular product or project. Instead these are materials that assist the plant in completing materials fabrication and pro- duction operations. Examples range from oils, greases, sol- vents, and cutting bits to parts, such as spare motors or cylin- ders for a production machine. These plant materials assist in the production, maintenance, and repair of the facilities. Commodity plant materials such as oils, greases, solvents, and cutting bits, are typically low- cost items with predictable usage patterns. Moreover, sources of supply are readily available and order/procurement lead times are minimal. Specialized Plant Materials Specialized plant materials such as production equipment replacement parts can pose more difficult problems. A partic- ular replacement part may be available only from the original equipment manufacturer (OEM) and require significant lead time. Those responsible for this area will want to maintain an inventory of critical replacement parts. Supplementing replacement parts inventory is networking with other manu- facturers or fabricators owning the same type of equipment that may be willing to “loan” out a replacement part item in an emergency. A secondary strategy is to have a backup plan in place to procure replacement parts through other manu- facturers if there are difficulties with the OEM. Plant Materials Benchmarking Plant materials usage and longevity should be tracked through such measures as benchmarking. Benchmarking involves the examination of other organizations as to their 3.5 AACE INTERNATIONAL MATERIALS
- 45. practices. The benchmarking organizations do not need to be competitors but merely similar organizations. Therefore, a structural steel fabricator may examine the operations of a steel pipe fabricator for comparison of operational practices. Often it becomes easier to study the actions and practices of another organization than your own because it is easier to be objective. Studying your own organizations’ materials man- agement practices brings with it a certain degree of defen- siveness and rationalization of poor practices. Benchmarking can, in turn, invite others from various organizations into the subject organization for an evaluation of practices. MATERIALS WASTE PRODUCT AND HAZARD ISSUES Users and producers of materials deemed as hazardous to humans are required to comply with government regulations concerning hazard communication. The purpose of these reg- ulations is to ensure that potential hazards are properly eval- uated and hazard information is properly communicated to employers and employees. These requirements include labels, warnings, material safety data sheets, information, and training. A fabricator, for example, may be utilizing a solvent for clean- ing parts prior to a welding operation necessary to join the parts. The potential effects of the solvent on employees from fumes or direct contact must be properly evaluated prior to use. Moreover, some employees may have special allergic reactions to this particular cleaning solvent. Material Safety Data Sheets and Hazard Communication Materials safety is always an important issue in the safe han- dling, fabrication, and transport of materials. In the United States, material safety data sheets (MSDS) must be readily available and accessible to those dealing with the particular hazardous materials as required by Occupational Safety & Health Administration (OSHA). Other countries may have similar regulations. An organization with multiple work locations must have complete files on these MSDS sheets for review and inspection. The MSDS requirements can force a re-examination of various issues in terms of the use and application of hazardous materials. The organization may find that they are using four different types of cleaning sol- vent for the same application, each with its own attendant MSDS issues. Based on an evaluation, these four solvent types may be narrowed to one type, promoting standardiza- tion and, thus, reducing potential problems. With the wide- spread advent of the Internet, Web publishing of this MSDS information may be a viable alternative. Web publishing ensures current up-to-date information is available anywhere in the organization through computer access. These MSDS sheets contain information on chemical and com- mon names of ingredients including substances that may be carcinogenic along with physical and chemical material char- acteristics such as vapor pressure and flash point. Other MSDS information includes physical hazards, such as fire and explo- sion potentials. Health hazards listed in MSDS information include primary routes of entry, exposure symptoms, and medical conditions which may be aggravated by exposure. Environmental Regulations Materials production operations involving potential hazards to the environment must pay attention to environmental reg- ulations. As an example, in the United States, solid waste is regulated from “cradle to grave” through the Resource Conservation And Recovery Act (RCRA). RCRA regulates three categories of hazardous waste handlers: (1) generators, (2) transporters, and (3) owners and operators of treatment, storage, and disposal (TSD) facilities. Hazardous waste gen- erators must keep accurate records, store waste in approved containers, label the waste, and utilize a manifest system to track the waste until delivery to a TSD facility. Violations of RCRA can result in civil and criminal penalties including fines of up to $25,000 per day assessed by the U.S. Environmental Protection Agency. Waste Materials and Surplus Materials Production operations on materials frequently result in the production of significant quantities of waste materials. This production of waste materials or scrap is a significant cost in numerous production processes. This cost comprises the original materials’ cost plus waste material handling and dis- posal costs. Reduction in materials waste thus provides a cost reduction potential in these three areas. Some waste materi- als can be reused in the production process. A grade of steel not meeting requirements in one use may be reutilized for a product not requiring a premium steel grade. A steel manu- facturer can take scrap steel from downstream production processes and transfer the scrap upstream to re-melt the scrap as a raw material component. Surplus materials result from either mistakes due to exces- sive ordering, changes in material requirements, and/or incorrect original quantity information. The production of an order for a job shop production process may have specified a given number of pieces of steel plate. The original take-off regarding material requirements was incorrect. Mistakes may have taken place in development of the bill of materials. If this is material for which there is a continuing use, it may make sense to return the materials to inventory with a credit to the job shop order. Purchasing may have incorrectly processed the order with an incorrect quantity requirement. With a fast-track fabrication job, the requirements for the steel plate may have been a late design change where the materials procurement function could not act soon enough to cancel the order. In any case, the existence of surplus materials 3.6 MATERIALS AACE INTERNATIONAL
- 46. points to inefficiencies in the materials process. Returning the materials to the original vendor may be possible, although, in most cases, a restocking fee of 15 to 20 percent or more may be charged to the organization. However, unless, as noted above, the materials have a continuing use in fabrication operations, this may be the most economical course of action. The prevalence of surplus materials should be tracked with the goal of minimization of this expensive practice. SUMMARY Users and producers of materials must recognize potential areas for practice improvement. The recognition of the impact and potential of materials issues will lead to more rational decision processes by those responsible. This will result in an improved cost structure for the organization bet- ter able to achieve competitive advantage. The general objec- tive of materials procurement is to minimize total costs through reduction in purchase costs, material handling costs, storage costs, and shortage costs. Tools such as the EOQ for- mula can lead to more rational decision processes in this area. In recent years, techniques such as just-in-time inventory methods have seen widespread introduction in materials- intensive applications. PRACTICE PROBLEMS AND QUESTIONS Questions: What materials handling method would be most appropriate for each choice? What factors must be consid- ered for each of these alternatives? Problem 2: What is meant by the concept of materials lead time? Outline the procedure through a flow chart for deter- mining the reorder point for a given material. Problem 3: Survey the methods at a supermarket used for merchandizing liquids in approximately one liter containers. Describe at least five different products, identifying the mate- rials of construction and probable production processes. Problem 4: Take a site visit to a large construction project. Survey the methods used for material handling on the proj- ect and suggest potential feasible alternatives. REFERENCES 1. Azadivar, Farhad. 1984. Design And Engineering of Production Systems. San Jose, California: Engineering Press, Inc. 2. Hayes, Robert H., Steven C. Wheelwright, and Kim B. Clark. 1988. Dynamic Manufacturing: Creating the Learning Organization. New York: The Free Press. 3. Kalpakjian, Serope. 1991. Manufacturing Processes for Engineering Materials. 2nd ed. Reading, Massachusetts: Addison-Wesley Publishing Company. 3.7 AACE INTERNATIONAL MATERIALS Problem 1: You are planning a materials production process that utilizes cement as a raw material. You can have the cement (1) received in bags, (2) received through a dry-transfer piping system from a rail head located one mile from your plant, (3) receiving the cement in bulk con- tainer bins, or (4) receiving the cement via a hopper truck.
- 48. INTRODUCTION As an owner, employer, project manager, and estimator, I have a given set of work tasks that I need a worker to com- plete. As such, I need to know how much this will cost me. I also need to know how to set up and monitor the effort, so that I can be assured that I am getting the desired work prod- uct in the timeframe required and for a price that I can afford. In order to do this, I need to understand the cost factors that go into this work and the techniques to monitor progress to ensure that I will achieve my goals. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • identify different classifications of labor and how each contributes to the final completed project; • develop labor rates for estimating, and develop and use weighted average rates/composite crew rates; • include indirect and overhead labor and other costs; • estimate work hours for a given work scope at a given location; and • use labor hours to monitor work progress. LABOR CLASSIFICATIONS The following definitions were taken or adapted from AACE International’s Cost Engineer’s Notebook [1]. • Direct Labor—The labor involved in the work activities that directly produce the product or complete the instal- lation being built. • Indirect Labor—The labor needed for activities that do not become part of the final installation, product, or goods produced, but that are required to complete the project. • Overhead Labor—The labor portion of costs inherent in the performing of a task (such as engineering, construction, operating, or manufacturing), which cannot be charged to or identified with a part of the work, and, therefore, must be allocated on some arbitrary basis believed to be equi- table, or handled as a business expense independent of the volume of production. Table 4.1 provides examples of different labor classifications and costs. The examples are not all-inclusive and only serve to illustrate the elements of each type of labor. 4.1 AACE INTERNATIONAL LABOR Chapter 4 Labor Morris E. Fleishman, PE CCE Cost Type Direct Labor Indirect Labor Overhead labor Construction Carpenters, Electricians, Ironworkers, etc. and Foremen working on the project General Foremen, Construction Management, Field Purchasing, Field Warehouse personnel, Payroll Personnel, Jobsite Computer Support, Project Cost Engineers and Schedulers etc. Home Office Support such as; Legal Assistance, Procurement, Human Resources, Senior Management review, Corporate Computer Support, Estimating and Business Development, etc. Manufacturing Plant Equipment Operators, First Line Foreman, and Supervisors, etc. Plant Accountants, Maintenance Personnel, Purchasing Personnel, Security, Plant Supervision, Warehouse Personnel, Production Planning and Cost Personnel, On-site Computer Support Corporate support: Legal, Human Resources, Computer Support, Corporate Finance and Accounting Support, Sales, etc. Engineering Civil, Mechanical, Electrical, Instrumentation and Controls Engineering and first line supervision Documentation Support – duplicating and record keeping, Engineering Cost and Scheduling Personnel, Project Supervision Corporate Support: Human Resources, Computer Support, Corporate Accounting Support, Estimating, Business Development, etc. Table 4.1—Examples of Labor Costs
- 49. The difference between indirect and overhead labor appears to be somewhat vague. Depending upon the size of a project, plant, or office and its location, some elements could shift from indirects to overheads, and there may be instances where direct labor moves to indirects and overheads as well. For example, if the construction project is small, payroll and accounting may be located offsite and may be composed of personnel who are splitting their time between several proj- ects at different locations. In this instance, this function could be an indirect or an overhead. Therefore, it is imperative that the estimator and/or cost engineer understand where within his project, industry, and company each of these costs are included, so that they can be correctly estimated and includ- ed in the estimate and budget. DEVELOPING LABOR RATES Base Wages The base wage is the amount that will go directly to the employee. The source of these wage structures can be found in databases from previous projects, labor contracts, unit rates supplied by contracting and engineering firms, local chamber of commerce data, government labor statistics, pub- lished labor databases, and standardized estimating publica- tions, such as Means and Richardson [2–5]. Base wages are usually calculated on a per hour basis. However, it can also be a breakdown of weekly or monthly base salary prorated to a daily or hourly rate. The reason for an hourly breakdown is that estimates are usually based upon the amount of work hours to complete. Therefore, the labor cost rates need to be developed on a comparable basis. If one is costing out craft labor, their pay rate is usually given in hourly increments. Supervision, support staff, and engi- neering, etc., often are paid on a weekly, bi-weekly, or month- ly rate. This rate can also be broken down to an hourly rate for estimating and payroll purposes. The following are examples of base wages: • craft personnel—$25.00 per hour, • supervision—$1,200 per week divided by 40 hours per week = $30.00 per hour, and • engineering—$ 60,000 per year divided by 2,080 hours per year = $ 28.85 per hour (2,080 hours = 5 days per week at 8 hours per day for 52 weeks). The examples above can be used to calculate the direct amount that each employee will earn and be paid for each hour that they work. Fringe Benefits Paid time off (PTO)—Most employees have additional ben- efits of time off for local and national holidays, vacation, and sick time. Therefore, in developing a unit cost for labor, a fac- tor is added to increase the estimated and booked cost per hour worked each week to cover PTO. Most companies trans- fer this money to special fund to be used when an employee takes paid time off. In the case of construction craft that may work for many employers during a given period, wages are usually paid into a fund managed by their union or trade organization who distributes the salary for PTO. For example, an engineer gets 5 days of sick time, 10 days of vacation, and 10 holidays per year. His base salary is $28.85 per hour. Adders are • sick time: 5 days at 8 hours /day @ $28.85 = $1,154 per year • vacation: 10 days at 8 hours /day @ $28.85 = $2,308 per year • holiday: 10 days at 8 hours /day @ $28.85 = $2,308 per year • total: $5,770 per year This Engineer is now working 2,080 hours (52 weeks x 40 hours per week) less 25 days at 8 hours or 200 hours for PTO. So his productive time is 1,880 hours. His hourly cost is $28.85 base wage + 3.07 PTO adder ($5,770 divided by 1,880 hours) = $31.92 total. Medical & Life Insurance Benefits—Some firms and labor contracts include contributions to a medical and life insur- ance program. These costs are usually can be calculated on an hourly, weekly, or monthly cost basis and added to the per hour work cost. If the firm that employs the engineer in the previous example contributes $400 per month for medical and other insurances, the following should be added to the hourly costs: $400/month x 12 months = $4,800/year divided by 1,880 hours = $2.55 per hour If the company contributes to 401ks and other retirement- plans for the engineer, the following should be added: $300/month x 12 months = $ 3,600/year divided by 1,880 hours = $1.91 per hour 4.2 LABOR AACE INTERNATIONAL
- 50. Government Mandated Benefits These benefits include such items as government retirement funds, unemployment insurance, retirement healthcare insurance, etc. In the United States, these funds are federal old age insurance (Social Security), Medicare, state unem- ployment insurance, etc. These costs are usually calculated on a straight percent of the worked hours. Continuing with our example engineer, we will add the following: • retirement (6.2%) = .062 x $28.85 =$ 1.79 • retirement medical (1.35%) = .0135 x $28.85 =$ 0.39 • state unemployment (1.0%) = .01 x $28.85 =$0.29 total government mandated benefits = $ 2.47 Summary of Engineer’s Wages Example The cost basis for an engineer who makes $60,000 is summa- rized in Table 4.2: Engineer/Contractor Overhead and Profit The above calculations will apply for the direct hire of indi- vidual workers. When hiring contract employees, or estimat- ing an engineer or contractor’s costs, labor rates are usually broken down differently: • base wages including fringes, • worker’s compensation (if applicable), • overhead, and • profit (if applicable for time and material situations). In these instances, the vacation, sick time, retirement contri- butions, and medical contributions are included in the fringes. Worker’s compensation is a direct government rate. Overhead will apply to the home office cost of administra- tion, payroll, and billing, etc. Profit usually only applies to approved time and material changes. All of these costs are dependent upon what type of contract is negotiated. R.S. Means, for example, includes a table of average rates for various types of contractor personnel including overhead and profit in their manual Concrete & Masonry Cost Data 2001 [5]. These labor rates are based upon a survey of union rates in 30 cities. Fully-Loaded or Billing Rate A fully-loaded rate is the base salary plus adders that will be paid for an hours work on the job. An owner employing a con- tractor on time and material basis only pays for the workers time when he is on the job. If he is sick, on vacation, or holiday, the contractor cannot bill the owner. However, the payment rate charged usually includes funds to cover this paid time off. The contractor either places the funds in a separate account for use when the worker is off or, if the worker is in a union, the union may get the funds to disburse when the worker is off. All estimates relating cost of labor to work performed are usu- ally calculated using the fully-loaded rates. Overtime Wages There are many different overtime wage situations and there are several aspects that need to be evaluated in developing an overtime wage structure. Overtime can range from straight time pay for the additional hours beyond the stan- dard workweek of 40 hours or 8 hours per day, to 1.5 and 2.0 times the regular pay. When developing the overtime formula the estimator needs to take into account that some benefits are calculated on an 8- hour day or 40-hour week and are not added to overtime hours. Benefits such as PTO, some insurance, and some gov- ernment funding programs may be included in this category. Government funded retirements, such as Social Security and Medicare, are calculated as a percentage of the wage and are usually added to the overtime rate. The estimator needs to confirm what needs to be added for the specific work area that the project is located in order to develop the correct rate. For example, a craft worker earning $25.00 per hours is work- ing overtime at 1.5 times his base rate at $ 37.50. PTO adders, company insurance adders, and state unemployment are not included. Federal retirement and medical is included at 7.55 percent, which equals $2.83. The total cost per hour for 1.5 overtime is $40.33. 4.3 AACE INTERNATIONAL LABOR GLOSSARY TERMS IN THIS CHAPTER base wages ◆ direct labor indirect labor ◆ overhead labor Per Hour Base Salary Working 1,880 hrs/yr = $28.85 Fringe Benefits: company retirement contributions = $1.91 PTO (holidays, vacation, sick time) = $3.07 company medical and life insurance = $2.55 government mandadted benefits (retirement, etc.) = $2.47 Total Cost Per Hour Benefits Adder = ($38.85 - $28.85) = $10.00 = $10.00/28.85 =$34.7% Table 4.2—Example Labor Costs for Engineer
- 51. WEIGHTED AVERAGE RATES/CREW COMPOSITION RATES Most estimates are for groups of workers who have a variety of backgrounds, years of experience, etc. In the craft area, within each craft you could have a range of apprentices to journeymen at the top step of the salary ladder based upon their training and years of experience. The same applies in the engineering ranks as your team mix will have beginning engineers right out of school, engineering aides, registered engineers, senior engineers, etc. Since you don’t know who will be part of the actual team, you must make some assump- tions in order to develop a comparable base wage rate to use. In most cases you will build a weighted average team. Example Calculation: A contractor needs to make up time in his schedule. If he works the concrete crew shown above 10 hours per day for two weeks and 10 hours a day on two Saturdays, how much extra will it cost him? Overtime is paid for all hours over eight, Monday thru Friday and the first eight hours on Saturday. Double-time is paid for hours greater than eight on Saturday and all Sunday work. Monday thru Friday = 2 hours per day = 10 hours of 1.5 time Saturday = 8 hours Total 1.5 time = 18 hours Saturday Double time = 2 hours Crew Cost (1.5 time) = $29.58/hour x 9 workers x 18 hours x 2 weeks = $ 9,584 Crew Cost (2 time) = $ 39.44/hour x 9 workers x 2 hours x 2 weeks = $ 1,420 Total = $11,004 Normal time cost if no OT worked = $23.83/hour x 9 work- ers x 20 hours x 2 weeks =$ 8,579. Additional cost to work overtime $2,425. INDIRECT AND OVERHEAD LABOR The examples above have shown how to determine wage rates and how to use them to develop an estimate for the direct portion of the work. However, a complete estimate needs to include indirect and overhead labor and other costs as well. Overhead and indirect positions were discussed at the beginning of this chapter and were illustrated in Table 4.1. There are two methods of determining these costs that will be addressed here. The first method is to do a direct estimate of the indirect staff required and cost them out the same way as the direct work crews. For example, if we were building a manufacturing facility that will take a year, the indirect support could consist of the personnel listed in Table 4.4 using wage rates determined by methods explained earlier: As was shown in Table 4.1 on page 4.1, a manufacturing facil- ity or power plant will have the same kinds of functions that will be included in their list of indirect labor positions. 4.4 LABOR AACE INTERNATIONAL Civil Engineering Design Team No. Classification Hourly Base Wage Extension 2 Engineering Aides $14.00 $28.00 2 Junior Engineers $20.00 $40.00 4 Engineers $25.00 $100.00 2 Senior Engineers $30.00 $60.00 1 Eng. Supervisor $35.00 $35.00 11 Total $263.00* *Average cost for the group = $263.00/ 11 = $23.91/hour with benefits adder of 34.7% = $32.21/hour. Composite Concrete Crew– Normal Time (40 hours per week) No. Classification Hourly Base Wage Extension 2 Laborers $14.00 $28.00 4 Carpenters $18.00 $72.00 2 Cement Masons $20.00 $40.00 1 Foreman $25.00 $25.00 9 Total $165.00* *Average cost for the group = $165.00/ 9 = $18.33/hour with benefits adder of 30.0% (assumed) = $23.83/hour Composite Concrete Crew—Overtime (1.5 times Normal wages over 40 hours per week) No. Classification Hourly Base Wage Extension 2 Laborers $14.00 x 1.5 $42.00 4 Carpenters $18.00 x 1.5 $108.00 2 Cement Masons $20.00 x 1.5 $60.00 1 Foreman $25.00 x 1.5 $37.50 9 Total $247.50* *Average cost for the group = $247.00/ 9 = $27.50/hour with benefits adder of 7.55% (assumed) = $29.58/hour Composite Concrete Crew—Double Time (2 times Normal wages) No. Classification Hourly Base Wage Extension 2 Laborers $14.00 x 2 $56.00 4 Carpenters $18.00 x 2 $144.00 2 Cement Masons $20.00 x 2 $80.00 1 Foreman $25.00 x 2 $50.50 9 Total $330.50* *Average cost for the group = $330.00/ 9 = $36.67/hour with benefits adder of 7.55% = $39.44/hour Table 4.3—Weighted Average Example
- 52. The second method will be to use historical job percentages to determine an appropriate allowance for indirect labor. Typical examples would include applying a percentage of direct labor, based upon historical data, or applying a per- centage of the total direct costs for both indirect labor, materi- al, and other costs. For example, Estimated Direct Costs = $360, 000 Indirect Costs at 25% = $90,000 (25% is from company historical data) or Estimated Direct Labor = $250,000 Indirect Labor at 30% = $ 75,000 In the second example, material and other indirect costs would have to be estimated separately. The choice of methods will depend upon how much detailed information is available for the estimator to use in develop- ing his estimate. Overhead Labor While indirect costs are often located at the plant or jobsite, overhead personnel are more likely to be located at a corpo- rate facility, which is physically separate from the manufac- turing facility or construction site. These personnel usually work on many different projects for their company at the same time, or just spend short periods, days or weeks, on each project. Examples of theses kinds of positions were included in Table 4.1. For early estimates, the general methodology is to apply a percentage factor to either direct costs, direct labor costs, etc. as determined by corporate historical data to develop your overhead estimate. This method can be used for more detailed estimates as well. A detailed estimate for overhead labor also can be developed using number of persons similar to the indirect labor estimate already illustrated. It is up to management and the estimators involved to determine which method will supply them with the estimate accuracy they need. ESTIMATING WORK HOURS TO COMPLETE A GIVEN WORK SCOPE Estimating work hours is usually not done in detail until enough scope information is available to do at least a Class 3 estimate. A Class 3 estimate, as defined by AACE International1, is a project on which the major equipment has been identified, layout drawings are available, and rough quantities are available for many of the major elements (such as cubic yards of concrete, linear feet of pipe, etc.). (Class 2 or Class 1 estimates would have more detailed unit information, as more of the final drawings would be available). With this kind of information available, the estimators will group these quantities into appropriate work packages, and working with the schedulers, start to develop the work package sequence. They can then estimate the labor costs by multi- plying work hours, from their databases, times the identified quantities. It is critical to do this so that overall staffing requirements over the project duration can be used to con- firm the sum of the individual work package requirements. 1The AACEI classification starts with the least detail, a Class 5 estimate, going to the most detailed, a Class 1 estimate, in which all of the drawings and specifications are completed. AACE International Recommended Practice 18R-97: Cost Estimate Classification System for Process Industries. 4.5 AACE INTERNATIONAL LABOR Indirect Positions Duration On-Site (months) No. of Positions Worker Months Monthly Rate* Estimate warehouse workers 12 2 24 $3,500 $84,000 6 2 12 $3,500 $42,000 accounting clerks 12 1 12 $3,800 $45,600 6 1 6 $3,800 $22,800 payroll supervisor 8 1 8 $4,500 $36,000 first aid person 12 1 12 $4,000 $48,000 safety engineer 10 1 10 $4,600 $46,000 office manager 12 1 12 $5,200 $62,400 clerical support 12 1 12 $3,000 $36,000 6 1 6 $3,000 $18,000 On-site computer support 11 1 11 $5,000 $55,000 Project Manager 10 1 10 $8,000 $80,000 Total Indirect Labor $575,800 * monthly rate includes benefits Table 4.4—Example Indirect Labor for Facility Project
- 53. Work Packaging/Work Breakdown Structure (WBS) The first step is to review the project and develop meaning- ful work packages. Often several summary level estimates are completed before enough of the project is designed to provide the estimator with detailed quantities of material so that a detailed labor estimate can be developed. An example of a WBS is shown below for a small manufacturing facility consisting of a main building, warehouse and office building, site work area including entrance roads and utilities. The WBS for this project is shown in Table 4.5: In the above example, the work hour estimates will be done at the level 3. We will use the main building concrete foun- dation as an example [5, p. 89]: • the building is 300 ft/m x 100 ft/m; • the concrete foundation consists of wall footings, foun- dation walls, and a slab; • the slab will be our example, and it is 1 foot/meter thick; and • the quantity of concrete in the slab is; 200 ft/m x 100 ft/m x 1 ft/m = 20,000 cubic ft/cubic meters = 741 CY/CM. Determination of the work hours required is done by con- sulting a reference database to determine how many hours it has taken historically to complete a foundation slab of this type. There are multiple places to obtain this data including company historical data for projects on this site or in the area, a commercial estimating database, Means, Richardson, etc. For example, using Means2 to place this slab will take .026 labor hours per sf/sm. This equals 20,000 sf/sm x .026 = 520 labor hours. Costs to Support the Worker The costs above include only the direct work required to place the slab. The assumption is that all of the material is on hand, the site is prepared, and the crew is ready to start work. The reality is that the costs need to include many items and support personnel that allow the worker to perform his/her task. In addition to indirect and overhead labor, the following examples further illustrate indirect and overhead costs. Construction indirects and overheads can include items, such as storage and fabrication facilities, lunch and restroom facil- ities, and tool rooms, etc. Manufacturing indirects could include warehouse space, administrative offices, rest rooms, lunchrooms, locker rooms, and raw material loading and unloading facilities. Engineering indirects could include duplicating facilities, computer facilities, administrative offices, and personnel. When doing a conceptual or Level 1 estimate, these will normally be added as a percentage or allowance. When doing a definitive or Level 5 estimate, these costs will be estimated in detail. If you are doing a less detailed estimate, often these support costs are estimated by adding a historical factor to the direct work estimate to pro- vide for these necessary personnel and activities. Factors Affecting Productivity Most estimates are developed from a common database that equates so much work done for so many work hours expend- ed. In the petrochemical industry, common indices are based upon “Houston-Gulf Coast“ production. These rates are then adjusted for conditions at the jobsite. The following is a typi- cal, but not all-inclusive, list of items that each estimator needs to review to determine if they affect the job and the estimate: • Will union or non-union craft labor be used? • Is sufficient labor available locally, or will workers have to come from a long distance away? • If the area is remote, do workers have to be bused in? • What will the weather conditions be like (hot, cold, rainy, etc.)? • Are there any local holidays? • Are temporary living quarters needed? • Is overtime necessary to attract workers? • What are the standard work hours and work days? 2 In this example, measurements are in feet or meters and are designated by ft/m (feet/meters), sf/sm (square feet/square meters), etc. 4.6 LABOR AACE INTERNATIONAL Level 1 - ABC Manufacturing Plant Level 2 - Site Development Main Building Warehouse Roads Foundation Foundation Utilities Excavation Excavation Water Base Fill (gravel) Base fill (gravel) Gas/Electrical Concrete Concrete Sewerage Structural Steel Structural Steel Lighting Building walls Building walls Parking Lot Building roof Building roof Building interior Building interior Building lighting Building lighting Building utilities Building utilities Equipment Office furniture (installation) Equipment (cost) Warehouse equipment Electrical Piping Table 4.5—Example WBS for Small Facility
- 54. The Richardson Estimating System suggests adjustments to their rates for the following [3, p. 1–2]: Jobsite Conditions Good + 3% to 5% Average + 6% to 8% Poor + 9% to 15% Worker Skill Level High + 2% to 5% Average + 6% to 10% Poor + 11% to 20% Temperature Below 40 degrees or above 85 degrees add 1% per degree of variance Work Weeks in excess of 40 hours 40 to 48 hours + 5%b to 10% 49 to 50 hours + 11% to 15% 51 to 54 hours + 16% to 20% 55 to 59 hours + 21% to 25% 60 to 65 hours + 26% to 30% 66 to 72 Hours + 31% to 40% Example Calculation: The standard labor cost for 100 LF of footing 8 inches by 12 inches = $130.90 [3, p. 3–1]. The jobsite conditions are as follows Adders Jobsite conditions Good + 4% Worker Skill Average + 8% Temperature 95 degrees +10% Work week = 40 hours + 0 % Total adders = +22% Unit Rate = $130.90 x 1.22 =$159.70 Productivity Improvements The discussion above was meant to make the reader aware of various conditions that affected both the cost and schedule of the project. Learning Curve—One of the most important items affecting learning curve is the productivity improvement that results from a crew performing repetitive type operations. In a man- ufacturing environment or a construction project where sim- ilar kinds of work are done, the more the crew does the work, the faster and more efficient they become as they become familiar with working together, using the tools, possibly fab- ricating special tooling to make the work easier and faster, etc. This needs to be encouraged and factored into any budg- et or estimate made. Examples of other types of productivity improvements— While it is one thing to recognize existing factors, there is also the opportunity to put in place procedures or make changes to improve productivity and minimize the cost of some of these factors. For example, to shorten waiting time for a crew, mate- rial may be prestaged at the work location, stored on trailers which can be easily moved to the work site, fabricated in sec- tions, and assembled at the work site. To minimize the impact of adverse weather, temporary shelters can be built which pro- vide shelter from the elements. Using portable tool sheds, which can be moved around to various locations as the work progresses, can shorten the time required to pick up tools. In addition to these physical actions, there is a whole series of actions, including training and team building, which can be used to improve communications and working relations between the various crews and personnel on a site. A manufac- turing plant has the added benefit of more permanent person- nel and the same physical location at which all of these ideas can be used to improve the worker’s efficiency. There are many books and programs dealing with ways to improve productiv- ity, and these should be consulted for a complete list of options available. The cost of these types of programs can more than offset by the savings. Using Commercially Available Data for Location Estimating and Comparisons In addition to your own company database, sources for com- parison data include R.S. Means and Richardson Estimating Systems [2–5]. R.S. Means publishes a city-by-city comparison that is also broken down by material and installation costs as by cost division (concrete, masonry, etc.). Their system involves com- paring the ratio of the different city indices to develop a mul- tiplier to apply to your labor cost estimates. Since they also publish unit rates, they offer comparison factors by states by zip code, which can then be adjusted to determine a factor to apply to their unit rate extensions. An example of R.S. Means comparison data for two cities is given in Table 4.6 on page 4.8. The comparisons listed in Means are comparisons to a national average. Therefore, in order to compare one city to another, you need to calculate the ratio difference, not the numerical difference. The city index number = Specific City Cost x 100 National Average Cost 4.7 AACE INTERNATIONAL LABOR
- 55. For example, a building in Chicago was erected for $1,540,000. I want to estimate the cost of the same building in Los Angeles. Index of LA Index of Chicago 108.5 111.4 Note: Explanation from R.S. Means Concrete & Masonry Cost Data 2001 [5, p. 430]. PERFORMANCE MONITORING Work Packaging/Work Breakdown Structure (WBS) An estimate is usually assembled in work packages. Work packages should be clearly identified. Items that determine what makes up a work package include portions of the job that complete a specific portion, building, or area, or are assigned to one subcontractor, can clearly be designed and scheduled, etc. Construction activity has been fairly standard for years. However, manufacturing, power plants, and other portions of industry also utilize labor estimating and control. In their situ- ations, work output and their organizations are more compli- cated than the labor craft versus work activities on the con- struction site. In order to better address their situations, activi- ty-based cost (ABC) methodology has been developed to aid in organizing, analyzing, and setting up labor monitoring systems within these industries. This methodology gives some guide- lines and suggests procedures that can be used to clearly define appropriate work packages. While there is not sufficient time to discuss this methodology here, a discussion of ABC is included in Chapter 8. For purposes of this presentation, we will start with a simple construction-related WBS for a project to install a new boiler at an existing manufacturing facility. 1. mobilization 2. excavation 3. subfoundation 4. slab placement 5. support steel 6. piping 7. boiler installation 8. utilities 9. startup 10. cleanup 11. demobilization The labor estimate is usually the basis for project perform- ance monitoring. The comparison of actual work hours expended, versus the estimated work hours and the devel- opment of a relationship between milestone goals, is a key tool in determining how much of the project is completed, how much effort has been expended to get to the current point, if there are problems, what has to be worked on to overcome these problems, and how this will affect the com- pletion date and final costs. The estimate is shown in Table 4.8: 4.8 LABOR AACE INTERNATIONAL Chicago, Illinois1 Los Angeles, California2 Matl Inst Total Matl Inst Total 02 Site Construction 86.0 91.0 89.8 89.5 109.0 104.5 03 Concrete (Summary) 100.6 134.6 117.6 108.2 115.6 111.9 04 Masonry 93.9 131.5 117.0 97.8 116.5 109.3 05 Metals 96.4 123.7 106.3 111.2 99.3 106 06 Woods & Plastics 103.3 128.9 116.5 99.6 117.3 108.7 07 Thermal & Moisture Protection 99.3 128.7 113.3 114.2 114.6 114.4 08 Doors & Windows 104.1 136.4 111.9 99.1 114.8 102.9 09 Finishes 89.4 129.9 110.1 108.5 116.6 112.7 Total (10-14) (Define) 100.0 123.7 105.0 100.0 114.5 103.1 15 Mechanical 100.0 124.5 111.3 100.2 114.0 106.6 16 Electrical 101.1 130.7 121.4 109.8 113.6 112.4 Weighted Average 98.2 125.4 111.4 104.3 112.9 108.5 1. R.S. Means 2001, Concrete & Masonry Cost Data, page 436 2. R.S. Means 2001, Concrete & Masonry Cost Data, page 433 Table 4.6—Comparison Data for Two Cities as per R.S. Means 2001[4]. x cost of Chicago = Cost in LA x $1,540,000 = $1,500,000 (rounded)
- 56. Since each of these activities have different units of work, you cannot add the units for each piece together. However, you can add the work hours together. So, if you have done 100 CY/MY of the slab to place and you are 50 percent complet- ed, you have earned 135 work hours (50% x 270 estimated work hours). Adding the earned hours up for each of the work packages will then allow a composite percent complete for the entire project to be determined. A more detailed example is shown in Table 4.9: It is important when reporting percent complete that the milestones and the credit for each are as clearly defined as possible. This will build credibility with your system in that everyone reporting progress will do it the same way and the data collected will stand up to Management scrutiny. For an example, refer to Table 4.10. For some activities, such as cleanup or mobilization and demobilization, it may be very difficult to define the mile- stones. Progress for these activities may be monitored using a duration scale. In other words, if these are to take 4 days to complete, and 2 days have gone by, then this portion of the work is 50 percent complete (see Table 4.11). This is a subjec- tive approximation and is one of many ways to obtain an earned value when a mathematical calculation is not practical. For these activities, it is imperative that management under- stand and agree to the methodology used prior to the start of the project. Graphic Presentation of Earned Value Data The project status data for Example 1 is shown in Figure 4.1 on page 4.10. Reviewing this work package in graphic form, it appears that this work will finish ahead of schedule and under budget. The differences on the graph between the plan, earned, and expended lines provide a visual analysis of this example. As long as the curves are above the budgeted line, the status is OK. The addition of the cost per- formance indicator (CPI) and schedule perform- ance indicator (SPI) calculations provides a numerical calculation to further define the status: CPI = hours earned/hours expended = 243/200 = 1.22 SPI = hours earned/hours planned = 243/189 = 1.29 If the indicators are equal to or above 1, then the project is generally on or ahead. If the project, or elements of the project, is below 1, then these 4.9 AACE INTERNATIONAL LABOR Work Quantities Units Work hrs Mobilization 1 Lot 50 Excavation 300 CF/CM 100 Sub Foundation 100 CF/CM 50 Slab Placemen 100 CY/MY 270 Support Steel 2 Tons 60 Piping 30 LF/LM 90 Boiler Installation 1 Lot 50 Utilities 1 Lot 80 Startup 1 Lot 100 Cleanup 1 Lot 50 Demobilization 1 Lot 50 Total Work Hours = 950 Table 4.8—Boiler Project Labor Estimate Work Quantities Units Work hrs %Complete Earned hrs. Mobilization 1 Lot 50 100% 50 Excavation 300 CF/CM 100 100% 100 Sub Foundation 100 CF/CM 50 100% 50 Slab Placemen 100 CY/MY 270 50% 135 Support Steel 2 Tons 60 10% 6 Piping 30 LF/LM 90 10% 9 Boiler Installation 1 Lot 50 0% 0 Utilities 1 Lot 80 0% 0 Startup 1 Lot 100 0% 0 Cleanup 1 Lot 50 0% 0 Demobilization 1 Lot 50 0% 0 Total Work Hours = 950 35% 335 Table 4.9—Detailed Boiler Project Labor Estimate Slab Placement Estimated % Complete Work hrs. Work hrs. Earned Formwork 25%/67.5 100 % 67.5/ 25% Reinforcing Steel 25%/67.5 100% 67.5/25% Concrete Placed 40%/108.0 0% 0.0/ 0% Cured 10%/27.0 0% 0.0/0% Total 100%/270.0 135.0/50% Table 4.10—Slab Placement Percent Complete Activity Est. Work Day 1 Day 2 Day 3 Day 4 Day 5 hrs. Formwork 67.5 67.50 Reinforcing Steel 67.5 12.50 55.0 Concrete Placed 108.0 54.0 54.0 Cured 27.0 27.0 Total 270.0 80.0 55.0 54.0 54.0 27.0 Cumulative Hours (Plan) 80.0 135.0 189.0 243.0 270.0 Table 4.11—Example Slab Placement Work Progress
- 57. activities need to be reviewed to determine if action is required to improve their perform- ance, as they are not progressing as planned. (Note: If more work is completed on noncriti- cal activities, it is mathematically possible for the indicators to be above 1, and the project still to be in trouble. That would be because the critical path activities are behind schedule.) Example 1 — Work Package Status In Example 1 (Figure 4.1, Table 4.11), the costs are higher than the plan. This is normally not good, except when the sched- ule is also ahead of the plan. Since the project is ahead of schedule, and the CPI (Cost) is less than the SPI (schedule), this indicates that this portion of the project will finish early and may finish less than budgeted. Example 2 — Work Package Status In Example 2 (Figure 2, Table 4.12), the costs (work hours expended) are higher than the plan. This is normally not good, and since the earned is less than the plan, it looks like there are some problems. Confirming that there are prob- lems, the CPI (cost) and the SPI (schedule) are less than 1.0. So, the work package appears to be over- running the budget and behind schedule as well. Example 3—Work Package Status In Example 3 (Figure 4.3, Table 4.13, p 4.11), the costs are less than the plan. This would normally be OK. However, the earned is less than the plan, and it looks like there are some schedule problems. Confirming that there are schedule problems, the CPI (cost) is 1.03 (greater than 1.0), and the SPI (schedule) is 0.93 (less than 1.0). So, the work pack- age appears to be underrunning the budget at a greater rate than the work package is behind schedule. If the schedule slip- page is allowed to remain, then the budget may still be OK. Work Sampling Work sampling is a method that can be used to determine production or unit rates for specific work activities. These rates are to be used in setting up a company database, or determining the relationship between work at an individual site and labor standards, which have been or may be used for estimating projects in the future. The process involves picking a sample work item or items and having personnel record all activities and labor hours associ- ated with those activities so that unit rates per production measure can be deter- mined. Personnel who witness and record the activities and the labor hours worked on each activity can collect from timesheets, or create their own database based upon their observation of the work activities. Comparisons can then be made against existing experience or databases to determine the most reasonable data to use as the standard. Or, the data can be used 4.10 LABOR AACE INTERNATIONAL Earned Value Example 1 0.0 50.0 100.0 150.0 200.0 250.0 300.0 1 2 3 4 5 Workdays s r u o H k r o W Plan Expended Earned Figure 4.1—Earned Value Example 1 Activity Estimated Day 1 Day 2 Day 3 Day 4 Day 5 CPI SPI Work Hours cumulative hours (plan) 80.0 135.0 189.0 243.0 270.0 actual hours expended 90.0 165.0 200.0 1.22 actual hours earned 80.0 135.0 243.0 1.29 Table 4.11—Example 1 Work Package Status Activity Estimated Day 1 Day 2 Day 3 Day 4 Day 5 CPI SPI Work Hours cumulative hours (plan) 80.0 135.0 189.0 243.0 270.0 actual hours expended 90.0 165.0 200.0 0.83 actual hours earned 80.0 135.0 243.0 0.87 Table 4.12—Example 2 Work Package Status Earned Value Example 2 0.0 50.0 100.0 150.0 200.0 250.0 300.0 1 2 3 4 5 Workdays s r u o H k r o W Plan Expended Earned Figure 4.2—Earned Value Example 2
- 58. to determine how the actual work is deviat- ing from the standard. CONCLUSION In this chapter, the basics of labor cost development and progress monitoring have been discussed. In all instances, it is imperative that the estimator /cost engineer understand the basics in order to make sure that all of the areas impacting the estimate are thoroughly investigated and that the correct data is used in a consistent manner. PRACTICE PROBLEMS AND QUESTIONS Question: What is the composite rate per hour for this crew? Questions: What is the fully loaded rate per hour for this crew? How much would it cost to have this crew work 8 hours on Saturday at time and one- half? (Assume that the only adder included in overtime is the government programs.) Problem 3: A building was completed in Chicago for $2,755,000. Question: How much will it cost to build that same building in Los Angeles? (Refer to page 4.8.) Question: Which of the above are factors that could affect productivity? 4.11 AACE INTERNATIONAL LABOR Activity Estimated Day 1 Day 2 Day 3 Day 4 Day 5 CPI SPI Work Hours cumulative hours (plan) 80.0 135.0 189.0 243.0 270.0 actual hours expended 90.0 140.0 170.0 1.03 actual hours earned 80.0 120.0 175.0 0.93 Earned Value Example 3 0.0 50.0 100.0 150.0 200.0 250.0 300.0 1 2 3 4 5 Workdays s r u o H k r o W Plan Expended Earned Figure 4.3—Earned Value Example 3 Table 4.13—Example 3 Work Package Status Problem 2: The following adders are given: PTO = 10% Government Programs = 8% Benefits =15% Problem 4: • union or non-union craft labor, • Super Bowl week, • labor availability, • a supermarket strike, • number of shopping days to Christmas, • weather conditions, • erection of temporary living quarters, • several large projects being built concurrently within 5 miles of the jobsite. Problem 1: The following personnel run a production line: Crew Mix Base Wage/Hr 1 foreman $20.00 2 operators $16.00 2 assistant operators $12.00 1 material handler $13.00 1 material handler helper $10.00
- 59. Questions: Calculate the SPI and the CPI. What is the status of the production run? Draw the earned value graph. Sample Problem Answers Answer: The composite rate per hour for this crew is $99.00/7 =$14.14. Answers: The fully loaded rate per hour for this crew is $14.14 x 1+.33 = $ 18.81. The following equation solves how much would it cost to have this crew work 8 hours on Saturday at time and one- half, assuming that the only adder included in overtime is the government programs: $14.14 x 1.5 = $21.21 x 1.08 (govt. programs) = $22.91 x 7 workers x 8 hrs = $1282.96 4.12 LABOR AACE INTERNATIONAL Problem 5: The following data is provided for a production run of plastic bottles Activity Estimated Work Hours Day 1 Day 2 Day 3 Day 4 Day 5 Setup 24.0 24.0 Material handling 20.0 4.0 4.0 4.0 4.0 4.0 Production run 64.0 16.0 16.0 16.0 16.0 QC Check 12.0 4.0 4.0 4.0 Packaging 24.0 8.0 8.0 8.0 Loading & Shipping 12.0 12.0 Total 156.0 28.0 20.0 32.0 32.0 44.0 Cumulative Hours (Plan) 28.0 48.0 80.0 112.0 156.0 Thru Day 3 the following data is given: Actual work hours expended 32.0 60.0 95.0 Earned 28.0 52.0 90.0 Answers Problem 1: The following personnel run a production line: Crew Mix Base Wage/Hr No. Extension (1) (2) (3) = 1 x 2 1 foreman $20.00 1 $20.00 2 operators $16.00 2 $32.00 2 assistant operators $12.00 2 $34.00 1 material handler $13.00 1 $13.00 1 material handler helper $10.00 1 $10.00 Answers Problem 2: The following adders are given: PTO = 10% Government Programs = 8% Benefits =15% Total = 33%
- 60. Problem 3: A building was completed in Chicago for $2,755,000. How much will it cost to build that same building in Los Angeles? Answer: Answers Problem 5: SPI = Earned/Planned = 90.0/80.0 = 1.13 CPI = Earned/Expended = 90.0/95.0 = 0.95 What is the status of the production run? Ahead of schedule but over budget. Draw the earned value graph: REFERENCES 1. AACE International. Cost Engineer’s Notebook. Morgantown, West Virginia. 2. Richardson Engineering Services, Inc. 2001. Rapid Construction Cost Estimating System. Mesa, Arizona. 3. Richardson Engineering Services, Inc. 2001. Process Plant Construction Estimating Standards. 4. R.S. Means Co., Inc. 2001. Construction Cost Data 2001. Kingston, Massachusetts. 5. R.S. Means Co., Inc. 2001. Concrete and Masonry Cost Data 2001. Kingston, Massachusetts. The following is a partial list of companies (by no means all available) that provide estimating data ARES Corporation Building Systems Design, Inc. Icarus/Richardson – Aspen Technology, Inc. R.S Means Win Estimator 4.13 AACE INTERNATIONAL LABOR 108.5 x $2,755,000 = $ 2,683,000 (rounded) 111.4 Answers Problem 4: • union or non-union craft labor—Yes • Super Bowl week—No • labor availability—Yes • a supermarket strike—No • number of shopping days to Christmas—No • weather conditions—Yes • erection of temporary living quarters—Yes • several large projects being built concurrently within 5 miles of the jobsite—Yes Sample Problem 0.0 20.0 40.0 60.0 80.0 100.0 120.0 140.0 160.0 180.0 1 2 3 4 5 Workdays s r u o H k r o W Plan Expended Earned
- 62. INTRODUCTION The success of many products and projects is predicated upon an effective and efficient engineering effort. Improved engineering is essential in many applications given global- ized competition and product/project liability issues among other concerns. Globalization has meant that countries around the world are now competitors. Adequate engineer- ing is no longer sufficient as previous trade barriers have fall- en or seen substantial reductions. Where not offset by advantages in materials and transportation costs, labor-intensive tasks are exported around the world. Labor-intensive engineering tasks have, in some instances, fol- lowed the same pattern. Businesses out-source engineering tasks off-shore to lesser-developed countries, where an educat- ed engineering workforce environment yields competitive advantage. In some cases, the engineering itself may be com- ponentized, with various elements of a design done in many countries and eventually integrated into a unified whole. Traditional product and project engineering has been revolu- tionized iby the advent of computer-aided design and manu- facturing (CAD/CAM), which enable the rapid development and prototyping of design concepts. Businesses realize they must automate many heretofore manual engineering prac- tices to compete in a globalized environment. Practitioners in this area must understand the potential of CAD/CAM and business reengineering for maintaining a competitive advan- tage. One must be able to relate engineering decisions on product selection to their impact on process selection. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • identify engineering issues involved in product, project, and process development, including research, the use of CAD/CAE/CAM, product liability, patents, trade secrets, and developing prototypes; • understand product and process design and production issues, including process selection, standardization, manufacturability, constructability, and “make” or “buy” decisions; • identify production health and safety issues; • know issues involved in planning facility layout; • design assembly and flow process charts; and • understand other engineering production/construction concepts, such as reengineering, and relate engineering decisions on product selection to their impact on process selection. PRODUCT, PROJECT, AND PROCESS DEVELOPMENT Development of products, projects, and processes ranges from the simple to the incredibly complex. Similarly, time- frames for their development can range from days, weeks, and months to several years or more. In addition, develop- ment may depend upon concurrent and predecessor devel- opment of other items. The advent of low-cost functional microprocessors has enabled control on a real-time basis of processes that were previously only imagined. Pure and Applied Research Organizations conduct research in the development of prod- ucts. The research can be divided into two types: pure research and applied research. Pure or basic research involves work without a specific particular end product or use in mind. A common example might be a researcher in a lab examining the interactions of different chemical com- pounds. Pure research functions most often take place at uni- versities or foundations and may be financed from govern- ment grants or private sector grants. On the other hand, applied research is the attempt to develop usable products or add new feature-sets to existing products. Applied research 5.1 AACE INTERNATIONAL ENGINEERING Chapter 5 Engineering Neil D. Opfer, CCE
- 63. is more specific than pure research and is typically carried out by the organization producing the product. Product, Project, and Process Life Cycles The life cycle of a particular product/project will have a sig- nificant influence on all design decisions, including produc- ing plant and equipment. Some products such as automo- biles have long lives while seeing significant changes in fea- ture sets over their history. Civil infrastructure projects often have lives of many decades and should be designed for easy maintenance and upgrade. Other products may have a life cycle measured in a handful of years or less. With short life-cycle items, time to market is essential requir- ing both rapid design and production to avoid missing win- dows of opportunity. It makes no sense to build a factory and its associated equipment with a 30 year life cycle for a prod- uct that will be obsolete in five years. There is, of course, a prediction problem inherent in life cycles and forecasting demand. In the era of large mainframe computers, who could have foreseen the era when computers would be prevalent on desktops in both homes and offices? Phonograph records were a viable product for decades until supplanted by superior compact disc technology. Videotapes are now being replaced by digital video discs, while other technologies, such as laser discs, have fallen by the wayside. Computer-Aided Design (CAD)/Computer-Aided Engineering (CAE) In product, project, and process development, designers have been aided significantly by the advent of computer-aided design (CAD) and computer-aided engineering (CAE) soft- ware. CAD/CAE software involves the utilization of comput- erized work stations and software, including databases and computer graphics, to quickly develop and analyze a product, project, or process design. Combined with the Internet revolu- tion with high bandwidth connections, designers and engi- neers around the world can work on a single design. For example, electrical engineers in Germany may be work- ing with mechanical engineers in India to develop a new product that will actually be produced in China. The Indian mechanical engineer can call up a part in a database, such as a motorcycle strut on a suspension system. The part then can be automatically generated as a finite model and run in a mechanical design optimizer package for a certain number of cycles. At the same time, the Indian mechanical engineer can be engaged in an on-line conversation with the German elec- trical engineer on a key mechanical/electrical interface issue for routing of a wiring harness. In a half-hour, the conversa- tion ends, and the results of the mechanical design optimizer software are now available. The optimizer software has con- tinually refined the design through numerous iterations. The engineer can now review the results including color graphic views of stress/strain diagrams. The mechanical engineer can then bring this strut into the complete design and per- form analysis on this design as well. Once designs are finalized, design data can then be ported to the manufacturing process through the interface between CAD/CAE software and CAM software. Computer-Aided Manufacturing (CAM) Computer-aided manufacturing (CAM) provides the coun- terpart advantages of CAD/CAE software to the factory floor. Design information from CAD/CAE software can be ported directly into CAM software. Design dimensional information then can directly be sent to machines to control their actions in producing parts and products. This degree of automation can range from the simple to the complex, as pre- viously noted. A fabricator of wood roof trusses for residential and light com- mercial structures can take its designs and port them to its CAM software. The CAM software aggregates the design infor- mation for computer-controlled cutting of wood roof truss members. The software package calculates member’s dimen- sional requirements against lumber piece length to optimize production and minimize waste. Truss designs are stored on computer diskette, and when time comes to actually produce the truss, the truss layout is projected onto a laser layout table. Therefore, truss assembly personnel do not have to measure truss chord and web locations with the computer laser table projection. Thus the CAM process is faster with fewer mistakes. In more complex cases, computer-numerically controlled (CNC) machines are linked with design and receive tool- ing/machining instructions. Design information can be sent separately to various machines for production with final assembly to take place later. These CNC tools are typically multi-function for operations, such as machining, with numerous operations being accomplished automatically at one workstation. Prototypes For a variety of reasons, organizations will typically develop prototypes prior to large-scale production. Prototypes are developed to test designs and also to test customer reaction. An equipment manufacturer planning a new type of equip- ment may place prototypes in the hands of customers for real-world testing and demonstration. Design concepts may be uncertain, or user reaction may be a key element in down- stream product success. Prototype development is expensive, but is less expensive than producing an unwanted item or an item with a key flaw that otherwise may only be discovered after numerous units are in customer hands. Prototype devel- opment may mean the actual construction of a small-scale pilot plant to test concepts, such as is done in the petrochem- ical business. 5.2 ENGINEERING AACE INTERNATIONAL
- 64. The advent of CAD/CAE has led to the development of vir- tual prototypes on computer. Organizations, at a fraction of the cost of physical prototypes, can produce computer simu- lations of a prototype for testing by operators and designers. These computer simulations mean that operator mistakes will not cause real physical damage, further reducing testing costs. Changes to a computer simulation can be readily accomplished far faster than with a physical prototype. This is important anywhere time-based competition is an issue. Whether the prototypes be actual physical models or com- puter simulations, their use and application provides signifi- cant benefits for the organization. Customers may be exposed to both physical and computer-simulation proto- types. This also provides for interaction of the design team with customers that can provide important feedback. This one-on-one interaction gathers information far better than simple survey form methods. Physical or computer proto- types represent a significant financial and time outlay by the organization, but eliminating this development step has typ- ically proven to be a short-sighted measure. Patents and Trade Secrets Investing in new products and their research is usually both expensive and time-consuming. This investment must be protected. Typically, organizations can protect their invest- ments through either patents or trade secrets. In the United States, a patent’s duration is 17 years. In return for publish- ing the information underlying the patent, protection is granted to the inventor(s) for an exclusive period of 17 years. Those organizations wishing to emulate the patent’s provi- sions will either have to develop a creative approach differ- ent from the patented design or pay royalties to the patent holder. Copying patented features before the 17-year patent expiration date will result in a case of patent infringement. Trade secrets also serve as protection for intellectual proper- ty. Trade secrets can be somewhat broader than patent pro- tection in that they protect both commercial and technical information from disclosure. Organizations producing a pop- ular soft drink, a fried chicken recipe, or services, such as a particular business method, have all successfully protected these through the trade secret route. The advantage of trade secrets is their perpetual nature, as long as disclosure can be prevented. Employees are prohibited from disclosure of trade secrets through employment contracts. In addition, organizations may subdivide processes to prevent the repos- itory of total information with one or two employees. Product Liability In today’s increasingly litigious society, product liability is gaining importance in engineering design and production. In some cases, the product liability issue can act as a drag on engineering innovation, retarding the advancement of design due to these concerns. Product liability provides a means by which those injured by a product can seek compensation for their damage. The tort law in this area has evolved over decades from a concept of “buyer beware” to a concept of “seller beware.” In part, this is due to the increasing complexity of today’s products. The old concept of buyer beware was more applicable in days of peddlers selling bolts of cloth. The buyer could reasonably examine a bolt of cloth as to quality. Compare this with the purchase of a rotary lawnmower at a store. The variety of pieces and parts on the lawnmower make it more difficult to examine, and certain defects in design may only become apparent after extended use of this unit. PRODUCT, PROJECT, AND PROCESS DESIGN Standardization Design engineers must pay close attention to standardization concepts. Standardization is the attempt to base product designs, in whole or in part, on existing product items and tooling. The advantages of standardization are readily appar- ent in that by incorporating existing elements into new prod- ucts, overall product development costs will be lower and time to market will be shorter. An example of design stan- dardization may be through utilization of common parts, such as an automotive frame. One automotive frame system may provide the basis for several automobile types. The same principles would apply to engines as one powerplant is utilized in a number of applications. Engine horsepower may be varied by use of turbochargers versus naturally aspirated engines. Engine displacement can be varied by changing the stroke and holding the cylinder bore constant. There economic benefits to standardization not only for the producer, but for the customer as well. Product standardiza- tion means less investment in spare parts inventory and lower general maintenance costs. Maintenance personnel are able to become more familiar with fewer equipment compo- nents resulting in faster repairs and fewer mistakes. However, standardization can pose a problem concerning product defects. If there is a product flaw, the flaw will be spread over a wide variety of products. These general product 5.3 AACE INTERNATIONAL ENGINEERING GLOSSARY TERMS IN THIS CHAPTER computer-aided design (CAD) ◆ computer-aided manufacturing (CAM) ◆ constructability manufacturability ◆ patent ◆ product design reengineering ◆ robot ◆ system design variance analysis ◆
- 65. flaws can be costly from a repair/recall standpoint in addition to harming the organizations’ overall image and reputation. Process Selection Part and parcel of product engineering design will be process selection. Process selection relates to the production methods chosen to produce the product. There are two basic types of production methods: • continuous production, and • discrete production. Examples of continuous production methods would be petrochemical plants, power plants and manufacturers with assembly-line methods, such as wire/cable manufacturers and automotive manufacturers. Examples of discrete pro- duction would be manufacturers of any type of custom prod- uct, such as a pre-cast concrete plant, structural steel fabrica- tion shop, or machine shop. Some products will envelope both methods sometimes by the same firm. A structural steel fabrication shop will take basic steel products from a steel manufacturer engaged in a continuous process method, such as continuous casting, and turn them into customized “one- off” structural steel fabrications for a particular project. Continuous production method systems are less expensive in the long run because the high fixed costs of extensive pro- duction machinery can be amortized over many units of pro- duction. The determining factor in deciding in favor of con- tinuous production is whether demand is such that produc- tion volumes can justify the investments required for this method. In general, continuous production methods use specialized equipment including conveyor lines and special- ized machinery. Discrete production methods use general-purpose equip- ment. Production equipment, such as forklifts, welders, fab- rication tables, and machining centers can be utilized for a wide variety of items. Discrete production methods will have a higher labor factor versus continuous methods. In regions of the world where labor costs are less expensive relative to capital equipment, discrete methods may be favored due to their more favorable capital/labor tradeoff ratios. Manufacturability Engineering design methods must focus not only on issues of product design, but also on issues of manufacturing the design [3]. A design may work perfectly in terms of function, but if it is unnecessarily complicated to produce, problems may ensue. Design tolerances may be specified that are unnecessary for product function yet create substantial prob- lems in production. Designs, where possible, should be • forgiving of minor inaccuracies, • easy to fabricate, and • based on efficient utilization of labor, materials, and equipment. Slight changes or modifications in a design that don’t affect the product but instead promote ease of assembly of the product are referred to as manufacturability. During the design and development process, experienced manufactur- ing personnel should view products from the manufactura- bility perspective. These reviews can pinpoint problems before designs are developed to the point where changes cre- ate significant delays and associated costs. Constructability Constructability is the counterpart of manufacturability applied to constructed projects and their elements. The same issues apply to the realm of constructability. Designs can be developed on paper and in the computer that may make sense from the designer’s viewpoint but present significant problems in their construction. The Construction Industry Institute has defined constructability as the optimum use of construction knowledge and experience in planning, design, procurement, and field operations to achieve overall project objectives [1]. The same precepts of manufacturability apply to constructability. Early preconstruction implementation of these techniques can pinpoint problems before designs are developed to the point where changes create significant delays and associated costs. Make or Buy Decisions Product, project, and process development must concern decision-makers with “make” or “buy” decisions. That is to say, which items should be subcontracted out to others and which should be made in-house. Decision-makers must question whether their organization’s quality and cost on an item can compete with outside suppliers. If trade secrets are involved, the decision will typically be to make the item, unless the trade secret is the result of certain combinations of widely-sourced ingredients. For example, if a commodity such as sugar is part of a fermentation trade secret process, the organization will not find it practical to produce its own sugar unless it is already in that line of business. The overarching goal with make or buy decisions is making the best selections to enhance overall quality at a lower cost. If a manufacturer is producing 100,000 units of a piece of equip- ment on an annual basis, it will usually make far more sense to purchase motors from another manufacturer specializing in motors. The motor manufacturer may be making 1,000,000 of these motors for their own use and as OEM-sourced equip- ment for others. There is no practical way to achieve these kinds of economies-of-scale benefits at the relatively low 5.4 ENGINEERING AACE INTERNATIONAL
- 66. 100,000 units per year. Therefore, the motor selection will be a buy decision. ENGINEERING PRODUCTION/CONSTRUCTION Numerous decisions must be made with regards to engineer- ing production/construction. These decisions will naturally occur based on decisions reached in other areas as discussed previously. Production Health And Safety Personnel health and safety is paramount in any production situation. Health and safety is important from both a human- itarian and an economic standpoint. Advanced civilizations place a premium on human health and safety. From the eco- nomic viewpoint, health and safety lapses are expensive. An accident, for example, results in the loss of a trained worker and an interruption in the process. Systems must be selected that reduce and/or eliminate the potential of accidents. Health issues are more difficult to ascertain because usually they are not immediate as opposed to a safety-related accident. Health issues include exposures to fumes, dust, noise, and heat. Fumes from a production process may cause long-term health problems for personnel. The exposure risk may require a change to eliminate fumes or robotic operation so that human exposure is unnecessary. Facility Layout Facility layout involves decisions as to arrangement, includ- ing equipment location, labor location, and services location. The facility may be existing requiring renovation or one that is being built from the ground up on a “greenfield” basis. Layout decisions should always consider the potential impact of additional demand therefore considering future expansion and additions to the base layout. Assembly And Flow Process Charts Assembly and flow process charts assist in planning the facil- ity layout. They help to analyze production operations in terms of operations sequences performed, distances between operations, and operation time require- ments [4]. Process charts are developed based on standard symbols for studying operations. The symbol O represents an operation. An operation occurs when any change takes place whether of a physical nature or when new information is received. The symbol ∇ represents storage of an item. Storage is when any item is kept or held in the process. The symbol ⇒ represents transportation or movement in the process as when items are moved from one location to another. The symbol represents inspection. An inspection occurs when an object is examined for conformance as to quality or quan- tity. The symbol D represents delay. Delays occur with inter- ruptions to the process that prohibit the next operation or item from taking place. A production operation might entail the cutting of steel beams to length and drilling holes in the beams. Flow chart- ing of this operation would be as shown in Table 5.1 below: Flow charts offer the advantage of mapping product flow, which helps in spotting inefficiencies in the production process. Steps can be changed and rearranged to promote higher productivity and lower costs. Therefore, these charts can be a powerful tool. Quantitative Analysis In Facility Layout Techniques such as linear programming and Monte Carlo can significantly assist in facility layout and production deci- sions. Linear programming is a mathematical technique that is widely used in finding optimal solutions to problems. Linear programming techniques are designed to either minimize or maximize some objective function. Thus, material distances in a facility can be minimized or space available may be max- imized. These linear programming decisions are also bound- ed by parameters, which are limitations or restraints. There may only be a limited amount of space available or limited milling machines available for a certain production opera- tion. Detailed linear programming techniques are beyond the scope of this chapter since entire books have been written on these topics. Monte Carlo techniques provide for simulation. Queuing problems, such as wait time for a crane in a plant, can be ana- lyzed with Monte Carlo techniques. Data can be generated via computer programs with random number generators. Information, such as wait time costs, are factored into the 5.5 AACE INTERNATIONAL ENGINEERING Symbol Operation ∇ Beams In Storage ⇒ Transport Beam To Saw Ο Cut Beam To Length At Saw ∇ Place On Pallet ⇒ Transport By Forklift To Vertical Drill Ο Drill Beam Inspect Beam To Verify Quality D Store On Pallet Until Needed ⇒ Transport To Paint Booth Ο Prime Beam Table 5.1—Flow Chart of Steel Beam Production
- 67. equation and simulations are conducted on this basis. Again, these techniques are beyond the scope of this chapter. Practitioners in this area are encouraged to consult the many books published on these techniques for further information. Reengineering Reengineering is the fundamental rethinking and radical redesign of business processes to achieve dramatic improve- ments in critical contemporary measures of performance, such as cost, quality, service, and speed. Some of these steps include combining two or more jobs into one and enabling workers to make decisions with work being performed where it makes most sense. An example of reengineering might have your supplier monitoring your inventory of their supplied item since they are better able to accomplish this task. This then frees the organization to focus on its own mis- sion-critical work. Reengineering focuses on the optimization of the total organ- ization, rather than suboptimization of individual depart- ments or units. In the context of this section, disparate units, such as design, manufacturing, sales/marketing, and cus- tomer service are brought together to deliver optimal solu- tions that benefit the entire organization as opposed to the individual unit. Moreover, reengineering focuses on the “whys” of an action or process as opposed to the “hows.” An appliance manufacturer may be concerned with welding spatter on new appliances and how to control this. However, a change in the steel purchased from a smooth pattern to an embossed pattern on steel sheet may make the welding spat- ter not noticeable in the finished product. Here, a focus on why the welding spatter needs to be controlled is more impor- tant than the how and results in a simple purchasing specifi- cations change. Reengineering focuses on these global issues. SUMMARY The recognition of the impact and potential of engineering issues will lead to more rational decision processes by those responsible. Traditional product and project engineering has been revolutionized in many cases by the advent of CAD/CAE/CAM concepts, which enable the rapid develop- ment and prototyping of design concepts. Businesses are realizing that they must automate many heretofore manual engineering practices in order to compete in a globalized environment. Individuals practicing in this area must under- stand the potential of CAD/CAM and business reengineer- ing for competitive advantage. One must be able to relate engineering decisions on product selection to their impact on process selection. REFERENCES 1. Construction Industry Institute. 1986. Constructability Primer Publication 3-1. University of Texas, Austin. 2. Hammer, M., and J. Champy. 1993. Reengineering The Corporation. New York: HarperBusiness. 3. Mazda, F. 1998. Engineering Management. Addison- Wesley. Harlow, England. 4. Meyer, C. 1993. Fast Cycle Time. New York: The Free Press. 5.6 ENGINEERING AACE INTERNATIONAL
- 68. INTRODUCTION Selecting, purchasing, tracking, storing, maintaining, and sell- ing equipment, parts, and tools is an important project man- agement function that can greatly impact project schedules and costs. This chapter outlines current issues and industry practices regarding equipment for the cost engineer. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • establish an equipment valuation database and identify the different equipment value categories and subcate- gories; • research equipment cost information; and • understand the factors that affect current and residual values for new and used equipment. ESTABLISHING AN EQUIPMENT VALUATION DATABASE In order to establish a reliable equipment valuation database upon which to base estimates or appraisals, emphasis must be placed on the quality and level of trade data being cata- loged so that the values contained in the database are appro- priate for their intended use. Such data can be used to estab- lish reliable current value appraisals and residual value esti- mates (future values) for equipment needed on a project. Equipment Value Categories Equipment values can be divided into two major categories: (1) Replacement Cost New (new equipment cost), and (2) Market Value (used equipment, secondary market value). Within each category are subcategories. The first catagory, Replacement Cost New, has the following subcategories: • Reproduction Cost is the cost new of an identical item. • Replacement Cost is the cost new of an item having the same or similar utility. • Fair Value is the adjusted cost new of an item, giving consideration for the cost of similar items, and taking into account utility and all standard adjustments and discounts to list price. The second category, Market Value, also contains several subcategories: • Fair Market Value-in-Place is the amount expressed in terms of money that may reasonably be expected to exchange between a willing buyer and a willing seller with equity to both, neither under any compulsion to buy or sell, and both fully aware of all relevant facts as of a certain date, and taking into account installation and the contribution of the item to the operating facility. This value presupposes continued utilization of the item in connection with all other installed items. • Fair Market Value-in-Exchange is the value of equipment in terms of the money that can be expected to be exchanged in a third-party transaction between a willing buyer, who is under no compulsion to buy, and a willing seller, who is under no compulsion to sell, both being fully aware of all relevant facts (also referred to as retail value). • Orderly Liquidation Value is the probable price for all capital assets and equipment in terms of money that could be realized from a properly executed orderly liqui- dation type of sale, given a maximum time of six months to conduct such sale and adequate funds available for the remarketing campaign. This value further assumes that all assets will be sold upon completion of the allot- ted time period (also referred to as wholesale value). • Forced Liquidation Value is the value of equipment in terms of money that can be derived from a properly advertised and conducted auction where time is of the 6.1 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Chapter 6 Equipment, Parts, and Tools Dr. Carl C. Chrappa
- 69. essence (also referred to as “under the hammer” or “blow-out” value). • Salvage Value/Part-Out Value is the value of equipment in terms of money that a buyer will pay to a seller, rec- ognizing the component value of parts of the equipment that can be used or resold to end-users, usually for repair or replacement purposes. • Scrap Value is the value of equipment in terms of money that relates to the equipment’s basic commodity value. For example, dollars per ton of steel or pound of copper. Valuation Examples/Subcategories of Value The Table 6.1 is an example of market value subcategories for the sale of a certain four-year-old CNC machining center (original cost new $350,000): This example illustrates the relative meaning and weight of some of the valuation terms previously discussed. It is based on these terms and definitions that valuation data should be collected and cataloged. Replacement Cost New, Sources of Data Replacement Cost New is the highest value that can be attrib- utable to a piece of equipment. Thus, it can be considered 100 percent of value (new). Several source are available for collect- ing and monitoring equipment replacement cost (new) data. several sources are available. Among these are prices and data obtained from the following sources: • manufacturers price lists, • data obtained verbally from sales representatives and new equipment dealers, • published prices from technical and trade journals, • literature obtained at trade shows, • invoices containing cost data relating to past transactions; • purchase orders from past transactions, • equipment quotations from manufacturers or dealers, and • appraised values obtained from replacement value (new) or insurance appraisals, which typically list replacement cost (new). By cataloging valuation data obtained through the various sources listed above, the estimator/appraiser can establish a sizeable and meaningful database from which to plot value trends for a specific piece of equipment over time, or to vali- date the fair value of a similar item in the future. Market Value, Sources of Data An equipment valuation database can also be established for market values. Sources of this data (for the various subcate- gories already mentioned) include the following: • trade publications listing sales advertisements for used equipment, • retail prices obtained from used equipment dealers or brokers, • equipment price quotations for the purchase of used equipment documented in previous transactions, • values from “market data publications” available for purchase, • auction “sales catalogs” available from auction compa- nies at a nominal cost ($20 to $50), • regulatory filings, and • past remarketing and sales results from one’s own firm. Market Valuation Example To better illustrate the basis for some of the subcategories of market value (how equipment is bought and sold), an exam- ple is given in Table 6.2 involving a 10-year-old metal lathe. It is followed by an example summary (Table 6.3), which shows the relationship of subcategories of market value to one another. 6.2 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL Type of Value Sales Price % of Highest Price Fair Market Value-in- Place $275,000 100% Fair Market Value-in- Exchange $200,000 73% Orderly Liquidation Value $175,000 64% Forced Liquidation Value $150,000 55% Salvage/Part-Out Value $15,000 5% Scrap Value $2,000 1% Table 6.1—Market Value Subcategories for CNC Machining Center
- 70. Trade Data/Cost Adjustments Used equipment sales data is often inconsistent for the same or similar pieces of equipment. In order to adjust or normal- ize this data, the following considerations should be addressed and value added or deducted as appropriate. These adjustments include the following: • the same equipment, but with different years of manu- facture (normally adding value for newer equipment); • the same equipment, but with different attachments, drive motors, etc.; • the location of the sale (i.e., equipment sold in a prime geographic market area will usually achieve a higher sales price than equipment sold in a remote area); • utilization (amount of wear/use); and/or • condition (one of the most important considerations). Condition alone in some instances can cause considerable value swings for identical pieces of equipment. It is extreme- ly important that the condition of a piece of equipment be noted at the time of sale to ensure that equipment sold in excellent condition for a relatively high price will not later be used to anticipate the price of a piece of equipment expected to be in average or fair condition at the end of the lease. Once again, this is one of the most important parts of any database and should not be overlooked. Equipment Condition Terms and Definitions Following is a sample selection of condition terms and defi- nitions used to describe equipment. Example 1: • Very Good (VG)—This term describes an equipment item in excellent appearance and being used to its full design specifications without being modified and with- out requiring any repairs or abnormal maintenance at the time of inspection or within the foreseeable future. 6.3 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Event Cost/Value a. purchase price as-is at auction $5,500 (orderly liquidation sale) b. sales tax exempt (equipment dealer) c. deinstallation, rigging, shipping, and delivery to warehouse $600 d. cost of money (estimated) time to sell: 90 days, 10% annual rate x 3 months x $6,100 purchase and deinstall $154 e. overhead (20% of pur- chase price, includes some preparation and advertising $1,100 f. profit (15%–20%: use 20% of purchase price plus dein- stallation $1,220 g. subtotal (a+c+d+e+f) $8,574 (min. desired selling price) h. ask (advertise for sale) $9,800 (retail asking) i. take (sale to end user) $8,600 (fair market value-in- exchange) j. buyer (end user) pays sales tax (6%) $516 k. delivery $600 l. installation and debugging $1,400 Total installed cost to end user (i+j+k+l) $11,116 (fair market value-in- place) Table 6.2—Market Value Subcategories for Metal Lathe Table 6.3—Metal Lathe Example Summary Type of Market Value % of Value Fair Market Value-in-Place ($11,116) 100% Fair Market Value-in- Exchange ($8,600) 77% Orderly Liquidation Value ($5,500) 49% GLOSSARY TERMS IN THIS CHAPTER fair market value-in-exchange ◆ fair market value-in-place fair value ◆ forced liquidation value orderly liquidation value ◆ replacement cost reproduction cost ◆ salvage value scrap value ◆
- 71. • Good (G)—This term describes equipment that was modified or repaired and is being used at or near its fully specified utilization. • Fair (F)—This term describes equipment used at some point below its fully specified utilization because of the effects of age and/or application and that will require general repairs and some replacement of minor elements in the foreseeable future to raise the level of utilization to or near its original specifications. • Poor (P)—This term describes equipment being used at some point well below the fully specified utilization and that will require extensive repairs and/or the replace- ment of major elements in the near future to realize full capacity. • Scrap (X)—This term describes equipment that is no longer serviceable and cannot be utilized to any practical degree regardless of the extent of the repairs or modifi- cations that may be undertaken. This condition applies to equipment that has been used for 100 percent of its useful life or that is 100 percent technologically or func- tionally obsolete. Another variation is Example 2: • Excellent (E)—This term describes equipment that is new or in practically new condition, with extremely low uti- lization, no defects, and that may still be under warranty. • Good (G)—This term describes equipment that has good appearance, may have just recently been complete- ly overhauled or rebuilt with new materials, and/or has had such use and maintenance that no repairs or worn part replacement is necessary. This equipment shows no deferred maintenance. • Average (A)—This term describes equipment that is in 100 percent operating condition with no known major mechanical defects but may have some worn parts that will need repair or replacement in the future. This equip- ment may have high utilization, but any defects are not obvious. • Fair (F)—This term describes equipment that shows high utilization; defects are obvious and will require repair or a general overhaul or rebuild soon. This equip- ment is operational but questionable and may exhibit deferred maintenance. • Poor (P)—This term describes equipment that isThis term describes equipment that has seen severe and long hours of service. It requires rebuild, repair, or overhaul before it can be profitably used and is not operational. In summary, the logging of raw data and condition, along with the cost adjustments previously mentioned, will permit a fine tuning of market data, yielding a more reliable and meaningful value. Data Filing Systems Once data is obtained in sufficient quantities, a decision can be made on how to record it. Most valuation and research firms file data using one of four methods: 1. The first is by Standard Industrial Classification (SIC) code where data is stored in broad industry category codes, such as #34-machine tools, #44-marine, etc. This method is quite effective when utilizing an electronic database, since a numerical method of encoding each piece of data lends itself to an SIC type of listing. 2. Another method of filing is to list data by equipment class and type, such as machine tools-lathes, aircraft- commuter, construction-crawler crane, trailers-dry van, barges-covered hopper, or railcar-center beam flat. 3. A third method lists equipment by industry category, such as machine shop equipment, construction, mining equipment, aircraft, or marine vessels. 4. Finally, another filing system is based strictly on the equipment manufacturer’s name, such as Freuhauf - trailers, Warner and Swasey-machine tools, Caterpillar- construction equipment, Boeing-commercial aircraft, and IBM-computers, etc. By using any one of the above methods of filing, a workable cataloging system can be created that will enable the user to obtain valuation data in a minimal amount of time. The larg- er the database, however, the more complex the filing system must be for prompt retrievals. Data Storage Data can be stored via several methods. The system most wide- ly used is electronic data storage. Here, systems can be devel- oped utilizing hardware ranging from PCs to servers that file (log) everything from individual equipment specifications to a manufacturer’s total equipment production run, listing all per- tinent data and serial numbers for each piece of equipment studied. When establishing an electronic data filing system, sufficient time should be devoted to selecting appropriate soft- ware that is user-friendly and can be adapted to listings and searches by whatever method of retrieval the user desires. Also, numerous sites on the Internet have databases that can be eas- ily accessed when needed. Such use of third-party information can augment or support an in-house (proprietary) database. 6.4 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL
- 72. Additionally, estimators/appraisers may wish to consider purchasing certain trade data available in the public domain. There is no substitute for actual trade data. Equipment Valuations One of an estimator/appraiser’s most difficult tasks is the analysis and calculation of equip- ment residual values (future values) for leases or life cycle costing. Unfortunately, there are no magic formulas or short cuts, and no col- lege to teach how to properly calculate residu- als—the only way to gain this knowledge is through hard work and years of experience. Because industry and business place such an importance on (future) residual values, the role of the esti- mator/appraiser has become vital. One key component of estimating residual values is the appraiser’s understanding of the equip- ment and the industry in which it operates. The analyst must have access to trade (sales) data. There are no substitutes for facts. Sometimes unqualified opinions can cause serious financial damage to a company. Although the determination of residual val- ues using trade data does not guarantee the future value of equipment, it nonetheless pro- vides a sound basis upon which to predicate future values. In addition, there are many variables the analyst should consider in arriv- ing at a realistic residual value estimate. Residual Value Curves Residual value is the expected future amount of money an owner/lessor will realize from an asset at a specified future date, such as the end of a lease term or project, from any and all sources, including sale, re-lease, holdover rent, penalties, dam- age, litigation, and payments for noncompliance to the lease documentation (such as return and maintenance provisions). Figures 6.1 and 6.2 illustrate that wholesale market value (Orderly Liquidation Value) of equipment does not follow predefined curves or formulas. In fact, the shape of a resid- ual curve may change on an annual or even monthly basis, depending on circumstances. It is important to remember that the market is constantly changing. The variables that cause this change will be discussed later. Figure 6.3 on page 6.6 illustrates some of the classic, as well as unusual, residual value curves for used equipment. The “normal” residual value curve of long-lived equipment usually follows an L-shaped curve that is illustrated in Figures 6.1–6.3. Another shape is the disrupted market curve, which is a deviation from the normal curve and is usually in the shape of a U. This curve is typically results from excess sup- ply or regulatory pressures causing the market value for a piece of equipment to suddenly plunge or deviate from nor- mal for a period of time. Past examples include the “U” curves for covered hopper railcars and intercostal barges during the mid-1980s. 6.5 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Figure 6.1—Executive Aircraft Methods of Depreciation Figure 6.2—Machine Tools Methods of Depreciation
- 73. Another curve that can be studied is the regulatory change curve, which illustrates the sudden impact on market value that regulation can cause, such as the effect of FAA Part 36 Stage 3 on the values of Boeing 727s and 737–100s, 200s, etc. The high obsolescence curve is a truncated shape that illus- trates the impact of technological obsolescence. This curve is particularly prevalent among items such as computers and certain other types of high-tech equipment. Another deviation from the normal shape is the (new) tax law/high inflation residual curve. Tax laws and inflation can, in some cases, cause a normal residual curve to rise dramati- cally in a short time. Although this pattern is quite appealing to the lessor when selling in a strong market, it should also be recognized that an elevated curve will sooner or later likely fall back to its “normal” shape. Variables That Affect Residual Value In general, there are twelve items that should be considered in estimating residual values: 1. initial cost, 2. maintenance, 3. use/wear and tear, 4. population, 5. age, 6. economy, 7. changes in technology, 8. foreign exchange, 9. tax laws, 10. legislation/regulation, 11. location of equipment 12. method of sales. 1. Initial Cost—One of the most frequently overlooked items in any transaction is the ini- tial cost of equipment. Many times, the owner/lender/lessor is presented with a funding containing indirect costs that it may not be aware are included in the price. For residual purposes, the estimator/appraiser should consider basing his or her residual esti- mate on ‘hard costs’ only for individual items. The hard cost of an asset includes the cost new of the basic machine and the cost of any addi- tional items necessary to make it operate, including drives, motors, electricals, and con- trols. Items referred to as “soft costs” that should not be included are as follows: • foundations (which some large machines may require due to their size or overall sensitivity), • freight, • debugging, • taxes (which may include federal, state, and local taxes, as well as duty on foreign imports), and • installation (which includes fastening the equipment to a foundation, piping, and electrical wiring from a main distribution system, and other items necessary to the machine’s operation). The following is an example of an actual situation involving a transfer stamping press line in an automotive facility. A leasing company was presented with a transaction valued at $2.1 million. Subsequent investigation found the following: • the basic cost of the machine was $1.5 million, • the cost of foundations was about $400,000, • the cost of freight was $40,000, • taxes were $60,000, and • installation was estimated at $100,000 (all totaling $2.1 million). In this instance, if a leasing company’s historical “residual curve” for this equipment indicated 30 percent of the new cost at the end of the term, the difference between calculating the residual on a value-in-exchange basis for the hard asset only versus the value-in-place including soft costs would equal $180,000 at lease term. Total Cost: $2.1 million x 30% = $630,000 Hard Cost: $1.5 million x 30% = $450,000 Difference = $180,000 6.6 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL Figure 6.3—Residual Value Curves for Used Equipment
- 74. This difference could present a future shortfall if the asset were sold on a value-in-exchange basis. It should be under- stood that in some instances—such as a facility lease or financing or life-cycle costing—soft costs should be consid- ered in determining residual values. 2. Maintenance—The next consideration is maintenance. The difference in value received from a well-maintained versus a poorly maintained piece of equipment can be substantial. Maintenance can also affect the useful life of equipment. In calculating a residual value, estimators/appraisers must con- sider how the equipment will be maintained and/or the maintenance language in the lease. Maintenance provisions in leases can be relied upon by the lessor as a future condition statement and also for future claims for damage, abuse, or deferred maintenance. If the lease contains strong mainte- nance provisions, a higher residual usually can be assumed strictly on the basis of the condition in which the equipment is expected to be returned at the end of the lease. 3. Use/Wear and Tear—Use/wear and tear is another impor- tant consideration that should be understood by the estima- tor/appraiser in estimating residual values. The difference between equipment in harsh service versus mild service can be substantial and, in some instances, can affect the equipment’s useful life. An example is covered hopper railcars. Used in grain service, they can have useful lives of approximately 40 to 50 years. However, if used in salt service, their useful lives can be as short as 15 years. Other examples include construction equipment used in sand pits, which subject the undercarriage to excessive wear. Thus, the analyst should be aware of all such conditions when estimating residual values. Some types of equipment, such as aircraft, define use in hours of utilization and cycles (takeoffs and landings); other transportation equipment defines use in miles or kilometers per year. Mechanical equipment utilization is usually record- ed by the hour. Typically, most mechanicals tend to wear out at around 10,000 to 20,000 hours. At these milestones, usual- ly some form of rebuild or refurbishing is required. For analysis purposes, 1,700 to 2,000 hours per year utiliza- tion is usually considered one shift; 3,000 to 4,000 hours is considered two shifts; and 5,000+ hours per year is consid- ered three shifts. Leasing terms for equipment that will be utilized 5,000+ hours per year (as frequently happens in the mining industry) usually contain strong return and mainte- nance provisions in order to ensure the future condition of the equipment. The appraiser may then base his or her resid- ual value estimates on this assumption. An example of the effects of high utilization and wear and tear is the partial disintegration, in flight, of a commercial jet that had approximately 80,000 cycles of use in addition to high time. Besides the high utilization rate in this example, the geographic area of use, which was tropical, could have also played a part in the incident, since it may have caused the aircraft to be subjected to further wear and tear from the corrosion caused by the moist, tropical, salty air. 4. Population—Another important consideration is the over- all population of the subject equipment. Typically, the larger the population of equipment, the more data can be obtained. This gives statistical significance to the residual value, because the value will be based on a large sample referred to as a commodity. Residual valuations are particularly difficult and oftentimes meaningless for prototype equipment. When valuing a prototype, the equipment analyst can only attempt to compare the item being valued to another item having similar utility. Technology could be a large risk in such a transaction, as well as a very limited secondary market. Many times estimators/appraisers are able to obtain informa- tion on annual production runs of certain equipment. A review of this data may reveal a sizeable increase in the manufacture of the product during a certain year, which may have an impact on the future residuals; e.g., if much of the equipment pro- duced in a boom year comes off lease all at once. Boom years for particular types of equipment are generally related to the overall health of the economy, or, in particular market segments, to regulatory mandates and/or special tax incentives. One illustration of this is the chassis industry, which had production rates during the 1950s and 1960s in the area of 4,000 units per year. In the 1970s, this average increased to about 10,000 units per year, while in 1984 the number jumped to about 24,000, then in 1985 to almost 29,000 units. In such instances, the estimator/appraiser should have considered the potential downward impact of boom years on future residual values. (This, however, was mitigated by the explosion of the intermodal industry in the 1990’s.) These production spikes have also recently occurred in the truck and trailer markets. What drives the primary market today may not drive the secondary market in five to eight years. 5. Age—Another item that is often overlooked is the actual age of date of manufacture of a piece of equipment. Equipment presented as new in January 2003 could have a 2001 or 2002 build date. This is particularly important for transportation equipment. If, for example, the equipment comes off of a lease or project in 2006, which truck will sell for more: the 2001 or 2002 model? The answer is obvious. The estimator/appraiser should verify model years and serial numbers on each transaction. The following example is given to illustrate the different sales tiers that should be considered when estimating residual val- ues. Recently, an 8-year-old insulated trailer fleet was sold to an end-user. The equipment manager surveyed the market at all levels. The results of this survey are shown in Table 6.4 on page 6.8. 6.7 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS
- 75. The difference in the values above for the same equipment illustrates the importance of an appraiser recognizing at what level or sales tier the equipment typically sells, and then adjusting its residuals to reflect this level. 6. Economy—The equipment appraiser must also consider the overall shape of the economy. For instance, the U.S. economy usually performs at 4-to 7-year business cycles. A used truck that sells for $25,000 in a robust economy may sell for $17,000 in a recession. Further, the sale of equipment in a robust econo- my might take from 1 to 30 days, while in a recession it could take 60 to 90 days. The additional time it takes to sell should also be calculated in the overall cost of the sale (cost of money). 7. Changes in Technology—Changes in technology can also affect residual values. These changes occur in every type of equipment. However, some changes have a more profound impact on value. An analysis of technological changes occur- ring over the past 20 years shows that future advances in technology were generally known at the time of lease origi- nation. The astute analyst may choose to make an adjust- ment in the residual of a piece of equipment that is subject to such obsolescence. Some recent changes can be found in the computer micro- processor as reflected in the Pentium 4 chip. Big ticket medical imaging equipment, such as CT Scanners, are currently utiliz- ing fourth- and fifth-generation scanners that have reduced the time necessary to “fix” an image from minutes to seconds. Even the railcar industry now shows examples of obsolescence, such as the impact the container and chassis, along with the piggy-back trailer have had on the 50-foot boxcar. Locomotives have also undergone significant changes in technology affect- ing the levels of tractive horsepower and mode of power; i.e., AC versus DC. Trailers have also experienced changes in technology based on the “maximizing of cubes.” Trailers with a length of 53 feet con- form to state regulations for length, height, and weight, plus can carry more volume (cubic feet). Thus, in today’s market, 53- foot trailers hold an advantage over 48-foot trailers, and 48-foot trailers hold an advantage over the older and more obsolete 45- foot trailers, and 45-foot trailers hold an advantage over the yet older and more obsolete 40-foot trailers. 8. Foreign Exchange—Foreign exchange is also a considera- tion that may enter into a residual calculation. Factors that influence foreign exchange include international trade rela- tions and the international political environment, which can cause trade wars, embargoes and thus higher or lower duties. Consider the following example (which actually occurred during the mid-1980’s to 1990’s): A Japanese tractor manufacturer produces a tractor which sells for 10 million yen. At an exchange rate of 250 yen to the dollar, the tractor would cost U.S. $40,000; however, at 100 yen to the dollar, that same tractor would cost U.S. $100,000. This increase of 2.5 times is strictly due to currency. Thus, the value of foreign exchange, such as the yen or euro, can increase or decrease quite rapidly. Such changes could put pressure on selling prices (and residual values), causing them to suddenly drop or increase. The analyst should attempt to compare the cost of foreign manufactured equip- ment to that of similar domestically manufactured equip- ment in order to calculate a realistic base value on which to predicate the residual analysis. Strong foreign currency may cause the price of foreign equipment to rise in the U.S., which, in turn, may pull residuals up. However, it should also be understood that the reverse can also occur. 9. Tax Law—Tax law is another concern that leasing compa- nies deal with regularly. Tax law can affect such things as build rates (when incentives are given), and thus the second- ary market. As a result of 1990 tax laws, depreciation rates have been extended. The net effect is that, in many instances, it is more appealing for an end-user to buy used equipment rather than new equipment. Currently, the federal government is study- ing bonus depreciation rates in order to spur new equipment sales. It is imperative that the equipment appraiser consider the true economics of a transaction and not simply the tax rami- fications. The following two classic examples illustrate the impact of certain tax legislation and regulation. 6.8 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL Sales Tier % of Highest Sales Price Comments retail sales level 100% actual sales price $1,040,00 wholesale 76% offers received to purchase trailers by wholesalers auction 63% estimated proceeds from the sale at auc- tion received from several auctioneers end of economic useful life 7% estimate of the value of trailers to be used as storage units only Table 6.4—The Transaction: 195 trailers, 8 years old, original cost $3,510,000
- 76. In the early 1980s, because of tax incentives, the cost of new hopper barges suddenly increased from $220,000 to about $330,000. Between 1978 and 1981, approximately 3,000 hop- per barges were built, increasing the existing capacity by 33 percent. Further, because of certain tax incentives, two-thirds of the new barges were owned by private investors (limited partnerships, etc.). Many of these investors participated in leasing transactions for tax purposes. Most residuals were set without considering that the cost of the barges had increased almost 50 percent in only two to three years. In addition to the sudden jump in prices, the early 1980s also signaled the end of the U.S. coal export boom, and the end of the Polish and Australian coal strikes. Investors found themselves in a situation where too many barges were built for artificial purposes (i.e., tax benefits). The supply/demand balance was drastically altered. Charter rates for hopper barges fell from $130 per day to $35 per day, and the value of the $330,000 barge plummeted to about $80,000 for a five-year-old asset with a 25+ year useful life (see Figure 6.4). After a few years, many barge manufacturers went out of business. No new barges were built, and since there were a great number of barges laid up, up to 25 percent of the older barges were scrapped over a five-year period. This soaked up some of the glut. At that time, the dollar weakened 60 to 80 percent against for- eign currencies, and exports once again started to flow from the U.S. Increased exports, coupled with a sharp decrease in the production of new hopper barges, and the ongoing scrap- ping of the excess fleet, caused a barge shortage. The price of barges suddenly escalated in 1988 to approximately $175,000 (for the same 1981-built equipment). This example illustrates the disrupted U curve. Figure 6.5 illustrates an almost identical situation that occurred with covered hopper railcars, which were likewise over-built in the early 1980s because of tax incentives, and were owned to a great extent by private investors not familiar with the industry. An imbalance in the supply/demand curve resulted, causing the price of five-year-old equipment with a useful life of 50 years to plummet to the point where covered hopper railcars manufactured new in 1981 for $44,000 were selling a few years later for about $14,000, if at all. Once again, this scenario caused many railcar builders to cease operations. This situation was further aggravated by the Russian grain embargo and the Railroad Deregulation Act of 1980 (Stagger’s Act), which deregulated the rail industry and caused downward pressure on shipping rates. For five years, the rail industry had essentially not built any new railcars and had scrapped a significant portion of the older covered hopper car fleet. When the dollar weakened and exports started to flow, there was once again an equip- ment shortage that caused the price of the asset to suddenly rise, once again illustrating the disrupted U curve. Several operating lessors that followed this situation, correctly pre- dicted when the demand curve would pass above supply, and made tens of millions of dollars overnight. 10. Legislation/Regulation—Another important variable is legislation/regulation. Although it can’t be predicted, a sense of future legislation can be recognized, such as current talk about increased regulation related to commercial aircraft, or the impact of the CAFE or Clean Air Act on engine technolo- gy. Regulations sometimes impact values in positive ways, such as the effect of the Jones Act on U.S. hulled marine ves- sels. However, more often than not, the impact of legislation and regulation on the equipment market is a negative one. 11. Equipment Location—Finally, one last factor to be con- sidered is the location of equipment at the end of the lease. 6.9 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Figure 6.4—1981 Open-Top Barge Market Values Figure 6.5—Covered Hopper Car Market Values
- 77. Does the lessee require that the equipment be delivered to a prime market location or will it have to be sold in a remote area? To illustrate this point, consider the sale of seven off- highway rock trucks. Ideally, these trucks should have been marketed in prime mining areas of the country, such as Wyoming, Arizona, Minnesota, the Southeast, or the Appalachian area, where they had an estimated value of $130,000 each. However, since the owner could find no buyer in the immediate geographic area, each truck had to be phys- ically cut in half, matchmarked, disassembled, and shipped on nine flatbeds to buyer out of the area. The incremental cost of performing this work and reassembly amounted to a reduction in the sales price of approximately 35 percent. As a result, the owner/lessor was able to realize only $85,000 per truck. Thus, because the equipment was not delivered to a prime geographic marketing area, the owner/lessor lost $315,000 in residual value for the trucks. This illustrates the importance of recognizing the location of prime geographic equipment markets. In general, if the equipment analyst considers all of these fac- tors, along with the method of sale and current and historical trade data, the lessor should be well positioned to meet or exceed its estimated or booked residual at lease termination. Calculating Residual Values The calculation of residual values is more art than science. It has been said that economists only give major predictions on the economy every six months, the reason being that some- one might remember. The same can be said for the calculation of residual values. Professional economists sometimes miss short-term predictions by 100 percent or more, so a lessor might wonder what degree of accuracy a residual value cal- culation might have in ten years! However, if an analyst per- forms a thorough and proper analysis based on available market data, a high degree of accuracy is possible. In fact, during the 1980s, when the residual value guarantee industry was in its heyday, such values were typically calcu- lated for equipment with terms of 3 to 8 years. Based on available information, it was found that guarantee compa- nies annually experienced losses (on their guarantees) in the area of only 1.5 percent of the total values guaranteed. This is a somewhat startling statistic, but once again shows that if estimators/appraisers are thorough and perform a proper analysis, a high degree of accuracy is possible. Residual Valuation Formats Residual analysis formats differ from company to company, but should contain the same basic elements. Shown below are two of the more popular formats used in the industry: Example Format 1: • Marketplace—a general description of the marketplace in which the equipment is used; • Manufacturer—background on the manufacturer and the part in which the equipment plays in the overall sales and marketing of the manufacturer; • Model Run—the number of years the equipment has been manufactured; • U.S. Market—the number of units of the subject equip- ment in the U.S. market; • Installation—the estimated time to install a subject machine and estimated cost; • Software—a brief discussion of software, such as used in controls; • Versatility—the number of uses for the subject equipment; • Life Expectancy—the estimated economic useful life of the equipment, allowing for proper maintenance; • Residual Value—the analyst’s estimate of residual val- ues as of a given future date(s); • Manufacturer Name—a listing of the complete manufac- turer’s name, address of corporate headquarters, and phone number; • Type of Equipment—a complete description of the equipment being analyzed; • Manufacturing/Marketplace—a general discussion of the manufacturer’s future marketing plans and outlook; • Future Improvements—any technological break- throughs on the horizon; • Price Increases—a listing of any price increases that are planned in the future, as well as an analysis of past increases; • Deinstallation—the estimated time and cost to deinstall the equipment; and • Conclusion—a narrative summary of the entire analysis. Example Format 2: • Equipment Description—a detailed narrative on the piece of equipment being analyzed; • Transaction Price—the cost of equipment listed in the lease transaction (lessor’s cost); • Fair Value—the adjusted transaction price on which the residual is based, including only hard costs, those adjust- ed for discounts, and the prices of competitor’s equip- ment of similar quality and utility; • Estimated Residuals—the numerical estimate of resid- ual value given in terms of dollars as of a specified future date(s); and • Comments (Discussion)—a narrative description of the analysis, including a brief description of the equipment being analyzed with comments on the equipment’s desirability in the secondary market, what makes it bet- ter than a competitor’s, the manufacturer’s reputation in the industry, the amount of time the manufacturer has been in existence, the manufacturer’s estimated current marketshare, a list of market competitors, the equip- ment’s estimated useful life, obsolescence considerations (planned introductions of new models, etc.), and esti- mated time and cost to remarket the equipment, etc. 6.10 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL
- 78. As stated previously, appraisers may develop their own style or format, but regardless of which format is used, all of the items shown in the two previous examples should be addressed somewhere within the analysis. Residual Curves Estimators/appraisers who have been studying equipment values over a number of years should save their work. Since these analyses are based on actual market data, it is felt that similar equipment being valued over a period of years will start to develop a standard shape or residual curve as a per- centage of fair value (standard discounted price new). To illustrate the fair value of an item, consider a heavy-duty over-the-road truck tractor. The truck carries a list price of $115,000, yet can be readily purchased on a fleet basis for $65,000. Thus, the fair value is $65,000, and not the $115,000 list price. Using fair value will help the analyst avoid the trap of applying a “standard curve” (for conceptual purposes) against a list price that is inflated for whatever reason, yielding a resid- ual curve that is also inflated and most likely in error. From time to time, equipment manufacturers raise prices for no apparent reason other than perhaps not to be caught in case the government someday applies price controls. The same manufacturers routinely apply large discounts to their equipment, showing the importance of using a fair value as a benchmark for a realistic discounted selling price. “Standard curves” for indicative purposes can be developed through constant residual analysis over many years. Table 6.5 shows some residual curves that are used from time to time on a conceptual basis only. A study of these curves can be made to determine which curves may be applicable to “rusty iron” and which may apply to high-tech equipment. The higher the obsolescence factor, the shorter the equip- ment’s life, and the lower the residual curve. In some cases, the curve becomes almost trun- cated after a short period of time. Unless absolutely neces- sary, residual curves should not be used to determine actu- al residual values, but only for conceptual “order of magni- tude” purposes. They can, however, be useful in an analy- sis method called curve fitting, when only several points of data are obtained and the appraiser is left with informa- tion gaps at certain years. (This concept will be explained later in this chapter.) Methodology Estimators/appraisers have various methods available to use in determining residual values, including the cost approach, the income approach, and the market data (or trade data) approach to value. From a practical standpoint, the market approach is oftentimes felt to be the most accurate, because of its reliance on sales and trade data. A market approach analy- sis involves the following steps: 1. A complete market analysis and technical review of the subject piece of equipment is undertaken. Once that is finished, the appraiser collects all available sales trade data relating to the same or similar equipment, noting manufacturer, model, capacity, equipment age at the time of trade, trade level, condition and sales price. If dif- ferent trade levels are found, notations should be made next to the price noting levels, such as auction (liquida- tion value), retail (fair market value-in-exchange), and retail asking (fair market value-in-exchange/asking). 2. The current list price (new) is obtained for each piece of equipment analyzed and all standard discounts are applied. The discounted list price of the subject equip- ment is then compared to other equipment of similar quality and utility to arrive at a fair value. The fair value new represents a reference point of 100 percent that is the basis of the residual calculation. From this absolute dol- lar value, a residual curve in the form of a percentage (of fair value) can be determined. 3. After the fair value is determined, and all available trade data is collected, an equipment valuation history is com- 6.11 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Curve # 1 2 3 4 5 6 7 8 9 1 76% 63% 51% 43% 45% 30% 24% 17% 14% 2 60% 55% 50% 45% 40% 35% 30% 25% 20% 3 55% 50% 45% 42% 39% 36% 32% 30% 25% 4 50% 45% 35% 30% 25% 22% 20% 18% 15% 5 45% 33% 27% 22% 20% 18% 17% 16% 15% 6 45% 32% 20% 15% 10% 5% 4% 3% 2% 7 35% 30% 25% 20% 15% 10% 7% 5% 3% 8 31% 27% 23% 19% 16% 12% 9% 3% 1% 9 45% 25% 10% 5% 3% 0% 0% 0% 0% Table 6.5—Sample Residual Curves Years (% of Fair Value)
- 79. piled (see Figure 6.6). This form is used to compile avail- able residual information (in raw form) characterized by the age of the equipment sale. The example notes the fair value (100 percent) and various trades (auction) for the same or similar piece of equipment at different ages up to six years. The trade data shown represents equipment sold in average condition with normal wear and tear. 4. After the trade data is documented, an average is deter- mined and entered onto the residual analysis line. When a wide discrepancy exists in the values, the high and low may be discarded, or simple common sense can be used to determine what looks like the average. 5. The residual value in a percentage form is then calculated from the available data (see Figure 6.7). This data now represents the historical relationship between the current secondary market and the current fair value new. If this historical analysis is turned around, it can also be used in a conservative way to represent the residual value of equipment of the same age carried into the future. This type of analysis is based on zero inflation. For equipment where no trade data is available, data is obtained on the most comparable machine and applied. In instances where available trade data is limited, “curve fitting” (Figure 6.8) will fill the voids. Analysts who rou- tinely log residual curves will, over time, accumulate a large number of these curves. Each curve is based on actual equipment trades and represents how certain types of equipment tend to depreciate in trade value over a period of years. Thus, an analyst can complete the residual curve presented in Figure 6.8 by matching the known percentages with a standard curve having the same or similar percent- age at a given age (see Figure 6.7), and then filling in the unknown “gaps” on the curve with the known corresponding percentages of the fitted curve. 6.After the final curve is completed, it should be reviewed by the analyst and adjusted up or down accordingly for factors such as maintenance, use, location, regulation, tech- nology, and other relevant elements that could affect residual values. 7.After a final review and adjustment, the residual curve should be cross-checked with other curves of similar equipment. The analyst should notice a similarity in shape to the known curve. If not, then it should be re-analyzed to determine if an error was made. Additional research may be required to increase the sample of trade data, etc. An increase in sample size and additional research may lead to a change in the curve or confirm the original shape. 6.12 EQUIPMENT, PARTS & TOOLS AACE INTERNATIONAL Figure 6.6—Equipment Valuation History Figure 6.7—Residual Value Curves
- 80. In any event, the analyst should review the final results and base the findings on the body of knowledge as well as experience. This will lead the analyst to the selection of the final curve and appropriate residual values. In summary, the residual valuation method described above is basic. It is also noninflated, and based on actual historical sales, trades, and in some instances the use of curve fitting to fill voids in certain curves. Finally, and most importantly, the ana- lyst must review the curve and make subjective adjustments based on personal experience and variables that affect value. Inflation Factors The trade data method of residual value analysis described here does not use inflation factors. However, many own- ers/leasing companies routinely apply an inflation factor to residual values. Care must be taken in selecting an index. Several types of indices are published and are available for purchase by trade associations, insurance companies, appraisal companies, and/or the government. If an inflation factor is used, it should be based on a “machine-specific” index, that is, an index devoted strictly to that type of equipment being valued (e.g., a “handy-size” bulk carrier index, a Class 7 over-the-road truck/tractor index, a locomotive index, a plastic injection molding machine index, etc.) The use of machine-specific indices for equipment of a simi- lar type provides much greater reliability than the use of “industry-specific” indices. Industry-specific indices are based on a basket of goods felt to be representative of a typi- cal manufacturing plant or operation in a certain industry. For example, a machine shop index, reflective of the typical machine shop, may include milling machines, lathes, drilling machines, machining centers, turning centers, grinder, welders, cranes, measuring machines, and other related items. In reality, each type of equipment will escalate at its own rate. It is not uncom- mon to see one type of equipment escalat- ing at one percent per year, while another type may be escalating at five percent per year. Thus, a blending of weighting of the index can yield an answer that is half right (also half wrong). If the error is compounded over a number of years, the deviation from the actual inflation rate can be significant. This principle also applies to leasing com- panies that use governmental indices, such as the consumer price index (CPI). An analysis of the CPI would probably startle most leasing company executives. Not too many lessors would care to have the inflated value of their truck fleet or aircraft based on the cost of a loaf of bread, a pound of butter, or one month’s home rent. The analyst should take particular care and exercise caution when applying inflation factors to non-inflated residual val- ues. Each owner/leasing company will have its own philos- ophy regarding the use of inflation factors, which the analyst should follow in a responsible way. 6.13 AACE INTERNATIONAL EQUIPMENT, PARTS & TOOLS Figure 6.8—Curve Fitting
- 82. INTRODUCTION Economic costs is a wide-ranging area of importance for cost engineers and cost managers. Ultimately, there is an owner or client, public or private, supplying the funds for the proj- ect. The project must be economically feasible to construct. The same principle applies to producing a product. The price of the product must be in a range that is affordable for its target market. With globalization, the area of economic costs is complicated by the production of product components in various coun- tries. These countries have their own unique set of economic cost factors, including currency issues, inflation rates, and taxation rates. Cost engineers and cost managers thus need to be informed of economic cost concepts and their potential applications to their work. Often, one is faced with compar- ing alternatives, and the cost implications may not be imme- diately apparent. Economic analysis techniques, properly applied, can pinpoint the alternative with the most favorable cost aspects. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • evaluate, on an economic analysis basis, the differences between two or more alternative courses of action; and • understand such concepts and techniques as net present value, annual cash flow analysis, rate of return analysis, benefit-cost analysis, and payback periods. CONCEPTS Cost engineering professionals must make sensible decisions in the arena of economic costs. Often this task is complicated by the fact that certain elements of these decisions, such as costs, revenues, and benefits, occur at different times in the life cycle of a project. For example, manufacturing processes that proved economical over a lengthy period of time may end up at a net negative cost when the downstream costs of hazardous waste cleanup are factored into the equation. While no one can peer unerringly into the future, the more effective the analysis of the totality of economic costs is, the better the resulting decisions will be. Recognition of the impact of various factors of eco- nomic costs leads to more rational decision processes by cost engineers. Elements of economic costs may be outside the ability of the cost engineering professional to control. Taxation policies and the respective rates of taxation are set by political entities responding to their often-diverse constituencies. Depreciation rules, again, are enacted by political entities. Currency varia- tions may be outside even the control of the particular polit- ical entity and, instead, are influenced by the actions and inactions of governments and currency traders around the world. Some aspects of inflation may be the result of govern- ment actions as the government expands the money supply with the result that too much money chases too few goods and services. While some elements of economic costs may be outside the control of any one decision maker, one still can- not ignore their potential impact on investment decisions. TYPES OF COSTS Opportunity Costs Economic decision makers need to consider the impact of opportunity costs. An opportunity cost represents the fore- gone benefit by choosing one alternative over another. A stu- dent upon graduation from high school has many choices including work, military service, and further education. If the student decides to pursue further education, the costs of this endeavor represent not only tuition, books, and living costs, but also wages or salary foregone from work opportunities. Thus, a total cost calculation will include the lost salary or wages given up in favor of the further education decision. Similarly, other economic decisions need to consider foregone benefits for an accurate analysis. 7.1 AACE INTERNATIONAL ECONOMIC COSTS Chapter 7 Economic Costs Neil D. Opfer, CCE
- 83. Sunk Costs Sunk costs represent funds already spent by virtue of past decisions. Since these expenditures are in the past, by defini- tion, they should not influence current decisions. While a past investment may still be yielding benefits from an income stream, these current and future benefits are relevant. The past expenditure, however, is considered to be a sunk cost and is ignored in current and future decision-making. Book Costs Assets are carried on the firm’s books at original cost less any depreciation. Book costs represent the value of an item as reflected in the firm’s books. Books costs do not represent cash flows and thus are not taken into account for economic analysis decisions except for potential depreciation impacts for tax consequences. Conservative accounting principles dictate that if the market price for financial assets, such as a stock, is lower than the original price, this asset will be car- ried at the lower of cost or market value. The underlying land values may have significantly escalated over a period of years; however, the asset will still be carried at its original or book costs. For the firm to be a going concern, the sale of the land at a higher market price would not make sense unless this was part of a strategy to dispose of surplus assets. Incremental Costs In economic analysis decisions, focus must be on incremental costs or those cost differences between alternatives. As an example, in the comparison between two alternative pieces of processing equipment, if both units have the same yearly annual maintenance costs of $2,500 each, there is no incre- mental difference. Therefore, maintenance costs can be excluded from the analysis. On the other hand, if a third piece of processing equipment has annual maintenance costs of $1,500, then there is an obvious incremental cost difference of $1,000, which then must be considered in the analysis between the three alternative units. CHANGES IN COSTS Changes in costs occur for a number of reasons in the econo- my. Cost professionals must be conversant with the potential for cost changes and their implications. The most common cost changes concepts are • inflation, • deflation, • escalation, and • currency variation. Cost changes are usually measured by price indexes, which represent relative prices for either a single good or service or a market basket of goods and services. Generally, indexes are used over time to measure the relative price changes in goods and services. Price indexes can be inaccurate barometers of price changes in certain contexts. If the quality of a good or service changes for better or worse, price indexes do not account for this change in quality. Comparing a 1970-era car to a 2000-era car will find not only a change in relative price but in quality as well. Price indexes lose relevancy when the items being compared are not the same. A factory built in one country in 1995 of a given size with its own price index could be compared to a factory built in another country in 2005 only if adjustments are made for relevant differences. If the 1995 factory construction included several miles of addition- al utility lines for services, these differences must be consid- ered in the analysis along with currency translation issues. Inflation Inflation is a rise in the price level of a good or service or mar- ket basket of goods and/or services. Inflation does not occur by itself but must have a driving force behind it. There are four effects that can result in inflation either by themselves or in combination with other effects. These four effects are • money supply, • exchange rates, • demand-pull inflation, and • cost-push inflation. Money supply is influenced by the central bank of a country. Most countries’ governments are able to operate by selling and buying bonds and setting certain internal interest rates. These central bank operations will, therefore, have an impact on monetary policy, which thus can impact inflation. A loosening of monetary policy will increase the flow of money in the sys- tem, which means the increased money supply will be chasing the same amount of goods and services. This bids up the price of the goods and services resulting in inflation. Exchange rates can impact inflation by influencing the price of imported goods and services. If the currency of Country A falls in relation to the currency of Country B, imports from Country A are relatively less expensive. On the other hand, a rising Country A currency relative to Country B currency will make those same imports more expensive. If the import is a basic industrial commodity, such as copper, utilized in a wide range of products, the rise in relative price will lead to infla- tionary price ripples throughout the economy of Country A. Demand-pull inflation is when excessive quantities of money are chasing a limited amount of goods and services resulting in what is essentially a “seller’s market” as sellers receive premium prices. Examples of this can be anything from autos to real estate. An auto in short supply commands prices above list invoice. The same demand-pull inflation would apply to real estate in a popular location. 7.2 ECONOMIC COSTS AACE INTERNATIONAL
- 84. Cost-push inflation takes place when product producers encounter higher costs and then push these costs along to others in the production chain through higher prices. These higher costs may be for labor, material, or any other item with a significant cost element. A labor contract with workers may dictate 10 percent wage increases in a given year, and, if not offset by productivity gains, in a product with 50 percent labor content, these wage increases will be passed on to pur- chasers of the product. Deflation Deflation is the opposite of inflation with a fall in the gener- al price level for goods and services or a representative mar- ket basket of goods and services. The same aforementioned factors of money supply, exchange rates, demand-pull, and cost-push factors operate but in the opposite direction with a resultant decrease in prices. If costs for producers of goods and services fall in competitive industries, this cost decrease will be passed onto purchasers. For example, prices for per- sonal computers have fallen across the board since their large-scale introduction in the 1980s even while features have increased in the units. Complete personal computers can now be purchased twenty years later for a fraction of their original cost. A contracting money supply can result in price deflation. Exchange rates that rise in one country, giving that country a stronger currency relative to those countries from which it imports goods and services, will result in deflation- ary price decreases for those same imports. Escalation Escalation is a technique to accommodate price increases or decreases during the life of the contract. An escalation or de- escalation clause is incorporated into the contract so that the purchaser will compensate the supplier in the event of price changes. For instance, an aircraft maintenance firm may sign a five-year contract for the maintenance and fueling of a firm’s aviation fleet. If aviation fuel increases in cost during the contract, the escalation will be paid for by the purchaser as an additional contract amount. Similarly, if the price of fuel declines or de-escalates during the contract, the supplier will rebate a like amount to the purchaser. These escalation and de-escalation clauses help to shield both the supplier and the purchaser from unpredictable cost changes. Without such clauses, suppliers would include contingency amounts that might later be found to be unrealistically high. The supplier would gain from this windfall while the purchaser would be the loser. Similarly, excessive price increases in a commodity, such as aircraft fuel, might force a supplier into contractual default depending on magnitude. Currency Variation Currency changes can have a significant cost impact both on those inside the country as well as those outside the country. Currency prices are set in markets around the world and change on a constant basis as the result of daily trading fluctu- ations and moves by central banks. Many organizations oper- ate on a multinational basis. Therefore, the currency fluctua- tions in one country or many countries can have an overall impact on earnings. A contract for work or to supply products to one country if set in that countries’ currency can make the value of that contract go up or down when those earnings are repatriated to the home country of the firm. Financial assets held in one country can witness a significant decline in value if that countries’ currency is devalued by the central bank. Protecting against currency variation is complicated and can be accomplished through currency futures hedging or valuing contracts against very stable currencies, to cite two examples. GOVERNMENTAL COST IMPACTS The actions of governmental units and jurisdictions can impose significant cost impacts on the firm. In some cases, the cost impacts of governmental units are direct, such as in the case of imposed taxes. In other cases, such as in govern- mental regulations that require or prohibit certain action, governmental cost impacts may be more difficult to measure. Whether direct or indirect, an accounting of costs must rec- ognize these governmental actions. Taxes Governments are most often maintained by the taxes they impose. These taxes take many forms, such as income taxes, property taxes, inventory taxes, employment taxes, gross receipts taxes, and sales taxes. In the case of such taxes as sales taxes, the firm merely acts as the tax collector for the govern- ment adding the sales tax and collecting it from customers. While the firm does not pay the sales tax itself, excepting sales tax on items it may purchase for its own use, there are costs involved for the firm in administering these tax types. Other taxes, such as income taxes, directly impact the firm in terms of profitability as they tax the net income of the firm. Some countries have a value-added tax (VAT). The VAT is applied to the added value applied by the firm. Therefore, if a firm took $100 worth of raw materials and produced a product 7.3 AACE INTERNATIONAL ECONOMIC COSTS GLOSSARY TERMS IN THIS CHAPTER benefit/cost ◆ currency variation depreciation ◆ discount rate ◆ economic life escalation ◆ future value ◆ inflation opportunity cost ◆ present value ◆ price index price variation ◆ profitability ◆ sunk cost taxation ◆ taxes ◆ time value of money
- 85. valued at $250, the value-added tax (VAT) would be applied to the $150 difference or value added by the firm. Similarly, another firm taking the same product and incorporating it in an assembly would be assessed the VAT based, again, only on the added value. Effective Tax Rates and Marginal Tax Rates Effective tax rates, also termed average tax rates, are calcu- lated for income taxation purposes by the percentage of total taxable income paid in taxes. The effective tax rate results from dividing the tax liability by the total taxable income. The marginal tax rate is the tax rate on the next dollar of tax- able income. For financial decision-making, the marginal tax rate is a key element because the firm is concerned with the tax impact of additional income or income deductions. Investment Tax Credits To encourage economic activity, governments may give firms tax credits based on their investments in a given location. Governments may want to encourage the location of new plants in economically depressed areas and, therefore, pro- mote this through investment tax credits including abeyance on certain taxes such as property taxes. In other cases, tax credits may be granted for certain types of investments in plant and equipment. The investment tax credits may be tied to certain public policy goals. Thus, a firm installing more energy efficient equipment that reduces energy consumption may be able to avail it of energy investment tax credits. Depreciation and Depletion In order to encourage firms to invest in new plants and equipment, governmental entities often allow firms to depre- ciate their investments over time. This investment deprecia- tion allows the firm to reduce its income by a set proportion per year with a depreciation write-off until the investment is fully depreciated. The limits on investment depreciation write-off are proscribed by the governmental tax code. It must be realized that depreciation itself is not a cash flow. Depreciation instead is a non-cash expense that reduces tax- able income. Depreciation therefore provides an incentive for firms to invest in new plant and equipment. However, firms are only allowed to depreciate based on original plant and equipment costs. Therefore, current and future inflation dur- ing the asset’s depreciation cannot be taken into account for these purposes. The rationale underlying depreciation con- cepts is that physical assets lose value over time due to such factors as deterioration, wear, and obsolescence. Depletion is analogous to depreciation but for natural resources. Thus, owners of a stone quarry, an oil well, or standing timber as examples can take depletion allowances based on the percentage of the resource used up in a given time period. Depreciation Techniques Given that governments allow firms to depreciate their investments, there are numerous methods to accomplish the depreciation process. These standard methods simplify accounting for the depreciation expenses. Some of the more common depreciation techniques are • straight-line (SL) method, • double-declining balance (DDB) method, • sum-of-years digits (SOYD) method, • modified accelerated cost recovery system (MACRS), and (5) units of production (UOP) method. Straight-Line Depreciation Straight-line (SL) methods take an equal amount of deprecia- tion every year. The SL method takes the original cost less the salvage value divided by the number of years of life by the formula D = (C-S)/N Where D = depreciation charge, C = asset original cost, S = salvage value, and N = asset depreciable life (years). Therefore, an asset with a $5,000 original cost, 5-year life, and $1,000 residual salvage value would have SL depreciation of $800 per year: ($5,000 - $1,000)/5 years = $800. Double-Declining Balance Depreciation Double-declining balance depreciation applies a constant depreciation rate to the assets’ declining value. The DDB for- mula is: D = (2/N)(C-BVt-1) Where D = depreciation charge, C = asset original cost, BV = Book value at given year, and N = asset depreciable life (years). Note: Book value includes deduction for depreciation charges to date. In the SL example above, the similar DDB amounts would be as follows in Table 7.1 for an asset with a $5,000 original cost, 5-year life, and $1,000 residual salvage value: 7.4 ECONOMIC COSTS AACE INTERNATIONAL
- 86. Sum-of-Years Digits Depreciation Sum-of-years digits (SOYD) method allows depreciation to be taken at a faster rate than SL. This SOYD method takes depreciation in any one year as the product of a fractional value times the total original depreciable value. The fraction- al value for any given year has as numerator the years of asset life remaining, while the denominator is the sum of dig- its including 1 through the last year of the asset’s life. The SOYD formula is: Dr = (C – S)*[(2(N-r+1))/(N(N + 1)] Where: Dr = depreciation charge for the rth year C = asset original cost S = salvage value N = remaining asset depreciable life (years) r = rth year From the SL and DDB examples above, the similar SOYD amounts would be as follows in Table 7.2 for an asset with a $5,000 original cost, 5-year life, and $1,000 residual salvage value: SOYD = [(N/2)(N + 1)] = [(5/2)(5 + 1)] = 15 In the comparison between SL and SOYD methods, SOYD is similar to DDB in that it allows faster write-offs of the asset value in the early years. Again, as noted above, a general eco- nomic cost principle given the time value of money is that early money is of greater importance. Modified Accelerated Cost Recovery System Depreciation The modified accelerated cost recovery system (MACRS) method is unique to the United States Tax Code. Depreciation under this MACRS method is based on original asset cost, asset class, asset recovery period, and asset in- service date. Asset classes are differentiated based on 3-year, 5-year, 7-year, 10-year and other property lives, depending on asset type. Depreciation rates are set by percentages allowed under the U.S. Tax Code. Units of Production Depreciation The units of production (UOP) Method is utilized when depreciation more accurately based on usage instead of time. The UOP Method is particularly useful when an asset encounters variable demand. A piece of construction equip- ment may be utilized 1,200 hours in one year, 1,600 hours the next, and 900 hours the third year. The UOP method recog- nizes that the equipment wears out based on use and, there- fore, is a more accurate barometer than years. ECONOMIC ANALYSIS TECHNIQUES There are a variety of economic analysis techniques available to enable accurate choices between competing alternatives. The general principle is that there are competing alternatives and the goal is to choose the alternative with the highest return. In order to analyze returns from alternative choices, there are a number of techniques including • net present worth, • capitalized cost, • annual cash flow analysis, • rate of return analysis, • benefit-cost ratio analysis, and • payback period. 7.5 AACE INTERNATIONAL ECONOMIC COSTS Table 7.1—DDB Amounts for an Asset with a $5,000 Original Cost, 5-Year Life, and $1,000 Residual Salvage Value Year DDB Formula DDB Calculated Amount DDB Allowable Depreciation 1 (2/5)($5,000 – 0) = $2,000 $2,000 2 (2/5)($5,000 – $2,000) = $1,200 $1,200 3 (2/5)($5,000 – $3,200) = $720 $720 4 (2/5)($5,000 – $3,920) = $432 $80* 5 (2/5)($5,000 – $4,352) = $259.20 $0* Total = $4,611.20 $4,000 Year SOYD Formula SOYD Calculated Amount 1 (5/15)($5,000 - $1,000) = $1,333 2 (4/15)($5,000 - $1,000) = $1,067 3 (3/15)($5,000 - $1,000) = $800 4 (2/15)($5,000 - $1,000) = $533 5 (1/15)($5,000 - $1,000) = $267 Total = $4,000 *Note: An asset cannot be depreciated below its salvage value thus depreciation totals under the DDB method for Years 4 and 5 total $80. In the comparison between SL and DDB methods, DDB allows faster write-offs of the asset value. A general eco- nomic cost principle given the time value of money is that early money is of greater importance. Table 7.2—SOYD Amounts for an Asset with a $5,000 Original Cost, 5-Year Life, and $1,000 Residual Salvage Value
- 87. Except for the payback period method, these analysis tech- niques deal with a concept commonly referred to as the time value of money. Time Value of Money The time value of money is a key area in economic cost analy- sis. Different alternatives will have differing amounts of cash income and cash expenses over their lifetime. In order to compare these different alternatives on the same basis, these cash amounts of income and expenditure must be set to equivalent terms. There is a common unit of measure set in a currency whether it be dollars, euros, pesos, yen or some other measure. There will also be an interest rate set that provides the common basis for calculations. In order to perform this analysis, cer- tain information will be available with other information requiring calculation. The problem must be expressed in quantitative terms. A problem of whether it is best to paint a building blue or green cannot be judged on a quantitative basis. But if one type of building paint has a life of 10 years with its own cost structure, and another paint type has a life of 7 years with a separate cost structure, this is a problem suitable for quantitative analysis. Common language terms and their symbols for time value of money problems are as follows: P = present value or present worth F = future value or future worth A = annual amount or annuity G = uniform gradient amount n = number of compounding periods or asset life I = interest rate S = salvage value The standard formulas for economic analysis are shown in Table 7.3. Net Present Worth Method A common basis is needed when comparing alternatives. Alternatives typically will have different costs and benefits over the analysis period. The net present worth (NPW) method provides the platform to resolve alternatives into equivalent present consequences. Example NPW Problem: A firm is evaluating the potential purchase of one of two pieces of equipment. Unit A has a pur- chase price of $10,000 with a four-year life and zero salvage value. Annual maintenance costs are $500 per year. Unit B has a purchase price of $20,000 with a twelve-year life and $5,000 salvage value. In Year 1, maintenance costs are zero. In Year 2 maintenance costs are $100 and increase by $100 per year there- after. The firm’s cost of capital is 8 percent. Example NPW Problem Solution: This problem illustrates two common issues faced in comparison of alternatives. Units A and B have unequal lives of four years and twelve years respectively. Therefore, a common multiple of the respective unit lives must be selected, which, in this case, will be twelve years. Economic analysis problems view repur- chase of the same unit at four-year intervals at original cost unless there is concrete information to the contrary. The sec- ond issue this problem illustrates is that of a gradient where maintenance costs for Unit B are increasing on a year-to-year basis as opposed to steady costs. NPW Unit A: NPW = $10,000 + $10,000(P/F,8%,4) +$10,000(P/F,8%,8) + $500(P/A,8%,12) = $10,000 = + $10,000(0.7350) + $10,000(0.5403) + $500(7.536) = $26,521 NPW Unit B: NPW = $20,000 + $100(P/G,8%,12) - $5000(P/F,8%,12)-$100 = $20,000 + $100(34.634) - $5000(0.3971)-$100 = $21,347 Since in this example problem we are analyzing costs and not benefits, the unit with the lower NPW cost structure is prefer- able, which is Unit B since $21,478 < $26,521. If the calculation involved benefits greater than costs, then Unit A with the higher benefit NPW would be preferable. 7.6 ECONOMIC COSTS AACE INTERNATIONAL Formula Name Operation Symbol Formula Single-Payment Compound Amount P to F (F/P, I%, n) F=P (1+I)n Present Worth F to P (P/F,I%, n) P=F(1+I)-n Uniform Series Sinking Fund F to A (A/F,I%, n) A=F[I/((1+I)n - 1)] Capital Recovery P to A (A/P,I%, n) A = P[(I(1 + I)n))/ (1 + I)n - 1] Compound Amount A to F (F/A,I%, n) F = A[((1 + I)n - 1)/ I] Equal Series Present Worth A to P (P/A,I%, n) P = A[((1 + I)n - 1) / I(1 + I)n] Arithmetic Uniform Gradient Present Worth G to P (P/G,I%, n) P = G[((1 + I)n - In - 1)/ (I2(1+I)n] Table 7.3—Standard Formulas for Economic Analysis
- 88. Capitalized Cost Method In some cases, problems have an infinite analysis period. The need for a structure such as a road or a bridge, for example, is perpetual. With these types of situations, the capitalized cost method is chosen. Capitalized cost (CC) represents the present sum of money that needs to be set aside now, at some interest rate, to yield the funds required to provide the serv- ice indefinitely. The capitalized cost formula is A = PI. Example CC Problem: A bridge is built for $5,000,000 and will have maintenance costs of $100,000 per year. At 6 percent interest, what is the capitalized cost of perpetual service? Example CC Problem Solution: The $5,000,000 is a present cost with the $100,000 per year maintenance costs as ongoing. Therefore, Capitalized Cost = $5,000,000 + ($100,000) / 0.06 = $5,000,000 + $1,666,667 = $6,666,667 Equivalent Uniform Annual Cost or Benefit For some types of analysis, it may be preferable to resolve the comparison to annual cash flow analysis. The comparison may be made on the basis of equivalent uniform annual cost (EUAC), equivalent uniform annual benefit (EUAB) or on the EUAB-EUAC difference. Example EUAC Problem: Assume that the two units, Unit A and Unit B, are compared on the basis of EUAC. Unit A has an initial cost of $20,000 and $3,000 salvage value, while Unit B has an initial cost of $15,000 and $2,000 salvage value. Unit A has a life of 10 years, whereas Unit B has a 5-year life. Cost of capital is 10 percent. Example EUAC Solution: The relevant EUAC formula is (P-S)(A/P,I,n) + SI. EUAC Unit A: EUACA = ($20,000-$3,000)(A/P,10%,10) + $3,000(0.10) = ($17,000)(0.1627) + $300 = $2765.90 + $300 = $3065.90 EUAC Unit B: EUACB = ($15,000-$2,000)(A/P,10%,5) + $2,000(.10) = ($13,000)(0.2638) + $200 = $3429.40 + $200 = $3629.40 On the basis of the EUAC comparison between Unit A and Unit B, Unit A has the lower EUAC by $563.50 ($3629.40 - $3065.90) and would be the choice. Rate of Return Analysis Many organizations in making investment choices often set hurdle rates. The hurdle rate is the benchmark rate of return that a capital investment decision must achieve to be accept- able. A rate of return (ROR) is computed from the projected cash flows of the project. ROR values provide a ready basis for the comparison of alternatives. In the case where capital investment funds are limited, projects with the highest ROR values can be selected for the organization. Example ROR Problem: Assume that in the comparison between Unit A and Unit B (each with a 1-year life) that the cost of $20,000 for Unit A versus a $10,000 cost for Unit B also results in an incremental benefit of $15,000 for Unit A as compared to Unit B. If the organization has a hurdle rate of 20 percent for capital projects, which alternative is a bet- ter choice? Example ROR Solution: The NPW of the cost is set equal to the NPW of the benefit. The NPW Cost of Unit A versus Unit B is $10,000 ($20,000 - $10,000). The NPW of the Unit A – Unit B Benefit is $15,000. ROR NPW Cost = NPW Benefit $10,000 = $15,000(P/F,I,1) $10,000 / $15,000 = 0.6667 By inspection, if $10,000 cost difference increases benefits by $15,000 in one year, the ROR must be 50 percent. Consulting either compound interest factor tables or calculation by the P/F formula for 1 year at a 50 percent, ROR confirms this fact. Since the organizations’ hurdle rate is 20 percent, the additional investment in Unit A meets the criteria. Benefit-Cost Ratio Analysis Method Benefit Cost (B/C) Ratio Analysis involves the simple com- parison between benefits and costs of a proposed action. Benefits are placed in the numerator and costs are placed in the denominator. If the ratio of benefits to costs is greater than one, the project is viable. Comparisons can be made between proj- ects to select those projects with the highest B/C ratio. Example B/C Problem: Project A with the NPW of Benefits of $1,500,000 and NPW Of Costs of $1,200,000 is being com- pared to Project B with NPW Benefits of $2,000,000 and NPW Costs Of $1,700,000. Which is the preferred project on a B/C analysis basis? Example B/C Solution: Project A: B/C = $1,500,000 NPW Benefits/$1,200,000 NPW Costs = 1.25 B/C Ratio 7.7 AACE INTERNATIONAL ECONOMIC COSTS
- 89. Project B: B/C = $2,000,000 NPW Benefits / $1,700,000 NPW Costs = 1.17 B/C Ratio On the basis of the above B/C analysis, both Projects A and B have a positive B/C ratio, but Project A would be selected as its 1.25 Ratio is greater than the Project B 1.17 ratio. Payback Period Method Payback period is the period of time necessary for the bene- fits of the project to pay back the associated costs for the proj- ect. This is a very simple method and can prove inaccurate. A project with a payback period of three years may be select- ed over a similar project with a five-year payback period. Differences in the timing of cash flows are not considered nor are benefits and costs beyond the payback period. Payback period analysis is approximate and may not yield the same result as with other more precise methods such as NPW or EUAC criteria. As an example, an investment of $4,000 with benefits of $800 per year would have a payback period of 5 years ($4,000/$800 = 5 years). CONCLUSION The area of economic costs presents problems ranging from the simple to the complex. In this era of intense global com- petition, economic cost decisions must be made by gathering as much relevant information as possible and then applying the most appropriate analysis technique. Enhanced knowl- edge of these economic cost analysis tools will lead to improved decisions for an organization. RECOMMENDED READING 1. DeGarmo, E. P., W. G. Sullivan, J. A. Bontadelli, and E.M Wicks. 1997. Engineering Economy, Tenth Edition. Upper Saddle River, New Jersey: Prentice Hall. 2. Humphreys. K. K. 1991. Jelen’s Cost And Optimization Engineering. Third Edition. New York: McGraw-Hill. 3. Newnan, D. G., J. P. Lavelle, and T. G. Eschenbach. 2002. Engineering Economic Analysis, Eighth Edition. New York: Oxford University Press. 7.8 ECONOMIC COSTS AACE INTERNATIONAL
- 90. INTRODUCTION Growing Discontent with Traditional Cost Calculation Why do managers shake their heads in disbelief when they think about their company’s cost accounting system? I once heard an operations manager complain, “You know what we think of our cost accounting system? It is a bunch of fictitious lies—but we all agree to them.” It is sad to see users of accounting data resign themselves to hopelessness. Unfortunately, many accountants are comfortable when the numbers all “foot-and-tie” in total and could care less if the parts making up the total are correct. The total is all that mat- ters, and any arbitrary cost allocation can tie out to the total. The sad truth is that when employees and managers are pro- vided with reports that have accounting data in them, they use that information regardless of its validity or their skepti- cism of its integrity. Mind you, they are using the data to draw conclusions and make decisions. This is risky. Activity-Based Cost Management to the Rescue How can traditional accounting, which has been around for so many years, suddenly be considered so bad? This chapter on activity-based cost management (ABC/M) systems explains the reasons leading to the interest and acceptance of ABC/M, as well as how to construct an ABC/M cost assign- ment model. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • understand why managers and employees are misled by arbitrary cost “allocations;” • understand how ABC/M transforms spending expenses on resources (e.g., salaries) into “calculated” costs of work activities and processes and then into products, service-lines, channels, and customers; • learn how cost “drivers” cause costs to occur; • understand how “attributes” are tags or scores that attached to activities to suggest actions; and • understand how ABC/M is used in addition to strategic purposes, such as profit margin analysis, but also for cost management, productivity, and asset utilization. OVERHEAD EXPENSES ARE DISPLACING DIRECT COSTS The direct laborers in organizations are the employees who perform the frontline, repeated work that is closest to the products and customers. However, numerous other employ- ees behind the frontline also do recurring work on a daily or weekly basis. These employees’ work is highly repeatable at some level, for example, a teller in a bank. Figure 8.1 on page 8.2 is a chart that includes this type of expense plus the other two major expense components of any organization’s cost structure, its purchased materials and its overhead. Most organizations are experienced at monitoring and meas- uring the work of some of the laborers who do recurring work by using cost rates and standard costs. In the bottom layer of the chart is cost information that also reveals per- formance-related costs other than the period’s spending, such as labor variance reporting. It is in this area of the chart, for example, that manufacturers use labor routings and process sheets to measure efficiency. These costs are well known by the name standard costs. Service organizations also measure this type of output-related information. For exam- ple, many banks know their standard cost for each deposit, each wire transfer, and so forth. Problems occur in the overhead expense area appearing at the top portion of Figure 8.1. The chart reveals that over the last few decades, the support overhead expenses have been displacing the recurring costs. The organization already has 8.1 AACE INTERNATIONAL ACTIVITY-BASED COST MANAGEMENT Chapter 8 Activity-Based Cost Management Gary Cokins
- 91. substantial visibility of its recurring costs, but it does not have any insights into its overhead or what is causing the level of spending of its overhead. ABC/M can help provide for insights and learning. (Note: Organizations often refer to this support-related work as overhead. Overhead is also referred to as indirect costs. The two terms can be used interchangeably; however the term “overhead” can be misleading and often has a negative connotation. In many cases overhead is a crucial and is a very positive thing to have.) In a bank, for example, managers and employee teams do not get the same robustness of financial information about the vice presidents working on the second floor and higher up in the building as they do about tellers. The only financial infor- mation available to analyze the expenses of the vice presi- dents and other support overhead is the annual financial budget data. These levels of expenses are annually negotiat- ed. The focus is on spending levels, not on the various cost rates. The expense spending is monitored after the budget is published. Spending is only monitored for each department or function for each period to see if the managers’ spending performance is under or over their budget or plan. ABC/M extends to the overhead the understanding and vis- ibility of spending that is already applied to the recurring laborers. ABC/M can then become an organization-wide method of understanding work activity costs as well as the standard costs of outputs. Impact of Diversity in Products, Service Lines, Channels, and Customers When you ask people why they believe indirect and overhead expenses are displacing direct costs, most answer that it is because of technology, equipment, automation, or computers. In other words, organizations are automating what previ- ously were manual jobs. However, this is only a secondary factor in the shift in organizational expense components. The primary cause for the shift is the gradual pro- liferation in products and service lines. Over the last few decades, organizations have been increas- ingly offering a greater variety of products and services as well as using more types of distribu- tion and sales channels. In addition, organizations have been servicing more and different types of customers. Introducing greater variation and diversity (i.e., heterogeneity) into an organization creates complexity, and increasing complexity results in more overhead expenses to manage it. So the fact that the overhead component of expense is displacing the recurring labor expense does not automatically mean that an organization is becoming inefficient or bureaucratic. It simply means that the company is offering more variety to different types of customers. In short, the shift to overhead displacing direct labor reveals the cost of complexity. ABC/M does not fix or simplify com- plexity; the complexity is a result of other things. But what ABC/M does do is point out where the complexity is and where it comes from. ACTIVITIES ARE EXPRESSED WITH ACTION VERBS AND TRACE EXPENSES TO OUTPUTS Figure 8.2 begins to reveal the explanation as to why tradi- tional cost allocations of expenses are flawed and, therefore, misleading. The left side shows the classic monthly responsi- bility-center statement report that managers receive. Note that the example used is the back office of an insurance com- pany. This is to demonstrate that, despite misconceptions, indirect white-collar workers produce outputs no differently than do factory workers. If you ask managers who routinely receive this report ques- tions such as, “How much of these expenses can you control or influence? How much insight do you get into the content of work of your employees?” they will likely answer both questions with, “Not much!” This is because the salary and fringe benefit costs usually make up the most sizable portion 8.2 ACTIVITY-BASED COST MANAGEMENT AACE INTERNATIONAL Figure 8.1—Overhead Costs Are Displacing Direct Costs
- 92. of controllable costs, and all that the manager sees are those expenses reported as lump-sum amounts. When you translate those “chart-of-account” expenses into the work activities that consume the financial general ledger’s expenses, a manager’s insights from viewing the activity costs begin to increase. The right side of Figure 8.2 is the ABC/M view that is used for analysis and as the starting point for calculating the costs for both processes and diverse outputs. In effect, the ABC/M view resolves the deficiencies of traditional financial accounting by focusing on work activ- ities. ABC/M is work-centric, whereas the general ledger is transaction-centric. “Expenses” must be distinguished from “costs.” They are not the same thing. All costs are calculated costs. It is impor- tant to recognize that assumptions are always involved in the conversion and translation of expenses into costs. The assumptions stipulate the basis for the calculation. Expenses occur at the point of acquisition with third parties, including employee wages. This is when money (or its obligation) exits the company. At that special moment, “value” does not fluc- tuate; it is permanently recorded as part of a legal exchange. From the expenses, all costs are calculated representations of how those expenses flow through work activities and into outputs of work. A key difference between ABC/M and the general ledger and traditional techniques of cost allocation (i.e., absorption cost- ing) is that ABC/M describes activities using an “action- verb-adjective-noun” grammar convention, such as inspect defective products, open new customer accounts, or process cus- tomer claims. This gives ABC/M its flexibility. Such wording is powerful because managers and employee teams can bet- ter relate to these phrases, and the wording implies that the work activities can be favorably affected, changed, improved, or eliminated. The general ledger uses a chart of accounts, whereas ABC/M uses a chart of activities. In translating gen- eral ledger data to activities and processes, ABC/M preserves the total reported revenues and costs but allows the rev- enues, budgeted funding, and costs to be viewed differently. Also, notice how inadequate the data in the chart of accounts view are for reporting business process costs that run cross- functionally, penetrating the vertical and artificial boundaries of the organization chart. The general ledger is organized around separate departments or cost centers. This presents a reporting problem. As a result of the general ledger’s struc- ture of cost center mapping to the hierar- chical organization chart, its information drives vertical behavior—not the much more desirable process behavior. The gen- eral ledger is a wonderful instrument for what it was designed to do—to “bucke- tize” and accumulate spending transac- tions into their accounts. But the data in that format is structurally deficient for decision support other than the most primitive form of control, budget vari- ances. In effect, using traditional cost systems, managers are denied visibility of the costs that belong to the end-to-end business processes. This is particularly apparent in the stocking, distribution, marketing, and selling costs that traditional accounting “expenses to the month’s period.” With traditional cost allocations, these sales and general and administrative expenses (SG&A) are not proportionately traced to the costs of the unique products, contain- ers, services, channels, or customers that cause those costs to occur. 8.3 AACE INTERNATIONAL ACTIVITY-BASED COST MANAGEMENT GLOSSARY TERMS IN THIS CHAPTER chart of accounts ◆ cost indirect cost ◆ overhead Figure 8.2—Each Activity Has Its Own Driver
- 93. In summary, the general ledger view describes “what was spent,” whereas the activity-based view describes “what it was spent for.” The ledger records the expenses, and the activity view calculates the costs of work activities, processes, and all outputs, such as products. Intermediate output costs, such as the unit cost to process a transaction are also calculated in the activity view. When employees have reliable and relevant information, managers can manage less and lead more. DRIVERS TRIGGER THE WORKLOAD Revisit Figure 8.2. Much more information can be gleaned from the right-side view. Look at the second activity, “ana- lyze claims” for $121,000, and ask, “What would make that cost significantly increase or decrease?” The answer is the number of claims analyzed. That is that work’s activity driv- er. It shows that each activity on a stand-alone basis has its own activity driver. At this stage the costing is no longer rec- ognizing the organizational chart and its artificial bound- aries. The focus is now on the work that the organization per- forms and what affects the level of that workload. There is additional information. Let’s assume there were 1,000 claims analyzed during that period for the department shown in Figures 8.2. The unit cost per each analyzed claim is $100 per claim. If a specific group of senior citizens over the age of 60 were responsible for half those claims, we would know more about a specific customer or beneficiary of that work. The senior citizens would have caused $60,500 of that work (i.e., 500 claims times $121 per claim). If married cou- ples with small children required another fraction, married couples with grown children a different fraction, and so forth, ABC/M would trace all of the $121,000. If each of the other work activities were similarly traced using the unique activity driver for each activity, ABC/M would pile up the entire $914,500 into each group of beneficiary. This reassign- ment of the resource expenses would be much more accurate than any broad-brush cost allocation applied in traditional costing procedures and their broad averages. In the past, calculating costs using volume-based allocations may have been acceptable and may not have introduced excessive error. But most organizations’ cost structures began to change in the 1970s. With greater overhead costs relying on a basis for cost allocations that were tied to unrelated vol- umes of usage, the traditional costing method had become invalid relative to how the rich variation of products and services consumed costs. Therefore, the unfavorable impact of the costing errors was becoming much more intense than in the past. ABC/M resolves the problem of poor indirect and overhead cost allocations, but it also provides additional information for analysis to suggest what positive actions, strategic or operational, can be taken based on the new data. To sum up Figure 8.2, when managers receive the left-side responsibility center report, they are either happy or sad, but rarely any smarter. The cost assignment network is one of the major reasons that ABC/M calculates more accurate costs of outputs. The assignment of the resource expenses also demonstrates that all costs actually originate with the customer or beneficiary of the work. This is at the opposite extreme of where people who perform “cost allocations” think about costs. Cost allo- cations are structured as a one source-to-many destinations redistribution of cost. But the destinations are actually the origin for the costs. The destinations, usually outputs or peo- ple, place demands on work, and the costs then “measure the effect” by reflecting backward through the ABC/M cost assignment network. ABC/M IS A COST RE-ASSIGNMENT NETWORK In complex support-intensive organizations, there can be a substantial chain of indirect activities prior to the work activ- ities that eventually trace into the final cost objects. These chains result in activity-to-activity assignments, and they rely on intermediate activity drivers in the same way that final cost objects rely on activity drivers to re-assign costs into them based on their diversity and variation. The direct costing of indirect costs is no longer, as it was in the past, an insurmountable problem given the existence of integrated ABC/M software. ABC allows intermediate direct costing to a local process or to an internal customer or required component that is causing the demand for work. That is, ABC cost-flow networks no longer have to “hit the wall” from limited spreadsheet software that is restricted by columns-to-rows math. ABC/M software is arterial in design. Eventually, via this expense assignment and tracing network, ABC re-assigns 100 percent of the costs into the final products, service lines, channels, customers, and business sustaining costs. In short, ABC connects customers to the unique resources they consume—and in proportion to their consumption. Let’s review the ABC cost assignment network in Figure 8.3, which consists of the three modules connected by cost assignment paths. This network calculates the cost of cost objects (e.g., outputs, product lines, service lines, or cus- tomers). It is basically a snap-shot view of the business con- ducted during a specific time period. Resources, at the top of the cost assignment network, are the capacity to perform work because they represent all the available means that work activities can draw upon. Resources can be thought of as the organization’s checkbook; 8.4 ACTIVITY-BASED COST MANAGEMENT AACE INTERNATIONAL
- 94. this is where all the period’s expenditure transactions are accumulated into buckets of spending. Examples of resources are salaries, operating supplies, or electrical power. These are the period’s cash outlays and amortized cash outlays, such as for depreciation, from a prior period. It is during this step that the applicable resource drivers are developed as the mechanism to convey resource costs to the activity. In sum, resources are traced to work activities. It is during this step that the applicable resource drivers are developed as the mechanism to convey resource expenses into the activity costs. A popular basis for tracing or assigning resource expenses is the time (e.g., number of minutes) that people or equipment spend performing activities. Note that the terms tracing or assigning are preferable to the term allocation. This is because many people associate the allocation with a redistribution of costs that have little to no correlation between source and destinations; hence to some organizations, overhead cost allocations are felt to be arbitrary and are viewed cynically. The activity module is where work is performed. It is where resources are converted into some type of output. The activi- ty cost assignment step contains the structure to assign activ- ity costs to cost objects (or to other activities), utilizing activ- ity drivers as the mechanism to accomplish this assignment. Cost objects, at the bottom of the cost assignment network, represent the broad variety of outputs and services where costs accumulate. The customers are the final-final cost objects; their existence ultimately creates the need for a cost structure in the first place. Cost objects are the persons or things that benefit from incurring work activities. Examples of cost objects are products, service lines, distribution chan- nels, customers, and outputs of internal processes. Cost objects can be thought of as the for what or for whom that the work is done. 8.5 AACE INTERNATIONAL ACTIVITY-BASED COST MANAGEMENT Figure 8.3—ABC/M Cost Re-Assignment Network
- 95. Once established, the cost assignment network is useful in determining how the diversity and variation of things, such as different products or various types of customers, can be detected and translated into how they uniquely consume activity costs. USING THE ATTRIBUTES OF ACTIVITY-BASED COSTING One role for calculating costs is to help suppliers and service- providers identify which of their organization’s work activi- ties are as follows: • not required at all and can be eliminated (e.g., a duplica- tion of effort); • ineffectively accomplished and can be reduced or redesigned (e.g., due to outdated policies or procedures); • required to sustain the organization (i.e., the work is not directly caused by making product or delivering servic- es through channels to customers), and, therefore, it may not be possible to reduce or eliminate the work activity (e.g., provide plant security, compliance with govern- ment regulations, etc.); and • discretionary and can potentially be eliminated (e.g., the annual employees’ picnic). Activity-based cost management (ABC/M) systems provide for distinguishing these work activities either by including them in a cost assignment structure (i.e., sustaining cost objects) or by tagging their costs as an overlay (i.e., attributes). Organizations have very little insight about how their indi- vidual costs—whether in products, customers, or business processes—vary among themselves aside from the amount of the cost. Traditional cost accounting methods do not provide any way for individual costs to be tagged or highlighted with a separate dimension of cost other than the amount that was spent. An example of a range of a tag that can be scored for activities is as “very important” versus “required” versus “postponable.” These are popular ways of measuring how much value-added costs exist and where they are located. What this introduces is visibility to the colors of money. In short, traditional accounting simply provides racked-and- stacked numbers; aside from the cost amount or emphasis in the appearance of the numbers, one cannot differentiate one cost from another. This is true whether one is examining resource expenditures or their calculated costs of activities, processes, and final cost objects (i.e., workflow outputs, products, or customers). Attributes solve this money-level- only limitation of traditional costing. One can think of attrib- utes as offering many other dimensions to segment costs that are different from absorption costing’s single dimension, which only reflects variation and diversity consumption of cost objects like outputs, products, service lines, and cus- tomers. Attributes can be used as a grading method to evalu- ate the individual activities that contribute to a process out- put’s goods or services. ABC/M attributes allow managers to differentiate activities from one another even if they are equal in amount. Advanced, mature users are masters at employing ABC/M attributes. A popular attribute involves scoring activities along their “high- versus low-value-adding” scale. The idea is to eliminate low-value-adding activities and optimize higher-value-adding activities, thus enabling employees to focus on the worth of their organization’s work. Employees can see how work really serves customers and which activi- ties may be considered wasteful. Focus and visibility are enhanced because people can more easily see where costs are big or small and also which costs can be managed in the near- term. Scoring costs with attributes invokes action beyond just gazing at and analyzing costs. In the early days of ABC/M, the scoring choices for value- adding were limited to either value-added (VA) or nonvalue- added (NVA). This either-or choice created problems. First, it was considered a personal insult to employees to tell them that part or all of what they do is nonvalue-adding. Employees are not real happy to hear that. But even more restrictive is the ambiguity of scoring value that can lead to unsolvable debates. For example, take the activity “expedite order” to prevent a late shipment to an important customer. Is this VA or NVA work? A solid argument can support either case. It is better to simply discard the VA versus NVA dichotomy with a different set of words that scale along a continuum and better describe levels of importance (e.g., crit- ical, necessary, regulatory, or postponable.) Regardless of what type of scale you use to score or grade value, the objective is to determine the relation of work or its output to meeting customer and shareholder requirements. The goal is to optimize those activities that add value and minimize or eliminate those that do not. Following are some tips, but by no means hard rules, for classifying value attrib- utes. High-value-adding activities are those • required to meet customer requirements; • that modify or enhance purchased material of a product; • that, if more of them are accomplished, the customer might pay more for the product or service; • that are critical steps that cannot be eliminated in a busi- ness process; • that are performed to resolve or eliminate quality prob- lems; • that are performed due to a request or expectation of a satisfied customer; and • that, in general, if time permitted, you would do more of. 8.6 ACTIVITY-BASED COST MANAGEMENT AACE INTERNATIONAL
- 96. Low-value-adding activities are those that • can be eliminated without affecting the form, fit, or func- tion of the product; • begin with the prefix “re” (such as rework or returned goods); • result in waste and add no value to the product or service; • are performed due to inefficiencies or errors in the process stream; • are duplicated in another department or add unneces- sary steps to the business process; • are performed to monitor quality problems; • are performed due to a request of an unhappy or dissat- isfied customer; • produce an unnecessary or unwanted output; and • if given the option, you would prefer to do less of. Another popular attribute scores how well each activity is performed, such as “exceeds” “meets,” or “below customer expectation.” This reveals the level of performance. Multiple activities can be simultaneously tagged with these grades from two or more different attributes. As an option, activities can be summarized into the processes the activities belong to. Using two different attributes along the process view, organ- izations can see, for example, that they are spending a lot of money doing things they are good at but that they have judged to be unimportant. Attributes are very suggestive. In this example, it is obvious the organization should scale back and spend less on that kind of work. Figure 8.4 illustrates the four quadrants that result from combining the two attributes for performance (vertical axis) and importance (horizontal axis). The activity costs for such unimportant activities would be in the upper-left quadrant. Although most attributes are subjectively scored or graded by managers and employees, when the attributes’ targeted activities or cost objects are grouped together, any subjectivi- ty begins to become directionally reliable (assuming there was no bias in the scoring of every single attribute). As a result, the attributed costs introduce emotionally compelling business issues, like the example above. Attributes make ABC/M data come alive to some people. And when the attributed ABC/M data are exported into OLAP software and executive information system (EIS) tools, they can have a very stimulating impact on users. LOCAL VERSUS ENTERPRISE-WIDE ABC/M A common misconception is that the scope of an ABC/M sys- tem must be enterprise-wide. That is, the expenses included in the system must account for all the employees in the organization and 100 percent of a time period’s expenditures. (Or alternatively, the expenses must include all the people in a substantial portion of the organization, such as a factory or service-delivery arm.) People with this misconception have usually been exposed only to ABC/M models or systems that are used for calculating the total costs of a product or service line used to determine their total profitability. In practice, the vast majority of ABC/M is applied to subsets of the organization for process improvement rather than revenue enhancement and profit margin increases. An example of a subset is an order-processing cen- ter or equipment maintenance function. These ABC/M models and systems are designed to reveal the cost structure to the participants in the main department and related areas. In ABC/M’s cost assignment view, the cost struc- ture is seen from the orientation of how the diversity and variation of the function’s out- puts cause various work to happen, and how much. The costs of the work activities that belong to the processes are also revealed in the ABC/M model as they relate in time and sequence. However, it is ABC/M’s powerful revealing of the costs of various types of out- puts that serves as a great stimulant to spark discussion and discovery. For example, if an order-processing center learns that the cost per each adjusted order is roughly eight times more costly than for each error-free or adjust- ment-free entered order, that would get peo- ple’s attention. This result happens even if the 8.7 AACE INTERNATIONAL ACTIVITY-BASED COST MANAGEMENT Figure 8.4—ABC/M’s Attributes Can Suggest Action
- 97. order entry process has been meticulously diagrammed, flowcharted, and documented. Commercial ABC/M software now enables consolidating some, and usually all, of the local, children ABC/M models into the enterprise-wide, parent ABC/M model. The local ABC/M model data are used for tactical purposes, often to improve productivity. In contrast, the consolidated enterprise- wide ABC/M model is often used for strategic purposes because it helps focus on where to look for problems and opportunities. Also, enterprise-wide models are popular for calculating profit margin data at all levels, including channel- related and customer- and service-recipient-related profit con- tribution layers. Table 8.1 illustrates how the unit costs of the output of work can be made visible for a government’s highway mainte- nance department. The benchmarking of relative data can be more powerful than process flow charts in stimulating dis- cussion about what to change. In short, this approach places intra-ABC/M models within an enterprise ABC/M model. A large parent ABC/M model is simply subdivided into its component children ABC/M models. Commercial ABC/M software accommodates con- solidations of children into parent ABC/M models. The costs and information are unaffected regardless of which ABC/M models you work with. APPLICATIONS OF LOCAL ABC/M The vast majority of ABC/M data are applied locally. Examples, such as that for the purchasing process, are limitless. Whenever you have people and equipment doing work where the outputs have diversity, a local ABC/M model can be con- structed. The objective of local ABC/M models is not to calcu- late the profit margins of products, service lines, and cus- tomers; it is to compute the diverse costs of outputs to better understand how they create the organization’s cost structure. An interesting application is when a marketing, recruiting, or promotion department has employees who are trying to gen- erate new or continuing inbound orders. They may be trying multiple avenues, such as newspapers, radio, television, tradeshows, Websites, billboards, and so forth. The costs for advertising placements are different, and so might be the results in terms of success (including any additional differ- ences in the type of sale, recruit, or sale). This is an ideal case for an ABC/M calculation to determine the costs versus ben- efits of all the channel combinations to rank in order which are the least to best return on spending. In addition to analyzing the impact of diverse cost objects, there is also the traditional activity analysis and cost driver analysis. Figure 8.5 reveals the link between an activity driv- er and its work activity. In a simple fashion it describes how each work activity can be judged based on its need by the product or customer, its efficiency, and its value content. Some managers believe that the only way to truly cut costs is remove the work activ- ity altogether. Their reasoning is that to try to cut back on costs is rarely effective. They believe there is little point in trying to do cheaply what should not be done at all. That is, a job not worth doing is not worth doing well. Regardless of how one attacks achieving improvements, the main message here is that work is central to ABC/M. What do we do? How much do we do it? Who do we do it for? How important is it? Are we very good at doing it? Some refer to the application of local mod- els as activity-based management (ABM), an earlier-generation term for ABC/M, because the uses of the ABC/M data are more operational than strategic. I like to view local ABC/M models using the analo- gy of a musical symphony orchestra con- ductor in rehearsal first working the violins, then the trumpets, then all the string instru- ments, then all the brass instruments, and 8.8 ACTIVITY-BASED COST MANAGEMENT AACE INTERNATIONAL Table 8.1—Example of Unitized Costs
- 98. finally the entire orchestra in a live concert. The combined orchestra represents a consolidated parent ABC/M model, with local models rolled up into a parent model, then per- forming as a repeatable and reliable system. When ABC/M is applied at all organizational levels—local departments, processes, enterprise-wide, or across the sup- ply chain—it provokes intelligent actions and supports better decisions. IF ABC/M IS THE ANSWER, WHAT IS THE QUESTION? In addition to the need to address the distortion of true costs that are misreported by traditional systems, the rise in ABC/M has resulted from external factors. The level of com- petition that most firms face has increased dramatically. In the past, most organizations were reasonably profitable. They could make mistakes, and their adequate profitability would mask the impact of their wrong or poor decisions. But competition has intensified. A company can no longer carry unprofitable products and service lines and unprofitable cus- tomers by hoping the profitable ones will more than offset and make up the difference. They can no longer survive with misleading cost allocations and without having visibility of their costs across their end-to-end business processes. Today the margin for error is slimmer. Businesses cannot make as many mistakes as they could in the past and remain competitive or effective. Price quotations, capital investment decisions, product mix, technology choices, outsourcing, and make-versus-buy decisions today all require a sharper pencil. More competitors are better understanding the cause-and- effect connections that drive costs, and they are fine-tuning their processes, removing cost of quality (COQ), and adjust- ing their prices accordingly. The resulting price squeeze from more intense competition is making life for businesses much more difficult. Budget tightening is similarly affecting gov- ernment and not-for-profit organizations. Knowing what your real costs are for outputs, product costs, and the “costs- to-serve” channels and customers is becoming key to sur- vival. With activity-based costing visibility, organizations can identify where to remove waste, low-value-adding costs, and unused capacity, as well as understanding what drives their costs. They can also see the degree of alignment of their cost structure with their organization’s mission and strategy. Today an organization’s road is no longer long and straight; it is windy, with bends and hills that do not give much visibili- ty or certainty to plan for the future. Organizations need to be 8.9 AACE INTERNATIONAL ACTIVITY BASED COST MANAGEMENT Figure 8.5—Activity Analysis
- 99. agile and continuously transform their cost structure and work activities. This is difficult to do when an organization does not understand its own cost structure and economics. ABC/M IN ADVANCED, MATURE USERS The advanced and mature users of ABC/M, such as the Coca-Cola Company, are interested in two goals: 1. to institutionalize ABC/M company-wide into a perma- nent, repeatable, and reliable production reporting sys- tem; and 2. to establish the ABC/M output data to serve as an enabler to their ongoing improvement programs, such as TQM, change management, cycle-time compression, core competency, BPR, product rationalization, target costing, and channel/customer profitability. More recently, new issues for the advanced and mature ABC/M users are emerging; they include the following: • integrating the ABC/M output data with their decision- support systems, such as their cost estimating, predictive planning, budgeting, activity-based planning (ABP) sys- tems, customer relationship management (CRM), and balanced scorecard performance measurement systems; • learning the skills and rules for resizing, reshaping, re- leveling, and otherwise readjusting their ABC/M sys- tem’s structure in response to solving new business problems with the ABC/M data; • collecting and automatically importing data into the ABC/M system; and • automatically exporting the calculated data out of their ABC/M system. It is evident that among experienced ABC/M users, ABC/M eventually becomes part of their core information technologies. More specifically, the output data of an ABC/M system is fre- quently the input to another system, such as a customer order quotation system. ABC/M data also complement other productivity or logistics management tools such as simula- tion software, process modelers, business process flow char- ters, executive information systems (EIS), and online analyti- cal programs (OLAP). In the future we will see a convergence of these tools that to many organizations are separate soft- ware applications but now can be integrated to become part of the manager’s and analyst’s tool suite. 8.10 ACTIVITY-BASED COST MANAGEMENT AACE INTERNATIONAL
- 102. INTRODUCTION Cost estimating is one of the cornerstones of cost engineering and total cost management. The objective of this chapter is to introduce the reader to the various classifications of cost esti- mates, and the estimating methodologies and procedures used to prepare cost estimates. Cost estimating is the predictive process used to quantify, cost, and price the resources required by the scope of an investment option, activity, or project. The output of the estimating process, the cost estimate, may be used for many purposes, such as • determining the economic feasibility of a project, • evaluating between project alternatives, • establishing the project budget, and • providing a basis for project cost and schedule control. Cost estimating may be used to quantify, cost, and price any investment activity, such as building an office building or process power plant, developing a software program, or pro- ducing a stage play. The basic estimating steps are the same: • understand the scope of the activity to quantify the resources required, • apply costs to the resources, • apply pricing adjustments, and • organize the output in a structured way that supports decision-making. For the purposes of this chapter, the primary focus will on estimating as applied to support the creation of capital assets (a building, industrial facility, bridge, highway, etc.); howev- er, the estimating processes described can be applied to any investment activity. 1 For more information on definitive estimating, see Appendix C. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • understand the classification of cost estimates, • understand some of the common methodologies used in preparing cost estimates, • relate estimate accuracy to the level of scope information and methodologies used in preparing cost estimates, • understand how to apply risk analysis to determine con- tingency in an estimate, • understand how to present and review estimates, and • apply the knowledge gained to specific project estimat- ing situations. ESTIMATE ACCURACY As potential projects are considered, there are many decision points at which to decide whether a specific project should be continued to be developed. Each subsequent decision-making point during the project life cycle typically requires cost esti- mates of increasing accuracy. Estimating is thus an iterative process that is applied in each phase of the project life cycle as the project scope is defined, modified, and refined. The cost estimate is obviously of paramount importance to the success of a project. The capital cost of a proposed project is one of the key determinants in evaluating the financial viability and business case of the project. From an owner’s perspective, if the cost estimate is not accurate, the financial return from the capi- tal investment may not be realized; and compounding this problem is the fact that other deserving projects may not have been funded. It is obvious that estimating is critical for the eco- nomic and optimal use of an owner’s limited capital budget. From a contractor’s perspective, accurate estimating is just as important. In a lump-sum bidding situation, the profit margin of the contractor is dependent on the accuracy of his estimate. If the project is exceptionally large, the loss from an inaccurate 9.1 AACE INTERNATIONAL ESTIMATING Chapter 9 Estimating1 Larry R. Dysert, CCC
- 103. estimate on a lump-sum bid can potentially put a contractor out of business. For cost-plus projects, the contractor will face less direct economic risk from an inaccurate estimate, but the damage to the contractor’s reputation can be severe. The cost estimate, however, serves other purposes besides establishing the budget for a project. It also serves as a tool or resource used for both scheduling and cost control of projects. The estimate not only establishes a project budget, but plays an equally important role in monitoring the budget during project execution. It is the relationship between estimating, scheduling, and cost control, which is typically identified by the term “cost engineering” that serves as a driver for successful and cost- effective projects. Thus, an effective estimate must not only establish a realistic budget, but must also provide accurate information to allow for scheduling, cost monitoring, and progress measurement of a project during execution. ESTIMATE CLASSIFICATIONS Estimate classifications are commonly used to indicate the overall maturity and quality for the various types of esti- mates that may be prepared; and most organizations will use some form of classification system to identify and categorize the various types of project estimates that they may prepare during the life cycle of a project. Unfortunately, there is often a lack of consistency and understanding of the terminology used to classify estimates, both across industries as well as within single companies or organizations. AACE International (AACE) developed the “Recommend- ed Practice for Cost Estimate Classification” (AACE 17R-97, see appendices) to provide generic guidelines for the gen- eral principles of estimate clas- sification that may be applied across a wide variety of indus- tries. This document has been developed to • provide a common understanding of the concepts involved in classifying project cost estimates; • fully define and correlate the major characteristics used in classifying cost estimates so that differ- ent organizations may clearly determine how their particular practices compare to the AACE guidelines; • use degree of project definition as the primary charac- teristic in categorizing estimate classes; and • reflect generally accepted practices in the cost engineer- ing profession. AACE 17R-97 maps the phases and stages of project estimat- ing with a maturity and quality matrix; providing a common reference point to describe and differentiate various types of cost estimates. The matrix defines the specific input informa- tion (i.e., design and project deliverables) that is required to produce the desired estimating quality at each phase of the estimating process. The matrix defines the requirements for scope definition and indicates estimating methodologies appropriate for each class of estimate. Table 9.1 shows the generic AACE cost estimate classification matrix. AACE identifies five classes of estimates. A Class 5 Estimate is associated with the lowest level of project definition (or project maturity), and a Class 1 Estimate is associated with the highest level of project definition. Five characteristics are used to dis- tinguish each class of estimate from another. The five charac- teristics used in the AACE recommended practice are • degree of project definition; • end usage of the estimate; • estimating methodology; • estimating accuracy; and • effort required to produce the estimate. 9.2 ESTIMATING AACE INTERNATIONAL Table 9.1—Generic Cost Estimate Classification Matrix Notes: [a] If the range index value of “1” represents +10/-5%, then an index value of 10 represents +100/-50%. [b] If the cost index value of “1” represents 0.005% of project costs, then an index value of 100 represents 0.5%.
- 104. Degree of project definition is the primary (or driving) char- acteristic used to identify an estimate class. The other charac- teristics are “secondary,” with their value typically deter- mined by the level of project definition. In addition to the generic estimate classification system, a more specific version has been created for the process indus- tries (Table 9.2). The term “process industries” is intended to include firms involved with the manufacturing and produc- tion of chemicals, petrochemicals, pulp/paper and hydrocar- bon processing. The commonality among this industry (for the purpose of estimate classification) is their reliance on process flow diagrams (PFDs) and piping and instrument diagrams (P&IDs) as primary scope defining documents. These documents are key deliverables in determining the level of project definition, and thus the extent and maturity of estimate input information, and subsequently the estimate class for an estimate for a process industry project. This estimate classification system for the process industries is meant to supplement the generic standard. Over time, addi- tional matrices will be developed which are specific to other industries (such as general construction, highway construction, software development, etc.). Included with the supplemental guideline for the process industries is a chart that maps the maturity of estimate input information (project definition deliverables) against the class- es of estimates (Table 9.3 on page 9.4). 9.3 AACE INTERNATIONAL ESTIMATING GLOSSARY TERMS IN THIS CHAPTER allowance ◆ battery limits ◆ basis ◆ basis of estimate budget ◆ budgeting ◆ code of accounts (COA) contingency ◆ cost ◆ cost estimate cost estimating relationship (CER) ◆ direct cost price variation ◆ profitability ◆ sunk cost taxation ◆ taxes ◆ time value of money Table 9.2—Cost Estimate Classification Matrix for the Process Industries Notes: [a] The state of process technology and availability of applicable reference cost data affect the range markedly. The +/- value represents typical percentage variation of actual costs from the cost estimate after application of contingency (typically at a 50% level of confidence) for given scope. [b] If the range index value of “1” represents 0.005% of project costs, then an index value of 100 represents 0.5%. Estimate preparation effort is highly dependent upon the size of the project and the quality of estimating data and tools.
- 105. This is a checklist of basic deliverables found to be in common practice in the process industries. The maturity level is an approximation of the degree of completion of the deliverable. The degree of deliverable is indicated by the following letters: • None (blank)—Development of the deliverable has not yet begun. • Started (S)—Work on the deliverable has begun. Development is typically limited to sketches, rough out- lines, or similar levels of early completion. • Preliminary (P)—Work on the deliverable is advanced. Interim cross-functional reviews have usually been con- ducted. Development may be near completion except for final reviews and approvals. • Complete (C)—The deliverable has been reviewed and approved as appropriate. ESTIMATING METHODOLOGIES In general, estimating methodologies commonly fall into two broad categories: conceptual and deterministic. As can be seen from the cost estimate classification matrices (Tables 9.1 and 9.2), as the level of project definition increases, the esti- mating methodology tends to progress from conceptual (sto- chastic or factored) methods to deterministic methods. With conceptual estimating methods, the independent vari- ables used in the estimating algorithm are generally something other than a direct measure of the units of the item being meas- ured. They usually involve simple or complex modeling (or factoring) based on inferred or statistical relationships between costs and other, typically design-related, parameters. Often, the cost estimating relationships used in conceptual estimating methods are at least somewhat subject to conjecture. For deterministic estimating methods, the independent vari- ables used in the estimating algorithm are more or less a direct measure of the item being estimated, such as straight- forward counts or measures of items multiplied by known unit costs. Deterministic estimating methods require a high degree of precision in the determination of quantities, pric- ing, and the completeness of scope definition. Of course, any particular estimate may involve a combination of conceptual and deterministic methods. There is another key difference between conceptual and deter- ministic estimating methods. Conceptual estimating methods require significant effort in data-gathering and methods devel- opment before estimate preparation ever begins. There is a sig- nificant effort in historical cost analysis to develop accurate fac- tors and estimating algorithms to support conceptual estimat- ing. Preparing the conceptual estimate itself takes relatively little time, sometimes less than an hour. 9.4 ESTIMATING AACE INTERNATIONAL Table 9.3—Estimate Input Checklist and Maturity Matrix for the Process Industries
- 106. In contrast, a deterministic (or detailed) estimate requires a large effort during the actual preparation of the estimate. The evaluation and quantification of the project scope can take a substantial amount of time, sometimes weeks or even months for extremely large projects. Research and applica- tion of accurate detailed pricing information, and application of specific estimating adjustments to the quantified scope, can also take considerable time. The estimating method used for any particular estimate will depend on many factors: the end use of the estimate, the amount of time and money that is available to prepare the estimate, the estimating tools and data available, and, of course, the level of project definition and design information on hand [1]. Conceptual Estimating Methodologies Conceptual estimating methods are typically used for Class 5 and Class 4 (and sometimes Class 3) estimates. They are often referred to as “order-of-magnitude” (OOM) estimates in ref- erence to their typically wide range of estimate accuracy (as previously defined in the estimate classification matrices). They provide a relatively quick method of determining the approxi- mate probable cost of a project without the benefit of detailed scope definition. As indicated in the estimate classification matrices, these estimates may be used for the following: • establishing an early screening estimate for a proposed project or program, • evaluating the general feasibility of a project, • screening project alternatives (such as different locations, technologies, capacities, etc.), • evaluating the cost impacts of design alternatives, and • establishing a preliminary budget for control purposes during the design phase of a project. Conceptual estimates are generally based on little project def- inition (i.e., engineering deliverables), thus subjecting them to a wide range of estimate accuracy. Their accuracy can depend on several factors, including the level of project definition, the quality of the past historical cost data used in development of the factors and algorithms, as well as the judgment and expe- rience of the estimator. These limitations should, of course, be recognized in using conceptual estimating methods. Nonetheless, there are many cases where conceptual esti- mates can be very reliable, especially in estimating repeat projects. Generally, the emphasis with conceptual estimating is not on detailed accuracy, but on obtaining a reasonable cost estimate of sufficient accuracy to insure that the results are meaningful for management to make the decision at hand. There are a wide variety of conceptual or OOM estimating methodologies. Several of the more commonly used methods are end-product units, physical dimensions, capacity factor, various ratio or factor methods, and parametric modeling. Most conceptual estimating methods rely on relationships of one form or another. End-Product Units Method This conceptual estimating method is used when the estima- tor has enough historical data available from similar projects to relate the end-product units (capacity units) of a project to its construction costs. This allows an estimate to be prepared relatively quickly, knowing only the end-product unit capac- ity of the proposed project. Examples of the relationship between construction costs and end-product units are • the construction cost of an electric generating plant and the plant’s capacity in kilowatts, • the construction cost of a hotel and the number of guest rooms, • the construction cost of a hospital and the number of patient beds, and • the construction cost of a parking garage and the num- ber of available parking spaces. To illustrate, consider a client that is contemplating building a 1,500 luxury hotel in a resort area. The client needs an approximate cost estimate for the proposed hotel as part of the feasibility study. Assume that a similar luxury hotel has been recently completed at a nearby resort and the following information is available: The hotel just completed included 1,000 guest rooms, as well as a lobby, restaurants, meeting rooms, parking garage, swimming pool, and nightclub. The total construction cost for the 1,000 room hotel was $67,500,000. The resulting cost per room is thus calculated as $67,500,000/1000 = $67,500 per room. Therefore, we can use this information to determine the cost of the 1,500 room hotel of comparable design and a nearby location as $101,250,000 ($67,500/room x 1,500 rooms). While this cost estimate may serve to meet the needs of the feasibility study, it has ignored several factors that may impact costs. For example, it has ignored any economies-of-scale that may be generated from constructing a larger hotel and has assumed that the cost of the common facilities (lobby, restau- rants, pool, etc.) vary directly with the increase in the number of rooms. If the data exists to understand the cost impact of these differences, then adjustments may be made to the ini- tial cost estimate. Similarly, if the location or timing of the proposed hotel had differed significantly from the known cost data point, then cost indices can be used to adjust for these differences. 9.5 AACE INTERNATIONAL ESTIMATING
- 107. Physical Dimensions Method Somewhat similar to the end-products units method is the physical dimensions estimating methodology. The method uses the physical dimensions (length, area, volume, etc.) of the item being estimated as the driving factor. For example, a building estimate may be based on square feet/meters or cubic volume of the building; whereas pipelines, roadways, or railroads may be based on a linear basis. As with the end-product units method, this method also depends on historical information from comparable facilities. Consider the need to estimate the cost of a 3,600-m2 ware- house. A recently completed warehouse of 2,900 m2 in a nearby location was recently completed for $623,500, thus costing $215/m2. The completed warehouse utilized a 4.25-m wall height, thus containing 12,325 m3 and resulting in a cost of $50.59/m3 on a volume basis ($623,500/12,325 m3). In determining the cost for the new warehouse, we can esti- mate the new 3,600 m2 warehouse using the m2 basis at $774,000 ($215/m2 x 3,600m2). However, the new warehouse will differ from the one just completed by having 5.5-m-high walls; so we may decide that estimating on a volume basis may provide a better indication of costs. The volume of the new warehouse will be 19,800 m3 (3,600 m2 x 5.5m), and the new estimate will be $1,002,000 (rounded to the nearest $1,000). Again, we have ignored the cost impact of economies-of- scale in developing the estimate, and any other differences in quality between the two warehouses. If additional informa- tion is available, we may make further adjustments to the cost estimate. If location or timing differences had existed, we would also account for those cost impacts by utilizing cost indices or other adjustments. Capacity Factor Method A capacity factored estimate is one in which the cost of a new facility is derived from the cost of a similar facility of a known (but usually different) capacity. It relies on the non- linear relationship between capacity and cost. In other words, the ratio of costs between two similar facilities of different capacities equals the ratio of the capacities multiplied by an exponent: $B/$A = (CapB/CapA)e where $A and $B are the costs of the two similar facilities, and CapA and CapB are the capacities of the two facilities. This is shown in Figure 9.1. If we rewrite this equation to use as an estimating algorithm, it becomes: $B = ($A)(CapB/CapA)e where $B is the cost of the facility being estimated, $A is the known cost of a similar facility, CapB is the capacity of the facility being estimated, CapA is the capacity of the similar facility, and “e” is the exponent or proration factor. The exponent “e” typically lies between 0.5 and 0.85, depend- ing on the type of facility, and must be analyzed carefully for its applicability to each estimating situation. The exponent “e” used in the capacity factor equation is actually the slope of the curve that has been drawn to reflect the change in the cost of a facility as it is made larger or smaller (Figure 9.1). These curves are typically drawn from the data points of the known costs of completed facilities. The slope will usually appear as a straight line when drawn on log-log paper. With an exponent value less than 1, scales of economy are achieved such that as facility capacity increases by a percentage (say, 20 percent), the costs to build the larger facility increase by less than 20 percent. The methodology of using capacity factors is sometimes referred to as the “scale of operations” method or the “six tenth’s factor” method due to the common reliance on an exponent value of 0.6 if no other information is available. With an exponent of 0.6, doubling the capacity of a facility increases costs by approximately 50 percent, and tripling the capacity of a facility increases costs by approximately 100 percent. 9.6 ESTIMATING AACE INTERNATIONAL B A $B $A CapA CapB Capacity (logarithmic scale) Cost (logarithmic scale) $B/$A = (Cap B /CapA )e Fi 4 C i F R l i hi Figure 9.1—Capacity Factor Relationship
- 108. It is also important to realize that, although the data when plotted on a log-log graph will usually appear as a straight line over a small range of capacity values, it is probably not constant over the entire range of possible capacities or facili- ty sizes. In reality, as facility capacities increase, the exponent tends to increase as illustrated in Figure 9.2. As an example, between the capacities A and B (in Figure 9.2), the capacity factor exponent may have a value of 0.6; however between the capacities B and C, the exponent has a value of 0.65. Between the capacities C and D, the value of the exponent may have risen to 0.72. Eventually, as the facility capacity increases to the limits of existing technology, the exponent tends towards a value of 1. At this point, it becomes more economical to build two facilities of a smaller size than one large facility. In other words, cost becomes a linear function of capacity, and scales of economy are no longer obtained. Capacity factored estimating can be quite accurate. If the capacity factor used in the estimating algorithm is relatively close to the actual value, and if the facility being estimated is relatively close in size to the similar facility of known cost, then the potential error from capacity factoring is quite small, and is certainly well within the level of accuracy that would be expected from such a conceptual estimating method. For example, if the new facility is triple the size of an existing facility, and the actual capacity factor is 0.80 instead of an assumed 0.70, you will have underestimated the cost of the new facility by only 10 percent, calculated as (3 .8 – 3 .7)/3.7. Similarly, for the same threefold scale-up in facility size, but the actual capacity factor should be 0.60 instead of an assumed 0.70, you will have overestimated the facility cost by only 12 percent, calculated as (3.7 – 3.6)/3.6. Thus, if the facility size being estimated is reasonably close to the size of the known facility, and a realistic capacity factor exponent is used, error from the capacity factoring algorithm is small. However, this error can be compounded by other assumptions we must make in an actual estimating situation. Typically, we must also adjust for differences in scope, loca- tion and time between the estimated facility and the known facility. Each of these adjustments can also add to the level of error in the overall estimate. Let’s examine a typical situation where we need to estimate the costs of a 100,000 BBL/day hydrogen peroxide unit to be built in Philadelphia and completed in 2004. We have recent- ly completed a 150,000 BBL/day plant in Malaysia with a final cost of $50 million in 2002. Our recent history shows a capacity factor of 0.75 is appropriate. The simple approach is to just use our capacity factor algorithm: $B = ($A)(CapB/CapA)e $B = $50M X (100/150).75 = $36.9M This would be fine for as far as it goes, but as we have noted in our earlier discussions of estimating methodologies, we have thus far ignored differences in quality (or scope), loca- tion, and time. For this example, let’s adjust for the differences in scope, location, and time. The plant in Malaysia included piling, tankage, and owner costs that will not need to be included in the proposed plant for Philadelphia. Construction in Philadelphia is expected to cost 1.25 times the construction costs in Malaysia (location adjustment). Escalation will be included as a 1.06 multiplier from 2002 to 2004 (an obviously simple approach). There are costs for additional pollution requirements in Philadelphia that were not included in the cost of the Malaysian plant. Taking these into account, the estimate now appears like this: 150,000 BBL/day plant in Malaysia $50M deduct piling, tankage, owner costs -$10M adjusted cost for scope =$40M Malaysia to Philadelphia adjustment (x 1.25) = $50M escalate to 2002 (x 1.06) = $53M factor = $53M x (100/150).75 = $39M add pollution requirements (+$5M) = $44M 9.7 AACE INTERNATIONAL ESTIMATING Figure 9.2—Capacity Factor Exponents Are Not Constant Across All Capacity Ranges A $A CapA CapB Capacity (logarithmic scale) Cost logarithmic scale) $B/$A = (Cap B /CapA )e CapC CapD B C D $B $C $D
- 109. The key steps in preparing a capacity factor estimate, there- fore, are the following: • Deduct costs from the known base case that are not applicable in the new plant being estimated. • Apply location and escalation adjustments to normalize costs. (This now determines what the adjusted scope for the base case will cost in the new location and time frame.) • Apply the capacity factor algorithm to adjust for plant size. • Add any additional costs which are required for the new plant but which were not included in the known plant. The capacity factor estimating method provides a relatively quick and sufficiently accurate means to prepare early esti- mates during the concept screening stage of a project. The method requires historical cost and capacity data for similar plants and processes. Although published data on capacity factors exists, the best data would be from your own organi- zation and requires a level of commitment to maintain. When using this method, the new and existing known plant should be near duplicates, and reasonably close in size. You must account for differences in scope, location, and time. Each of the adjustments that you make adds additional uncertainty and potential error to the estimate. Despite this, capacity fac- tor estimates can be quite accurate and are often used to sup- port decision-making at the pre-design stage of a project. Ratio or Factor Methods Ratio or factored estimating methods are used in situations where the total cost of an item or facility can be reliably esti- mated from the cost of a primary component. For example, this method is commonly used in estimating the cost of process and chemical plants, where the cost of the specialized process equipment makes up a significant portion of the total project cost. This is often referred to as “equipment factor” estimating. Equipment factored estimates are used to develop costs for process and utility units for which the behavior of the costs of the direct labor and bulk materials used to construct the facilities is correlated with the costs (or the design parame- ters) of the major equipment. Typically, this estimating methodology relies on the principle that a ratio or factor exists between the cost of an equipment item and costs for the associated nonequipment items (foundations, piping, electrical, etc.) needed to complete the installation. An equipment factored estimate can typically be generated when project definition (engineering complete) is approxi- mately 1 percent to 15 percent complete (Class 4). An equip- ment list should be available at this point in the project. This estimate is often a feasibility estimate used to determine whether there is a sufficient business case to pursue the proj- ect. If so, then this estimate may be used to justify the funding required to complete the engineering and design required to produce a funding or budget estimate (Class 3). Depending on the particular factoring techniques and data used, the factors may estimate Total Installed Costs (TIC) or Direct Field Cost (DFC) for the facility. Usually, the factors generate costs only for the Inside Battery Limits (ISBL) facili- ties, and require the Outside Battery Limit Facilities (OSBL) costs to be estimated separately; however sometimes appro- priate factors are used to estimate the costs of the complete facilities. Therefore, it is extremely important to understand the basis of the particular factors being used in an equipment factored estimate. In 1947, Hans Lang first published an article [11] in Chemical Engineering introducing the concept of using the total cost of equipment to factor the total estimated cost of a plant: Total plant $ = total equipment $ x equipment factor Lang proposed three separate factors based on the type of process plant (Table 9.4). Lang’s factors were meant to cover all the costs associated with the total installed cost of a plant including the Battery Limits Process Units (ISBL Costs) and all Offsites Units (OSBL Costs). The following is an example of a Lang Factor estimate for a fluid process plant: Total estimated equipment cost = $1.5M Total plant cost = $1.5M X 4.74 Total plant cost = $7.11M Lang’s approach was rather simple, utilizing a factor that var- ied only by the type of process. Since that first publication, many different methods of equipment factoring have been pro- posed, and some methods have become very sophisticated. The term “Lang Factor,” however, is often used generically to refer to all the different types of equipment factors. In 1958, W. E. Hand [10] elaborated on Lang’s work by pro- posing different factors for each type of equipment (columns, vessels, heat exchangers, etc.), rather than process type. 9.8 ESTIMATING AACE INTERNATIONAL Type of Plant Factor Solid Process Plant 3.10 Solid-Fluid Process Plant 3.63 Fluid Process Plant 4.74 Table 9.4—Lang Factors
- 110. Hand’s factors estimated DFCs, excluding instrumentation. Hand’s published equipment factors ranged from 2.0 to 3.5 (which might correlate to approximately 2.4 to 4.3 including instrumentation). Hand’s factors excluded indirect field costs (IFC), home office costs (HOC), and the costs for offsite or outside battery limit (OSBL) facilities. These costs would need to be estimated separately. An example of an estimate prepared for a fluid processing plant using Hand’s equipment factoring techniques appears in Table 9.5. In this example, the total cost of all equipment items for each type of equipment was multiplied by a factor for that specific type of equipment to derive the DFC for that equipment type. For instance, the total cost of all vertical ves- sels ($540K) was multiplied by an equipment factor of 3.2 to obtain an installed DFC of $1,728K. The DFC costs for all equipment types totals $7,753K. Direct Field Labor (DFL) was estimated at 25 percent of DFC or $1,938K. The IFC were then estimated at 115 percent of the DFL costs, totaling $2,229K. The sum of the DFC and IFC costs make up the total field costs (TFC) of $9,982K. HOC are factored as 30 percent of DFC, which totals $2,326K. For this estimate, the project commissioning costs were factored as 3 percent of DFC, and contingency was factored as 15 percent. The total installed cost (TIC) for this estimate thus totals $14,422K. Note the various equipment factors displayed in this exam- ple. Total equipment cost to DFC is a factor of 2.8 (a typical range would be 2.4 to 3.5). Total equipment cost to TFC is a factor of 3.6 (with a typical range being 3.0 to 4.2). Total equipment cost to total project cost, including contingency, is a factor of 5.1 (a typical range would be 4.2 to 5.5). This cor- relates closely with Lang’s original overall equipment factor of 4.74 for fluid plants. Arthur Miller proposed another enhancement to the concept of equipment factors in 1965 [13]. Miller recognized the impact of three specific variables that affect the equipment 9.9 AACE INTERNATIONAL ESTIMATING Table 9.5—Equipment Factored Estimate Example Adj Eqmt % Acct No Item Description Factor Labor $ Eqmt $ Eqmt Factor Total Mult Total 51 Columns 650,000 2.1 1,365,000 52 Vertical Vessels 540,000 3.2 1,728,000 53 Horizontal Vessels 110,000 2.4 264,000 54 Shell & Tube Heat Exchangers 630,000 2.5 1,575,000 55 Plate Heat Exchangers 110,000 2.0 220,000 56 Pumps, Motor Driven 765,000 3.4 2,601,000 2,805,000 DIRECT FIELD COSTS 25% 1,938,000 7,753,000 2.8 53.8% Of DFC 10 Temporary Construction Facilities 11 Construction Services/Supplies/Consumables 12 Field Staff/Subsistence/Expense 13 Payroll Burdens/Benefits/Insurance 14 Construction Equipment/Tools 15 International Expense INDIRECT FIELD COSTS 115% 2,229,000 15.5% Of DFL TOTAL FIELD COSTS 9,982,000 3.6 69.2% 20 Project Management 21 Project Controls/Estimating 22 Project Procurement 23 Project Construction Management 24 Engineering/Design 25 Home Office Expenses HOME OFFICE COSTS 30% 2,326,000 16.1% Of DFC TOTAL FIELD and HOME OFFICE COSTS 12,308,000 4.4 85.3% 30 Owner's Costs 31 Project Commissioning Costs 3% Of DFC 233,000 32 Escalation 33 Other Non-Assignable Costs 34 Contingency 15% Of Above 1,881,000 35 Fee OTHER PROJECT COSTS 2,114,000 14.7% TOTAL PROJECT COSTS $14,422,000 5.1 100.0% Costs
- 111. material cost to a greater degree than they affect the cost of the associated bulk materials and installation. These three factors are: the size of the major equipment, the materials of construction (metallurgy) of the equipment, and the operat- ing pressure. Miller noted that as the size of a piece of major equipment gets larger, the amount of corresponding bulk materials (foundation, support steel, piping, instruments, etc.) required for installation does not increase at the same rate. Thus, as the equipment increases in size, the value of the equipment factor decreases. A similar tendency exists for metallurgy and operating pres- sure. If the equipment is made from more expensive materi- als (stainless steel, titanium, monel, etc.), the equipment fac- tor will become smaller. If the operating pressure increases, the equipment factor gets smaller. Again, as the equipment becomes more costly due to expensive materials of construc- tion or higher operating pressures, the costs for the associat- ed bulk materials required for installation increase at a lower proportion or rate, and the resulting equipment factor becomes smaller. Miller suggested that these three variables could be summa- rized into a single attribute known as the “average unit cost” of equipment. The average unit cost of equipment is Total cost of process equipment/number of equipment items If the average unit cost of equipment increases, then the equipment factor is scaled smaller. The correlation between increasing average unit cost of equipment and decreasing equipment factors was statistically validated in subsequent studies [16, 18]. Thus far, the equipment factors we have discussed have been used to generate all in DFC or TIC costs. Another method of using equipment factors is to generate separate costs for each of the disciplines associated with the installation of equipment. Using this methodology, each type of equipment is associated with several discipline-specific equipment factors. For exam- ple, one discipline equipment factor will generate costs for con- crete, another factor will generate costs for support structural steel, another generates the cost for piping, etc. An advantage to this approach is that it provides the estimator with the capa- bility to adjust the costs for the individual disciplines based on specific knowledge of the project conditions, and improves the accuracy of the equipment factoring method. It also allows the costs for each specific discipline to be summed and compared to other similar projects. Miller, and later, Guthrie [9] described this methodology. An example of using discipline specific equipment factors is shown in Table 9.6 on page 9.11. The example shows disci- pline equipment factors for a 316SS shell & tube heat exchanger with a size range of 350 to 700 m2. In this example, the equipment cost of $10,000 is multiplied by each of the indicated factors to generate the DFC costs for that discipline. For example, the equipment installation labor is factored as $10,000 x 0.05 = $500; piping material and labor is factored as $10,000 x 1.18 = $11,800; etc. The total DFC costs for installa- tion of this heat exchanger is $28,600 (including the equip- ment purchase cost of $10,000). This equates to an overall DFC equipment factor of 2.86. These costs do not include IFC, HOC, or OSBL Costs. Development of the actual equipment factors to be used in preparing process plant estimates is a tedious and time-con- suming affair. Although some published data exists on equipment factors (see the articles included in the refer- ences), much of this data is old, and some of the assumptions in normalizing the data for time, location, and scope are incomplete or unavailable. A clear explanation of what is or what is not covered by the factors is sometimes missing. Lacking anything better, the published data provides a start- ing point for your database of equipment factors; however the best information will be data that comes from your own organization’s project history and cost databases and that matches your engineering and construction techniques. Overall equipment factors from total equipment cost to DFC/TIC (true “Lang” factors) are the easiest to generate. Historical data from completed projects should be normal- ized to a common time and location/labor productivity base- line. The total equipment costs, direct field costs, and total installed costs should be very easy to derive from the histor- ical data. The results can then be analyzed, plotted, and test- ed to establish overall equipment “Lang” factors. Developing individual equipment factors that vary based on the type of equipment, or separate factors for each discipline, is much more complicated. Generally, it is difficult to derive the required data from the actual cost histories for completed projects. Project accounting and cost coding typically does not collect actual cost data in the necessary format. Instead, these types of equipment factors are typically developed by generating detailed estimates for a matrix of equipment types, size ranges, metallurgies, operating pressures, etc. The estimates are then carefully analyzed to develop individual equipment and adjustment factors so that equipment size, metallurgy, and operating pressure can be accounted for. The factors developed in this manner can then be tested and calibrated against actual project histories. The proposed equipment factors (and adjustment factors, if necessary) are applied to the actual equipment costs for completed projects, and the results from the factoring exercise are compared to the actual project costs to determine if a reasonable degree of accuracy has been obtained. If the factoring results vary widely from the actual costs, or are consistently low or con- sistently high, then an analysis to determine the reasons will need to be performed, and development of the factors will continue until sufficient accuracy can be obtained. 9.10 ESTIMATING AACE INTERNATIONAL
- 112. When preparing an equipment factored estimate, the first step, of course, is to estimate the cost for each piece of process equipment. The equipment list needs to be examined care- fully for completeness, and compared against the process flow diagrams (PFDs) and/or the piping and instrument dia- grams (P&IDs). When an equipment factored estimate is pre- pared, the equipment list is often still in a preliminary stage. Although the major equipment is identified, it may be neces- sary to assume a percentage for auxiliary equipment that has not yet been defined. Equipment sizing should also be verified. At this preliminary stage of engineering, a common problem is that equipment is often sized at 100 percent of normal, operating duty. However, typically, by the time the purchase orders have been issued, some percentage of oversizing has been added to the design specifications. The percentage of oversizing that occurs varies by the type of equipment, and an individual organization’s procedures and guidelines. It is prudent to check with the process engineers and determine if an allowance for oversizing the equipment as listed on the preliminary equipment list should be added before pricing the equipment. The purchase cost of the equipment may be obtained by sev- eral methods: purchase orders or cost information from recent equipment purchases, published equipment cost data, prelim- inary vendor quotations, or firm vendor quotations. Since the material cost of equipment can represent 20 percent to 40 per- cent of the total project costs for process plants, it is extremely important to always estimate the equipment costs as accurate- ly as possible. When using equipment factoring methods to develop the project estimate, this becomes even more impor- tant. If historical purchase information is used, you must ensure that the costs are escalated appropriately, and adjusted for location and/or market conditions as required. Once the equipment cost is established, the appropriate equipment factors need to be established and applied. Ensure that adjustments for equipment size, metallurgy, and operat- ing conditions are included if necessary. Also, any specific project or process conditions need to be evaluated to deter- mine if additional scope-based adjustments to the factored costs are required. For example, the particular plot layout of the project being estimated may require much closer equip- ment placement than is typical. Therefore, you may want to make some adjustment to account for the shorter piping, con- duit, and wiring runs than the factors would normally account for. Locating a project in an active seismic zone may require adjustments to foundations, support steel, etc. Once the equipment factored costs have been developed, you must account for the remainder of the project costs that are not covered by the equipment factors. Depending on the par- ticular type of equipment factors used, this may require developing the costs for indirect field costs, home office (proj- ect administration and engineering/design) costs, outside battery limit costs, etc. Equipment factored estimates are typically prepared during the feasibility stage of a project. They can be quite precise if the equipment factors are appropriate, the correct adjust- ments have been applied, and the list of process equipment is complete and accurate. They have an advantage over capaci- ty factored estimates in that they are based upon the specific process design for the project. It is extremely important to understand the basis behind the equipment factors being used, and to account for all costs that are not covered by the factors themselves. Ratio or factored methods may often be used in other situa- tions, such as estimating the cost for outside battery limit facilities (OSBL) from the cost of inside battery limit facilities (ISBL); or estimating the costs of indirect construction cost from the direct construction costs. Derivation of the appro- priate multiplying factors from accurate historical cost infor- mation is critical to the resulting accuracy from this estimat- ing methodology. Parametric Method A parametric cost model is an extremely useful tool for preparing early conceptual estimates when there is little tech- nical data or engineering deliverables to provide a basis for using more detailed estimating methods. A parametric model is a mathematical representation of cost relationships that provide a logical and predictable correlation between the physical or functional characteristics of a plant (or process 9.11 AACE INTERNATIONAL ESTIMATING Exchanger, Shell & Tube, 316 Stainless Steel, 350 - 700 SM Equipment Cost Eqmt Install Labor Concrete Structural Steel Piping Electrical Instruments Painting Insulation Total DFC Costs Factor 0.05 0.11 0.11 1.18 0.05 0.24 0.01 0.11 2.86 Cost $10,000 $500 $1,100 $1,100 $11,800 $500 $2,400 $100 $1,100 $28,600 Table 9.6 - Discipline Equipment Factor Example
- 113. system) and its resultant cost [NASA]. A parametric estimate comprises cost estimating relationships and other parametric estimating functions that provide logical and repeatable rela- tionships between independent variables, such as design parameters or physical characteristics and the dependent variable, cost. Capacity factor and equipment factor estimates are simple examples of parametric estimates; however sophisticated parametric models typically involve several independent variables or cost drivers. Yet similar to those estimating methods, parametric estimating is reliant on the collection and analysis of previous project cost data in order to develop the cost estimating relationships (CER’s). The development of a parametric estimating model can appear to be a daunting task; however, the use of modern computer technology (including popular spreadsheet pro- grams) can make the process tolerable, and much easier than it would have been years ago. The process of developing a parametric model should generally involve the following steps [3, 7]: 1. cost model scope determination, 2. data collection, 3. data normalization, 4. data analysis, 5. data application, 6. testing, and 7. documentation. The first step in developing a parametric model is to establish its scope. This includes defining the end use of the model, the physical characteristics of the model, the cost basis of the model, and the critical components and cost drivers. The end use of the model is typically to prepare conceptual estimates for a process plant or system. The type of process to be cov- ered by the model, the type of costs to be estimated by the model (TIC, TFC, etc.), the intended accuracy range of the model, etc. should all be determined as part of the end-use definition. The model should be based on actual costs from complete projects, and reflect your organization’s engineering practices and technology. The model should generate current year costs or have the ability to escalate to current year costs. The model should be based on key design parameters that can be defined with reasonable accuracy early in the project scope development, and provide the capability for the esti- mator to easily adjust the derived costs for specific complex- ity or other factors affecting a particular project. Data collection and development for a parametric estimating model requires a significant effort. The quality of the result- ing model can be no better than the quality of the data it is based upon. Both cost and scope information must be identi- fied and collected. The level at which the cost data is collect- ed will affect the level at which the model can generate costs, and may affect the derivation of the CERs. It is best to collect cost data at a fairly low level of detail [19]. The cost data can always be summarized later if an aggregate level of cost information provides a better model. It is obviously impor- tant to include the year for the cost data in order to normal- ize costs later. The scope information should include all pro- posed design parameters or key cost drivers for the model, as well as any other information that may affect costs. The type of data to be collected is usually decided upon in cooperation with the engineering and project control com- munities. It is usually best to create a formal data collection form that can be consistently used, and revised if necessary. After the data has been collected, the next step in the process of developing a parametric model is to normalize the data before the data analysis stage. Normalizing the data refers to making adjustments to the data to account for the differences between the actual basis of the data for each project, and a desired standard basis of data to be used for the parametric model. Typically, data normalization implies making adjust- ments for escalation, location, site conditions, system specifi- cations, and cost scope. Data analysis is the next step in the development of a para- metric model. There are many diverse methods and tech- niques that can be employed in data analysis, and are too complex to delve into in this chapter. Typically, data analysis consists or performing regression analysis of costs versus selected design parameters to determine the key drivers for the model. Most spreadsheet applications now provide regression analysis and simulation functions that are reason- ably simple to use. The more advanced statistical and regres- sion programs have goal-seeking capabilities, which can also make the process easier. Generally, a series of regression analysis cases (linear and non- linear) will be run against the data to determine the best algo- rithms that will eventually compose the parametric model. The algorithms will usually take one of the following forms: Linear Relationship $ = a + bV1 + cV2 + … Nonlinear Relationship $ = a + bV1 x + cV2 y + … where V1 and V2 are input variables; a, b, and c are constants derived from regression; and x and y are exponents derived from regression. 9.12 ESTIMATING AACE INTERNATIONAL
- 114. The various relationships (cost versus design parameters) are first examined for “best-fit” by looking for the highest “R- Squared” value. R2 has the technical sounding name of “coef- ficient of determination,” and is commonly used as a meas- ure of the goodness of fit for a regression equation. In simple terms, it is one measure of how well the equation explains the variability of the data. The resulting algorithms from the regression analysis are then applied to the input data sets to determine on a project-by-project basis how well the regres- sion algorithm predicts the actual cost. Regression analysis can be a time-consuming process (espe- cially with the simple regression tools of a spreadsheet pro- gram), as iterative experiments are made to discover the best- fit algorithms. As an algorithm is discovered that appears to provide good results, it must be tested to ensure that it prop- erly explains the data. Advanced statistical tools can quicken the process but can be more difficult to use. Sometimes, you will find that erratic or outlying data points will need to be removed from the input data in order to avoid distortions in the results. It’s also very important to realize that many costs relationships are nonlinear, and, therefore, one or more of the input variables will be raised to a power (as in the equation above). You will need to experiment both with the variables you are testing against, and the exponential powers used for the variables. Regression analysis tends to be a continuing trial-and-error process until the proper results are obtained that appears to explain the data. Several individual algo- rithms may be generated and then later combined into a com- plete parametric model. The data application stage of the development process involves establishing the user interface and presentation form for the parametric cost model. Using the mathematical and statistical algorithms developed in the data analysis stage, the various inputs to the cost model are identified; and an interface is developed to provide the estimator with an easy and straightforward way in which to enter this infor- mation. Electronic spreadsheets provide an excellent mecha- nism to accept estimator input, calculate costs based upon algorithms, and display the resulting output. One of the most important steps in developing a cost model is to test its accuracy and validity. As mentioned previously, one of the key indicators of how well a regression equation explains the data is the R2 value, providing a measure of how well the algorithm predicts the calculated costs. However, a high R2 value by itself does not imply that the relationships between the data inputs and the resulting cost are statistical- ly significant. Once you have performed the regression analysis, and obtained an algorithm with a reasonably high R2 value, you still need to examine the algorithm to ensure that it makes com- mon sense. In other words, perform a cursory examination of the model to look for the obvious relationships that you expect to see. If the relationships from the model appear to be reasonable, then you can run additional tests for statistical significance (t-test and f-test), and to verify that the model is providing results within an acceptable range of error. One of the quick checks to run is to test the regression results directly against the input data to see the percent error for each of the inputs. This lets you quickly determine the range of error, and interpreting the results can help you to deter- mine problems and refine the algorithms. After all of the individual algorithms have been developed and assembled into a complete parametric cost model, it is important to test the model as a whole against new data (data not used in the development of the model). You should consult statistical texts for more information about testing regression results and cost models. Lastly, the resulting cost model and parametric estimating application must be documented thoroughly. A user manual should be prepared showing the steps involved in preparing an estimate using the cost model, and describing clearly the required inputs to the cost model. The data used to create the model should be documented, including a discussion on how the data was adjusted or normalized for use in the data analy- sis stage. It is usually desirable to make available the actual regression data sets and the resulting regression equations and test results. All assumptions and allowances designed into the cost model should be documented, as should any exclusions. The range of applicable input values, and the limitations of the model’s algorithms should also be explained. As an example of developing a parametric estimating model, we will examine the costs and design parameters of induced- draft cooling towers. These units are typically used in indus- trial facilities to provide a recycle cooling water loop. The units are generally prefabricated and installed on a subcon- tract or turnkey basis by the vendor. Key design parameters that appear to affect the costs of cooling towers are the cool- ing range, approach, and flow rate. The cooling range is the difference in temperature between the hot water entering the cooling tower and the cold water leaving the tower. The approach is the difference in the cold water leaving the tower and the design wet bulb temperature of the ambient air; and the flow rate measures the desired cooling capacity of the tower. Table 9.7 on page 9.14 provides the actual costs and design parameters of six recently completed cooling towers. The costs have been normalized (adjusted for location and time) to a Northeast U.S., Year 2000 timeframe. 9.13 AACE INTERNATIONAL ESTIMATING
- 115. This data provides the input to the data analysis steps of run- ning a series of regression analyses to determine a sufficiently accurate algorithm for estimating costs. After much trial and error, the following cost estimating algorithm was developed: Cost = $86,600 + $84500(Cooling Range in Deg F).65 - $68600(Approach in Deg F) + $76700 (Flow Rate in 1000GPM).7 From this equation, we can see that the cooling range and flow rates affect costs in a nonlinear fashion (i.e., they are raised to an exponential power), while the approach affects costs in a linear manner. In addition, the approach is nega- tively correlated with costs. Increasing the approach will result in a less costly cooling tower (as it increases the effi- ciency of the heat transfer taking place). These appear to be reasonable assumptions. In addition, the regression analysis resulted in an R2 value of 0.96, which indicates the equation is a “good-fit” for explaining the variability in the data, and the F-Test shows statistical significance between the input data and the resulting costs. In Table 9.8, the design parameters are displayed as used in the model (raised to a power where needed) and shown against the actual costs and the predicted costs from the estimating algo- rithm. In addition, the amount of the error (the difference between the actual and predicted costs), and the error as a per- cent of actual costs are shown. The percentage of error varies from -4.4 to 7.1 percent for the data used to develop the model. Using the estimating algorithm developed from regression analysis, we can develop tables of costs versus design parameters (Table 9.9), and plot this information on graphs (Figure 9.3). 9.14 ESTIMATING AACE INTERNATIONAL Cooling Range (Deg F) Approach (Deg F) Flow Rate (1000 GPM) Actual Cost 30 15 50 $1,040,200 30 15 40 $787,100 40 15 50 $1,129,550 40 20 50 $868,200 25 10 30 $926,400 35 8 35 $1,332,400 Induced Draft Cooling Tower Costs and Design Parameters Table 9.7—Cost and Design Information for Recent Cooling Tower Projects Cooling Range (Deg F).65 Approach (Deg F) Flow Rate (1000 GPM).7 Actual Cost Predicted Cost Error % Error 9.12 15 15.46 $1,040,200 $1,014,000 -$26,200 -2.5% 9.12 15 13.23 $787,100 $843,000 $55,900 7.1% 11.00 15 15.46 $1,129,550 $1,173,000 $43,450 3.8% 11.00 20 15.46 $868,200 $830,000 -$38,200 -4.4% 8.10 10 10.81 $926,400 $914,000 -$12,400 -1.3% 10.08 8 12.05 $1,332,400 $1,314,000 -$18,400 -1.4% Induced Draft Cooling Tower Predicted Costs from Parametric Estimating Algorithm Cooling Range (Deg F) Approach (Deg F) Flow Rate (1000 GPM) Predicted Cost 30 15 25 $559,000 30 15 30 $658,000 30 15 35 $752,000 30 15 40 $843,000 30 15 45 $930,000 30 15 50 $1,014,000 30 15 55 $1,096,000 30 15 60 $1,176,000 30 15 65 $1,254,000 30 15 70 $1,329,000 30 15 75 $1,404,000 40 15 25 $717,000 40 15 30 $816,000 40 15 35 $911,000 40 15 40 $1,001,000 40 15 45 $1,089,000 40 15 50 $1,173,000 40 15 55 $1,255,000 40 15 60 $1,334,000 40 15 65 $1,412,000 40 15 70 $1,488,000 40 15 75 $1,562,000 Induced Draft Cooling Tower Costs Based On Parametric Model Table 9.9—Data for Cost Graph Based on Parametric Estimating Example Table 9.8—Predicted Costs for Cooling Tower Parametric Estimating Example
- 116. This information can then be rapidly used to prepare esti- mates for future cooling towers. It would also be very easy to develop a simple spreadsheet model that will accept the design parameters as input variables, and calculate the costs based on the parametric estimating algorithm. Parametric cost models can be a valuable resource in prepar- ing early conceptual estimates. They are often used during both the concept screening and feasibility stages of a project. Parametric models can be surprisingly accurate for predict- ing the costs of even complex process systems. Parametric estimating models can be developed using basic skills in esti- mating, mathematics, statistics, and spreadsheet software. It is important to understand that the quality of results can be no better than the quality of the input data, and great care should be taken during the data collection stage to gather appropriate and accurate project scope and cost data. Deterministic (Detailed) Estimating Methodologies1 A detailed estimate is one in which each component of a proj- ect scope definition is quantitatively surveyed and priced using the most realistic unit prices available. Detailed esti- mates are typically prepared to support final budget author- ization, contractor bid tenders, cost control during project execution, and change orders (Class 3 through Class 1 esti- mates). Detailed estimates use a deterministic estimating methodology and require a substantial amount of time and cost to prepare. It is not unusual for detailed estimates on very large projects to take several weeks, if not months, to prepare and can require thousands of engineering hours to prepare the required technical deliverables. The following is a description for detailed esti- mating activities associated with a process or industrial project, but could easily be adopted for other types of construction-related projects, such as commercial construction. At a minimum, the required engineering and design data required to prepare a detailed estimate include process and utility flow drawings, piping and instrument dia- grams, equipment data sheets, motor lists, elec- trical one-line diagrams, piping isometrics (for alloy and large diameter piping), equipment and piping layout drawings, plot plans, and engi- neering specifications. Pricing data should include vendor quotations, current pricing infor- mation from recent purchase orders, current labor rates, subcontract quotations, project sched- ule information (to determine escalation require- ments), and the construction plan (to determine labor productivity and other adjustments). In a completely detailed estimate, all costs are detailed including the DFC, IFC, HOC costs, and all other miscella- neous costs for both the ISBL and OSBL facilities. One varia- tion of the detailed estimate is a semi-detailed estimate in which the costs for the ISBL process facilities are factored, and the costs for the OSBL facilities are detailed. Another variation is the forced-detailed estimate in which detailed estimating methods are used with incomplete design infor- mation. Typically in a forced-detailed estimate, detailed take- off quantities are generated from preliminary drawings and design information. The following steps comprise the activities undertaken dur- ing preparation of a detailed estimate: 1. prepare project estimate basis and schedule, 2. prepare direct field cost (DFC) estimate, 3. prepare indirect field cost (IFC) estimate, 4. prepare home office cost (HOC) estimate, 5. prepare sales tax/duty estimates, 6. prepare escalation estimates, 7. prepare project fee estimate (for contractors), 8. prepare cost risk analysis/contingency determination, and 9. review/validate estimate. The first step in preparing a detailed estimate is to begin establishing the project estimate basis and schedule. This is essentially the preplanning phase for the estimate. As men- tioned, a detailed estimate for a large industrial facility may take weeks to prepare, and involve several estimators and extensive support from engineering. The estimate basis doc- uments the activities and course of action that will be used to prepare the estimate. The first activity is to review the orga- 9.15 AACE INTERNATIONAL ESTIMATING Subcontract Installed Cost for Induced Draft Cooling Tower $0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 25 30 35 40 45 50 55 60 65 70 75 Flow Rate - 1000 Gallons per Minute ) $ S U ( t s o C 30 Deg Cooling Range - 15 Deg Approach 40 Deg Cooling Range - 15 Deg Approach Figure 9.3–Graph of Cooling Tower Costs Based on Parametric Model 1See Appendix C for additional refernce material.
- 117. nization’s estimating guidelines and procedures with the esti- mating team. The project work breakdown structure (WBS) should be reviewed with the project controls team, and agree- ment should be reached on the estimate format, structure, and deliverables. The detailed estimate is typically used to sup- port cost control during execution of the project and should be structured to accomplish that purpose. The listing of engi- neering and technical deliverables to be used to prepare the estimate should be reviewed, and the procedures for receiv- ing and tracking the drawings and other design information established. The estimating team should identify the estimat- ing resources, techniques, and data that will be used during estimate preparation. Any estimate exclusions that are known at this time should be reviewed and documented. The estimate schedule should be prepared, documenting when the various engineering deliverables are to be sup- plied, when each of the major sections of the estimate should be completed, and when estimate reviews will be scheduled. The estimate basis and schedule should be reviewed with the project team at an estimate kickoff meeting prior to estimate preparation. The estimate kickoff meeting provides an opportunity for the entire project team to understand the roles and responsibilities of the various participants, and to review the plans for the estimate preparation activities and estimate schedule. On very large projects, it is often beneficial to establish a few key contacts that will act as the liaisons between estimating and engineering. Any questions devel- oped by the estimators during estimate preparation are fun- neled through a liaison that will then work with the respon- sible engineering representative to develop the answers. Preparing the DFC estimate is the most intensive activity of preparing the detailed estimate. The project scope should be reviewed and understood, and all technical deliverables assembled. On large projects, the engineering drawings and technical information may be submitted to estimating over time. As each drawing or other information is received from engineering, it should be logged and kept track of. Performing the estimate takeoff (described in more detail below) should take place according to the estimating depart- ment (and any special project) guidelines. This involves quantifying all the various material and labor components of the estimate. Care should be taken to ensure that all quanti- ties are accounted for, but not double-counted. Material pric- ing is applied to the material quantities using the best pricing information available. The labor hours are assigned to the labor activities, adjusted for labor productivity, and wage rates applied. Any estimate allowances are established. Any owner supplied materials or other owner costs are accounted for. The DFC estimate is then summarized and formatted. Finally, the DFC estimate should be reviewed for complete- ness and accuracy. After the DFC estimate has been prepared, the IFC estimate is started. The DFC estimate should be reviewed, and the total labor workhours identified. The labor workhours are typically a basis for factoring many of the of IFC costs. The indirect estimate factors should be determined and applied. Indirect labor wage rates and staff labor rates are established and applied, and any indirect estimate allowances are accounted for. The IFC estimate is then summarized, format- ted, and reviewed for completeness and accuracy. The con- struction manager should be specifically involved in the ini- tial review of the IFC estimate. The HOC estimate is then prepared. For a detailed estimate, the various project administration and engineering disci- plines should provide detailed workhour estimates for their project activities. The appropriate wage rates are then applied to the workhour estimates. Home office overhead factors are determined and applied to develop the home office overhead costs and expenses. The HOC estimate is then summarized, formatted, and reviewed. Other miscellaneous activities and costs are then estimated. If sales tax is applicable to all (or portions) of the facility, they will need to be estimated using the appropriate local sales tax rates. If materials are to be imported, duties may be charged and will need to be estimated. Escalation costs should be esti- mated based on the project schedule. Depending on the proj- ect delivery method and contracting strategy, appropriate project fee estimates will need to be calculated and included. Finally, a cost risk analysis study should be performed and appropriate contingency is included in the estimate. As with an equipment factored estimate, particular attention should be paid to pricing the process equipment for a detailed estimate as it contributes such a large share of the costs (20 to 40 percent of the total installed cost of the facili- ty). Estimating the costs for process machinery and equip- ment requires many sources of input. The minimum infor- mation requirements for pricing equipment include the process flow drawings, the equipment lists, and the equip- ment process data sheets (usually prepared by the process engineering group). Often, the equipment process data sheets are provided to the mechanical/vessels engineering group to prepare narrative specifications and request for quotation (RFQ) packages. Whenever possible, these engineering groups (perhaps in association with the procurement group) should be responsi- ble for providing the equipment material purchase costs to the estimator for inclusion in the project estimate. Although estimating is typically responsible for pricing the material costs for bulk materials, the process and mechanical engineers are best able to accurately determine equipment material pric- ing, and are generally in close contact with potential equip- ment vendors. Slight differences in equipment specifications 9.16 ESTIMATING AACE INTERNATIONAL
- 118. can sometimes result in large differences in pricing which an estimator may be unaware of. Formal vendor quotes for equipment pricing are preferred; however sometimes time constraints in preparing the estimate do not permit solicita- tion of formal vendor quotes. In this case, equipment pricing may depend on informal quotes from vendors (i.e., phone discussions), in-house pricing data, recent purchase orders, capacity factored estimates from similar equipment, or from parametric pricing models. The estimator should be responsible for checking the equip- ment list against the flow diagrams (or P&IDs) to ensure that all equipment items are identified and priced. The estimator must also be responsible for verifying that the costs for all equipment internals and accessories (trays, baffles, ladders, etc.) are included with the cost of the appropriate equipment. As opposed to most bulk commodity accounts (where the materials are generally available locally), freight costs for equipment can be significant and should usually be identi- fied explicitly. Also, any vendor assistance and support costs should be identified and included with the material costs of the equipment. Major spare parts for process equipment will also need to be accounted for and included in the estimate. Equipment installation costs are usually prepared by the esti- mator, with assistance from construction where required. Construction assistance is usually needed for heavy lifts, or where special installation methods may be used. The place- ment of large process equipment in an existing facility may also require special consideration. Workhours for equipment installation are usually based on weight and equipment dimensions, which are obtained from the equipment process data sheets). Using the equipment weights (or dimensions), the installation workhours are typically determined from curves based on historical data. Other forms of in-house or published data may also be used. When referencing the labor workhour data for equipment, the estimator must be careful to include all labor associated with the pieces of equipment (vessel internals, etc.). Depending on the information avail- able, the labor hours to set and erect a heavy vessel may not include the hours to erect, takedown, and dismantle a guy derrick, gin poles, or other special lifting equipment. Special consideration may also be required to ensure costs for cali- bration, soil settlement procedures, special internal coatings, hydrotesting and other testing costs are included in the esti- mate. Some equipment may be erected by subcontractors or the vendor, and included in the material purchase costs. Care must be taken to identify these situations. As with the rest of the estimate, the responsibility of the esti- mator is to make sure that all costs are accounted for. For equipment in particular, this requires attention to detail, working closely with engineering and construction, and ask- ing the right questions. With chemical process plants being so “equipment-centric,” the costs for purchasing and installing equipment make up a significant portion of the total installed cost of the facility. Detailed estimates are the most accurate of the estimating methods, but also require the most time and effort to prepare. Although detailed estimates are desirable for final budget authorization, the level of engineering progress needed and the time required for estimate preparation will sometimes preclude them from being used for this purpose. In today’s economy, budgeting and investment decisions are often need- ed sooner than a detailed estimate would allow. Semi-detailed and forced-detailed estimates will often be employed for final budget authorizations, and a complete detailed estimate may be prepared later to support project control. TAKE-OFF As mentioned previously, estimating take-off is the process of quantifying the material and labor quantities associated with the project. The term take-off is also used to refer to the quan- tities themselves (often known as a bill of quantities). Take- off involves a detailed examination of the engineering draw- ings and deliverables to count the number of each item appearing on the drawings. The quantities of like items are then summarized according to the control structure (WBS/RBS) of the project. Once the take-off is complete, and total quantities for each like item summarized, the items can be costed (or priced), and the results added together resulting in the estimated direct field costs for the project. Generally, the process of “take-off” for the estimate is much more efficient when standard estimating guidelines are established and followed. This provides advantage enough when a single estimator is preparing a specific estimate, but is even more important when multiple estimators are work- ing on the same project. Guidelines for preparing an efficient take-off include the following: • Use preprinted forms for the orderly sequence of item descriptions, dimensions, quantities, pricing informa- tion, etc. • Abbreviate (consistently) whenever possible. • Be consistent when listing dimensions (i.e., length x width x height). • Use printed dimensions from drawings when available. • When possible, add up the printed dimensions for a given item. • Measure all dimensions carefully. • Use each set of dimensions to calculate multiple quanti- ties where possible. • Take advantage of design symmetry or repetition. • List all gross dimensions that can be used again to rough check other quantities for approximate verifications. • Convert imperial dimensions (feet/inch) to decimal equivalents. 9.17 AACE INTERNATIONAL ESTIMATING
- 119. • Do not round until the final summary of quantities. • Multiply the large numbers first to reduce rounding errors. • Do not convert the units until the final quantities are obtained. • Items should be measured/converted to the same units consistently throughout the take-off. • Mark the drawings as quantities are taken off. Use dif- ferent colors to identify various types of components or items, as well as to identify items on hold, etc. • Verify the drawings taken-off versus the approved draw- ing list to be used with the estimate. Check off drawings on the drawing list as take-off is completed. • Keep similar items together, different items separate. • Organize the take-off to match the control structure and format of the estimate. • Identify drawing numbers, section numbers, etc. on the take-off forms to aid in future checking for complete- ness, and for incorporating late changes later on. • Be alert for notes shown on drawings, changes in scale used on different drawings, drawings that are reduced from original size, discrepancies between drawings and specifications, and changes in elevation that may not be obvious, etc. • Be careful to quantify all labor operations that may not have a material component. By keeping a uniform and consistent take-off process, the chance of error or omission is greatly reduced, and produc- tivity is increased. Multiple estimators will find it easier to work on the same project; and if a personnel change takes place, it is much easier for a new estimator to pick up. After the take-off is completed, the quantities can be extended, consolidated, and priced. If a procurement department or other resources will be utilized to investigate certain pricing (major equipment, large bulk material purchases, subcontracts, etc.), a listing should be compiled and sent to the appropriate person. With today’s computerized estimating software, the process of take-off is often performed directly into the estimating soft- ware, rather than compiled manually onto forms. The software will often prompt for key dimensions and/or parameters for the specific item being quantified and perform many of the required calculations automatically. In some cases, electronic digitizers can be used which automate the time-consuming task of measuring quantities from drawings and can help to reduce errors. Using a digitizer, an estimator can measure the area of a concrete slab, the length of a piping run, or count a quantity of valves by tracing a boundary, touching end points, or selecting items from a paper drawing. In combination with the estimating software, the digitizer performs the required calculations required to accurately quantify the various items. The estimating software can also summarize quantities, and apply pricing. COSTING VERSUS PRICING Costing is the process of applying unit costs to the individual quantities of items associated with the estimate. For a detailed estimate, this is usually in the form of labor hours, wage rates, material costs, and perhaps subcontract costs. These costs may come from a variety of sources such as an estimating database (either in-house or commercial), vendor quotes, the procure- ment department, estimating experience, etc. Pricing, on the other hand, is adjusting the costs that have been applied for specific project conditions, and commercial terms. Pricing includes adjustments to cost to allow for over- head and profit, to improve cash flow, or otherwise serve the business interests of the party preparing the estimate. Thus, the level and type of pricing adjustments depends on the par- ticular party preparing the estimate. For example, to a concrete contractor preparing a bid for a defined scope of foundation work, his costs will include the direct material and labor costs associated with pricing and installing the foundations. However, the price reflected by his bid will include not only his costs, but also an allowance for his overhead and profit; so the price reflected in his bid is higher than his cost. Pricing also includes adjustments to costs for specific project conditions. Depending on the specific cost information used in preparing the estimate, material costs may need to be adjusted for location, materials of construction, or to account for differ- ences between the item being installed and the item you may have an available cost for. Labor hours may require productiv- ity adjustments for a variety of conditions such as weather, amount of overtime, interferences from production, material logistics, congestion, the experience of the labor crews, the level of contamination control, etc. Labor rates may also need to be adjusted for location, crew mix, open shop versus union issues, and specific benefit and burden requirements. ESTIMATE ALLOWANCES Allowances are often included in an estimate to account for the predictable but undefinable costs associated with project scope. Allowances are most often used when preparing deterministic or detailed estimates. Even for this class of esti- mate, the level of project definition may not enable certain costs to be estimated definitively. There are also times when it is simply not cost-effective to quantify and cost every small item included with the project. To account for these situa- tions, an allowance for the costs associated with these items may be included in the estimate. Allowances are often included in the estimate as a percentage of some detailed cost component. Some typical examples of 9.18 ESTIMATING AACE INTERNATIONAL
- 120. allowances that may be included in a detailed construction estimate are • design allowance for engineered equipment, • material take-off allowance, • overbuy allowance, • unrecoverable shipping damage allowance, and • allowance for undefined major items. A design allowance for engineered equipment is often required to account for continuing design development that occurs even after placement of a purchase order for the equipment. At the time of a detailed estimate, vendor quotes are usually available to account of the purchase cost of the equipment. However, for specialty engineered equipment, it is often likely that the quoted cost is not the final cost incurred by the project. We don’t necessarily understand when or how the costs will increase, but we can often predict that they will based on past project experiences. After initial placement of the order for specialty equipment, continuing design activities may tighten tolerances, increase the quality of finish required, change metallurgies, etc. The predicted additional cost will frequently be included in the estimate as an design allowance for engineered equipment (or design development allowance) and be applied as a percentage of the total cost of engineered equipment, or the total cost of specific engineered equipment types when the percentage allowance will vary by equipment type. Typical percentages are from 2 to 5 percent of engineered equipment cost. Material take-off allowances are usually intended to cover the cost of undefinable materials at the time of estimate preparation. The completeness of bulk material take-off can vary widely, depending on the status of engineering deliver- ables at the time estimate preparation begins. For example, all of the small-bore piping may not be included on the design drawings, or perhaps not all of the embeds and relat- ed small accessories are identified in the concrete design. A material take-off allowance may be included to cover for the lack of complete project definition. It may also account for those small items it is simply not economical to take-off or detail in the estimate. Generally, material take-off allowances are included as both a material and labor cost. They are intended to cover materials that are an actual part of the proj- ect and will thus need to be installed. Material take-off allowances are typically applied as a percentage of direct commodity costs by discipline (or trade). The percentages will vary by discipline, and from project to project depending on the estimating methods used and the level of engineering deliverables to support the estimate. Percentages may run from 2 to 15 of discipline costs. Overbuy allowances provide for inventory losses due to such things as damage at the jobsite, cutting loss or waste, misuse of materials, theft, etc. Every project experiences these types of losses, depending on jobsite location and other project con- ditions. Some organizations may split these into several sep- arate allowances (breakage, theft, etc.). Overbuy allowances usually apply to material costs only, may vary from 2 to 10 percent of discipline material costs. Damage to equipment and materials during shipment can be expected on virtually every project. Usually, the cost of dam- age is covered by insurance if detected upon arrival at the jobsite and dealt with expeditiously. An allowance for unre- coverable shipping allowance is intended to cover such loss- es that are not covered by insurance. This allowance will vary based on project conditions, project material delivery and handling procedures, and the types of material and equip- ment being shipped. Occasionally, an order-of-magnitude cost for a major seg- ment of scope must be stated before definition of that work has begun. A particular area of scope may simply not have progressed in design as far as the rest of the project, but a cost for that scope must be included in the estimate. In this case, the cost is included as an allowance and may simply be a best “guestimate” to be included in the estimate until a later time when better definition can be obtained. This is sometimes referred to as an allowance for an undefined major item. Other miscellaneous allowances may sometimes be included in an estimate for situation where a statistical correlation is more reliable that a detailed quantification, or where it is not economical to perform a detailed take-off. Percentage allowances are often included for such items. Material and/or labor costs routinely covered by such items include: • percentage of hand excavation/backfill (vs. machine excavation/backfill), • formwork accessories, • structural steel connection materials, • bolts, gaskets, etc., • piping hangers, guides, etc., • miscellaneous welding operations, and • hydrotesting, other testing operations. Specific application of estimating allowances will depend on many things. For conceptual estimates, such as a capacity fac- tored estimate, allowances may not be required as the esti- mating methodology itself covers all scope and costs includ- ed in the project. Allowances are usually more applicable to semi-detailed and detailed estimates, with the cost value of allowances (or percentage costs) becoming less as project def- inition increases. The specific allowances and values will usually depend on specific organization estimating proce- dures and experience. 9.19 AACE INTERNATIONAL ESTIMATING
- 121. ESTIMATE ACCURACY An estimate is a prediction of the expected final cost of a proposed project (for a given scope of work). By its nature, an estimate is associated with uncertainty, and, therefore, is also associated with a probability of over- running or underrunning the predicted cost. Given the probabilistic nature of an estimate, it should not be regarded as a single point number or cost. Instead, an estimate actually reflects a range of potential cost out- comes, with each value within this range associated with a probability of occurrence. Typically, however, the preparation of an estimate results in a single value. If we prepare a conceptual esti- mate using capacity factored techniques, we calculate a single point value as the estimated cost. When prepar- ing detailed estimates, as the sum of many individual estimating algorithms, we also calculate the estimate total as a single point value. What we need to understand is the uncertainty associated with that single point value, and the true probabilistic nature of an estimate. Most of the end-uses of an estimate require a single point value within the range of probable values to be selected. For example, when used to develop a project funding amount or budget, we must select a single value to represent the esti- mate. When taking into account the uncertainty associated with an estimate, we will often add an amount (contingency) to the initially developed point value to represent the final estimate cost. When doing so, we must take into account such things as the accuracy range of the estimate, confidence levels, risk issues, and other factors in selecting the best sin- gle point value to represent the final value of the estimate. Estimate accuracy is an indication of the degree to which the final cost outcome of a project may vary from the single point value used as the estimated cost. It should generally be regarded as a probabilistic assessment of how far a project’s final cost may vary from the single point value that is select- ed to represent the estimate. Accuracy is traditionally repre- sented as a +/- percentage range around the point estimate; with a stated confidence level that the actual cost outcome will fall within this range. This common +/- percent measure associated with an estimate is merely a useful simplification given the reality that each individual estimate will be associ- ated with a different probability distribution explaining its unique level of uncertainty. Estimate accuracy tends to improve (i.e., the range of proba- ble values narrows) as the level of project definition used to prepare the estimate improves. Generally, the level of project definition is closely correlated with engineering progress; thus, as the level of engineering progresses, estimate accura- cy improves. This is shown in Figure 9.4. This chart is intended only as an illustration of the general relationship between estimate accuracy and the level of engi- neering complete. As shown in Figure 9.4, and described in the Recommended Practices on Estimate Classification, there is no absolute standard range on any estimate or class of esti- mate. For the process industries, typical estimate ranges are illustrated as follows: • Typical Class 5 Estimate: High range from +30 to +100% Low range from -20 to -50% • Typical Class 4 Estimate: High range of from +20 to +50% Low range of from -15 to -30% • Typical Class 3 Estimate: High range of from +10 to +30% Low range of from -10% to -20% Although the percent of engineering complete (or level of project definition) is an important determinant of estimate accuracy, there are many other factors that also affect it. Some of these other factors include the state of new technology in the project, the quality of reference cost information used in preparing the estimate, the experience and skill of the esti- mator, the estimating techniques employed, the level of effort budgeted to prepare the estimate, and the desired end use of the estimate. Other important factors affecting estimate relia- bility are the project team’s capability to control the project, and the capability to adjust the estimate for changes in scope as the project progresses. Consideration of all of these factors is the reason that the high and low ranges of typical estimate accuracy are themselves 9.20 ESTIMATING AACE INTERNATIONAL Figure 9.4—Relationship Between Estimate Accuracy and Engineering Progress
- 122. variable. It is simply not possible to define a precise range of estimate accuracy based solely on the percentage of engineer- ing complete or class of estimate. Any specific estimate may not exhibit the patterns shown above. It is possible to have a Class 5 estimate with a very narrow estimate range, particularly for repeat projects with good historical costs upon which to base the estimate. Conversely, it is possible to have a Class 3 or Class 2 estimate with a very wide accuracy range, particularly for first-of-a-kind projects or those employing new technologies. The +/- percent accuracy range of the estimate should be determined from an assessment of the design deliverables and estimating information used in preparation of the esti- mate. Cost risk analysis studies will often be used for indi- vidual projects to determine their accuracy range based on this type of information. The resulting output of the cost risk analysis model should then establish a final estimate cost based on the level of confidence (or risk) acceptable to man- agement in order not to overrun the project budget. When discussing estimate accuracy, it is also important to real- ize that for early conceptual estimates, variations in the design basis will have the greatest impact on costs. Estimating tools and methods, while important, are not usually the main prob- lem during the early stages of a project when estimate accura- cy is poorest. In the early phases of a project, effort should be directed towards establishing a better design basis than con- centrating on utilizing more detailed estimating methods. CONTINGENCY AND RISK ANALYSIS Contingency is, in many respects, the most misunderstood ele- ment contained in an estimate. This is due in large part to how the different members of a project team view contingency from their own frame of reference. A project manager may want the project budget to include as much funding as possible in order not to overrun the budget and may want as a large contin- gency value included in the estimate as he can get away with. An engineering manager may want contingency funds to cover any overruns in engineering, while the construction manager hopes that engineering doesn’t use any of the contin- gency funding so that he has the entire amount to use in fund- ing construction overruns. Corporate management may think of all requests for contingency as “padding” the estimate, and may consider any use of contingency funds as only being required because a project is poorly managed. To the estimator, contingency is an amount used in the esti- mate to deal with the uncertainties inherent in the estimating process. The estimator regards contingency as the funds added to the originally derived point estimate to achieve a given probability of not overrunning the estimate (given rel- ative stability of the project scope and the assumptions upon which the estimate is based). Contingency is required because estimating is not an exact science. One definition of an estimate is that it is the expected value of a complex equa- tion of probabilistic elements, each subject to random varia- tion within defined ranges. Since the value assigned to each individual component of an estimate is subject to variability, the estimate total itself is also subject to variation. Figure 9.5 illustrates the potential variability of a single com- ponent of an estimate. In this example, the variability is shown as a normal probability distribution around the esti- mated value of $100. Since this is a normal probability distri- bution, the probability of underrun (shown as the area under the curve to the left of the vertical dotted line) equals 50%, the same as the probability of overrun (the area under the curve to the right of the dotted line). The estimate line item has an estimated cost of $100; however the accuracy range of the cost varies from $50 to $150, or an accuracy range of +/- 50%. Unfortunately, most items of cost in an estimate do not exhib- it a normal probability distribution in respect to its potential variability. Most of the time, variability is more closely asso- ciated with a skewed distribution. Figure 9.6 shows the vari- ability of an estimate line item for which the accuracy range of the cost is skewed to the high side. 9.21 AACE INTERNATIONAL ESTIMATING 50 100 150 Estimated Cost y t i l i b a b o r P 50% 50% Figure 9.5—Variation of an Estimate Line Item with Normal Probability Distribution 80 100 140 Estimated Cost y t i l i b a b o r P 40% 60% Figure 9.6—Variation of an Estimate Line Item with a Skewed Probability Distribution
- 123. In this example, the item has been estimated at $100; howev- er the accuracy range of the cost varies from $80 to $140, or - 20 to +40 percent. With an estimated value of $100, this exam- ple shows that there is only a 40 percent probability of under- run, while there is a 60 percent probability of overrun. In order to equalize the probability of underrun and overrun, an amount would need to be added to the original point value of $100. This amount would be considered contingency. Contingency would not change the overall accuracy range of $80 to $140; however it would increase the probability of underrun while decreasing the probability (risk) of overrun. Most items of cost in an estimate will demonstrate some measure of skewness, usually to the high side where the prob- ability of overrun is higher than the probability of underrun. However, there are usually items where the skewness will be to the low side as well. The variability of the total estimate is then a function of the variability associated with each indi- vidual line item. Since the probability distribution of most line items is skewed to the high side, the overall probability dis- tribution for the estimate as a whole is also typically skewed to the high side. Contingency is thus usually a positive amount of funds added to cover the variability surrounding the point value of the estimate, and to reduce the chances of overrunning the point estimate to an acceptable level. Items typically covered by contingency include the following: • errors and omissions in the estimating process; • variability associated with the quantification effort; • design that may not be complete enough to determine final quantities at the time of estimate preparation; • some items that may defy precise quantification but are required to be estimated; • some items to be quantified that are generally computed by factored or other conceptual methods; • labor productivity variability; • labor availability, skills, and productivity that may vary from that originally assumed; • the fact that there is no such thing as an “average” tradesman that installs every incremental quantity of an item at the “average” rate typically used in preparing the estimate; • weather, which may vary from that assumed affecting labor productivity; • wage rate variability; • wages that may vary from that assumed in the estimate due to inflationary reasons, changes in assumed crew mix, labor availability, and market conditions; • material and equipment costs; • material and equipment costs that may vary from those in the estimate due to inflationary reasons and market conditions; • certain materials of construction that may be substituted from that assumed in the estimate; and • changes in actual quantities that may change discount schedules from that assumed in the estimate. Contingency specifically excludes the following: • significant changes in scope, • major unexpected work stoppages (strikes, etc.), • disasters (hurricanes, tornadoes, etc.), • excessive, unexpected inflation, and • excessive, unexpected currency fluctuations. Risk analysis is a process that can be used to provide an under- standing of the probability of overrunning (or underrunning) a specified estimate value. It provides a realistic view of com- pleting a project for the specified estimate value by taking a sci- entific approach to understanding the uncertainties and proba- bilities associated with an estimate and to aid in determining the amount of contingency funding to be added to an estimate. Its purpose is to improve the accuracy of project evaluations (not to improve the accuracy of an estimate). Risk analysis generally uses a modeling concept to determine a composite probability distribution around the range of pos- sible project cost totals. It provides a way in which to associate a level of risk with a selected project funding value. If the orig- inal point value of an estimate is assumed to be approximate- ly the midpoint of the possible actual cost outcomes of project cost, that means that there is a 50 percent probability that the final outcome will exceed the estimated cost (without contin- gency). In reality, there is usually a greater probability that costs will increase rather than decrease. This means that the distribution of project cost outcomes is skewed, and there is a higher than 50 percent probability that final actual costs will exceed the point estimate (and this is historically the case). Two types of risk analysis are commonly used: • strategic risk analysis models that evaluate the level of project definition and project technical complexity in determining the overall risk to project cost, and • detailed risk analysis models that evaluate the accuracy range for individual or groups of estimate components in determining the overall risk to project cost. Both forms of risk analysis models usually generate overall probability distributions for the expected final cost outcomes for the project, and tables equating confidence levels with specific final cost values. The resulting probability distribu- tions of final cost outcomes can be used to determine an amount to be included in the estimate as contingency. Basically, management typically makes this determination based on the level of risk they are willing to accept. The dif- ference between the selected funding value and the original point estimate is the amount of contingency. 9.22 ESTIMATING AACE INTERNATIONAL
- 124. Table 9.10 shows an example of a cumulative probability dis- tribution table produced by a typical risk analysis model. In this example, the original point estimate (before contingency) is $23.3 million. As can be seen from this table, the point esti- mate of $23.3M results in only a 20 percent probability of not exceeding (or underrunning) this value. If we wanted to achieve a 50 percent probability of underrun (and thus a 50 percent probability of overrun), we would need to fund the project at $25.4M. This would mean adding a contingency amount of $2.1M in the estimate, equivalent to 9 percent of the original point value of the estimate. If we wanted to provide a 70 percent probability of not exceeding our project funding, we would need to fund $26.6M, which would add a contingency amount of $3.3M to the estimate (equivalent to 14.2 percent of the point estimate). This can also be shown in a typical graphical output from a risk analysis model for the same estimate as shown in Figure 9.7. As can be seen from this graph, increasing the amount of con- tingency increases the probability of not exceeding the proj- ect funding amount (the point estimate plus contingency). Note: Contingency does not increase the overall accuracy of the estimate—it doesn’t change the overall accuracy range of approximately of $18.5M to $32.5M. Contingency does, however, reduce the level of risk associat- ed with the estimate and improve project evaluations when properly used. Appropriately applied, risk analysis provides an effective means of determining an amount for estimate contingency, and of providing management with information about the variability of project estimates. In addition, the process of preparing a risk analysis model typically identifies specific project areas associated with both risk and opportunity. Those areas identified with high risk can then become focus areas in order to reduce and mitigate any risk issues, and the areas of low risk can become focus areas in order to capital- ize on the opportunities they may provide. STRUCTURING THE ESTIMATE The control structure for a project is the breakdown of the total work into manageable units or packages for the pur- poses of estimating and control of cost and schedule. The structure will vary with the size and complexity of the proj- ect, as well as the reporting requirements. The proper struc- turing of a project for control purposes contributes greatly to the effective implementation of project control procedures and the success of the project itself. To maintain some kind of order in the estimate (and later in project execution), it is necessary to segregate costs into vari- ous categories: • material vs. labor vs. subcontracts, • direct costs vs. indirect costs vs. home office costs, and • concrete vs. structural steel vs. piping vs. other construc- tion disciplines. The control structure should be established as early as possi- ble in the project life cycle, because it will set the pattern for accumulation of project costs, and it should be used to form the basis for the structuring the estimate. The process of pro- ducing the project’s control structure, often known as work 9.23 AACE INTERNATIONAL ESTIMATING P Project Estimate Cumulative Indicated Estimated Probability Funding Contingency of Underrun Amount (Million $) (Million $) (%) 10% $22.3 20% $23.3 30% $24.2 40% $24.8 50% $25.4 $2.1 9.0% 60% $26.0 70% $26.6 $3.3 14.2% 80% $27.4 90% $28.6 Table 9.10—Sample Cumulative Probability Distribution Table 20% 40% 60% 80% 100% 22 24 26 28 30 32 34 Estimated Costs, $US Millions 50%, $25.4M $23.3M g n i d e e c x E t o N f o y t i l i b a b o r P Contingency Figure 9.7—Graphical Cumulative Probability Distribution
- 125. breakdown planning, is often an ongoing process requiring updates as the scope of the project is refined during the project life cycle. The segregation of costs can be referred to as establishing the project “coding” structure, and more specifically as the “code of accounts.” Codes are the umbilical cords between cost accounting and cost engineering (estimating and cost control). Large projects will often use work breakdown sstructures (WBS) and resource breakdown structures (RBS) as components of the overall coding structure. Smaller projects will often use a simpler code of accounts based simply on the disciplines or construction trades used on the project. The WBS and RBS are basic project management tools that define the project along activity levels that can be clearly identified, managed, and controlled. The WBS is the division of a project, for the purposes of management and control, into sub-projects according to its functional components. The WBS typically reflects the manner if which the work will be performed, and should reflect the way in which cost data will be summarized and reported. A WBS should be customized to be specific to a particular project, and is usually organized around the geographical and functional divisions of a project. It forms the high-level structure for an estimate. Figure 9.8 illustrates how a typical WBS might be organized. The RBS is a breakdown of all labor and material resources required in the execution of the project. The RBS identifies func- tional lines of authority, and extends to the level at which work is actually assigned and controlled. The RBS typically remains consistent from project to project (at least for the same project types). Figure 9.9 illustrates a sample project RBS. The matrix of the WBS and RBS forms the full project control structure or project breakdown system (PBS). The intersec- tion points of the WBS and RBS structures is called a “cost center,” and corresponds to a defined unit of work and the resources involved in executing that work. Each cost center equates to a specific “cost code.” Figure 9.10 displays a sam- ple project breakdown structure. Corresponding with the PBS is a numbering system used to identify each cost center. The collection of codes used to des- ignate the intersection of WBS and RBS identifiers forms the project’s “code of accounts.” Table 9.11 shows a sample cod- ing structure. For a specific unit of work, the labor to pour concrete in the hydrocracker unit, the cost code would be 01-02-C-2-003-1 (Onsite-Hydrocracker-Construction-Concrete-Pour-Labor). The code of accounts formally refers to the full coding struc- ture (including project identifier, WBS, and RBS elements), but the term is often used in regards to the RBS elements only. The coding structure must reflect the manner in which the project will be executed and the way in which costs can reasonably be expected to be collected. The coding structure should also reflect the way in which your par- ticular organization executes projects. Of importance is that the estimate, which predicts project execution, should be organized and structured to match the project code of accounts. The coding structure adopted by an organization should be documented in detail. Typically a code book is pub- lished and made available to all project personnel. The code book should contain a code by code listing that doc- uments a description of not only what should be includ- ed under a specific code, but also what is excluded (for those items that could be easily misunderstood). 9.24 ESTIMATING AACE INTERNATIONAL Figure 9.8—Sample WBS Figure 9.9—Sample RBS
- 126. ESTIMATE/COST/SCHEDULE INTEGRATION The integration of the project cost estimate with the project schedule and cost control system is crucial for effective proj- ect management and control. Accomplishing this goal can be difficult at best; yet the estimate, schedule, and cost system must share information with each other for each to be as accurate as possible. The schedule will provide dates that are essential to calculating escalation, cash flow, and commit- ment forecasts. The estimate provides labor hours and craft breakdowns essential to determining schedule activity dura- tions and resource loading. The estimate also provides cost and quantities to the cost control system. The cost reporting system’s record of labor and material expenditures needs to be correlated with schedule progress and remaining dura- tions for schedule activities correlated to the forecasts-to- complete in the cost system. The relationship between the cost estimate and schedule is not always straightforward. The natural breakdowns (or hierarchy) of cost and schedule structures are different. The cost system is organized to estimate, monitor and control dollars. The sched- ule system is organized to plan, monitor and control time. The control and monitoring of both variables are not necessarily compatible, and most often, the same people do not perform both tasks. The goal, then, is to align estimate cost data and schedule data at a level to support integration. One approach is to breakdown the estimate to the level of schedule activities. This can result in a tremendous amount of detail in the cost estimate and compromise efficient cost and schedule control. Some of the problems resulting from the one-to-one approach are the following: • Collecting costs by detailed schedule activities is gener- ally not feasible. 9.25 AACE INTERNATIONAL ESTIMATING Figure 9.10—Sample Project Breakdown Structure AREA UNIT FUNCTION DISCIPLINE DETAIL RESOURCE 01 - Onsites 01 - Crude Unit A - Project Administration 1 - Earthwork 001 - Formwork 1 - Labor 02 - Hydrocracker B - Enginering/Design 2 - Concrete 002 - Rebar 2 - Material 03 - Vacuum Unit C - Construction 3 - Structural Steel 003 - Pour 3 - Subcontract … 4 - Piping 004 - Embeds 02 - Offsites 01 - Utilities 5 - Equipment 005 - Finish 02 - Storage … 03 - Pipeway Table 9.11—Sample Project Coding Structure
- 127. Project Onsite Areas Offsite Areas Hydrocracker Crude Unit Hydrogen Unit Piping C/S/A Electrical Other Disciplines Erect Line #101 Fab Line #101 Fab Line #102 Erect Line #102 i h d l • Schedule activities are subject to much more change within the project than traditional cost codes. • Tracking bulk material costs by activity is cumbersome and requires high administrative costs. • Costs are often not incurred at the same time as con- struction activities. The goal must be to determine an appropriate level of detail to correlate cost and schedule. It is important not to let either the estimate or the schedule drive the other down to an inap- propriate level of detail. It is also important not to integrate at too high of a summary level. Integrating at a sufficient level of detail involves keeping the estimate and schedule structures the identical to a certain level of WBS. Below this level, additional cost accounts and schedule activities are defined separately as required by each. The desire is to interface at a level where meaningful relationships exist. Figure 9.11 illustrates a typical cost or estimate structure for a process plant, while Figure 9.12 illustrates a sample schedule structure for the same project. At some point, the cost and schedule WBS structures will diverge to meet each struc- ture’s particular control needs. 9.26 ESTIMATING AACE INTERNATIONAL Project Onsite Areas Offsite Areas Hydrocracker Crude Unit Hydrogen Unit Piping C/S/A Electrical Other Disciplines Material Labor Figure 9.12—Schedule WBS Structure Figure 9.11—Cost/Estimate WBS Structure
- 128. The basic methodology for integrating the cost estimate and schedule, therefore, is to let the estimator and scheduler com- municate on the high-level WBS, and determine the levels at which cost items and schedule activities can be correlated. Then each further defines the lower level of detail required for particular needs. Meaningful information can then be trans- mitted at the appropriate level of detail between the two. It should be acknowledged that one-to-one relationships between estimate cost items and schedule activities is not possible. Early and continuous communication between the estimator and scheduler can determine the best level at which to maintain compatibility and exchange information. The estimator can promote integration by assigning as many identification fields to the estimate line items as possible (i.e., building location, room number, system number, piping line number, foundation number, etc.). This will greatly assist in transferring estimate cost data and resource needs to the schedule. Computerized estimating and scheduling systems are making great strides in providing two-way communica- tion between systems. The cost estimate can be very sensitive to, and is usually pre- pared in correlation with, a specific schedule. If the schedule is undefined or subject to change, the estimate is compro- mised and should reflect the appropriate cost risk. Changes to the project plan that affect either schedule duration or completion dates may significantly affect project cost. The basis estimating algorithm is as follows: Total $ = (Qty x unit material $) + (Qty x unit labor hours x wage rate) The unit material $, unit labor hours, and wage rate can all be dependent on the assumed schedule and plan. Unit material costs are schedule dependent for impacts of inflation and sea- sonal variations. Unit labor hours are schedule dependent for seasonal labor availability, climate, and schedule impacts due to execution plan changes (affecting productivity). Wage rates are also sensitive for impacts of inflation, seasonal vari- ation, and execution plan changes (affecting overtime and/or shift premiums). Many costs in a project are very dependent on the duration. project management and related costs are often estimated (and incurred) on a “level of effort” basis. If the project duration is extended, cost for these activities is directly affected. Construction indirect costs, such as construction management, field office, construction equipment rental, security office, and site maintenance, etc., are also affected in a similar way. Some costs are dependent on when they occur in the calen- dar year. Labor productivity can be adversely affected by weather (both snow and rain in the winter, or hot weather in summer). Construction indirects, such as weather protection or other construction support costs, can also be similarly affected. Project costs can also be affected by schedule impact of exe- cution plan changes. Changes to the execution plan to short- en the project duration may cause out-of-sequence construc- tion, overtime, shift premiums, congestion, and inefficient labor usage, etc., adversely impacting costs. A delay in equip- ment delivery may extend the project schedule increasing duration dependent costs. On the other hand, this may also result in increased efficiencies if labor resources can be allo- cated more efficiently, perhaps resulting in less overtime and shift premiums. It is thus important to evaluate the effects of schedule and duration when preparing the estimate. Besides the obvious of accounting for the escalation costs to incorporate into the estimate, schedule impacts may directly affect labor produc- tivity as well as labor and material pricing. It is also essential to plan early for estimate/schedule integration so that esti- mate results can be shared with the schedule as required to assist in resource loading, and to aid in earned value analysis and progress reporting. ESTIMATE REVIEW Because an estimate is of critical importance to a project’s suc- cess, it makes sense that the estimate should undergo a rigor- ous review process. The estimate should be evaluated not only for its quality or accuracy, but also to ensure that it contains all the required information and is presented in a way that is understandable to all project team members and client person- nel. A structured (if not formal) estimate review process should be a standard practice for all estimating departments. The following sequence of steps will discuss a formal review process for an internally prepared appropriation grade esti- mate (an estimate submitted for capital budget authoriza- tion). The level of detail and diligence used during the esti- mate review cycle will vary both with the strategic impor- tance, total value, and purpose of the particular estimate. These steps can be easily adapted on a fit-for-use basis. In this discussion, we are focused on reviewing and validating an estimate—we are not discussing bidding strategies which can involve many other factors and decisions. Estimate Review Cycles The principle purpose of an estimate review process is to present information about both the estimate and the project in a way that allows the reviewer to evaluate that the esti- mate is of sufficient quality to meet its intended purpose. The estimate review process usually comprises a series of esti- mate reviews, beginning with internal estimating depart- ment reviews, engineering reviews, project team reviews, 9.27 AACE INTERNATIONAL ESTIMATING
- 129. and continuing with reviews by various levels of manage- ment, depending on the importance of the project. Estimating Team/Estimating Department Review The first review of the estimate should, of course, be held by the estimating team that prepared the project estimate. This is essentially a screening review to ensure that the math is correct (extensions of pricing are correct, summaries add up properly, etc.), that the estimate is documented correctly (comprehensive basis of estimate document is prepared), and that it adheres to estimating department guidelines. Typically, this review is held by the lead estimator with the members of his estimating team. On very large projects or those of significant importance, this review may be held by the estimating department manager or supervisor. Check the Math The first item to review is to ensure that all of the math used in the estimate is correct. With today’s computerized esti- mating systems, this is much less of a concern than twenty years ago when estimates were primarily prepared by hand using simple calculators; however math errors can still occur. This can be a major concern when using an electronic spread- sheets, such as Excel, for preparing the estimate (as opposed to a commercial computerized estimating system). Surprisingly, it is very easy to make a formula error in a spreadsheet, such as inserting a row or column which does not get included in a subtotal. All spreadsheet formulas, subtotals and totals should be examined carefully for correct- ness. From a client’s point of view, nothing will help to lose credibility in the entire estimate faster than a finding a math error that went undetected. Basis of Estimate The comprehensive basis of estimate (BOE) document should be reviewed carefully to ensure that it is both correct and com- plete. The BOE is an extremely important document. The dol- lar amount indicated on an estimate is meaningless without knowing the parameters, or what is included and not included in the estimate. The BOE serves to clearly define the design basis, planning basis, cost basis, and risk basis of the estimate. • Design Basis: The overall scope of the project should be summarized, with additional detail provided for each area/unit/work package of the project. Specific inclusions and, even more importantly, specific exclusions of items or facilities should be documented. All assumptions regard- ing project scope should be documented. If available, equipment lists should be attached or referenced, and a listing of all drawings, sketches, and specifications used in the preparation of the estimate should be documented, including drawing revision date and number. • Planning Basis: This portion of the BOE should docu- ment information from the integrated project plan that affects the estimate. It should include specific informa- tion about any contracting strategies for engineering, design, procurement, fabrication, and construction. It should include information about resourcing and project execution plans such as the length of the workweek, use of overtime, and number of shifts, etc. It should include information about the project schedule and key mile- stone dates affecting the estimate. • Cost Basis: The source of all pricing used in the estimate should be documented in this section of the BOE. This would include the source of all bulk material pricing, the pricing of major equipment (referencing quotes or pur- chase orders if used), and all labor rates including office, engineering, fabrication, and construction. The source of all labor workhours should be documented, along with any assumptions regarding labor productivities. All allowances included in the estimate should also be clear- ly identified. It is also important to document the time basis of the estimate (i.e., what point in time is assumed), and the basis for cost escalation included in the estimate. • Risk Basis: Since, by definition, every estimate is a pre- diction of probable costs, it is clear that every estimate involves uncertainty and risk. Contingency is typically included in an estimate to cover the costs associated with this uncertainty. This section of the BOE should docu- ment how the contingency was determined, and identi- fy key areas of risk and opportunity in the cost estimate. It is important to ensure that the BOE is clear and easily understood, and to verify that all information and factors documented in the BOE have been consistently applied throughout the estimate (i.e., wage rates, labor productivi- ties, material pricing, subcontract pricing, etc.). Again, the estimate can lose credibility if different pricing or labor rates have been used for the same item within the estimate detail. Estimating Department Guidelines A careful review should be done to verify that the cost esti- mate follows standard estimating guidelines for the depart- ment. This would include a review to verify that standard estimating procedures were followed regarding estimate for- mat, cost coding, presentation and documentation. This would include items such as the following: • Verify that the proper estimating methods, techniques, and procedures were used that match the stage of proj- ect completeness. In other words, different estimating techniques will be utilized depending on the type and completeness of the engineering documents and deliver- ables available to create the estimate. • Confirm that the estimate summary and details are organized and presented in the proper format (i.e., fol- lowing the project WBS and code of accounts); and that the format is consistent with the intended purpose of the estimate (i.e., an estimate serving as a basis for cost con- trol contains sufficient detail). 9.28 ESTIMATING AACE INTERNATIONAL
- 130. • Ensure that all estimate backup information is organized properly. Can all values on the summary page of the esti- mate be traced to the estimate detail pages, and can all information on the estimate detail pages be traced to the estimate backup or source documents? • Verify that all allowances and factors are appropriate for the type of estimate being prepared and are consistent with comparable projects and estimates. This level of estimate review helps to ensure that all esti- mates prepared by the department are utilizing established guidelines and are presented in a consistent manner from project to project. ENGINEERING/DESIGN REVIEW The next level of estimate review should be held with the engineering team and should evaluate the estimate in terms of accurately representing the project scope. The core mem- bers of the engineering team are key participants in this review, along with the lead estimator and estimating team. Completeness of Engineering Deliverables One of the first items to review is the listing of all drawings, sketches, specifications, and other engineering deliverables used in preparing the estimate to ensure that it is complete (see design basis above). The lead engineers need to cross-ref- erence this listing against their own engineering drawing and deliverables lists to make sure that all relevant information was passed on to the estimating team. The revision numbers of drawings should be checked to ensure that they match the intended revision for the estimate. If late changes to the engi- neering drawings have occurred, and are intended to be incorporated into the estimate, this needs to be checked to ensure that all late changes have been included. Equipment List For those projects involving major equipment, the equipment list and equipment pricing should be double-checked by the engineering team for completeness and accuracy. Equipment is often one of the key drivers of cost and scope, and needs to be checked carefully for completeness and accuracy. Design Basis of Estimate The engineers should review the BOE and summary of proj- ect scope carefully to verify and correlate their understand- ing of the project scope with that expressed in the estimate. All exclusions expressed in the BOE should be agreed to, and all allowances and assumptions verified. If an estimator has had any questions about interpretation of the drawings or engineering deliverables, now is the time to discuss the esti- mator’s interpretation with the engineers and to make sure that the project scope is accurately reflected in the estimate. All drawings used for the estimate should be available during this review. Sometimes it can help to have the estimator explain how each drawing was used in the preparation of the estimate (i.e., was a hard takeoff performed from isometric drawings; was a quantity developed from a P&ID and plot plan, etc.). Engineering/Design Costs The engineering team should also review the assumptions and costs associated with the engineering and design portion of the estimate. The engineering team needs to feel comfort- able that the amount of money included in the estimate for engineering, design, and support is adequate for the level of effort expected to be expended on the project. Risk Basis of Estimate Lastly, the engineering team should review the risk basis of the estimate, and be in position to agree with the analysis of cost risk associated with the estimate. The level of risk asso- ciated with scope definition, and with engineering/design costs should be of particular interest to the engineering team, and concurrence sought. As mentioned, the goal of this portion of the estimate review is to make sure that the scope of the project as understood by engineering is reflected in the estimate. At the end of the engineering review, the estimate should have the full support of the engineering team during subsequent reviews. PROJECT MANAGER/PROJECT TEAM REVIEW Once the estimate has been reviewed closely by the estimat- ing and engineering teams, it is ready for review by the Project Manager and the rest of the project team. The objec- tive now is to gain the entire project team’s support of the estimate, and especially that of the project manager. This is also the first point where the estimate should be able to pass overall validation tests, in addition to a quality review. Estimate Documentation The first part of this review should be the examination of the estimate documentation by the project team and project man- ager. This includes the BOE, as well as the estimate summa- ry and estimate detail pages. The purpose is to ensure that the estimate is presented in an understandable manner. If standard estimating guidelines have been followed (as dis- cussed above), all estimates should be presented in a consis- tent, and understandable style. It is very important that the project manager fully understand how the estimate is pre- pared because he/she often becomes the person responsible for presenting (and defending) the estimate to upper man- agement, and later to the eventual customer. The entire proj- ect team should also understand the entire estimate package, format and contents. 9.29 AACE INTERNATIONAL ESTIMATING
- 131. Cost Review Engineering should have already reviewed the engineering, design, and associated support costs. Now is the time for the other key members of the project team (project manager, proj- ect controls, procurement, construction manager, commis- sioning manager, etc.) to examine their respective costs, which are included in the estimate, and to obtain agreement that they are correct. Although primarily the responsibility of the estimating team, the scope related costs should also be reviewed by the rest of the project team to gain consensus. In particular, the following areas should be discussed: • Verify that the latest project schedule agrees with the estimate (particularly as it relates to escalation). • Examine the project administration and other home office- related costs for reasonableness (engineering/design costs should have already been reviewed). • Conduct a final constructability review to ensure that the methods of installation and construction assumed in the estimate are reasonable and cost-effective. • Review the construction indirect costs (i.e., field staff, temporary facilities, temporary services, construction equipment and services, construction tools and consum- ables, etc.) to make sure they are reasonable. • Ensure that all required start-up and commissioning materials are included (if necessary). This is often an area of costs which is overlooked. For international projects, there may be many more items of cost that should be carefully reviewed. These may include such items as international labor adjustments for productivi- ties and wage rates, adjustments for workweek variations, material cost adjustments for both local and globally sourced materials, international freight costs, international duties and taxes, labor camp costs, premiums for expatriate costs, etc. Estimate Validation In most organizations, the project manager is ultimately held responsible for the execution of the project. Therefore, the project manager has a vested interest in performing “sanity checks” or otherwise validating the estimate as reasonable. Most experienced project managers will have various rules- of-thumb that they will want to use to verify against the esti- mate. Regardless, the estimate should include an estimate review “metrics” report which summarizes and compares several key benchmark ratios and factors versus historical (and sometimes estimated) values from similar projects. The goal is to ensure that key metrics from the estimate are in line with the same metrics from similar projects. If there is a large discrepancy, it must be explainable by the particular cir- cumstances of the estimated project versus the similar com- pleted projects. Such comparison metrics may includes val- ues such as percent of administration (home office) costs, per- cent of engineering/design costs, equipment to total field cost ratios, equipment to totals project cost ratios, cost per piece of equipment, workhours per piece of equipment, cost to plant capacity ratios ($/BBL, $/SM), etc. Sometimes the metrics will be generated down to the discipline level where you may look at ratios, such as cost per diameter inch of pip- ing, cost per cubic meter of concrete, cost per ton of steel, etc. In addition to examining key benchmark metrics and ratios, another form of estimate validation may involve preparing a quick check estimate using order-of-magnitude estimating methods. Again, any large discrepancies between the esti- mates should be explainable by the peculiarities of the project. Estimate validation is a very important activity during the project review cycle, and the proper tools need to be in place to allow this to occur. Benchmarking key estimate ratios and metrics depends upon having a project history database in place to collect, analyze, and present the required informa- tion. Similarly, the capability to provide quick-check esti- mates depends on having the correct strategic and conceptu- al estimating information and tools ready for use. Risk Basis of Estimate The project manager and project team should again review the risk basis of the estimate and agree with the analysis of cost risk associated with the project. The project manager, in particular, should agree with the risk assessment and contin- gency amounts, and be able to defend it in subsequent review to upper or corporate management. Reconciliation to Past Estimates Lastly, the project manager will usually be interested in rec- onciliation of the current estimate to the preceding estimate (or estimates). This is an important, but often overlooked, aspect to the overall estimate review process. The current estimate can gain credibility by comparing it with earlier esti- mates and clearly explaining the differences and reasons for the differences. The reconciliation can usually be presented at a high level without excessive detail, but the backup should be available in case it is required during the review. Management Reviews The last series of reviews is usually held by various levels of corporate management. The number of upper management reviews and the level of management they are presented to typically varies with the strategic importance and/or total estimated cost of the particular project. These reviews are typically held at a very high level of analysis and usually do not involve the details of the estimate. Upper management reviews often focus on substantiating the overall adequacy of the estimate in regards to its intended use. In other words, can management be assured that the level of detail available for the estimate, the estimating methods employed, and the skills of the estimating and project teams support their deci- sion-making process on whether to proceed? 9.30 ESTIMATING AACE INTERNATIONAL
- 132. As with the project manager review, estimate validation is a key element of the upper management reviews. It is impor- tant to be able to explain and demonstrate that metrics for the current estimate are in line with data from other similar proj- ects—i.e., that the estimate is reasonable. It is also important to show where the metrics may be substantially different from other projects, and provide explanations for the differences. Management will also be interested in the cost-risk assess- ment. It is important to clearly and concisely explain how the contingency amount was developed and what the levels of risk are. It is then up to management to accept the level of risk indicated or change the amount of contingency and accept more or less risk for the project. When reviewing the risk analysis, it is always important to discuss the areas of high risk, and what is being done to mitigate those risks. Up until the management reviews, the estimate review will have typically concentrated on the project as defined by the project scope documents. If the project was built according to the defined project scope alternative, what will it cost? Usually, the recommended alternative for project scope has long since been determined and agreed to by the project team, and the engineering deliverables created for preparing the estimate have been focused on a single design alternative. However, many times management will start asking ques- tions concerning other alternative scopes or designs. One of the certainties is that management will always think the proj- ect cost is too high and will now be probing to determine if there are lesser cost options. Therefore, it is important to have available for the management reviews any earlier design/cost alternatives, and the decision tree leading to the selected design. The effectiveness of an estimate review relies on the informa- tion presented and the manner in which it is presented. The above discussion has concentrated on how to structure a sequence of estimate reviews for internally prepared estimates to ensure that estimates are well-documented, consistent, reli- able, and appropriate for their intended use. After this review cycle, the level of estimate accuracy should be apparent, reflec- tive of the scope information available for preparing the esti- mate, and capable of supporting the required decision-making process for the project. Next, we will discuss techniques for reviewing estimates prepared by others. REVIEWING ESTIMATES PREPARED BY OTHERS The foregoing discussion has focused on structuring an esti- mate review process for the estimates that we internally pre- pare to ensure that the estimate is of a high quality and sup- ports the decision making process of our management. Often, we may also find ourselves in a position to review (and/or approve) estimates prepared by others and that may or may not have gone through a rigorous internal review cycle as described above. When reviewing estimates by oth- ers, we always want to keep in mind the basic fundamentals previously described. Complicating the matter, however, is the problem that many times the amount of time allowed for a complete estimate review is very short. Thus the review of an estimate prepared by others is usually accomplished by a critical assessment of the estimate and its documentation, and a series of questions to assist in evaluating the level of diligence used in preparing the estimate. The following dis- cussion centers on guidelines that we can use to efficiently review estimates prepared by others. Basis of Estimate The first thing to assess is the BOE. Is it well-organized and complete? Does it provide the required information regard- ing the design basis, planning basis, cost basis, and risk basis of the estimate? Does the design basis clearly document the scope of the project, and have all engineering deliverables used in developing the estimate been identified? Have all scope assumptions been acknowledged? Is the planning basis (schedule, resource plan, construction plan, etc.) rea- sonable? Is the basis of cost (material prices, labor rates, labor productivities) reasonable, in line with expectations, and con- sistently applied throughout the estimate? Has the risk basis been clearly defined, and is it reasonable for the level of infor- mation available to prepare the estimate? Estimating Personnel Used Next, you will want to know who prepared the estimate, and what their level of estimating experience is. Do they have established estimating procedures and guidelines? Was the estimate checked and reviewed before publication? Estimating Methodology and Procedures What estimating methods, techniques and procedures were used in preparing the estimate? Are they appropriate for the level of information available and project type? Were differ- ent estimating methods used for different parts of the esti- mate? Is the level of detail in the estimate sufficient for the purpose of the estimate? Were parts of the project difficult to estimate, and why? Was sufficient time available to prepare the estimate? What adjustments were made to the estimate for location, complexity, etc., and are they reasonable? Was the estimate prepared utilizing a code of account structure? Estimate Documentation Is the estimate documented clearly? Are the estimate sum- mary and detail pages well-organized and presented at an appropriate level of detail? Is every cost appearing on the estimate summary traceable to the estimate detail and other estimate backup? 9.31 AACE INTERNATIONAL ESTIMATING
- 133. Estimate Validation Hopefully, the estimate for review will include a metrics report showing key estimating metrics and benchmark ratios for the estimate and similar past projects. You should review this report and question any significant differences. You should also have your own set of metrics and statistics from your own project history to compare against. At this point, you may also develop your own quick-check estimate (using conceptual estimating techniques) for com- parison purposes. This is always a good technique to see if the estimate being reviewed is reasonable. If there is a signif- icant difference, then question the estimator and listen to their explanations and opinions for the deltas. Significant dif- ferences between the check estimate and the estimate being reviewed may indicate the need for taking a more thorough examination of the estimate detail. Estimate Detail If the preceding inquiry (or should we say interrogation) has gone well, and you are confident that the estimate appears to have been prepared in a professional manner, you are ready to delve into some of the estimate details to verify estimate quality. The goal is to check that selected areas of the estimate can withstand further scrutiny. The key here is to not get too deep into the details and lose sight of the forest for the trees. An important point to remember here is the “80/20 rule.”This principle generalizes that 80 percent of the cost will come from 20 percent of the estimate line items. For any particular estimate, the significant cost drivers may vary. Sometimes, the main cost driver may be a particular process unit of the project; other times it may be the type of process equipment or machinery throughout the project; and still other times it may be the overall bulk material quantities or labor hours. You should examine the estimate summary and detail pages closely to ascertain which aspects of the estimate you may want to examine in closer detail. Basically, you should examine in detail those items of the estimate that will have the most significant cost impact if estimated incorrectly. One review technique that is often employed is to thorough- ly examine and review the estimating steps that were used for a particular part of the estimate. Select an area of the esti- mate, and ask how the quantities were derived. Don’t just take their word for it, however. Ask the estimators to show you the drawings from which the quantities were generated. Perform a quick takeoff to see if the quantities can be verified. Ask what the basis was for the unit material price and labor workhours. Have these been consistent throughout the esti- mate? What adjustments were made and why? If the answers to your questions are evasive, it may call into question the credibility of the entire estimate, and a more thorough review of the complete estimate may be necessary. If your questions are answered confidently, and the answers can be verified against the engineering deliverables and scope information, then you may decide to check the rest of the estimate details in a more cursory fashion. Typically in this situation, once you have shown the where- withal to compel the estimator to back up any claims or explanations, then he discovers he can’t just “pull the wool over your eyes.” From that point forward, you will usually find that you are getting honest answers to your questions. The goal of an estimate is to predict the probable cost of a project. The goal of an estimate review is to determine that a high quality and sufficiently accurate estimate has been pre- pared. The review should ensure that the proper estimating methods, procedures, techniques, data, and guidelines have been employed in the preparation of the estimate. The use of a structured estimate review cycle and estimating review techniques will help to ensure that quality estimates are con- sistently prepared which effectively support the decision- making process by management. PRESENTING THE ESTIMATE The method in which you present an estimate to your customer (internal company management or external client) is extremely important. An estimate should never be presented as just a list of numbers, or estimating calculations. A number (or even a range of numbers) is meaningless without the supporting information that describes what the number represents, and, sometimes even more importantly, what it doesn’t represent. In general, a complete estimate report will include the following: • basis of estimate (BOE), • estimate summaries, • dstimate detail, • estimate benchmarking report, • estimate reconciliation report, and • estimate backup. We have previously talked about the BOE in the prior dis- cussion on estimate reviews. This is a critically important document in describing the scope that is represented by the estimated cost and in conveying all the assumptions that have been embedded into the estimate. A well-written BOE document can go a long ways towards providing confidence in the estimate itself. Typically, various estimate summaries may be prepared according to the project WBS. For example, one estimate summary may be prepared by project area, and then broken down by process system, while another summary may be prepared by process system and then broken into project areas within each process system. The various parties inter- ested in the estimate will all have different ways in which they want to see the estimate summarized, depending on the 9.32 ESTIMATING AACE INTERNATIONAL
- 134. classification and end-use of the estimate being prepared. It is very important that every value appearing on an estimate summary be easily tracked back to the estimate detail. The Estimate Detail typically shows all of the individual cost estimating relationships (CERs) used in preparing the esti- mate. For a conceptual estimate, it may be a page or less of calculations; however, for a large detailed estimate it may include hundreds of pages of individual line items. This report is also prepared according to the project WBS, and may be provided in a variety of different sort options. An estimate benchmarking report will often be included. It should show benchmark information and metrics with other similar projects. For example, for a building estimate, this report may show the cost per square meter of building area ($/m2) compared to recent similar projects. The key bench- mark metrics and ratios presented may include the following items: • project administration costs as percent of total project cost, • engineering costs as percent of total project cost, • ratio of equipment cost to total project cost, • construction labor as percent of total field cost, • total field costs as percent of total project cost, • project cost per unit of capacity, and • average composite crew rate by trade. An estimate reconciliation report should also be prepared that reconciles the current estimate with any previous esti- mates prepared for the same project. This report should iden- tify the cost differences dues to changes in scope, changes in pricing, changes in risk, etc. Lastly, all estimate backup should be compiled and available. This information may not need to be presented to the esti- mate customer, but should be available if questions arise. This will include all notes, documentation, drawings, engi- neering deliverables, and vendor quotes, etc., that were used in preparation of the estimate. ESTIMATING RESOURCES Reliable estimate preparation depends on information. Besides the engineering and design information needed to quantify the scope of the project, other information is also required, such as • conceptual estimating factors; • material cost and pricing information; • labor workhour charts and information; • labor productivity information; • labor wage rates, composite crew mixes, etc.; and • other estimating factors and information. Successful estimators will rely on a myriad of resources to obtain this information. Estimating guideline and procedure manuals will be used to promote standard estimating meth- ods and procedures. In-house cost history manuals will pro- vide historical cost data for completed projects. Special cost studies may have been developed to serve as resources for particular estimating applications, such as special scaffolding studies, concrete placement studies, labor productivity stud- ies, etc. Engineering and design manuals and specifications will be used to identify the specific materials of construction, and all related labor operations required to complete the scope of work. Every completed project should be documented by a final job report covering everything about a project from design considerations to construction execution strategy to cost summaries. Selected data should from the final job reports should be collected and stored in a computerized database and made available to all estimators. Estimators continually rely on past project information and cost data in the prepa- ration of new estimates. Collections of labor charts will typically provide standard labor workhour units by task. These are generally normal- ized for location and time and serve as a base for estimate preparation, and then are adjusted for specific project requirements. They will often be supplemented by commer- cial estimating database publications. In-house and commer- cial material cost databases and publications will also be needed. Current wage rate information should be main- tained, including union agreements, for all locations the esti- mator may be involved with. A library of vendor catalogs should also be maintained. Many of these are now available on the Internet. These may provide technical information, pricing information, and other data required by an estimator. There are hundreds of sources published every year that con- tain useful information for an estimator. This includes AACE publications: (Recommended Standards and Practices, Professional Practice Guides, Cost Engineering Magazine, etc.), as well as publications from other professional organizations and commercial sources. Estimating software is another important resource. Estimating software can enhance the accuracy and consisten- cy of estimates, while reducing the time required to prepare estimates. The software may be commercial estimating soft- ware or be developed in-house. When using the cost data- bases supplied with commercial estimating software, it is always important to calibrate the data to your specific needs and estimating situations. Estimating software should also be regarded as simply a tool to facilitate the preparation of esti- mates by estimators. Estimating software can’t convert a non- estimator into an estimator. 9.33 AACE INTERNATIONAL ESTIMATING
- 135. All of the resources described above serve to help the most important resource to successful estimating—well trained and experienced estimators. Estimating is a profession requiring an ongoing commitment to training and development. CONCLUSION As potential projects are considered as investment opportu- nities, management will require various estimates to support key decision points. At each of these points, the level of engi- neering and technical information available to prepare the estimate will change. Accordingly, the techniques and meth- ods to prepare the estimates will also vary. The basic estimat- ing techniques are well established, and this chapter has been intended to review the estimating process and relevant esti- mating methodologies for the various types of estimates. The determination of using a conceptual approach versus a detailed approach will depend on many factors: the end use of the estimate, the amount of time and money available to prepare the estimate, the estimating tools available, and the previous historical information available. A conceptual esti- mating approach (capacity factored, equipment factored, parametric) requires a significant effort in data-gathering and methods development before estimate preparation ever begins. In contrast, a detailed estimating approach requires a large effort during the actual preparation of the estimate. With either approach, the challenge for the estimator is to evaluate the unique combination of required material and labor resources in order to prepare a cost estimate for a proj- ect to be completed in the future. The use of structured esti- mating techniques and tools, high-quality engineering deliv- erables, and good historical data and pricing information, combined with estimating skill and experience, will assure that the best possible estimate is prepared. The desired end result is to prepare estimates that are well-documented, con- sistent, reliable, appropriate, accurate, and that support the decision-making process for the project. Estimating is obviously a vital component to project success. Estimates are used not only to establish project budgets, but also to provide accurate information to support scheduling, cost monitoring, and progress measurement of a project dur- ing execution. Estimating is, thus, but one component to total cost management—the integration of cost engineering and cost management principles used in managing the total life cycle cost investment in strategic assets. REFERENCES 1. AACE International. Recommended Practice for Cost Estimate Classification. 17-R-97. Morgantown, West Virginia. 2. AACE International. Recommended Practice for Cost Estimate Classification—As Applied in Engineering, Procurement, and Construction for the Process Industries 18-R-97. Morgantown, West Virginia. 3. Black, Dr. J. H. 1984. “Application of Parametric Estimating to Cost Engineering.” AACE Transactions. Morgantown, West Virginia: AACE International. 4. Chilton, C. H. 1950. “Six-Tenths Factor Applies to Complete Plant Costs,” Chemical Engineering. April. 5. Dysert, L. R. 1999. “Developing a Parametric Model for Estimating Process Control Costs.” AACE Transactions, Morgantown, West Virginia: AACE International. 6. Dysert, L. R. and Elliott, B. G. 2000. “The Estimate Review and Validation Process.” AACE Transactions, AACE International, 2000 7. Dysert, L. R. and Elliott, B. G. 1999. “The Organization of an Estimating Department.” AACE Transactions. Morgantown, West Virginia: AACE International. 8. Guthrie, K. M. 1969. “Data and Techniques for Preliminary Capital Cost Estimating.”Chemical Engineering. March. 9. Guthrie, K. M. 1970. “Capital and Operating Costs for 54 Chemical Processes.” Chemical Engineering. June. 10. Hand, W. E. 1964. “Estimating Capital Costs from Process Flow Sheets.” Cost Engineer’s Notebook. Morgantown, West Virginia: AACE International. January. 11. Lang, H. J. 1947. “Cost Relationships in Preliminary Cost Estimation.” Chemical Engineering. October. 12. Lang, H. J. 1948. “Simplified Approach to Preliminary Cost Estimates.” Chemical Engineering. June. 13. Miller, C. A. 1965. “New Cost Factors Give Quick Accurate Estimates.” Chemical Engineering. September. 14. Miller, C. A. 1978. “Capital Cost Estimating – A Science Rather than an Art.” Cost Engineer’s Notebook. Morgantown, West Virginia: AACE International. 15. NASA. Parametric Cost Estimating Handbook. 16. Nishimura, M. 1995. Composite-Factored Engineering. AACE Transactions. Morgantown, West Virginia: AACE International. 17. Querns, Wesley R. 1989. “What is Contingency, Anyways?” AACE Transactions. Morgantown, West Virginia: AACE International. 18. Rodl, R. H., P. Prinzing, and D. Aichert. 1985. Cost Estimating for Chemical Plants. AACE Transactions. Morgantown, West Virginia: AACE International. 19. Rose, A. 1982. “An Organized Approach to Parametric Estimating.” Transactions of the Seventh International Cost Engineering Congress. 9.34 ESTIMATING AACE INTERNATIONAL
- 136. 20. Williams, R., Jr. 1947. “Six-Tenths Factor Aids in Approximating Costs.” Chemical Engineering. December. 21. Woodward, Charles P., and Mark T. Chen. 2002. “Cost Estimating Basics.” Skills and Knowledge of a Cost Engineer. 4th Edition. Morgantown, West Virginia: AACE International. 22. Woodward, Charles P., and Mark T. Chen. 2002. “Order- of-Magnitude Estimating.” Skills and Knowledge of Cost Engineering. 4th Edition. Morgantown, West Virginia: AACE International. 23. Woodward, Charles P., and Mark T. Chen. 2002. “Definitive Estimating.” Skills and Knowledge of Cost Engineering. 4th Edition. Morgantown, West Virginia: AACE International. 9.35 AACE INTERNATIONAL ESTIMATING
- 138. INTRODUCTION To perform an operating or manufacturing cost estimate properly, and to determine the potential profitability of a process, all costs must be considered in certain specific cate- gories. The distinction between the various categories is quite important, as they are treated differently for purposes of cal- culating taxes and profitability. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • understand how to determine the operating and manu- facturing costs of a continuous process on a conceptual basis, • distinguish between direct and indirect costs in manu- facturing as compared to construction, • relate operating costs at full production to reduced costs at less than full plant capacity, and • understand depreciation rules and their relationship to operating and manufacturing costs. TYPES OF OPERATING COST ESTIMATES AND ESTIMATING FORMS As is true for a capital cost estimate, the purpose of an oper- ating cost estimate is the controlling factor in determining the type of estimate to be performed. Preliminary or order-of- magnitude estimates are often used to screen projects and to eliminate uneconomical alternatives. More detailed estimates are then applied when the screening process has reduced the choice to a relatively few alternatives. In performing the operating cost estimate, particularly on a preliminary basis, good judgment is necessary to avoid excessive attention to minor items, which, even if severely over- or underestimated, will not have a significant effect on the overall estimate. In performing the operating cost estimate, it is also necessary to calculate costs at reduced production rates as well as at design capacity. Operating costs are decidedly nonlinear with respect to production rate. This fact and the fact that virtually no plant or process oper- ates all of the time at full design production rate make it imperative that reduced production rates be considered. This subject is discussed in considerable detail later in this chapter. Finally, when estimating the effect of changes or additions to an existing process, the cost analysis should be performed on an incremental basis to evaluate the effect of the change as well as on an overall basis to determine if the entire project is wor- thy of being continued even without the change. Frequently a process change will not be economical, but the total project will be attractive. In other cases, the incremental costs of a change will appear to be quite profitable, but this profit will not be enough to offset losses entailed in the existing portion of the plant. Thus both types of analyses must be made. Operating cost estimates can be performed on a daily, unit- of-production, or annual basis. Of these, the annual basis is preferred for the following reasons: • It “damps out” seasonal variations. • It considers equipment operating time. • It is readily adapted to less-than-full capacity operation. • It readily includes the effect of periodic large costs (scheduled maintenance, vacation shutdowns, catalyst changes, etc). • It is directly usable in profitability analysis. • It is readily convertible to the other bases, daily cost and unit-of-production, yielding mean annual figures rather 10.1 Chapter 10 Process Product Manufacturing1 Dr. Kenneth K. Humphreys, PE CCE AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING 1 Excerpted by permission from Humphreys, K. K., and P. Wellman. 1996. Basic Cost Engineering. 3rd ed.New York: Marcel Dekker, Inc.
- 139. 10.2 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Figure 10.1—Typical Production Cost Estimating Form Date By Location: Product(s): Capital Investment: Process: Total Nelson Index CE Index Less working capital M&S Index Annual Operating Less salvage value ENR Index Days Depreciable investment Annual production: Raw Materials Annual quantity Unit cost $/year $/ (1) (2) (3) (4) (5) Gross raw material cost (sum of lines 1 to 4): Misc. credits and debits (6) (7) (8) (9) Total debit (credit) (sum of lines 6 to 8): (10) Net raw material cost (lines 5 + line 9): Direct expense Unit Quantity Unit cost $/year $/ (11) Steam M lb (12) Water ( ) M gal (13) Water ( ) M gal (14) Electricity kW-hr (15) Fuel ( ) (16) Fuel ( ) (17) Labor (18) Supervision (19) Maintenance (20) Factory supplies (21) Indirect overhead (22) Payroll overhead (23) Laboratory (24) Contingencies (25) Total direct conversion cost (sum of lines 11 to 24): Indirect expense (26) Depreciation (27) Real estate taxes & insurance (28) Depletion allowances (29) Amortization (30) Total indirect conversion cost (sum of lines 26 to 29): (31) Total conversion cost (line 25 + line 30): (32) Total operating cost (line 31 + line 10: (33) Packing and shipping expense (34) TOTAL COST FOR PLANT (line 32 + line 33):
- 140. than a potentially high or low figure for an arbitrarily selected time of year. A basic flowsheet of the process is vital to preparation of an estimate. This flowsheet should detail to the maximum extent possible the quantity, composition, temperature, and pressure of the input and output streams to each process unit. In addition, to properly prepare an operating or manufactur- ing cost estimate, a prepared estimating form should be used to assure that the estimate is performed in a consistent man- ner and to avoid omitting major items. Figure 10.1 is an example of a suitable form for this purpose. The estimating form acts as a checklist and as a device for cost recording and control. It must include the date of the estimate; the capital investment information, which was pre- viously determined; an appropriate cost index value reflect- ing the date of the capital cost estimate; the plant location; the plant design capacity; the annual anticipated plant operating days and/or annual production rate; and the plant or product identification. In any event, if a form is not used, the cost engineer should be equipped with a checklist and should be familiar with the technical aspects of the process. An estimate should never be made without specific technical knowledge of the process. Last, wherever possible, cost data used in the estimate should be obtained from company records of similar or identical projects (with adjustment for inflation, plant site differences, and geography). For preliminary estimates, company records are probably the most accurate available source of cost data. If not available from company records, cost data also may be obtained from literature sources. Bear in mind, however, that such data are not always reliable. Published information must always be used with care. It is often inadequately explained and frequently is improperly dated. Date of publi- cation is meaningless, because the data may be months or years old and may require adjustment to current cost levels. Too often it seems that in the rush to complete an estimate, people will grasp any number they can find without fully understanding how it was derived, or what it represents. COST OF OPERATIONS AT LESS THAN FULL CAPACITY The preceding discussion emphasized the necessity of per- forming operating and manufacturing cost estimates both at full plant capacity and at conditions other than full capacity. Frequently, the inexperienced estimator will perform an esti- mate assuming operations only at full design capacity. This approach is totally erroneous as it does not consider unscheduled downtime, market fluctuations in product demand, time required to develop markets for a new prod- uct, and so forth. Figure 10.2 on page 10.4 is an illustration of cost effects of oper- ation at less than full capacity. This figure takes into account the fixed, variable, and semivariable costs discussed earlier. Semivariable costs, those which are partially proportional to production level, may include, among others, the following: • direct labor, • supervision, • general expense, and • plant overhead. Other costs that may be semivariable, depending upon indi- vidual circumstances, are royalties and packaging. Packaging may be either variable or semivariable depending upon the particular situation. Royalties may be variable, semivariable, fixed, or even a cap- ital expense. Thus they must be carefully examined to be cer- tain that they are included in the proper cost category. A roy- alty fee that is paid in a lump sum should be capitalized. Royalties that are paid in equal annual increments are treat- ed as fixed costs. Those paid as a fee per unit of production or sales are variable costs, and those that are paid in a sliding scale (ie, at a rate per unit of production that declines as pro- duction increases) are semivariable. In certain cases, royalty agreements may contain elements of more than one cost cat- egory—for example, an annual fee (fixed) plus a charge per unit of production (variable). Fixed-cost items, in addition to royalties if applicable, include the following: • depreciation, • property taxes, and • insurance. Variable costs generally include the following: • raw materials, • utilities, 10.3 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING GLOSSARY TERMS IN THIS CHAPTER direct cost ◆ fixed cost ◆ contingency distribution cost ◆ general and administrative expenses general works expense ◆ indirect cost ◆ manufacturing cost operating cost ◆ semivariable cost ◆ variable cost
- 141. • royalties (if applicable), • packaging (if applicable), • marketing, and • catalysts and chemicals. Figure 10.2 graphically demonstrates the implications of operating at less than full capacity. In this figure, at 100 per- cent of capacity, the following apply: • F is the fixed expense; • V is the variable expense; • R is the semivariable expense; • C is total operating cost; • S is sales income; and • N is the income required to achieve the minimum accept- able return on investment before taxes (P) for the capital investment (I). As can be seen from the figure, the variable expense declines to zero at 0 percent of capacity, fixed expense is constant, and semivariable expense declines at 0 percent of capacity to from 20 to 40 percent of its value at full capacity. This simple plot is used to determine the following: • the minimum production rate at which the desired return on investment will be achieved (C); • the breakeven point, or that point at which income will exactly equal total operating cost (B); and • the shutdown point, or that point at which it is advisable to shut down the plant rather than operating at lower production rates (A). The plot readily identifies the range of production rates at which the following apply: • the return on investment will equal or exceed the desired minimum (all production rates ≥ C); • the return on investment will be less than the desired value but will be greater than zero (production rates < C but > B); • the process will result in a loss, but losses will be mini- mized by continuing to operate the plant rather than shutting it down (production rates ≤ B but > A); and • losses will become so large that it is less expensive to close the plant and pay fixed expenses out of pocket rather than to continue operations (production rates ≤ A). The breakeven and shutdown points can also be determined mathematically as follows: B (breakeven point) = (F + nR) (equation 10.1) S - V - (1 - n)R A (shutdown point) = nR (equation 10.2) S - V - (1 - n)R 10.4 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Figure 10.2—Cost Effects of Operations at Less Than Full Plant Capacity DOLLARS/YEAR PRODUCTION RATE/YEAR, % CAPACITY Gross Return Sales Total Cost Fixed Expense Semivariable Expense Variable Expense 100% CAPACITY 0% CAPACITY SHUTDOWN POINT (A) BREAKEVEN POINT (B) MINIMUM RETURN POINT (C) 0.2 to o.4 R F F R V C N S
- 142. where n = decimal fraction of semivariable costs incurred at 0 production (usually about 0.3) Similarly, the total cost line can be expressed as Cp = [V + (1 - n)R]p + F + nR (equation 10.3) where Cp = total cost at production rate p p = actual annual production rate as a fraction of plant capacity Since total annual sales are proportional to production (assuming no stock-piling of production), and, therefore, have no value at zero output, the equation for the sales line is Sp = (S x p) (equation 10.4) where Sp = sales income at production rate p. The point at which the sales and total cost lines cross is the breakeven point for the plant and is equal to the level of out- put at which sales is equal to total cost. RAW MATERIALS COSTS Depending upon the particular process, raw materials costs can constitute a major portion of operating costs. For this rea- son, a complete list of all raw materials must be developed using the process flowsheet as a guide. In developing the raw materials list, the following information must be obtained for each raw material: • units of purchase (tons, pounds, etc), • unit cost, • available sources of the material, • quantity required per unit of time and/or unit of pro- duction, and • quality of raw materials (concentration, acceptable impurity levels, etc.). In estimating the quantity of each raw material, appropriate allowance must be made for losses in handling and storage, process waste, and process yield. Price data for purchased raw materials are generally available to a high level of accuracy from many sources. Purchased price information can generally be obtained from the suppliers. Alternatively, supplier catalogs and price lists can be used, as can published data. The Wall Street Journal, European Chemical News, and similar trade and business publications are all good sources of spot data. In estimating the cost of any raw material it must be remem- bered that, in general, raw material costs vary with quality (concentration, surface finish of metals, impurities, etc) and generally decrease in unit cost as quantity increases. There is little sense, for example, in relying on a cost figure for reagent-grade hydrochloric acid in 5-lb bottles when the process can utilize much lower cost commercial-grade hydrochloric acid (muriatic) in tank car or tank truck lots. Another major factor to be considered is availability of the raw material. Does sufficient productive capacity exist such that the market can supply the demands of the proposed process? A sudden large new demand for a raw material can, and often does, cause substantial price increases, particularly if the material is available only in small quantities or as a by- product of another process. In pricing raw materials, it must also be remembered that the prices are generally negotiated and that the discounts obtained can result in prices substantially less than quoted or published data. Where available, company experience in negotiating supply orders for the same or similar materials should be used to estimate the amount of any such probable discounts. A common pitfall in operating and manufacturing cost esti- mates is to neglect the cost of raw materials manufactured or obtained in-house or from another company division because they are not purchased. Such raw materials, however, do rep- resent a cost to the company and do have value. In the estimate, therefore, they should be included as a cost at their market value or company book value. The market value to be used is the going market price corrected for any direct sales costs which are not incurred due to internal use. In addition, internal company freight, handling, and transfer costs must be added. If the captive raw material is an intermediate product that has no established market price, the cost should be based upon the value of the nearest downstream product or mate- rial for which an established market price exists. The cost is equal to the value of the downstream product less direct sales costs not incurred plus internal company transfer costs less manufacturing costs for operations avoided by using the intermediate product instead of processing it further. Other raw materials cost items that are easily overlooked are fuels that are used as raw materials (eg, natural gas in methane conversion processes) and periodic makeup of loss- es to catalysts and other processing materials. In the case of catalysts and similar materials, the initial fill of such items is usually treated as a capital expense if its useful life exceeds one year. Otherwise it is considered as a start-up expense. Fuels that are used as a raw material should be treated in the same manner as any other raw material. Those which are used for utility purposes should be treated as a utility cost. 10.5 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING
- 143. Finally, in estimating raw materials costs, it must be recog- nized that prices are usually quoted FOB the supplier’s plant or basing point, not at the point of use. Thus freight to the point of use and local handling costs must be added to the quoted prices. Current freight tariffs for each commodity should be checked when preparing the estimate since they are complex and often illogical and cannot be generalized. BY-PRODUCT CREDITS AND DEBITS All process by-products, including wastes and pollutants, must be considered in the operating cost estimate. Thus, every output stream shown on the process flowsheet must have a cost assigned to it. Obviously, these costs may be cred- its (in the case of salable or usable by-products) or debits (in the case of wastes or unsalable by-products). Items that are not immediately obvious as by-products are nuisance expenses. No longer can a plant discharge pollution at will into the air or water nor can high noise levels, thermal discharges, odors, etc remain unabated. These are all by- products, albeit undesirable ones, and the cost of treating them must be included in the estimate—either in the overall process costs or as a by-product debit. Similarly, the capital cost estimate must include the costs of associated pollution and nuisane abatement equipment. Nuisance costs also are not confined to things that leave or are discharged from the plant. In many cases, nuisances that are entirely confined to the plant premises (eg, high noise lev- els) must be eliminated due to safety and employer liability considerations. Salable by-products have values, which can be established in the same manner as determining the cost of raw materials. The by-product credit then may be estimated from the mar- ket prices or anticipated selling prices of the by-products less any costs of processing, packaging, selling and transporting them to market. In many cases it is necessary to do a com- plete capital and operating cost estimate on the by-product processing facilities in order to determine the latter costs. If the by-product is not sold but instead is converted to another salable product, it is valued at the market value of the subsequent product less the associated conversion and transfer costs. Wastes similarly carry the negative value asso- ciated with their treatment and disposal. Again, it may be necessary to perform another complete capital and operating cost estimate to determine these costs. Credits should be taken for by-products with great care. Many processes have been economic failures because assumed by-product credits were not realized. In many cases, the production of a by-product can glut its market, particu- larly if the current market is a small one. Similarly, introduc- tion of the by-product into competition with other materials can depress prices due to competitive pressures. A notable example of this type of situation is the sulfur mar- ket. In the mid-1960s sulfur was in short supply and carried an inflated price. At that time, many estimates were being made on pollution control devices and systems that would produce sulfur as a by-product and were justified on the basis of the high by-product credits for sulfur. However, due to improved methods of sulfur production and the addition- al sulfur being produced as a by-product, in a very short peri- od of time, the market for sulfur and sulfur products such as sulfuric acid changed to a state of oversupply and depressed prices. As a result, many supposedly profitable processes actually became uneconomical. UTILITY COSTS The estimation of utility costs, particularly in light of rapidly increasing energy costs, is another critical area of operating cost estimation. In estimating utility costs, it is necessary first to determine the requirements for each utility including a reasonable allowance for nonproduction items, such as plant lighting, sanitary water, etc. An allowance should also be made for miscellaneous usage and contingencies. Table 10.1 is a typical utility summary of the nature that is required. In addition to the utility summary, consumption patterns should be examined to determine if consumption will be at a uniform rate during each day and from day to day. If con- sumption rates fluctuate, utility pricing may be based not only on total consumption, but also in the peak demand rate and, in some cases, the time of day in which the peak occurs. A further consideration is whether or not the utility must be available on a noninterruptable basis. If the process has an alternate utility source or can tolerate periodic cutbacks in utility supplies, rates may be available that are somewhat lower in cost than noninterruptable rates. The estimate also should consider the fact that in certain areas, noninterrupt- able rates are not available and electric power, natural gas, etc., can be curtailed by the utility companies at any time if residential demands exceed available supplies. In these situ- ations both the capital and operating cost estimates must consider standby alternative utility sources, such as emer- gency power generators or combustion units that can operate on alternate fuels, etc. In general, utility costs decrease as demand increases (although there is a growing tendency toward national and state policies to increase unit cost with quantity artificially in order to encourage reductions in consumption). 10.6 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL
- 144. Electric power charges are usually based upon a demand fac- tor—the maximum power draw during a 15- to 30-min peri- od in any given month. A load factor is computed as the ratio of average usage to the demand factor and rates are estab- lished to give preference to high load factors (i.e., steady con- sumption). The rate schedules also generally include an esca- lation factor, which is tied to increases in fuel costs. Electric rates in the past were remarkably stable for many, many years, and it was common estimating practice to arbi- trarily assume a cost of the order of a cent or two per kW-hr for preliminary estimating purposes. This is no longer true, and no generalization can be made about electric rates. The estimator must obtain current rates from the utility compa- nies serving the proposed plant and can no longer safely assume any “rule-of-thumb” figure for power costs. If the power is not purchased and instead is obtained from a cap- tive company-owned generating system, utility costs must be based upon a study of the system itself. Natural gas prices depend on quantity required. Steam costs are dependent upon many factors, including pressure, cost of fuel, temperature, credit for heating value of condensate, etc. If company data are not available on steam cost, it must be estimated taking into account fuel cost, boiler water treat- ment, operating labor, depreciation on investment, mainte- nance, and other related costs of steam production. Black [1] has suggested that steam costs can be approximated as 2 to 3 times the cost of fuel. Water costs are highly variable depending upon the water quality needed and the quantity required. Purification costs, if contamination occurs before disposal, must also be includ- ed, as must cooling costs if the process results in heating of process water. In most jurisdictions, water may not be dis- charged into streams or the natural water table unless it is equal or better in quality and temperature as when it was withdrawn from the stream. Fuel costs vary with the type of fuel used, the Btu value of the fuel, and the source of supply. Careful consideration should be given in the estimate not only to fuel cost but to the type of firing equipment required and to required fuel storage facilities. Often these factors can rule out what would other- wise be the least expensive available fuel. Another factor to be considered is that, as mentioned earlier in this chapter, certain fuels, although lower in cost than alter- native fuels, may not be available in sufficient quantities, if at all. In some cases, a fuel may be abundant in warm weather but in short supply during the heating season, necessitating use of alternate fuel supplies or planned production cutbacks or stoppages during periods of severe winter weather. In estimating utility requirements, equipment, efficiency losses, and contingencies must be considered. Utility con- sumption generally is not proportional to production due to economies of scale and reduced energy losses per unit of vol- ume or production on larger process units. Black [1] has sug- gested that utility consumption varies to the 0.9 power of capacity, rather than in direct proportion to capacity. Last, while not normally thought of as a utility, cost of motor fuels and greases for all mobile equipment must be estimated. Fuel costs are based upon annual operating hours for each piece of equipment times fuel consumption per hour, times the 10.7 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Table 10.1—Typical Utility Summary Power (kWh/hr) 1,830 1,920 18,550 4,050 26,350 400 300 150 150 150 27,500 Water required (gpm) 1,000 38,650 1,330 40,980 500 300 520 42,300 Mine Crushing plant Concentrating plant Pelletizing plant Subtotal: Utilities: Makeup water Plant lighting Sanitary water General facilities Miscellaneous and contingencies Total: Water recovery and makeup (gpm) 36,720 36,720 5,580 42,300
- 145. prevailing cost for the fuel to be used. Greases and lubricant costs are directly related to fuel costs, and amount to approxi- mately 16 percent of the fuel cost for most types of equipment. LABOR COSTS Labor costs, particularly in a labor-intensive process, may be the dominant cost factor in an operating or manufacturing cost estimate. To properly estimate these costs, a staffing table must be established in as detailed a manner as possible. This table should indicate the following: 1. the particular skill or craft required in each operation, 2. labor rates for the various types of operations, 3. supervision required for each process step, and 4. overhead personnel required. It is not always possible to determine the extent of supervi- sion and overhead personnel required. In such cases, alter- nate methods of estimating these costs may be used as dis- cussed later in this book. However, if sufficient data are avail- able, these factors should be included in the staffing table for maximum estimate accuracy. Table 10.2 is a typical staffing table for a complete estimate. This table illustrates the detail required in a complete staffing table. Note that the table includes general and administrative personnel, production workers, maintenance workers, and direct supervision. Once the staffing table is developed (at a minimum including all direct production labor), labor costs can readily be esti- mated from company records of wages and salaries by posi- tion, union wage scales, salary surveys of various crafts and professions, or other published sources. Because labor rates are prone to rapid inflation, often at rates sharply different from general inflation rates, care must be taken to obtain cur- rent figures and to properly project future wage rates. Generally, data on wage rates includes shift differentials and overtime premiums. If not, these factors must be added to the extent applicable. Further, when estimating around-the-clock, 168-hr/wk oper- ations, allowance must be made for the fact that a week includes 4.2 standard 40-hr weeks. Even with four work crews on “swing shift,” one crew must work 8 hr/week of overtime to keep the plant in steady operation. Depending upon local custom, laws, and union contracts, this overtime is generally payable at 1.5 to 3 times the normal hourly rate. An alternate method of calculating labor requirements, if suf- ficient data are not available to establish a staffing table, is to consider a correlation of labor in workhours per ton of prod- uct per processing step. This relationship, which was devel- oped by Wessell [6], relates labor requirements to plant capacity by the following equation: (equation 10.5) where t = 23 for batch operations with a maximum of labor, t = 17 for operations with average labor requirements, and t = 10 for well-instrumented continuous process opera- tions. As pointed out previously, the relationship between labor requirements and production rate is not usually a direct one. The Wessell equation recognizes that labor productivity gen- erally improves as plant throughput increases. It can also be used to extrapolate known workhour requirements from one plant to another of different capacity. Another shortcut method of estimating labor requirements, when requirements at one capacity are known, is to project labor requirements for other capacities to the 0.2 to 0.25 power of the capacity ratio. A significant factor to be considered in estimating labor costs is overtime. As mentioned earlier, around-the-clock, 24-hr/day, 7- day/week operations have an inherent overtime penalty of 8 hr/week. With this exception, and occasional overtime to cover for absent workers, overtime is usually not a major considera- tion in manufacturing and production operations. However, in estimates involving construction projects, or those which anticipate regular scheduled overtime, these costs can be substantial and must be carefully evaluated. Scheduled overtime over an extended period can result in substantial decreases in worker productivity resulting in a major cost penalty for productivity losses in addition to the higher direct costs of premium pay at 1.5, 2, or even 3 times normal hourly rates. Scheduled overtime involves a planned, continuing schedule for extended working hours for individual workers or even entire crews. It is not occasional overtime caused on an irreg- ular basis by absenteeism, equipment malfunctions, etc. Unfortunately, scheduled overtime rarely saves money or accelerates production. Two articles which appeared in the AACE Bulletin in 1973 [2, 5] amply illustrated this point. These articles, prepared by representatives of the Construction Users Anti-Inflation Roundtable (now the 10.8 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Operating workhours tons of product = t number of processing steps (capacity, tons/day)0.76
- 146. 10.9 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Table 10.2—Typical Complete Staffing Table
- 147. 10.10 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Table 10.2—Typical Complete Staffing Table (continued)
- 148. 10.11 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Table 10.2—Typical Complete Staffing Table (continued)
- 149. Business Roundtable), clearly demonstrated that scheduled overtime rarely, if ever, is beneficial, and that overtime should be avoided in favor of additional employees working normal shifts or partial shifts. Quoting from one article [5]: Studies indicate that when a job is placed on overtime there is a sharp drop in productivity during the first week with a substantial recovery which holds for about two weeks and is followed by a fairly steady decline. At the end of seven to nine weeks the produc- tivity on an overtime basis is no greater than the pro- ductivity would be on a 40-hour week. In this period there is an increase in work accomplished of about 12 percent. After seven to nine weeks of operation, pro- ductivity continues to decline and the work accom- plished is less than would have been accomplished on a 40 hour per week schedule. After 18 to 20 weeks there is no gain in total work accomplished . . . . SUPERVISION AND MAINTENANCE COSTS As discussed above, supervision costs should be established, if at all possible, through a staffing table and tabulation of associated costs. Unfortunately, for most preliminary estimates, particularly those for proposed new processes, this is not possible. In such cases, costs of supervision can be roughly estimated by taking a fixed percentage of direct labor costs based upon company experience. In the absence of prior data on similar operations, a factor of 15 to 20 percent is generally satisfactory. The validity of the latter factor can readily be seen when con- sidering the fact that one front-line supervisor can effectively manage no more than 8 to 10 workers, i.e., supervision work- hours of 0.100 to 0.125 per direct labor workhour. With front- line supervision (i.e., foremen or forewomen) at labor rates approximately 50 to 60 percent above general labor rates, 15 to 20 percent supervision factor is evident. Maintenance labor costs, like supervision costs, should be delineated in the labor staffing table if at all possible. However, other than company records of existing similar plants, reliable data on maintenance costs are generally not available, and the staffing table approach is usually not feasible. For this reason, maintenance costs are often estimated as a fixed percentage of depreciable capital investment per year. For complex plants and severe corrosive conditions, this factor can be 10 to 12 per- cent or higher. For simple plants with relatively mild, noncor- rosive conditions, 3 to 5 percent should be adequate. Maintenance costs are a semivariable category, which is gen- erally distributed about 50 percent to labor and 50 percent of materials. For a preliminary estimate, the various factors making up plant maintenance can be back calculated from the total maintenance number using the following approxi- mate percentages: • direct maintenance labor, 35 to 40 percent; • direct maintenance labor, supervision, 7 to 8 percent; • maintenance materials, 35 to 40 percent; and • contract maintenance, 18 to 20 percent. Then as the project evolves toward a final staffing plan, the factors can be improved and are finally replaced with num- bers generated from the staffing table. The back calculation allows one to estimate the number of people required early in 10.12 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Table 10.2—Typical Complete Staffing Table (continued)
- 150. the project. When operating at less than 100 percent of capac- ity, maintenance costs generally increase per unit of produc- tion. Such operations can be estimated as follows: Maintenance generally increases with age of equipment, although most estimates use an average figure to simplify the estimate. This apparent error is offset in the overall estimate by use of average or “straight-line” depreciation, whereas accelerated depreciation is in fact generally used for tax pur- poses. Figure 10.3 illustrates the validity of using an average maintenance figure over the life of a project. Finally, for major projects, it may be necessary to include costs for additional maintenance supervisors. However, for small plant additions, additional supervision is generally not required. OPERATING SUPPLIES AND OVERHEAD COSTS Generally, operating (or factory) supplies are a relatively minor cost of operations. Nevertheless, these must be includ- ed in the operating or manufacturing cost estimate. Such costs include miscellaneous items, such as lubricating oil, instru- ment charts, wiping cloths, etc. Lacking more detailed infor- mation, they may be estimated as a percentage of payroll. This percentage can range from a few percent to 20 percent or more, depending upon plant complexity and whether or not routine maintenance items and supplies are included or accounted for separately. For example, 6 percent of payroll is probably an adequate allowance for operating supplies in a coal preparation plant, while 20 percent is probably more rea- sonable for an oil refinery, a more complex operation requir- ing a cleaner environment. The best source of such costs, how- ever, is always company records of similar past projects. Overhead or burden costs are operating and manufacturing costs, which, while not directly proportional or related to production, are associated with payroll or general and administrative expense. Such costs, depending upon what they represent, are either semivariable or indirect costs. The major semivariable overhead costs are so-called payroll overheads. These are costs associated with employee “fringe benefits.” They include workers’ compensation, pensions, group insurance, paid vaca- tions and holidays, Social Security, unemployment taxes and benefits, profit-sharing programs, and a host of others. The extent of these costs varies markedly from industry to industry, and company records are the best measure of their magnitude. However, in the absence of company data, payroll overheads may be roughly estimated at 25 to 40 per- cent of direct labor plus supervision, plus mainte- nance labor costs for the U.S. For other countries this factor must be adjusted to suit local conditions. In heavily socialized nations, payroll overheads can exceed 100 percent of the basic labor costs. In addition, payroll overhead must be applied to indirect overhead (clerical, administrative, etc., personnel) if not previously included in cost esti- mates for this item. It must be noted that, if company data are used, care must be exerted to avoid including items in payroll overhead, which are, by accounting defini- tion of the company, included in general expense. Further, it should be recognized that in some industries, notably the U.S. and Canadian coal mining industry, a major portion of fringe benefits 10.13 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Maintenance cost as percentage Percent of capacity of cost at 100 percent capacity 100 100 75 85 50 75 0 30 Figure 10.3—Comparison of Maintenance and Depreciation Costs Over the Life of a Plant 0 20 PLANT LIFE, YEARS TOTAL COST, DEPRECIATION + MAINTENANCE ACCELERATED DEPRECIATION MAINTENANCE COST ANNUAL COST, $
- 151. is based upon royalties levied by the unions on production rather than being a function of labor costs. Such royalties are variable production costs and must be treated as such. The expense of operating company testing and research labo- ratories is another overhead expense which must be included in the estimate. Generally, such costs are indirect costs, although in the case of product laboratories they may be direct semivariable costs. Laboratory overhead is best estimated based upon company experience. Lacking suitable data, these costs can be estimat- ed as follows: • from workhours required plus associated overhead, • from literature sources, and • as a percentage of direct labor costs. If the last is used, laboratory overhead costs may range from 3 to 20 percent or more for complex processes. A suitable fig- ure for average situations might be 5 to 10 percent. ROYALTIES AND RENTALS As was discussed earlier in this chapter, royalties may be variable, semivariable, fixed, or capital costs (or a combina- tion of these), depending upon the conditions of the royalty agreement. The same is true of rental costs. Single-sum royalty, rental, or license payments are properly considered as capital investment items, whereas payments in proportion to production or fixed payments per annum are treated as direct operating costs. Royalty expenses, in the absence of data to the contrary, are treated as a direct expense and may be estimted at 1 to 5 per- cent of the product sales price. Due to the complexity of agreements for royalty payments and to variations in tax laws and accounting methods, extreme care should be exercised to be sure that such costs are properly included in the appropriate expense category. CONTINGENCIES As is true with a capital cost estimate, any operating or man- ufacturing cost estimate should include a contingency allowance to account for those costs that cannot readily be determined or defined or that are too small to estimate indi- vidually but may be significant in the aggregate. The contin- gency allowance applies both to direct and indirect costs and ranges from 1 to 5 percent (and more in some cases), depend- ing upon the uncertainty in the data used to prepare the esti- mate and the risk associated with the venture. Hackney [3] has suggested the following guidelines for con- tingency allowances in operating and manufacturing cost estimates: 1. installations similar to those currently used by the com- pany, for which standard costs are available—1 percent; 2. installations common to the industry, for which reliable data are available—2 percent; 3. novel installations that have been completely developed and tested—3 percent; and 4. novel installations that are in the development stage—5 percent. GENERAL WORKS EXPENSE General works expense or factory overhead represents the indirect cost of operating a plant or factory and is dependent upon both investment and labor. Black [1] suggested that fac- tory overhead be estimated by the sum of investment times an investment factor and labor times a labor factor. In this case, labor is defined as total annual cost of labor, including direct operating labor, repair and maintenance, and supervi- sion; and labor for loading, packaging, and shipping. Black’s suggested labor and investment factors for various industries are as follows: Alternately, for preliminary estimates, indirect overhead may be approximated at 40 to 60 percent of labor costs or 15 to 30 percent of direct costs. Humphreys [4] has suggested 55 per- cent of operating labor, supervision, and maintenance labor for the mineral industries. Again, these factors may be some- what higher outside the U.S. depending upon local customs and laws. It is important to note that indirect or factory overhead (gener- al works expense) does not include so-called general expense (i.e., marketing or sales cost) and administrative expense. 10.14 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Investment factor Labor factor Industry (% per year) (% per year) Heavy chemical plants (large-capacity) 1.5 45 Power plants 1.8 75 Electrochemical plants 2.5 45 Cement plants 3.0 50 Heavy chemical plants (small capacity) 4.0 45
- 152. DEPRECIATION Depreciation, while not a true operating cost, is considered to be an operating cost for tax purposes. It is customarily listed as a fixed, indirect cost. The purpose of depreciation is to allow a credit against oper- ating costs, and hence taxes, for the nonrecoverable capital expense of an investment. The basis for computation of depreciation is the total initial capital expense for tangible assets, including interest during construction and start-up expense. The depreciable portion of capital expense is equal to the total initial investment less working capital and salvage value as shown in Figure 10.1. In theory, working capital can be totally recovered at any time after the plant or process is shut down. Similarly, sal- vage value, the scrap or sales value of the process equipment at the end of its useful life, can, in theory, be recovered at any time after plant shutdown. Thus, the sunk and permanently lost capital is the total initial investment less working capital and salvage value (including land value). Through deprecia- tion, this sunk investment may be recovered as an operating expense over the useful life of the project. Unfortunately, the true useful life of a project generally does not correlate with the permissible depreciation period dictat- ed by tax laws. The U.S. Internal Revenue Service (IRS) estab- lishes criteria for useful life of various investments that must be observed in cost and tax calculations whether or not these criteria actually reflect the true projected life of the plant or process. Table 10.3 lists typical permissible depreciation peri- ods (the class life) for various plants and investments as approved by the IRS. In countries other than the U.S., local taxing authorities should be consulted to determine the per- missible life that can be used in depreciation calculations for any particular type of investment. Taxing authorities usually permit the use of any generally accepted method of depreciation calculation provided that it is applied in a consistent manner to all investments applica- ble to the plant or process being considered. Different depre- ciation techniques may not be applied to various portions of the total investment. Further, effective in 1981 in the U.S., a specialized system known as the accelerated cost recovery system (ACRS) was mandated by law. Subsequently, in 1986, the U.S. tax laws were revised again, and the ACRS system was replaced by a system called the modified accelerated cost recovery system (MACRS). Both systems are described later in this chapter. Most industrial firms utilize accelerated depreciation in their actual operating cost and tax calculations. Such techniques permit a major portion of the investment to be deducted from costs in the early years of the life of the plant, thus deferring taxes to the latest possible date. However, for the purpose of making preliminary operating and manufacturing cost estimates, straight-line depreciation is normally used even though the company may in fact use accelerated depreciation in its books. The reason for this apparent anomaly is, as explained in the previous discussion, that maintenance costs, which are known to increase with time, are generally assumed to be constant with time. As shown in Figure 10.3, accelerated depreciation increases with time. Assuming both to be con- stant (i.e., assuming straight-line depreciation), this general- ly results in offsetting errors, as the actual sum of the two fac- tors, for most plants, tends to be constant, or essentially con- stant, over the life of any given plant. To calculate straight-line depreciation, annual depreciation is simply made equal to the depreciable portion of the initial cap- ital investment divided by the depreciable life of the project. In the case of projects with components having different depreciable lives, each component may be depreciated sepa- rately, or the weighted average life may be used on the total depreciable investment. Mathematically, annual straight-line depreciation is equal to where Ds1 = annual straight-line depreciation, C = depreciable portion of capital investment, and Y = IRS-approved life, in years. There are many other acceptable depreciation techniques, of which the double-declining balance and sum-of-years-digits methods, both forms of accelerated depreciation, are the most commonly used. In the double-declining balance method, an annual deprecia- tion deduction is permitted on the undepreciated portion of the investment at a rate equal to twice the straight-line rate. For example, if an investment has an approved life of 5 years for depreciation purposes, the straight-line deduction is 20 percent of the original depreciable investment per year. Thus, the double-declining balance deduction is twice this rate, or 40 percent. 10.15 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Ds1 = (equation 10.6) C Y
- 153. 10.16 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Recovery periods (in years) Class GDS life (MACRS) ADS SPECIFIC DEPRECIABLE ASSETS USED IN ALL BUSINESS ACTIVITIES, EXCEPT AS NOTED: Office furniture, fixtures, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 . . . . . . . . . . . . . 7. . . . . . . . . . 10 Information system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5. . . . . . . . . . 5 Data handling equipment, except computers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5. . . . . . . . . . 6 Airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5. . . . . . . . . . 6 Automobiles, taxis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 . . . . . . . . . . . . . 5. . . . . . . . . . 5 Buses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 . . . . . . . . . . . . . 5. . . . . . . . . . 9 Light general purpose trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 . . . . . . . . . . . . . 5. . . . . . . . . . 5 Heavy general purpose trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5. . . . . . . . . . 6 Railroad cars and locomotives, except those owned by railroad transportation companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 . . . . . . . . . . . . . 7. . . . . . . . . . 15 Tractor units for use over-the-road . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 . . . . . . . . . . . . . 3. . . . . . . . . . 4 Trailers and trailer-mounted containers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5. . . . . . . . . . 6 Vessels, barges, tugs, and similar water transportation equipment, except those used in marine construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 . . . . . . . . . . . . .10 . . . . . . . . . . 18 Land improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 . . . . . . . . . . . . .15 . . . . . . . . . . 22 Industrial steam and electric generation and/or distribution systems . . . . . . . . . . .22 . . . . . . . . . . . . .15 . . . . . . . . . . 22 DEPRECIABLE ASSETS USED IN THE FOLLOWING ACTIVITIES: Agriculture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 . . . . . . . . . . . . . 7. . . . . . . . . . 10 Cotton ginning assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 . . . . . . . . . . . . . 7. . . . . . . . . . 12 Cattle, breeding, or dairy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 . . . . . . . . . . . . . 5. . . . . . . . . . 7 Any breeding or work horse that is 12 years old or less at the time it is placed in service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 . . . . . . . . . . . . . 7. . . . . . . . . . 10 Any breeding or work horse that is more than 12 years old at the time it is placed in service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 . . . . . . . . . . . . . 3. . . . . . . . . . 10 Any race horse that is more than 2 years old at the time it is placed in service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .None . . . . . . . . . . 3. . . . . . . . . . 12 Any horse that is more than 12 years old at the time it is placed in service and that is not a race horse, breeding horse, nor a work horse . . . . . . . . . .None . . . . . . . . . . 3. . . . . . . . . . 12 Any horse not described above . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .None . . . . . . . . . . 7. . . . . . . . . . 12 Hogs, breeding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 . . . . . . . . . . . . . 3. . . . . . . . . . 3 Sheep and goats, breeding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 . . . . . . . . . . . . . 5. . . . . . . . . . 5 Farm buildings except single-purpose agricultural or horticultural structures . . .25 . . . . . . . . . . . . .20 . . . . . . . . . . 25 Single-purpose agricultural or horticultural structures (GDS = 7 years before 1989) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 . . . . . . . . . . . . .10 . . . . . . . . . . 15 Mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 . . . . . . . . . . . . . 7. . . . . . . . . . 10 Offshore drilling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7.5 . . . . . . . . . . . . 5. . . . . . . . . . 7.5 Drilling of oil and gas wells . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 . . . . . . . . . . . . . . 5. . . . . . . . . . 6 Exploration for and production of petroleum and natural gas deposits . . . . . . . . .14 . . . . . . . . . . . . . 7. . . . . . . . . . 14 Petroleum refining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 . . . . . . . . . . . . .10 . . . . . . . . . . 16 Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 . . . . . . . . . . . . . . 5. . . . . . . . . . 6 Manufacture of grain and grain mill products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 . . . . . . . . . . . . .10 . . . . . . . . . . 17 Manufacture of sugar and sugar products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 . . . . . . . . . . . . .10 . . . . . . . . . . 18 Manufacture of vegetable oils and vegetable oil products . . . . . . . . . . . . . . . . . . . . .18 . . . . . . . . . . . . .10 . . . . . . . . . . 18 Manufacture of other food and kindred products . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 . . . . . . . . . . . . . 7. . . . . . . . . . 12 Manufacture of food and beverages—special handling devices . . . . . . . . . . . . . . . .4 . . . . . . . . . . . . . . 3. . . . . . . . . . 4 Manufacture of tobacco and tobacco products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 . . . . . . . . . . . . . 7. . . . . . . . . . 15 Manufacture of knitted goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7.5 . . . . . . . . . . . . 5. . . . . . . . . . 7.5 Manufacture of yarn, thread, and woven fabric . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . 7 . . . . . . . . . .11 Manufacture of carpets and dyeing, finishing, and packaging of textile products and manufacture of medical and dental supplies . . . . . . . . . . . . . . 9. . . . . . . . . . . . . 5 . . . . . . . . . . 9 Manufacture of textured yarns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . . 5 . . . . . . . . . . 8 Table 10.3—Depreciation Class Lives and Recovery Periods
- 154. 10.17 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Recovery periods (in years) Class GDS life (MACRS) ADS Manufacture of nonwoven fabrics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Manufacture of apparel and other finished products . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . 5 . . . . . . . . . . 9 Cutting of timber . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6. . . . . . . . . . . . . 5 . . . . . . . . . . 6 Sawing of dimensional stock from logs, permanent or well established . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Sawing of dimensional stock from logs, temporary. . . . . . . . . . . . . . . . . . . . . . . . . . . 6. . . . . . . . . . . . . 5 . . . . . . . . . . 6 Manufacture of wood products and furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Manufacture of pulp and paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . 7 . . . . . . . . . .13 Manufacture of converted paper, paperboard, and pulp products . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Printing, publishing, and allied industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . 7 . . . . . . . . . .11 Manufacture of chemicals and allied products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5 . . . . . . . . . . . . 5 . . . . . . . . . .9.5 Manufacture of rubber products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . 7 . . . . . . . . . .14 Manufacture of rubber products—special tools and devices . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . . . . . 3 . . . . . . . . . . 4 Manufacture of finished plastic products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . 7 . . . . . . . . . .11 Manufacture of finished plastic products—special tools . . . . . . . . . . . . . . . . . . . . . . 3.5 . . . . . . . . . . . . 5 . . . . . . . . . .3.5 Manufacture of leather and leather products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . 7 . . . . . . . . . .11 Manufacture of glass products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . 7 . . . . . . . . . .14 Manufacture of glass products—special tools. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 . . . . . . . . . . . . 3 . . . . . . . . . .2.5 Manufacture of cement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20. . . . . . . . . . . . . 15 . . . . . . . . . .20 Manufacture of other stone and clay products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15. . . . . . . . . . . . . 7 . . . . . . . . . .15 Manufacture of primary nonferrous metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . 7 . . . . . . . . . .14 Manufacture of primary nonferrous metals—special tools. . . . . . . . . . . . . . . . . . . . . 6.5 . . . . . . . . . . . . 5 . . . . . . . . . .6.5 Manufacture of foundry products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . 7 . . . . . . . . . .14 Manufacture of primary steel mill products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15. . . . . . . . . . . . . 7 . . . . . . . . . .15 Manufacture of fabricated metal products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . 7 . . . . . . . . . .12 Manufacture of fabricated metal products—special tools. . . . . . . . . . . . . . . . . . . . . . 3. . . . . . . . . . . . . 3 . . . . . . . . . . 3 Manufacture of electrical and non-electrical machinery and other mechanical products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Manufacture of electronic components, products, and systems . . . . . . . . . . . . . . . . 6. . . . . . . . . . . . . 5 . . . . . . . . . . 6 Any semiconductor manufacturing equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. . . . . . . . . . . . . 5 . . . . . . . . . . 5 Manufacture of motor vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . 7 . . . . . . . . . .12 Manufacture of motor vehicles—special tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. . . . . . . . . . . . . 3 . . . . . . . . . . 3 Manufacture of aerospace products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Ship and boat building machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . 7 . . . . . . . . . .12 Ship and boat building dry docks and land improvements . . . . . . . . . . . . . . . . . . . . 16. . . . . . . . . . . . . 10 . . . . . . . . . .16 Ship and boat building—special tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.5 . . . . . . . . . . . . 5 . . . . . . . . . . 6.5 Manufacture of locomotives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.5 . . . . . . . . . . . 7 . . . . . . . . . .11.5 Manufacture of railroad cars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . 7 . . . . . . . . . .12 Manufacture of athletic, jewelry, and other goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . 7 . . . . . . . . . .12 RAILROAD TRANSPORTATION:. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Railroad machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . 7 . . . . . . . . . .14 Railroad structures and similar improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30. . . . . . . . . . . . . 20 . . . . . . . . . .30 Railroad wharves and docks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20. . . . . . . . . . . . . 15 . . . . . . . . . .20 Railroad track . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . 7 . . . . . . . . . .10 Railroad hydraulic electric generating equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50. . . . . . . . . . . . . 20 . . . . . . . . . .50 Railroad nuclear electric generating equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20. . . . . . . . . . . . . 15 . . . . . . . . . .20 Railroad steam electric generating equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28. . . . . . . . . . . . . 20 . . . . . . . . . .28 Railroad steam, compressed air, and other power plant equipment. . . . . . . . . . . . . 28 . . . . . . . . . . . . .20 . . . . . . . . . . 28 Motor transport--passengers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 . . . . . . . . . . . . . 5 . . . . . . . . . . 8 Motor transport--freight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 . . . . . . . . . . . . . 5 . . . . . . . . . . 8 Water transportation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 . . . . . . . . . . . . .15 . . . . . . . . . .20 Air transport . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 . . . . . . . . . . . . . 7 . . . . . . . . . .12 Air transport (restricted). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5 . . . . . . . . . . 6 Pipeline transportation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 . . . . . . . . . . . . .15 . . . . . . . . . .22 Table 10.3—Depreciation Class Lives and Recovery Periods (continued)
- 155. 10.18 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Table 10.3—Depreciation Class Lives and Recovery Periods (continued) Recovery periods (in years) Class GDS life (MACRS) ADS TELEPHONE COMMUNICATIONS: Telephone central office buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 . . . . . . . . . . . . .50 . . . . . . . . . .45 Telephone central office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 . . . . . . . . . . . . .10 . . . . . . . . . .18 Computer-based telephone central office switching equipment . . . . . . . . . . . . . . . 9.5 . . . . . . . . . . . . 5 . . . . . . . . . .9.5 Telephone station equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 . . . . . . . . . . . . . 7 . . . . . . . . . .10 Telephone distribution plant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 . . . . . . . . . . . . .15 . . . . . . . . . .24 Radio and television broadcasts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 . . . . . . . . . . . . . 5 . . . . . . . . . . 6 TELEGRAPH, OCEAN CABLE, AND SATELLITE COMMUNICATIONS (TOCSC): TOCSC--Electric power generating and distribution systems . . . . . . . . . . . . . . . . 19 . . . . . . . . . . . . .10 . . . . . . . . . .19 TOCSC--High frequency radio and microwave systems . . . . . . . . . . . . . . . . . . . . . 13 . . . . . . . . . . . . . 7 . . . . . . . . . .13 TOCSC--Cable and long-line systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.5 . . . . . . . . . . .20 . . . . . . . . . .26.5 TOCSC--Central office control equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.5 . . . . . . . . . . .10 . . . . . . . . . .16.5 TOCSC--Computerized switching, channeling, and associated control equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.5 . . . . . . . . . . . 7 . . . . . . . . . .10.5 TOCSC--Satellite ground segment property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 . . . . . . . . . . . . . 7 . . . . . . . . . .10 TOCSC--Satellite space segment property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 . . . . . . . . . . . . . 5 . . . . . . . . . . 8 TOCSC--Equipment installed on customer's premises. . . . . . . . . . . . . . . . . . . . . . . 10 . . . . . . . . . . . . . 7 . . . . . . . . . .10 TOCSC--Support and service equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.5 . . . . . . . . . . . 7 . . . . . . . . . .13.5 CABLE TELEVISION (CATV): CATV--Headend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 . . . . . . . . . . . . . 7 . . . . . . . . . .11 CATV--Subscriber connection and distribution systems . . . . . . . . . . . . . . . . . . . . . 10 . . . . . . . . . . . . . 7 . . . . . . . . . .10 CATV--Program origination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 . . . . . . . . . . . . . 5 . . . . . . . . . . 9 CATV--Service and test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.5 . . . . . . . . . . . 5 . . . . . . . . . .8.5 CATV--Microwave systems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5 . . . . . . . . . . . 5 . . . . . . . . . .9.5 ELECTRIC, GAS, WATER, AND STEAM, UTILITY SERVICES: . . . . . . . . . . . . . Electric utility hydraulic production plant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 . . . . . . . . . . . . .20 . . . . . . . . . .50 Electric utility nuclear production plant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 . . . . . . . . . . . . .15 . . . . . . . . . .20 Electric utility nuclear fuel assemblies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 . . . . . . . . . . . . . 5 . . . . . . . . . . 5 Electric utility steam production plant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 . . . . . . . . . . . . .20 . . . . . . . . . .28 Electric utility transmission and distribution plant . . . . . . . . . . . . . . . . . . . . . . . . . 30 . . . . . . . . . . . . .20 . . . . . . . . . .30 Electric utility combustion turbine production plant . . . . . . . . . . . . . . . . . . . . . . . . 20 . . . . . . . . . . . . .15 . . . . . . . . . .20 Gas utility distribution facilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 . . . . . . . . . . . . .20 . . . . . . . . . .35 Gas utility manufactured gas production plants. . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 . . . . . . . . . . . . .20 . . . . . . . . . .30 Gas utility substitute natural gas (SNG) production plant (naphtha or lighter hydrocarbon feedstocks). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 . . . . . . . . . . . . . 7 . . . . . . . . . .14 Substitute natural gas-coal gasification. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 . . . . . . . . . . . . .10 . . . . . . . . . .18 Natural gas production plant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 . . . . . . . . . . . . . 7 . . . . . . . . . .14 Gas utility trunk pipelines and related storage facilities . . . . . . . . . . . . . . . . . . . . . 22 . . . . . . . . . . . . .15 . . . . . . . . . .22 Liquefied natural gas plant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 . . . . . . . . . . . . .15 . . . . . . . . . .22 Water utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 . . . . . . . . . . . . .20 (1) . . . . . . .50 Central steam utility production and distribution . . . . . . . . . . . . . . . . . . . . . . . . . . 28 . . . . . . . . . . . . .20 . . . . . . . . . .28 Waste reduction and resource recovery plants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 . . . . . . . . . . . . . 7 . . . . . . . . . .10 Municipal wastewater treatment plant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 . . . . . . . . . . . . .14 . . . . . . . . . .24 Municipal sewer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50. . . . . . . . . . . . . 20 (2) . . . . . . . 50 Distributive trades and services 9 5 9 Distributive trades and services--billboard, service station buildings and petroleum marketing land improvements 20 15 20 Recreation 10 7 10 Theme and amusement parks 12.5 7 12.5 Notes: (1) 25-year straight line may apply if placed in service after June 12, 1996. See IRS Publication 946. (2) In those cases where guidelines are not listed for any given industry or type of equipment, or where the listed guidlines are clearly inap- propriate, the depreciable life of such property shall be determined according to the particular facts and circumstances. Source: Depreciation, U.S. Department of the Treasury, Internal Revenue Service, Publication No. 534, 1994.
- 156. For example, with an investment of $1 million, a salvage value of zero, and a 5-yr life, annual double-declining bal- ance depreciation allowances are as follows: Mathematically, the double-declining balance method is D = 2(F - CD) (equation 10.7) n where D = depreciation in any given year F = initial asset value CD = cumulative depreciation charged in prior years n = asset life, in years Note that in the double-declining balance method, the basis for depreciation ordinarily is the total depreciable investment without deducting for salvage values other than land value. In this method, the investment is depreciated down to the salvage value, and the final undepreciated balance may not be less than salvage value. Another common method of computing accelerated depreci- ation is the “sum-of-years-digits” method. This technique is based upon the depreciable portion of the investment, i.e., excluding land and salvage value. To use this technique, the approved years in the life of the plant are summed. Deductions are based on the remaining years of plant life divided by the sum of years. For example, with a 5-year life, the sum of years digits equals 5 + 4 + 3 + 2 + 1 = 15. In the first year 5/15 of the depreciable investment is deducted; 4/15 in the second year, 3/15 in the third year; and so forth. Using the same example as given above for the double- declining balance method, sum-of-years-digit depreciation deductions would be as follows: The sum-of-years-digits method is expressed mathematically as where Dy = depreciation in year Y C = depreciable portion of investment n = asset life, in years There are numerous other acceptable depreciation methods including some that are combinations of the above methods. However, the three methods described above are the most commonly used techniques. Also as mentioned earlier, if constant maintenance costs are assumed, no matter which depreciation technique is actually used by the company, the straight-line technique should be generally used for are all preliminary estimates. ACCELERATED COST RECOVERY SYSTEM In 1981 a major revision of tax laws in the U.S. replaced the pre-existing depreciation systems described above with a system known as the accelerated cost recovery system (ACRS). ACRS is mandatory for all capital assets acquired after 1980 and before 1987 when another system of deprecia- tion, the modified accelerated cost recovery system (MACRS), became mandatory. However, the tax laws specify that any acquisition must continue to be depreciated on its original basis. Thus, since many capital assets have deprecia- ble lives of up to 60 years, the old depreciation systems, MACRS, and ACRS will coexist and be used by cost profes- sionals for many years into the future. Under ACRS, capital assets are not subject to depreciation in the customary sense. It is not necessary to estimate salvage values or useful lives for equipment. Instead, the law estab- lishes various property classes and provides for deductions 10.19 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING Undepreciated Year Investment Depreciation at 40% Balance 0 $1,000,000 - $1,000,000 1 1,000,000 $ 400,000 600,000 2 600,000 240,000 360,000 3 360,000 144,000 216,000 4 216,000 86,400 129,600 5 129,600 129,600a 0 Total $1,000,000 aIn the final year of the life, the total remaining undepreciated balance may be deducted. Undepreciated Year Investment Depreciation($) balance 0 $1,000,000 - $1,000,000 1 1,000,000 5/15 = 333,333 666,667 2 1,000,000 4/15 = 266,667 400,000 3 1,000,000 3/15 = 200,000 200,000 4 1,000,000 2/15 = 133,333 66,667 5 1,000,000 1/15 = 66,667 0 Total $1,000,000 Dy = C 2 (n - Y + 1) n (n + 1) (equation 10.8)
- 157. calculated as specific percentages of the cost of the asset. Property classes are listed below: • Three-year property, which is defined as “property that has a mid-point class life of four years or less, or is used for research and experimentation, or is a race horse more than two years old when placed in service, or any other horse that is more than 12 years old when placed in serv- ice.” This obscure and somewhat confusing-sounding definition includes automobiles, light trucks, and short- lived personal property. • Five-year property, which is defined as property not oth- erwise defined and which is not real property. This class includes most types of equipment and machinery. • Ten-year property, which is public utility property hav- ing a midpoint class life of more than 18 but not more than 25 years. Also included are manufactured homes, railroad tank cars, certain coal utilization property, theme and amusement park property, and other proper- ty as defined in the act. • Fifteen-year property, which is long-lived public utility property. • Ten-year and fifteen-year real property classes. The 15- year class consists of real property with a midpoint class life in excess of 12.5 years. All other real property falls into the 10-year class. Detailed descriptions of each property class may be obtained upon request from the IRS. Under the 1981 law, ACRS deductions were phased in on a gradual basis over a period of years. Allowable deductions for personal property are listed in Table 10.4. Fifteen-year class real property deductions vary from Table 10.4 and are based in part on the month in which the property was placed in service. IRS regulations should be consulted to determine applicable deduction rates. It should also be noted that the ACRS requirements place cer- tain limitations on deductions for disposition of property prior to the end of its class life, and also provide for optional use of alternate percentages based on the straight-line method of depreciation. The logic of the standard ACRS percentages as outlined in Table 10.4 becomes apparent when it is realized that the 1981 to 1984 rates are approximately equal to those for 150 percent declining-balance depreciation with a switch to straight-line depreciation in later years. The 1985 rates similarly approxi- mate 175 percent declining-balance depreciation, and the rates for 1986 are essentially those for the double-declining- balance method, both with a switch to the sum-of-years-dig- its method at the optimum point in time. Thus ACRS is mere- ly a combination of previously used and widely accepted methods of computing accelerated depreciation. 10.20 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Table 10.4—ACRS Deductions (%) for Personal Property and 10-Year Real Property 1985 1986 Year property was put in service 25 38 37 15 22 21 21 21 8 14 12 10 10 10 9 9 9 9 1981-1984 29 47 24 18 33 25 16 8 9 19 16 14 12 10 8 6 4 2 33 45 22 20 32 24 16 8 10 18 16 14 12 10 8 6 4 2 3-year property 1st year 2nd year 3rd year 5-year property 1st year 2nd year 3rd year 4th year 5th year 10-year property 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year 11th year 12th year 13th year 14th year 15th year 15-year personal property 5 10 9 8 7 7 6 6 6 6 6 6 6 6 6 6 12 12 11 10 9 8 7 6 5 4 4 3 2 1 7 12 12 11 10 9 8 7 6 5 4 3 3 2 1
- 158. MODIFIED ACCELERATED COST RECOVERY SYSTEM When the ACRS depreciation system was adopted in the United States, it was phased in over a period of five years ending in 1986 and was originally anticipated to remain in effect after that time. The 1986 tax reform act, however, fur- ther revised the depreciation regulations and, effective in 1987, implemented a new system called the modified accel- erated cost recovery system (MACRS). MACRS expanded the ACRS property classes from 5 to 8, revised the depreciation periods for most items (see Table 10.3), and redefined the classes. The definitions including minor tax law changes since 1987 are as follows: • Three-year property, which was redefined as including “tractor units for use over the road, any race horse over 2 years old when placed in service, and any other horse over 12 years old when placed in service.” Also included in this class is qualified rent-to-own property. Three-year property generally includes those items with an IRS- approved class life of 4 years or less. The major change in this class was the elimination of automobiles, light trucks, and other short-lived personal property, which were moved to the 5-year class. • Five-year property, which was totally redefined as including “trucks, computers and peripheral equipment, office machinery, and any automobile.” Most items with an IRS-approved class life of 4-plus years and less than 10 years are included under this category. This class includes taxis, buses, property used in research and experimentation, breeding cattle, dairy cattle, and fur- nishings (furniture, rugs, etc) used in residential rental real estate. • Seven-year property, which is defined in part as includ- ing “office furniture and fixtures, any property that does not have a class life, and that has not been designated by law as being in any other class and, if placed in service before 1989, any single purpose agricultural or horticul- tural structure.” This category covers any items with an IRS-approved class life of 10 years or more and less than 16 years. It effectively includes almost all industrial machinery and equipment. It also includes agricultural machinery and equipment. • Ten-year property, which includes “vessels, barges, tugs and similar water transportation equipment, and, if placed in service after 1988, any single-purpose agricul- tural or horticultural structure, and any tree or vine bear- ing fruit or nuts. This category includes those items with an IRS-approved class life of 16 years or more and less than 20 years. • Fifteen-year property, which includes items with an IRS-approved class life of 20 years or more and less than 25 years plus wastewater treatment plants and equip- ment used for two-way exchange of voice and data com- munications. This class includes improvements made directly to land or added to it, such as shrubbery, fences, roads, and bridges. It also includes any retail motor fuels outlet, such as a convenience store. • Twenty-year property, which includes items with an IRS-approved class life of 25 years or more, excluding real property and including sewer systems. Farm build- ings (other than single-purpose agricultural or horticul- tural structures) fall into this category. • Twenty-seven and one-half-year property, which includes residential rental property. • Nonresidential real property, which includes real proper- ty other than residential rental property. For this category, the recovery period for depreciation is 31.5 years for prop- erty placed in service before May 13, 1993, and 39 years for property placed in service after May 12, 1993. The depreciation allowances under the MACRS system, like the ACRS, do not consider salvage value. For the 3-, 5-, 7-, and 10-year categories, the MACRS depreciation schedule (Table 10.5 on page 10.22) is equivalent to 200 percent declin- ing-balance switching to straight-line at the optimum point to maximize the deduction. In the first year, a half-year con- vention applies. The assumption is made that the item being depreciated was placed in service for only 6 months no mat- ter what the actual date of service was. However, if more than 40 percent of the cost basis was placed in service during the last 3 months of the year, a mid-quarter convention applies, ie, it is assumed that the equipment was in service for only 1.5 months of the first year. For the 15- and 20-year categories, the depreciation schedule, as shown in Table 10.4, is 150 percent declining balance with a switch to straight line at the optimum point. The half-year and half-quarter conventions also apply to these categories. For the real property categories, straight-line depreciation must be used with a mid-month convention in the first year. If all of the foregoing seems confusing and convoluted, it is. The logic of tax laws and their complexity is rarely clear, and the MACRS system is a significant example of how the polit- ical process can complicate what should otherwise be an eas- ily understood subject. To further complicate the calculation of depreciation, the MACRS system allows for an alternate method. As shown in Table 10.3, the alternate depreciation system (ADS) permits straight-line depreciation over specified periods which are equal to, or longer than, the regular MACRS recovery periods (GDS, the general depreciation system). Generally, the tax- payer must specifically choose to use the alternate method; otherwise the regular MACRS system applies. In a very few cases, the alternate system must be used. The exceptions are 10.21 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING
- 159. small in number and generally are not of concern to the cost engineer. The alternate system, however, is always a bad choice eco- nomically. The regular system permits far more rapid deduc- tions and resultant tax savings. The alternate system is easier to understand and is simple to calculate but is a poor choice—it costs money. Nevertheless, the government per- mits poor economic decisions. The wise cost engineer should avoid them. AMORTIZATION, DEPLETION, INSURANCE, AND REAL ESTATE TAXES Amortization is a term which is applied to writing off or recovering any portion of the initial capital expense which is intangible in nature and as such has no definable useful life. A lump-sum royalty payment is an example of such an investment. Such intangible assets are written off as an oper- ating cost over the life of the plant or process using exactly the same calculation techniques as are used for depreciation of tangible assets. Alternately, intangible assets may be writ- ten off as a function of production over the life of a project. In some cases amortization is, for simplicity, included in the depreciation charge (albeit erroneously). However, for prac- tical purposes the distinction between depreciation and amortization is usually of no consequence. Depletion allowances, while not considered to be an operat- ing cost, must be included in estimates involving extraction of a natural resource, e.g., in coal mining. These allowances are deductions from gross income prior to calculation of taxes on income. Thus they are, in effect, tax credits granted by law to compensate for eventual exhaustion of an irre- placeable natural resource such as coal or oil. They are com- puted as a fixed percentage of the market value of the resource in its first usable and salable form, even though the resource may be further processed and eventually sold in another form at a different cost. Depletion rates are estab- lished by law and are periodically changed. Thus it is neces- sary when performing an estimate first to determine the cur- rently applicable rate. Insurance and real estate (or property) taxes must also be included in the estimate if not previously considered in determining general works expense. In most areas, these costs total about 1.5 to 3 percent of investment per year. Two percent is about average for locations in the U.S. DISTRIBUTION COSTS The costs of packing and shipping products to market (i.e., distribution costs) are highly variable and dependent upon product characteristics. In many cases, especially with con- sumer products, these costs often exceed the cost of produc- ing the product itself. Distribution costs may include the following: • cost of containers, including their repair, testing, clean- ing, etc. (if reusable), and their depreciation or rental (if nonexpendable); • transportation costs; and • applicable labor and overheads for packing and shipping. If the product is sold FOB the plant, the cost of transportation is borne by the customer and need not be considered in the estimate. If, however, it is sold on a delivered basis, trans- portation costs must be included. The mode of transportation and the shipping distance drasti- cally affect transportation costs. In general, pipelines, barges, 10.22 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL Table 10.5—MACRS Deduction Rates If the recov- ery year is: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 3-year 33.33 44.45 14.81 7.41 5.76 5-year 20.00 32.00 19.20 11.52 11.52 8.92 7-year 14.29 24.49 17.49 12.49 8.93 7.37 8.93 4.46 10-year 10.00 18.00 14.40 11.52 9.22 6.23 6.55 6.55 6.56 6.55 3.28 15-year 5.00 9.50 8.55 7.70 6.93 5.285 5.90 5.90 5.91 5.90 5.91 5.90 5.91 5.90 5.91 2.95 20-year 3.750 7.219 6.677 6.177 5.713 4.888 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231
- 160. and tankers are the least expensive forms of transportation. Rail shipment is somewhat higher in cost, and truck ship- ment is the most expensive. Freight tariffs are regulated by the states (intrastate shipments) and the federal government (interstate shipments) and vary from product to product. In general, for any given product, freight costs per ton-mile are lowest for long hauls (250 to 300 miles or more) and high vol- umes. Short-distance haulage and small shipments incur con- siderably higher freight rates. PRACTICE PROBLEMS AND QUESTIONS 1. (a)Define fixed cost, variable cost, and semivariable cost. What items are included in each? (b) At zero production, what percentage of semivariable cost is normally incurred (as a percentage of total semi- variable cost at full production)? (c) What are the definitions of the breakeven and shut- down points? Question: Assuming that semivariable costs at zero produc- tion equal 30% of such costs at 100 percent of capacity, deter- mine the shutdown and breakeven points. Answer: Shutdown at 12.5 percent of capacity and breakeven at 47.3 percent of capacity Question: What are the IRS-approved depreciation allowances for the first five years? Answer: Year 1, $8.574 MM; Year 2, $14.694 MM; Year 3, $10.494 MM; Year 4, $7.494 MM; and Year 5, $5.358 MM. 4. (a) In the above problem, what is the straight-line depre- ciation for each of the first five years? (b) This technique is recommended for preliminary esti- mates. Why? Answer: (a) $5.5 MM per year Answer: Year 1, $12 MM; Year 2, $9.6 MM; Year 3, $7.68 MM; Year 4, $6.144 MM; Year 5, $4.9152 MM 6. What is a depletion allowance? How is it calculated? 7. What are general and administrative expenses? 8. What is general works expense? 9. Why should operating cost estimates be made on an annual basis rather than a daily or unit-of-production basis? 10. How can the cost of grease and lubricants be estimated for motor vehicles and mobile equipment? 11. How can fuel cost be estimated for motor vehicles and mobile equipment? 12. In order to estimate process labor requirements, what must first be established? 13. How many standard 40-hour/week shifts are required to staff a plant around the clock, 7 days a week? 14. What is a good rule of thumb for estimating electric power costs? 15. What rule of thumb can be used to estimate the cost of steam? 16. In scaling up utililty requirements for larger pieces of equipment, what rule of thumb can be used to estimate the utility requirements? 17. Is it advisable to use scheduled overtime work in indus- trial plants? 18. If a plant operates at 50% of capacity, what will its approximate maintenance cost be as a percentage of maintenance costs at full capacity. 19. For preliminary estimates, annual maintenance costs are generally assumed to be constant even though they are known to increase with time. Straight-line depreciation 10.23 AACE INTERNATIONAL PROCESS PRODUCT MANUFACTURING 2. In a manufacturing operation, at 100 percent of capaci- ty, annual costs are as follows: Fixed expense $ 4,730,400 Variable expense 6,446,400 Semivariable expense 5,652,500 Sales 23,986,800 3. You work for a chemical company that plans to install $60,000,000 worth of new equipment this year. You esti- mate that this equipment will have a salvage value of $5,000,000 at the end of its useful life. 5. Assume that for accounting purposes rather than tax purposes, your company uses double declining balance depreciation. Calculate the double declining balance depreciation allowances for each of the first five years of equipment life for problem 3.
- 161. is also assumed despite the fact that accelerated depreci- ation will be used in actual operations. Why are these two clearly erroneous assumptions made? 20. Are royalties and rental costs variable, semivariable, fixed, or capital costs? REFERENCES 1. J. H. Black. 1991. Operating Cost Estimation. Jelen’s Cost and Optimization Engineering. (K. K. Humphreys, ed.) New York: McGraw-Hil. 2. R. M. Blough. 1973. Effect of Scheduled Overtime on Construction Projects. AACE Bulletin 15 (5). 155–158, 160 (October). 3. J. W. Hackney. 1971. Estimate Production Costs Quickly. Chemical Engineering. 183 (April 17). 4. K. K. Humphreys. Coal Preparation Costs. Coal Preparation. 5th ed. (J. W. Leonard, ed.) Society of Metallurgy and Exploration. Littleton, Colorado. chap. 3. 5. W. McGlaun. 1973. Overtime in Construction. AACE Bulletin. 15 (5). 141–143 (October). 6. H. E. Wessell. 1952. New Graph Correlates Operating Labor Data for Chemical Processes. Chemical Engineering. 209 (July). 10.24 PROCESS PRODUCT MANUFACTURING AACE INTERNATIONAL
- 162. INTRODUCTION Discrete part or product manufacturing refers to the produc- tion of separate, individual products, whereas continuous manufacturing is concerned with large units to be further processed, such as a roll of sheet steel, or units in fluid form with no distinct shape. Discrete parts typically are solid prod- ucts that have the dimensions and sizes for final use, where- as solid continuous products will be further processed into specific shapes. Discrete production often yields low quanti- ties; the average lot size is less than 75 units. Discrete manu- facturing employs specialized tools for the various products, so set-up and tooling changes are much more frequent in dis- crete manufacturing than in continuous manufacturing. Another variable in discrete manufacturing is whether the manufacturing is that of an individual component part of a product or with the assembly or joining of parts to form a completed product. Assembly is often the final operation in the production of a manufactured product before it goes to the customer. For example, assembly lines are the final phase in the manufacture of automobiles, and this involves the assembly of many components. However, one of those com- ponents, the engine, is a subassembly of various components, one of which is the engine block. The engine block is consid- ered as a discrete manufactured part, whereas the automobile is considered as a discrete manufacturing assembly. The focus of this section is on the discrete manufactured part, although the approach is similar for discrete manufactured assemblies. LEARNING OBJECTIVES After completing this chapter, the reader should be able to: • understand the operations, terms, and philosophies used in discrete product manufacturing; • understand basic cost relationships, cost bases, and classifica- tion of costs; and • understand time-based and quantity-based break-even analy- sis and when it is best to use each approach. OPERATIONS IN DISCRETE PART MANUFACTURING There are a wide variety of products produced in discrete manufacturing, and, thus, an extreme variety of operations performed to obtain the desired shape and properties required of the product. The operations performed vary con- siderably depending on the material being used for the spe- cific component. Six major groups of component operations and a few of the manufacturing operations of each group are presented in Table 11.1. Note that some manufacturing operations are repeated in dif- ferent major component groups, and the machining opera- tions, which is listed in the metal component manufacturing group, would also be heavily utilized in the plastic compo- nent manufacturing and in several other groups. DISCRETE PART MANUFACTURING PHILOSOPHIES There are several manufacturing philosophies/techniques that have been introduced during the last 50 years to assist in the reduction of manufacturing costs. Some of these philoso- phies/techniques are: computer-aided process planning (CAPP), cconcurrent engineering, group technology, just-in- time, lean manufacturing, materials requirement planning, supply-chain management, and total quality management. Each of these techniques will be briefly presented to indicate the goals of that philosophy/technique. • computer-aided process planning (CAPP)—The goal of CAPP is to be able to automatically generate the process plan to produce the component from the component drawing and specifications. This would include the sequence of the operations as well as the particular oper- ation parameters and would optimize the processing time, operation costs, and product quality. The two 11.1 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING Chapter 11 Discrete Product Manufacturing Dr. Robert C. Creese, PE CCE
- 163. approaches to CAPP are (1) the variant approach, which searches a database for similar parts and modifies the closest similar component plan for the new component; and (2) the generative approach, which designs the process plan starting from “scratch,” that is, generating a completely original approach. • Concurrent Engineering—Concurrent engineering as defined by the Institute for Defense Analysis [9] is a sys- tematic approach to the integrated, concurrent design of products and their related processes, including manufac- turing and support. This approach is intended to cause the developer (designers), from the outset, to consider all elements of the product life cycle from conception through disposal, including quality, cost, schedule, and user requirements. • Group Technology—Group technology is a manufactur- ing philosophy that identifies and exploits the underlying sameness of component parts and manufacturing process [2]. There are two primary approaches, which are (1) clas- sifying parts into families that have similar design features and (2) classifying parts into families that have similar pro- cessing operations. This permits the standardization of parts in the design process and, in the second case, pro- duction of parts as families by permitting cell formation and reducing the set-up times via fewer set-up changes. • Just-in-Time—Just-in-time is the manufacturing philos- ophy that requires that the supplies (raw materials) are delivered when required, and, thus, inventory costs are theoretically driven to zero as there is no inventory. This is not only for external suppliers but also for internal use as parts go from one operation to the next, so the work- in-process inventory is a minimum. This is closely relat- ed to the “Kanban” system or “pull” system in which parts are not produced until ordered. • Lean Manufacturing—Lean manufacturing is a manufac- turing philosophy to shorten lead times, reduce costs, and reduce waste. This philosophy is implemented by (1) reducing waste through scrap reduction, improving yields, and developing new products from waste stream materi- als; (2) improving employee performance, skills, and satis- faction via training, recognition, and employee involve- ment and empowerment; and (3) investing capital to improve processes, process rates, and capabilities. Lean manufacturing is not “mean” manufacturing, and it is not a short-term process. Rather, it is a continuous improve- ment process. 11.2 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL Table 11.1—Component Operation Classification for Discrete Manufacturing [6, 7, 10] Major Component Group Illustrative Manufacturing Operations of Major Component Group 1. Metal Component Manufacturing Casting sand casting, investment casting, die casting, permanent mold casting, squeeze casting, full mold casting, slush casting, etc. Forming and Shaping rolling, open-die forging, impression die forging, impact extrusion, drawing, shearing, bending, powder processing, etc. Machining turning, drilling, milling, sawing, planning, shaping, grinding, water-jet machining, electrical discharge machining, etc. 2. Plastic Component Manufacturing injection molding, extrusion, blow molding, pultrusion, thermoforming, compres- sion molding, filament winding, etc. and many of the machining operations 3. Ceramic and Glass Component Manufacturing Ceramic slip casting, extrusion, pressing, injection molding, hot pressing, drying, firing, drawing, etc. Glass rolling, float forming, pressing, blowing, etc. 4. Component Surface Modification case hardening, hot dipping, porcelain enameling, electroplating, thermal spraying, vapor deposition, anodizing, painting, cleaning, peening, etc. 5. Assembly and Joining arc welding, resistance welding, laser welding, brazing, soldering, adhesive bonding, mechanical fasteners, etc. 6. Micro-Electronic Component crystal growth, wafer slicing and polishing, photolithography, doping, sputtering, Manufacturing chemical vapor deposition, etching, adhesive bonding, wave soldering, etc.
- 164. • Material Requirements Planning (MRP)*—MRP is a system that uses bills of material, inventory and open order data, and master production schedule information to calculate requirements for materials. It makes recom- mendations to release replenishment orders for materi- als. Further, since it is time-phased, it makes recommen- dations to reschedule open orders when due dates and need dates are not in phase. • Supply Chain Management—The production of com- plex products require the integration of many different components from a variety of suppliers. Supply chain management involves the assurance that the parts will arrive from the suppliers when required to avoid large inventories or production stoppages from a lack of parts. Supply chain management also requires the involvement of suppliers in the design process to eliminate unneces- sary operations and inefficient designs of components or even unnecessary components. Although the focus is on the movement of materials, it also involves the transfer of information on the status of delivery and financial flow of credit, terms and conditions, and payment sched- ules as the materials move through the various stages of the supply chain. The goals are to reduce inventory, time-to-market, and costs, and improve quality. • Total Quality Management—Total quality management is a leadership philosophy, organizational structure, and working environment that fosters and nourishes a per- sonal accountability and responsibility for the quality and a quest for continuous improvement in products, services, and processes [8]. BASIC COST RELATIONSHIPS The basic relationships between the various manufacturing cost terms are illustrated in Figures 11.1 and 11.2 on pages 11.4 and 11.5. Figure 11.1 shows the relationships between the various cost terms in a flow chart form [3], and Figure 11.2 illustrates the terms in a stepwise fashion referred to as the “ladder of costs.” The sum of direct material, direct labor, direct engineering, and direct expense is the prime cost. However, many companies do not keep adequate records of direct engineering and direct expenses, and, in many instances, the prime cost is the sum of the direct material and direct labor costs. Usually the design engineering and direct expense are included as overhead costs and not allocated to the specific product. This is partly because only 10 percent of new products make it into the production stage, and most of the design work cannot be assigned to the specific products. The relationships between the cost terms can also be illus- trated by equations such as the following: *prime cost = direct material cost + direct labor cost + direct engineering cost + direct expense (equation 11.1) **manufacturing cost = prime cost + factory expense (equation 11.2) production cost = manufacturing cost + administrative expense (equation 11.3) total cost = production cost + marketing, selling, and dis- tribution expense (equation 11.4) selling price = total cost + mark-up (profit and taxes) (equation 11.5) *prime cost is also called direct cost **manufacturing cost is also called factory cost The profit should be related to the value to the customer. Some items will generate more profit than others; parts that one is skilled at producing should yield more profit than new items or those that one does not have the ideal equipment to produce. Equal profits indicate your prices will be too high for items that you have difficulty making and too low for items that are your specialty area. Profit is usually meant to imply net profit; that is, the profit after all expenses have been incurred and after taxes have been paid. The other profit terms, that is gross profit and operating profit, do not include all the expenses and thus are larger than the net profit term. COST ESTIMATING FOR DISCRETE PART MANUFACTURING Direct and Indirect Costs Direct costs are those costs that can be directly related to a specific part and these most commonly are direct materials and direct labor. There can be other direct costs, such as direct engineering or direct burden expenses, but these are often 11.3 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING GLOSSARY TERMS IN THIS CHAPTER administrative expense ◆ break-even analysis contingency ◆ cost ◆ cost estimating costing/cost accounting ◆ discrete manufacturing direct cost ◆ direct labor indirect cost ◆ indirect labor ◆
- 165. not separated (even though they should be) and are thus included in the overhead components. The direct materials include all the direct material consumed in the product unless they are small and cost more to track. The direct labor and direct material costs are also referred to as the “out-of- pocket” costs; they are costs which are being directly paid to others and do not cover any of the direct or indirect overhead costs. The direct labor represents the fully burdened labor costs; that is the benefits as well as the wages. For example, in the copying of a report on a copy machine, the costs would be the paper cost, the toner cost, the machine rate costs, the operator cost, and the staple cost. The paper and toner would be direct material costs, the operator cost would be a direct labor cost, but the cost of an individual sta- ple is so small compared to the other costs, it typically would be included as part of the indirect burden costs. The machine rate cost includes the operating cost plus capital costs, so it would be a indirect cost but it is applied directly to the prod- uct. If one did not make the copy, the direct costs of the oper- ator and the paper would be saved and these would be the “out-of-pocket” costs. There are different degrees of the indirect costs. In the copy- ing machine example, there is a certain amount of energy consumed to operate the machine each time a copy is made. However, when the machine is on idle, it also consumes some energy, and this cost is built into the burden based upon its expected usage. The capital costs of purchasing and installing the machine are another level of burden based upon the expected life of the machine and the expected copies produced per year. Although these are direct costs, they are considered as indirect costs as the machine is used for a wide variety of reports and not only one report. 11.4 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL Selling Price Total Cost Production Cost Factory Cost or Manufacturing Cost Direct Cost or Prime Cost Direct Material Cost Direct Labor Cost Direct Engineering Cost Direct Expenses Mark-up (Tax and Profit) Marketing, Selling, and Distribution Expenses Administrative Expenses Factory Expenses Figure 11.1—Diagram of Basic Cost Relationships for Discrete Part Manufacturing
- 166. Other indirect costs are those which cannot be directly tied to the product such as supervision, administrative salaries, maintenance, janitorial, material handling, and legal, etc. These costs have different degrees of indirectness. For exam- ple, the immediate supervisor may have five people working for him, whereas the plant superintendent may have 500. More of the immediate supervisors cost must be allocated in the overhead burden than the plant superintendents over- head for particular component part, but the plant superin- tendents overhead will be applied over many more compo- nent parts. In large companies, indirect costs also include items such as basic and applied research and development, which must be done to develop future products. However, the costs of such activities must be recovered on the current products being produced and these research and develop- ment costs for future products are indirect burden costs for the current products. Cost Estimating Guide Form There are so many different types of operations and items that can be included on a cost estimating form, that only a general guide can be given. A form particular to the particu- lar products produced must be designed to obtain good cost estimates. The general form is illustrated in Table 11.2 on page 11.6. The mark-up amount is calculated as follows: mark-up (amount) = total cost x [% MU /[1 - % MU]] (equation 11.6) where total cost = total costs % MU = decimal percent of mark-up for profits and taxes For example, if the total costs are $10,000, and the mark up is 20 percent, the mark-up amount would be: mark-up (amount) = 10,000 x [0.20 /[1.00 – 0.20]] = $2,500 The selling price would be $10,000 plus $2,500 mark-up or $12,500. To illustrate the use of the form, an illustrative example is presented in Table 11.3 on page 11. 7. The values presented are for illustrative purposes and not specific values or rates to be used. These values must be evaluated for each individual company. An order has been received for 100 units of a component, which will require 240 lbs of material 1 at $0.75 per pound and 5 lbs of material 2, which is $ 4.00 per pound for each unit. The product requires two operations, operation 1, 11.5 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING Direct Cost or Prime Cost Factory Cost or Manufacturing Cost Production Cost Total Cost Selling Price Factory Expenses Selling and Distribution Expenses Mark Up Direct Expenses Direct Engineering Direct Labor Direct Materials Figure 11.2—Ladder of Costs for Discrete Part Manufacturing Administrative Expenses
- 167. 11.6 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL Table 11.2—General Discrete Costs Estimating Form With Illustrative Example Rates 1. Manufacturing/Factory Cost a. Prime Cost Direct Labor Amount(hours/unit) Rate($/hr) Quantity Total Cost Operation 1 ______ Operation 2 _ ______ ______ Direct Materials Amount(weight/unit) Rate($/weight) Quantity Total Cost Material 1 ______ Material 2 ______ ______ Direct Engineering/Expense Amount(units) Rate($/unit) Total Cost Item 1 ______ Item 2 ______ Item 3 (subcontracted) ______ ______ Total Prime Cost ______ b. Indirect Costs Indirect Materials Rate(% of direct materials) ______ Indirect Labor Rate(% of direct labor) ______ Indirect Engineering/Expense Rate(% of prime cost) ______ Contingency Costs Process Contingency Rate(% of prime cost) ______ Product Contingency Rate(% of prime cost plus contingency cost) ______ Direct Supervision Rate(% of direct labor) ______ Total Indirect Costs ______ Manufacturing/Factory Cost ______ 2. Production Plant Cost Plant Administrative Administration, Property Taxes, and Insurance Rate(% of manufacturing cost) ______ ______ Total Plant Administrative Cost ______ 3. Selling Expenses Marketing Costs Rate(% of manufacturing costs) ______ Selling Commissions & Salaries Rate(% of production costs) ______ Shipping Expenses Rate(% of Prime Cost) ______ Warehousing Rate(% of prime cost) ______ Total Marketing, Selling & Distribution Costs ______ Total Costs ______ 4. Mark-Up Profit and Taxes Rate(% of Total Cost) ______ ______ Selling Price ______
- 168. 11.7 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING Table 11.3—General Discrete Costs Estimating Form With Illustrative Example Rates 1. Manufacturing/Factory Cost % of Total Cost a. Prime Costs Component Cumulative Direct Labor Amount(hours/unit) Rate($/hr) Quantity Total Cost Operation 1 0.20 hr/unit $ 20/hr 100 $400 Operation 2 0.40 hr/unit $ 25/hr 100 $1,000 $ 1,400 3.0 Direct Materials Amount(weight/unit) Rate($/wt) Quantity Total Cost Material 1 240 lbs/unit $ 0.75/lb 100 $18,000 Material 2 5 lbs/unit $ 4.00/lb 100 $ 2,000 $20,000 41.9 Direct Eng./ExpenseAmount(units) Rate($/unit) Total Cost Item 1 1 tooling set $ 3,600 $ 3,600 Item 2 Item 3 (subcontracted) $3,600 7.5 Total Prime Cost $25,000 52.4 b. Indirect Costs Indirect Materials 20% of direct materials $4,000 Indirect Labor 100% of direct labor $1,400 Indirect Engineering/Expense 10% of prime cost $2,500 Contingency Costs Process Contingency 5% of prime cost $1,250 Product Contingency 10 % of prime cost plus contingency cost $ 3,750 Direct Supervision 20% of direct labor $ 280 Total Indirect Costs $13,180 27.6 Manufacturing/Factory Cost $38,180 80.0 2. Production Plant Cost Plant Administrative Administration, Property Taxes, Insurance 5% of manufacturing cost $1,909 Total Plant Administrative Cost $1,909 4.0 Production Costs $40,059 84.0 3. Selling Expenses Marketing Costs 3 % of manufacturing costs $1,145 Selling Commissions & Salaries 10% of production costs $4,006 Shipping Expenses 4% of prime cost $1,000 Warehousing 6% of prime cost $1,500 Total Marketing, Selling & Distribution Costs $7,651 16.0 Total Costs $ 47,710 100.0 4. Mark-Up Profit and Taxes 20% of selling price $ 11,928 $ 11,928 Selling Price $ 59,638 Unit Selling Price = $ 59,638/100 = $ 596.38 or $ 600.00/unit
- 169. which takes 0.20hrs/unit at $ 20/hr, and operation 2, which takes 0.40hrs/unit at $25/hr. The special tooling for the job is $ 3,600. The mark-up for profits and taxes is 20 percent of the selling price. The example costs and selling price are present- ed in Table 11.3, with the unit selling price of $596.38 and a unit cost of $477.10. With a tax rate of 40 percent, one must charge $1.67 for every $1.00 of after-tax profit desired, and this is one reason why businesses dislike the taxes so much. The contingency costs are primarily for new products and processes, and would be low for standard products. The con- tingency costs are for expected tooling changes and process changes that would be required from expected design errors or incorrect process parameters. The form is illustrative to indicate the various items that must be tracked to determine the total and unit costs. A form must be designed to the particular operations and materials of the particular company, and, as illustrated in Table 11.1, there are a wide variety of possible operations. It is not prac- tical to design a form to include all types of operations and materials. The costs in the form follow the ladder of costs, and the percentages of the total cost can be included in the form as illustrated in Table 11.3 BREAK-EVEN ANALYSIS 4.1 Introduction There are two critical issues in break-even analysis [9, 10] that must be considered and they are (a) the cost base and (b) the various break-even points. The two different cost bases are the time base and the quantity base. The quantity-based break-even analysis determines the production quantity at the specific break-even point, and this has worked for mar- keting, sales, and top management for forecasting yearly sales and other long-range planning activities. However, it provides little assistance at the plant management level where the production quantity is not a variable, but is a quantity specified by the customer. Time-based break-even analysis focuses on the time to pro- duce the order, which is something under the control of the plant supervision. Time-based break-even analysis deter- mines the production time for the specific break-even point, and this is what can be controlled at the plant level. The same break-even points can be used in either system, but the costs must be considered carefully as the different bases—time and quantity—result in different conclusions with respect to the variability of the costs. Costs are generally classified as fixed costs, variable costs, and semivariable costs, but whether a cost is fixed, variable or semivariable depends upon the cost base used. One of the difficulties in promoting the time-based system is that what has been treated as a variable cost in the quantity-based sys- tem is often fixed in the time-based system and vice-versa. The second issue with break-even points is that increased quantities are desired in the quantity-based system, whereas decreased times are desired in the time-based system. Cost Bases Costs are generally classified into three major groups: (1) fixed, (2) variable, and (3) semivariable. How the costs are assigned to a group depends upon the cost base; that is, whether the cost base is the quantity base or the time base. Since production quantity has been the standard base, this base will be considered first. Costs that do not vary with respect to production quantity are considered as fixed costs, and some of the commonly designated fixed costs are prop- erty taxes, administrative salaries, research and development expenses, and insurance. Variable costs are those that vary linearly with production quantity, and the most common variable cost items in the production quantity base are direct material costs and direct labor costs. The costs that do not fit into either of the fixed or variable costs are classified as semi- variable costs, and an example of semivariable cost is main- tenance cost. When a time-based system is used, many of the cost compo- nents in the fixed and variable categories change when com- pared to the quantity-based system. Costs that do not vary with respect to time are considered as fixed costs, and these would be items such as the direct material costs. For as the production quantity is fixed, the material costs would be fixed. On the other hand, costs such as property taxes, administrative salaries, research and development expenses, and insurance would be considered as variable as they must be recovered over time. Direct labor may be a fixed or vari- able quantity depending upon the policies used. If the direct labor does not vary per unit of production, then with a fixed quantity, the direct labor cost would be a fixed cost on the time basis. If the labor force were fixed, such as when man- agement does not layoff employees, then it would be similar to a fixed salary and the cost would be variable with respect to the time to do the work. Break-Even Points The four break-even points that are considered in the prof- itability evaluation of products or operations are the shut- down point, the cost point, the required return point, and the required return after taxes point. These points can be evalu- ated on either the time based or quantity based system. The points can be defined as follows: • Shutdown Point (SD)—The shutdown point is the quantity or time where the manufacturing costs equals the revenues. In the production quantity system, it is the production quantity at which the revenues equal the manufacturing costs. In the production time system, it is the production time at which the revenues equals the 11.8 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL
- 170. manufacturing costs. The manufacturing costs include the material costs, tooling costs, labor costs, and plant/shop overhead costs. • Cost Point (C)—The cost point is the quantity or time where the total costs equals the revenues. In the produc- tion quantity system, it is the production quantity at which the revenues equal the total costs and in the pro- duction time system, it is the production time at which the revenues equal the total costs. The total costs include the manufacturing costs plus all other costs such as the administrative costs, selling and marketing, research and development expenses, and etc. • Required Return Point (RR)—The required return point is the quantity or time where the revenues equals the total costs plus the required return. In the production quantity system, it is the production quantity at which the revenues equal the total costs plus the required return. • Required Return after Taxes Point (RRAT)—The required return after taxes point is the quantity or time where the revenues equals the total costs plus the required return and the taxes on the required return. In the production quantity system, it is the production quantity at which the revenues equal the total costs plus the required return plus the taxes on the required return. In the production time system the required return after taxes point is the time at which the revenues equals the total costs plus the required return plus the taxes on the required return. The breakeven points increase in quantity as one proceeds from the shutdown point to the required return after taxes point in the production quantity-based system, which implies higher production quantities are desired. However, the breakeven points decrease in time as one proceeds from the shutdown point to the required return after taxes point in the time-based system. The decrease in time indicates the impor- tance of decreasing production to increase profitability and is similar to the “just-in-time” concept that focuses on time. Breakeven Example Problem A metalcasting example will be used to illustrate both the production quantity-based approach and the time-based approach to determining the four breakeven points. The same data will be used to illustrate that both methods can be utilized, but the time-based system gives results that are more meaningful. A new job is being considered in the foundry. The order is for 40,000 castings, and the tentative price is $ 3.00/casting. The pattern will be designed for 4 castings per mold, and the pat- tern cost has been quoted at $ 10,000. The molding line is the rate controlling step in the production process in this partic- ular foundry, and the production rate is 125 molds/hr. The estimated time for the production of the 40,000 castings would be determined by: (40,000 castings)/(4 castings/mold x 125 molds/hr) = 80 hr The costs and overheads are included in Table 11.4, and the corporate tax rate is estimated at 40 percent. Production Quantity-Based Calculations—The calculations for the four break-even points will be made using “X” as the variable representing the number of units of production. Shutdown Point Revenues = Production Costs 3X = Material Costs + Labor Costs + Tooling Costs + Plant Overhead Costs 3X = 1.50X + 0.33X + 10,000 + 8,800 3X = 1.83X + 18,800 1.17 X = 18,800 X = 16,068 units Cost Point Revenues = Total Costs Revenues = Production Costs + Overhead Costs 3X = 1.83X + 18,800 + 12,000 3X = 1.83X + 30,800 1.17X = 30,800 X = 26,324 units Required Return Point Revenues = Total Costs + Required Return 3X = 1.83X + 30,800 + 9,600 3X = 1.83X + 40,400 1.17X = 40,400 X = 34,530 units Required Return After Taxes Revenues = Total Costs + Required Return + Taxes for Required Return 3X = 1.83X + 30,800 + 9,600 + 9,600 x (TR/(1-TR)) 3X = 1.83X + 40,400 + 6,400 1.17X = 46,800 X = 40,000 units The results from the production quantity model can be sum- marized as follows: a. If the production quantity is less than 16,068 units do not accept the order as the manufacturing costs will not be recovered. b. If the production quantity is between 16,068 and 26,324 units, the manufacturing costs will be recovered, but not all of the overhead costs. c. If production quantity is between 26,424 and 34,530 units, 11.9 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING
- 171. all costs will be recovered, but not all of the required return will be recovered. d. If the production quantity is between 34,530 and 40,000 units, all of the costs and the required return will be recov- ered, but not all of the taxes for the required return will be recovered. (Thus, the required return will not be recovered after taxes as the government will take its share for taxes). e. If the production quantity is more than 40,000 units, the required return will exceed the desired required return on an after tax basis. The results can be graphically illustrated using total costs versus production quantity as illustrated in Figure 11.3. The various breakeven points are shown increasing in quantity from the shutdown point to the required return after taxes. Figure 11.4 is a plot of unit cost versus production quantity and illustrates the various break-even points. The break-even points on the two graphs are the same values, but the two fig- ures are quite different. The symbols SD, C, RR, and RRAT represent the break-even points at the shutdown, cost, required return, and the required return after taxes. 11.10 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL Cost Item or Revenue $/unit $/hr $ Decimal Revenue 3.00* (120,000) Manufacturing Costs Direct Costs Material Costs Hot Metal Cost 1.00 Core Costs 0.35 Filter Cost 0.10 Sand Preparation Cost 0.05 1.50 1.50* (60,000) Pattern Cost ` 10,000** Labor Costs Melting 0.10 Molding & Coremaking 0.08 Finishing 0.15 0.33 0.33* (165) Indirect Costs Plant Overhead Rate (110) 8,800* Overhead Costs General Administrative, Sales, and Marketing Overhead Rate (150) 12,000* Required Return and Taxes Required Return (120) 9,600* Tax Rate (40%) 0.40** Taxes for Required Return (80) 6,400* *values used for quantity based model **values used for both models ( ) values used for time based model Conversion Factors for Data: Production Rate: 500 units/hr or 0.002 hours/units and thus 0.33$/unit x 500 units/hr = 165 $/hr Production Time: 40,000 units/ 500 units/hr = 80 hours and thus 110$/hr x 80 hr = $ 8,800 Table 11.4. Cost Data for Time-Based and Quantity-Based Break-Even Example Problem
- 172. Time-Based Calculations The calculations for the four break-even points will be made using “Y” as the variable representing the hours of production. Shutdown Point Revenues = Production Costs Revenues = Material Costs + Labor Costs + Tooling Costs + Plant Overhead Costs 120,000 = 60,000 + 165Y + 10,000 + 110Y 120,000 = 70,000 + 275Y 275Y = 50,000 Y = 181.8 hours Cost Point Revenues = Total Costs Revenues = Production Costs + Overhead Costs 120,000 = 70,000 + 275Y + 150Y 120,000 = 70,000 + 425Y 425Y = 50,000 Y = 117.6 hours Required Return Point Revenues = Total Costs + Required Return 120,000 = 70,000 + 425Y + 120Y 120,000 = 70,000 + 545Y 545Y = 50,000 Y = 91.7 hours Required Return After Taxes Revenues = Total Costs + Required Return+ Taxes for Required Return 120,000 = 70,000 + 425Y + 120Y + 120Y x (TR/(1-TR)) 120,000 = 70,000 + 425Y + 120Y + 120Y x (0.4/(1-0.4)) 120,000 = 70,000 + 425Y + 120Y + 80Y 625Y = 50,000 Y = 80.0 hours The results are from the production time-based model can be summarized as: a. If the production time is more than 181.8 hours, do not accept the order as the manu- facturing costs will not be recovered. b. If the production time is between 117.6 and 181.8 hours, the manufacturing costs will be recovered, but not all of the overhead costs. c. If production time is between 91.7 and 117.6 hours, all of the costs will be recovered, but not all of the required return will be recov- ered. d. If the production time is between 91.7 and 80.0 hours, the costs and the required return will be recovered, but not all of the taxes for the required return will be recovered. (Thus, the required return will not be recovered after taxes as the government will take its share for taxes). e. If the production time is less than 80.0 hours, the required return will exceed the desired required return level on an after tax basis. The results can be graphically illustrated using total costs versus production time as illustrated in Figure 11.5. The var- ious breakeven points are shown decreasing in time from the shutdown point to the required return after taxes. Figure 11.6 is the profitability plot, which shows the profitability as a function of the production time and the various break-even points. The profitability plot illustrates the importance of 11.11 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING 10000 20000 40000 30000 50000 0 0 20 60 40 80 100 120 140 Taxes Profits Revenue Production Quantity ) 0 0 0 1 $ ( e u n e v e R r o t s o C l a t o T RRAT SD RR C Cost + Required Return + Taxes on Return Cost + Required Return Total Cost Production Cost 1 2 3 4 1 2 3 4 10000 40000 30000 20000 1 3 4 2 0 5 Production Cost Total Cost Cost + Required Return Cost + Required Return + Taxes Revenue RR C SD Production Quantity ) t i n U / $ ( t s o C t i n U RRAT 0 Figure 11.3—Total Cost and Revenues Versus Production Quantity Figure 11.4—Unit Cost versus Production Quantity
- 173. reducing production time for increasing profitability. The plot can illustrate either constant amount or constant rates of required return on the break-even points. The advantage of the time-based break-even analysis is that it can answer questions such as what is the effect of a 4 hour delay due to a machine breakdown. The effect is not obvious from the quantity breakeven analysis, but the time based break-even analysis indicates that 84 hours is between the required return and required return after taxes break-even times; that is all costs are recovered and the required return will be exceeded before taxes but not after taxes. This can be evaluated by determining the profit fromthe following: Profit = Revenues - Costs Profit = $120,000 - ($70,000 + 425$/hr x time (hr)) Profit = $50,000 - 225$/hr x 84hr Profit = $14,300 Profit after taxes = (1-TR) x 14,300 = 0.6 x 14,300 = 8,580 Since the required return after taxes was 9,600 and the required return before taxes was $16,000, the $ 14,300 amount is between the two expected values. The loss on the time-base system could also be evaluated at $ 425 (165 + 110 + 150 = 425) per hour, and for 4 hours down the loss would be $1,700. The loss in the quantity-based system can be obtained by using some of the conver- sion factors; the loss of 4 hours is equivalent to the production loss of 2,000 units. This loss would be the labor lost plus the plant overhead and the overhead costs for four hours; thus the loss would be 2,000 units x 0.33$/unit + 4hr x (110 + 150) =$660 + $1,040 = $1,700 The time-based approach is much easier to determine and more straightforward. Time-based break-even analysis would also be useful in evaluating the cost of bottle- neck delays and provide data for the eco- nomic justification of new equipment to improve productivity. The high cost of delays indicate that one of the factors to consider is the evaluation management’s performance, and this can be done using a time-based system. The evaluation of bot- tlenecks and delays is critical in the “theory of constraints” and supply-chain manage- ment, and the focus is upon time in these situations. CONCLUSIONS Discrete part manufacturing involves the production of sepa- rate, individual products, usually in small batches of 75 units or less. A wide variety of operations are used for the manufactur- ing of discrete parts as well as a wide variety of materials. Various manufacturing philosophies and terms for estimating in discrete manufacturing have been presented. The ladder of costs (Figure 11.2) illustrates the interrelationships between the various cost terms, and a cost estimating form (Tables 11.2 and 11.3) has been presented for discrete manufacturing. 11.12 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL 0 25000 50000 75000 100000 125000 150000 0 25 50 75 100 125 150 175 200 Production Time (Hours) e u n e v e R r o t s o C l a t o T Revenue SD Production Cost Overhead Cost Required Return Taxes RRAT RR C -25000 0 25000 50000 75000 100000 125000 0 25 50 75 100 125 150 175 200 Production Time (hrs) ) $ ( y t i l i b a t i f o r P 0 Production Cost Taxes RRAT Required Return O.H Cost Profits RR C SD Figure 11.5—Total Cost and Revenues Versus Production Time Figure 11.6—Profitability Plot for Time-Based System
- 174. Time-based break-even analysis has been presented along with the traditional quantity-based breakeven analysis to illustrate the differences and similarities in the two approach- es in analyzing the same set of data. The classification of costs as to whether they are fixed, variable, or semivariable depends upon which cost base is used, and that is the time base or the quantity base. The four basic break-even points of shutdown, cost, required return, and required return after taxes are illustrated in both the time-based and production quantity-based systems. The quantity-based approach is appropriate for marketing and sales forecasting as they need to estimate the revenues obtained and predict the sales quantities. However, at the plant level, where scheduling of the daily operations are con- cerned, the focus is upon time and time-based break-even analysis is more appropriate. Time-based breakeven analysis is also more appropriate to the newer approaches to produc- tion management, such as the “theory of constraints,” “just- in-time,” supply chain management, and “lot-size-of-one,” in that the focus is upon time rather than quantity. The prof- itability plots indicated the importance of production time reductions upon improving profits, which complements the just-in-time philosophy for manufacturing. PRACTICE PROBLEMS AND QUESTIONS Questions: a. What is the prime cost? b. What is the factory cost? c. What is the production cost? d. What is the selling price? e. What is the manufacturing cost? f. What is the selling price per unit? Answers: a. $70,000 b. $73,000 c. $80,000 d. $108,000 e. $73,000 f. $36.00 Questions: Calculate the break-even points using the pro- duction quantity approach on the above data. Illustrate the break-even points on either the total cost-revenue versus the production quantity plot or on a unit cost versus production quantity plot. (Shut-down—33.3 units, cost—266.7 units, required return—333.3 units, after taxes—377.8 units) Questions: Calculate the break-even points on a production time basis for the above data. Illustrate the break-even points on a total cost-revenue versus production time plot. Also con- struct a profitability plot illustrating the break-even points. (Shut-down—500 hours, cost—250 hours, required return— 200 hours, after taxes—176.47 hours) REFERENCES 1. AACE International. 1990. Standard Cost Engineering Terminology. AACE Recommended Practice No. 16R 90. Morgantown, West Virginia: AACE International. 2. Creese, R. C., and I. Ham. 1979. Group Technology for Higher Productivity and Cost Reduction in the Foundry. AFS Transactions. Vol. 87. pp. 227–230. 3. Creese, R. C.. M. Adithan, and B. S. Pabla. 1992. 11.13 AACE INTERNATIONAL DISCRETE PRODUCT MANUFACTURING Problem 1—The data for the following product was obtained for an order of 3,000 parts: Direct material costs $40,000 Factory Expenses $ 3,000 Direct labor costs $8,000 Administrative Expenses $ 7,000 Direct engineering cost $6,000 Selling and Distribution Expenses $10,000 Direct burden $16,000 Mark-up rate 20 percent Units produced 3,000 Problem 2 Item $/unit $ Decimal Sales Revenue 20 Manufacturing Costs Direct 3 Indirect 2 500 Overhead 3,500 Required Return 1,000 Tax Rate 0.40 Problem 3 Item $/hr $ Decimal Sales Revenue 15,000 Manufacturing Costs Direct 18 4,000 Indirect 2 1,000 Overhead 20 Required Return 10 Tax Rate 0.40
- 175. Estimating and Costing for the Metal Manufacturing Industries. New York: Marcel Dekker. 4. Creese, R. C. 1998. Time-Based Break-Even Analysis and Costing. 1998 AACE International Transactions. Morgantown, West Virginia:AACE International. pp. ABC.02.1–ABC.02.6. 5. Creese, R.C. 1998. Time-Based Breakeven Analysis. 1998 Joint Cost Management Societies Proceedings. pp. AACE.02.01–AACE.02.07. 6. Creese, R.C. 1998. Introduction to Manufacturing Processes and Materials. New York: Marcel Dekker. 7. Kalpakjian, Serope, and Steven R. Schmid. 2001. Manufacturing Engineering and Technology. 4th ed. Upper Saddle River, New Jersey: Prentice Hall. 8. Postula, Frank D. 1989. Total Quality Management and the Estimating Process-A Vision. Paper for BAUD 653. System Acquisition and Project Management. July 13. 9. Winner, R. I., et.al. 1988. The Role of Concurrent Engineering in Weapons Systems Acquisition. IDA Report R-338. 1988, December, Institute for Defense Analysis, Alexandria, Virginia. 10. Wright, Paul Kenneth. 2001. 21st Century Manufacturing. Upper Saddle River, New Jersey: Prentice-Hall. 11.14 DISCRETE PRODUCT MANUFACTURING AACE INTERNATIONAL
- 176. Section 3 Planning & Scheduling
- 178. INTRODUCTION What Is Planning? “A stitch in time saves nine.” “Prior planning prevents poor performance.” “When all else fails, follow the instructions.” Each of these expressions has been heard many times, and each in its own way repeats a well-known fact: an undertak- ing that has the benefit of up-front planning and that is exe- cuted according to plan stands the best chance of success. Yet we often find ourselves feeling rushed, ignoring the need to plan, and stumbling ahead, planning as we go. When this happens, we usually end up muttering another oft-heard expression: “There's never time to do it right the first time, but there's always time to do it over.” And after doing it over, we often find we've lost time, money, and credibility. Planning can be defined as influencing the future by making decisions based on missions, needs, and objectives. It is the process of stating goals and determining the most effective way of reaching them. This future-oriented decision process defines the actions and activities, the time and cost targets, and the performance milestones that will result in success- fully achieving objectives. The process involves several steps: • setting objectives, • gathering information, • determining feasible alternative plans, • choosing the best alternative, • communicating the plan, • implementing the plan, • adjusting the plan to meet new conditions as they arise, and • reviewing the effectiveness of the plan against attain- ment of objectives. LEARNING OBJECTIVES After completing this chapter, the reader should be able to: • understand the importance of planning and of establishing a “planning culture” in an organization, • identify the planning tools available to the cost engineer, and • understand the major elements of planning. THE IMPORTANCE OF PLANNING Planning is of the greatest importance, because in its plan- ning, an organization makes implicit assumptions about its future so it can take action today. It would be convenient if cost/benefit studies were available to prove the value of planning. Theoretically, we could measure planning payoff by relating the value of what we have achieved through plan- ning to the cost of the planning. Unfortunately, it is a rare sit- uation that offers the opportunity to quantify both the out- comes attained through planning and the outcome attained without planning. Accordingly, we must rely on other indi- cators. The Stanford Research Institute did this in a formal study some years ago, finding that companies that support- ed planning programs experienced superior growth rates when compared to companies that did not. The reason for this becomes obvious when examined in light of the cycle that leads to growth. Given any project or opportunity, a company develops a plan to maximize that opportunity. In doing so, it uses the best information available. When the plan is implemented, activi- ties are carefully monitored and controlled, using the plan as a reference baseline. Complete records are maintained through the execution phase. Finally, the experience gained is fed back to the company to increase its knowledge base for the next planning action. This cycle represents the learning curve in action—each repetition makes planning for and achieving the next opportunity much easier. Without a firm commitment to the planning cycle, a company is continually 12.1 AACE INTERNATIONAL PLANNING Chapter 12 Planning Jennifer Bates, CCE
- 179. “reinventing the wheel,” wasting time and money, and jeop- ardizing its place in the competitive marketplace. Establishing a Planning Culture Planning is not done by upper management alone; it exists in a hierarchical structure made up of policies, strategic plans, and operational plans. Different organizational levels pro- duce plans that are quite different in type and scope. Nevertheless, everyone involved in an undertaking must plan, whether their charge is to develop a long-range plan for company growth or to develop a personnel procurement plan for a specific project. There are numerous reasons why a company that encourages a proactive, structured approach to planning will reap significant benefits over a company whose planning approach is reactive or random: • preparing a clear scope definition minimizes the poten- tial for overlooking an aspect critical to success; • if undertaken as a team effort, it permits various view- points and ideas to be expressed; • the resultant plan, if well documented, provides a means of communication between the participants; • the plan provides a baseline for control during the exe- cution phase; and • post-completion reviews greatly reduce the potential for planning errors on subsequent activities. Effective planning becomes routine when planning is an inte- gral part of the company's culture. This begins with commit- ment by top management, continues with communication of that commitment to mid-level managers, and becomes root- ed when every employee relates unequivocally with the com- pany's goals. As with any operation, if those who are to man- age a plan do not participate in its preparation, their level of commitment to success may be less than total. Therefore, using a team approach to planning builds participant confi- dence in the organization, stimulates communication among the parties, and promotes their feelings of ownership in the outcome. It also demonstrates that top management has a direction, that decision-making is under control, and that the total organization is working to achieve the same objectives. An additional, but no less important, result of the team approach is the training “in-action” that lower-tier managers receive as they participate with upper management in the planning process. They are thus better able to assume higher levels of responsibility as opportunities develop, bringing with them a planning philosophy that is fully ingrained. The effectiveness of planning, even at the independent craft level or crew level, was demonstrated by a University of California study that examined differences in productivity between workers performing tasks in a clear area on the ground and workers performing the same tasks in an elevat- ed area. While it was expected that productivity would be less for tasks performed in an elevated area, just the opposite proved true: the ratio of elevated to on-ground productivity was, surprisingly, greater than 2:1. Analysis of these results showed that while workers would always carefully plan ele- vated work to minimize their exposure, they would plan on- ground work as it was performed. As a result, productivity was greatly decreased. These findings are supported by other studies showing that when planning takes place concurrent with task execution, workers tend to neglect planning, con- centrating instead on operating routines. The obvious lesson? Plan! Plan! Plan! At all levels! PLANNING TOOLS When planning tools are mentioned, the tendency is to think in terms of hardware, software, and procedures. Yet, the most fundamental and useful planning tool available is the experi- ence planning team participants have gained during previ- ous undertakings. While impossible to quantify, this experi- ence provides a sound basis for using the other, more tangi- ble planning tools. These include the following: • Commercial handbooks and software programs, a vari- ety of which are available—These should be used, of course, with an understanding of their basis and limita- tions rather than applying them across the board. • Standard, companywide policies and operating proce- dures that have been officially issued—Planners can then feel free to use them without having to continually seek management guidance and approval. • Model plans that can be adapted as necessary to spe- cific undertakings—Organizations that tend to under- take repetitive work should develop a model project and plan for each type of work. • Checklists that will support planning and help pre- vent overlooking key items that may have cost or schedule implications. • Historical databases cataloging company experience on past projects in a standard format for use in new endeavors. • Codes of accounts structured to catalog work, cost accounts, resources, and other information—These are essential if planning is to take advantage of available soft- ware. Codes of accounts should be standardized to the extent practical to ensure consistency of data cataloging and use. For work breakdown structures and cost break- down structures, the codes should be hierarchical to per- mit capturing information at various levels of detail. MAJOR ELEMENTS OF PLANNING Summarizing Goals and the Scope of Work Every undertaking, whether large or small, has a goal: con- struct a building, produce a certain number of items, or 12.2 PLANNING AACE INTERNATIONAL
- 180. obtain new or additional financing. This goal should be clear- ly understood and agreed upon by all planning participants (including top management) before any actual planning is begun. The basic approach to planning involves segmenting the total endeavor into manageable parts, planning each part in detail, combining the parts, testing the total against project objectives, and then refining the planning as necessary to eliminate variances from the objectives. In addition, great attention should be paid to accurately defining the scope of work since scope definition in and of itself provides a means of identifying areas where planning for changes (as discussed later in this chapter) should take place. The most effective tool to use in ensuring that all work scope is planned is the work breakdown structure (WBS). The WBS is a tree structure of successively further break- downs of work scope into component parts for planning, assigning responsibility, managing, controlling, and report- ing project progress. All planning efforts should be organized to the WBS developed for the project. Planning takes place in numerous categories, but the most important of these are time, cost, resources, and quality. Time Planning Time planning entails developing plans, usually in the form of summary schedules, to accomplish all elements of an objective within an established time period. Later in the life cycle, these summary schedules are developed into detail schedules for accomplishing discrete tasks. This process begins with estab- lishing a need date or other milestone at which all actions must be complete, and works backward from that point. The second step in time planning is dividing the total effort into component parts. After components are identified, they should be arrayed in the order of their accomplishments. This goes beyond merely preparing a list, however, since some activities must be handled in strict sequence while oth- ers may be executed simultaneously. For still others, a num- ber of options may exist. One of the most advantageous for- mats for arraying activities is the critical path logic diagram. In this format, arrows or nodes representing each component or activity are displayed in logical sequence, showing dependencies among all activities where an actual constraint is present (e.g., one activity cannot start before another is fin- ished). Since several ways of handling the overall project may exist, it may be appropriate to develop two or more logic diagrams and then test each option. Figure 12.1 contains a simple logic diagram for marketing a new project manage- ment software program. After the logical display is complete, a duration is assigned to each activity, based either on data contained in a software program or on experience of the planning participants. Then, using critical path techniques (as discussed in chapter 13), the total time requirement for the endeavor is determined. If the total exceeds the available time, planners must reevaluate their work and take whatever action is needed to meet time objectives: perhaps optional activities can be dropped and others can be shortened by applying more resources or other schedule compression techniques. The results of time plan- ning can be displayed in numerous ways: the critical path logic diagram mentioned above, a bar chart, or a simple time table. Scheduling is discussed in greater detail in chapter 13. 12.3 AACE INTERNATIONAL PLANNING Figure 12.1—Simple Logic Diagram Prepare Marketing Survey Develop Advertising Plan Draft General Sales Brochure Layout General Sales Brochure Print General Sales Brochure Deliver Brochure to Sales Staff D r a f t S p e c i a l A p p l i c a t i o n s B r o c h u r e Layout Special Applications Brochure P r i n t S p e c i a l A p p l i c a t i o n s B r o c h u r e GLOSSARY TERMS IN THIS CHAPTER planning ◆ scheduling work breakdown structure (WBS)
- 181. Cost Planning Just as total time effort was partitioned, total cost must be partitioned as well. This may be done using a cost break- down structure (similar to the WBS mentioned earlier), which is merely a catalog of all cost elements expected to be incurred, the sum of which equals the budget for the endeavor. Ideally, this segmentation will parallel the time breakdown; in fact, the objective is to have the time breakdown exist within the cost breakdown. This, however, may not be possible since not all costs are directly related to a specific activity; i.e., they may be overhead costs or general and administrative costs, which will appear in the cost breakdown but not in the work breakdown. Where costs and actions do coincide, a control account is created. The basics of determining costs of individ- ual accounts and the subject of budgeting are discussed in other chapters. Figure 12.2 shows the relationship between a WBS and a cost breakdown structure (CBS) for an engineering/pro- curement/construction project. Resource Planning Resources involved in an undertaking generally include per- sonnel, support equipment and tools, permanent materials and installed equipment, and expendable supplies. Some combination of these are involved in each control account that appears on the integration of the WBS/CBS. The deci- sion as to the resources to be applied is primarily based on experience and judgment, although specific undertakings may require other input as well. Every resource requirement must be accounted for in the cost breakdown so that esti- mates of costs for individual control accounts, as well as total estimated costs, can be generated. Identifying resource requirements is only a first step in the resource planning process, since the resources also must be available in the quantities needed at the proper time. Thus, supporting resource plans will exist behind the total resource plan. In most instances, certain resources will be identified as critical to project success, and their management will be given par- ticular attention. Quality Planning The overall objective of planning is to achieve a high-quality result on time and within budget. Quality objectives are met if this is done without undue confusion or disruption. This requires developing a quality plan that consists of the under- 12.4 PLANNING AACE INTERNATIONAL Figure 12.2—The Relationship Between WBS and CBS DIRECTS Labor Equipment Material INDIRECTS (1) Detailed Engineering Startup PHASES Construction Procurement Conceptual Engineering Other (2) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ WH WH WH WH WH $ $ $ $ $ TOTAL PROJECT COST AND WBS RELATIONSHIP The cost breakdown structure (CBS) is composed of all elements in the matrix for which dollars ($) are budgeted. The total dollar value of all of these elements equals the project budget. The work breakdown structure (WBS) is composed of those direct labor elements in the matrix for which work- hours (WH) are budgeted and lend themselves to work progress measurement. Legend: Footnotes: 1. Supervision above first level, staff, facilities, supplies, and services, etc. 2. Home office overhead, contingency reserve, profit, etc.
- 182. taking's requirements (goals), a method for communicating the requirements to those responsible for achieving them, a plan for training the responsible persons, and a way of meas- uring successful achievement. Review Post-action review of the planning that went into an endeav- or is an important, yet often neglected area. Still, without good reporting and review even while the undertaking is in process, control does not exist. Therefore, everyone involved must be kept informed as to progress, problems, modifica- tions, and other factors critical to success. This requires mak- ing an early assessment of the required reports, meetings, presentations, and project documents, and determining which ones are vital to accurate performance assessment. PLANNING IN THE CONSTRUCTION INDUSTRY Research has shown that most owners and construction organizations are very limited in the scope of their construc- tion planning. They tend to emphasize time planning, and to a lesser extent, resource allocation and cash flow, paying min- imal attention to work methods, materials management, and similar areas. In fact, many commercial textbooks on project management treat planning and scheduling as synonymous, and many organizations even use the job classification Planning and Scheduling Engineer. Yet the term planning is rarely, if ever, part of the job titles of those involved in engi- neering, field erection, quality, materials, or budget planning. Beyond this, the construction industry has become very dependent on sophisticated scheduling software packages for time planning, while neglecting those available to facili- tate other types of planning. Most unusual of all, critical- path-based scheduling programs (that are predicated on strict, logical interrelationships of activities with fixed dura- tions) are being applied in an industry characterized by extreme variability and uncertainty. How important is construction project planning? Several years ago, a major U.S. contractor studied the factors con- tributing to the success or failure of its projects. By reviewing the records of several hundred completed projects, some suc- cessful in achieving project objectives and some not, factors common to successful projects but lacking in less successful ones were identified. It became evident that the major factor directly influencing success was the quality and depth of early planning by the project management group. What is the planning record of the construction industry? Many of the construction cost overruns experienced over the past two decades can be attributed to poor planning at some level. A 1981 study covering hundreds of construction proj- ects used an index of 100 to represent the expected cost of a project with reasonable planning. Actual costs were convert- ed to an index relative to that base. Results indicated that actual cost indices ranged from 60 to 500, with an average of 150. In other words, when planning was exceptional, savings reached 40 percent, while poor planning created overruns as high as 400 percent, and even average planning led to proj- ects costing 50 percent more. Construction industry groups, such as the Business Roundtable and the Construction Industry Institute, have recognized that reasonable planning efforts can yield savings of up to 40 per- cent if applied to critical areas. This has led them to emphasize the importance of scope definition, value engineering, con- structability, materials management, and quality management in successfully attaining project objectives. Why has the construction industry seemingly lagged in its planning efforts? Several reasons are usually given: • planning time is often limited, • staff resources are spread over numerous projects, and • lessons learned on completed projects cannot be applied directly to new projects. Valid as these reasons may be, they need not prevent the implementation and use of planning. While planning time may be limited, more time is seldom available. Still, the plan- ning process can be made faster and easier by using standard procedures and models that can be adapted easily to each new project. Checklists also will help to ensure coverage of all areas. The best solution to spreading staff resources over numerous projects is for management to become more selec- tive in choosing projects on which to bid, so the staff can con- centrate on the projects that have the most potential. Finally, while previous experience is a valid component of effective planning, the tendency is to place too much emphasis on database information and not enough on investigating the new project. Since no two projects are precisely alike, the information in the database must be adapted to each new project and adjusted accordingly. Integrating the Elements of Planning Integrated project or process control is possible only if the planning also has been integrated—in other words, when time, cost, and resource planning have been accomplished against the same basic structure. The WBS and CBS provide the common structure for this planning, since one level of the WBS elements becomes activities for scheduling as well as a center for tracking resources and costs. This enables resource loading the schedules, resource budgeting against time, and developing a variety of cost budgets plotted against time. Planning for Change A frequently neglected aspect of planning is contingency planning. Change is inevitable, whether it is internally or 12.5 AACE INTERNATIONAL PLANNING
- 183. externally driven. But even though it is unlikely that the objectives set forth at the beginning of an undertaking will change, the possibility of everything going according to plan is quite remote. Recognizing that change is inevitable, plans almost invariably must be based on assumptions subject to some variability. They must not be cast in stone but rather should be flexible enough to allow for changes at any point during the life cycle of the endeavor. A good plan provides sufficient alternatives so it still functions even when extreme changes occur. Contingency planning can take at least two forms, both based on “what-if” type questions. The first is developing an alter- nate plan that can be implemented in the event an adverse sit- uation arises: e.g., what if a concrete pump breaks down in the middle of a large pour? Even though every eventuality cannot be addressed, concentration on critical areas is advised. The second form of contingency planning addresses budget and schedule and sets out a way to handle unfavorable vari- ances in these areas. In establishing contingency accounts, planners must first attempt to identify risk elements—acci- dents, vandalism, theft, work quantity variances, productivi- ty, unfavorable weather, adverse labor activity, etc. While cer- tain of these risk elements are insurable, it is seldom at the 100 percent level. Structured techniques are available for evaluating combined exposure to uninsured risk elements in which exposure is usually expressed in terms of a probabili- ty of loss not exceeding certain limits. Using this information, amounts are established for both cost and schedule contin- gency. These accounts are managed with the same care as any other control account. CONCLUSION Strong, effective planning is the main ingredient in project or opportunity success, since it focuses the attention of an organization on its future. Planning is the responsibility of all participants: thus companies should strive, through training and practice, to develop a planning culture and to provide the tools necessary to facilitate the planning process. Plans should be documented and made available as appropriate to all individuals involved in the undertaking. Since the future is unknown, and changes will occur despite the best plan- ning efforts, plans must always be flexible. While time and cost planning are important, planning in other areas will reap nearly as many benefits. Finally, management should have rigid standards for bidding on projects, thus allowing staff resources to be applied where they will be most productive. Planning for success is no small endeavor. When done well, however, it will reap many large rewards. Portions of this chapter are from previous editions authored by Remo J. Silvestrini, CCE; Dr. James M. Neil, PE CCE; and Jennifer Bates, CCE. 12.6 PLANNING AACE INTERNATIONAL
- 184. INTRODUCTION Why Scheduling is Important Scheduling is the process that converts the project work plan into a road map, that if followed, will assure timely project completion. Scheduling is one of the tools used for monitor- ing and controlling projects to ensure the objectives of cost, quality, and time are met. Schedules provide the baseline against which progress is measured. Schedules are used to assess time impact of changes to the work scope. Effective project management involves coordinating activities such as planning, organizing, implementing, and controlling time and cost. Time control is usually achieved by preparing and using schedules to make the most efficient use of available time. Scheduling is an important and integral part of the over- all planning effort, since the scheduling process forces people to quantify their effort in discrete terms and to place activities in proper relationship to each other. The planning (as dis- cussed in Chapter 12) and scheduling functions are usually performed iteratively in order to accomplish all required tasks within the specified time frames. Benefits of Scheduling Scheduling provides a basis for management of the work, improves communications, and facilitates coordination. Using a schedule improves the effective use of resources. The project schedule gives the user a baseline to monitor and con- trol the work. Scheduling provides a way of contributing input during proj- ect execution concerning means, methods, techniques, sequences, or other conditions affecting the plan’s outcome. Scheduling provides a means for obtaining feedback since the development and use is a team effort incorporating the ideas and objectives of those responsible for the work. Schedules are good motivational tools providing intended work plans to those having to perform the work and report- ing progress against them. Schedules provide a baseline for measurement and a means for collecting and recording progress. Budgets, costs, and resources can be integrated into project schedule activities providing a basis for measuring cost as well as time per- formance. Schedules may be used as a basis for payment applications supporting work completed. Critical path schedules are used and relied upon by courts for amending contract completion dates. When projects are faced with significant cost and time overruns, schedules are used as analytical tools to support assessments of labor efficiencies resulting from compression or extension of time, congested work areas, and disruption to planned work. The cost engineer must have an understanding of the impor- tance of using schedules effectively. Knowing only the cost and cost estimating functions limits the ability of the cost engineer to perform as a true project controls professional. LEARNING OBJECTIVES The purpose of this chapter is to provide a basic understand- ing of scheduling for seasoned, as well as new, project staff and other department personnel who rely on timely project completion. The objectives are as follows: • Become familiar with scheduling terms. • Gain an understanding of scheduling methods and tech- niques including each one’s benefits and risks. • Become familiar with the most commonly used method and technique that will meet your project objectives. • Obtain an understanding of work breakdown structures (WBS) and the dependencies between work tasks to enhance team efficiencies. • Apply overlapping schedule techniques and calculations that reflect real-world management applications. • Become familiar with managing changes to the schedule. 13.1 AACE INTERNATIONAL SCHEDULING Chapter 13 Scheduling Anthony J. Werderitsch, PE CCE
- 185. SCHEDULE DEVELOPMENT Tools for Developing Schedules Computer software for developing, progressing, and updat- ing schedules is affordable and readily available. Although computers are the tools, and software provides the means for developing schedules, the individual user must understand what the computer is performing. While numerous scheduling methodologies exist for develop- ing project schedules, two of the most common are bar charts and critical path. A third method, project evaluation review technique (PERT), is mostly used by government agencies for calculating the most likely duration for networks. Bar Chart (Gantt Chart) Method The bar chart, also called a Gantt chart, is primarily meant to control only time elements of a program or project. However, since there are no relationships between the activities, it is not possible to assess the impact of one activity on another nor on the time of completion of the project. When preparing a bar chart, the work effort must be divided into components, which are then scheduled against time. Preparing a bar chart involves several steps: 1. Analyze the program or project and specify the basic approach to be used in its execution. 2. Segment the program or project into a reasonable num- ber of activities that can be scheduled. 3. Estimate the time required to perform each activity. 4. Place the activities in time order, considering both sequential and parallel performance. 5. Adjust the diagram until the specified completion date, if one exists, is satisfied. Figure 13.1 below depicts a typical bar chart. The primary advantage of using a bar chart is that it is simple to read. The plan, schedule, and progress of the program or project can be depicted graphically on a single chart. Figure 13.1 shows the six-activity plan, 15-week schedule, and cur- rent status. The current status shows that Activity B has not started and is behind schedule (by 5 weeks), Activity C is slightly ahead of schedule (by 1 week), Activity E is slightly behind schedule (by 2 weeks), and all other activities are on schedule. However, it cannot be determined if Activity B or Activity E will have an impact on another activity or on the project completion. This graphical representation of work versus time is easy to read and provides a simple, under- standable way to schedule small undertakings. Bar charts have not been used successfully for large-scope, one-time-through projects primarily due to the following reasons: • The inherent simplicity precludes including sufficient detail to enable timely detection of schedule slippages on activities of relatively long duration. • The dependent relationships between activities cannot adequately be shown; thus, it is difficult to determine how progress delays in individual activities affect proj- ect completion. • Developing bar charts is essentially a manual, graphical procedure, which makes them difficult to establish and maintain for large projects; they also tend to become quickly outdated, thus diminishing their usefulness. Many large and technically demanding undertakings, such as developing weapons systems or constructing power plants, require schedules showing thousands of activities that take place in widely dispersed locations. Manually developed bar charts cannot adequately display this data, and are thus unsuitable for anything other than a summary display of information. 13.2 SCHEDULING AACE INTERNATIONAL A B C D E F 1 2 3 4 10 11 12 5 6 9 7 8 13 14 15 s e i t i v i t c A Time in Weeks Time Now Figure 13.1—Typical Bar Chart.
- 186. With today’s computer technology, however, if a network diagram (as discussed in the following sections) is prepared and the work scheduled, the display of relationships between the activities can be turned off or masked. This masking pro- duces a bar chart, at any level of the project schedule, which can be used as a communication tool for the most complex and largest of projects. Critical Path Method (CPM) The disadvantages of manually developed bar charts, cou- pled with other disadvantages that became evident during the mid-1950s, set the stage for development of network- based project management methodology. One of the meth- ods that emerged to overcome these weaknesses was critical path scheduling. The critical path method (CPM) is a sched- uling technique using arrow, precedence, or PERT diagram- ming methods to determine the length of a project and to identify the activities and constraints on the critical path. The critical path method enables a scheduler to do the fol- lowing: • Determine the shortest time in which a program or proj- ect can be completed. • Identify those activities that are critical and that cannot be slipped or delayed. • Show the potential slippage or delay (known as float) available for activities that are not critical. The critical path method (CPM) was designed for, and is use- ful on, projects where the duration of each activity can be estimated with reasonable certainty; it predicts how long an endeavor will take to complete. It also identifies the activities that control the overall length of the project. CPM is widely used in the process industries, construction, single industrial projects, prototype development, and for controlling plant outages and shutdowns. CPM computer software, known also as project management software, allows for the assignment of resources to activities. Assigning resources to the activities and allowing the resources to accomplish their assigned work based on their availability provides another variable in the overall project duration. Since the software has this capability, CPM net- working is also used by industries with fixed pools of resources such as maintenance and information technology projects. Project Evaluation Review Technique (PERT) Project evaluation review technique (PERT) is a probabilistic technique, used mostly by government agencies, for calculat- ing the “most likely” durations for network activities. During development of the Navy’s Polaris Missile Program in the late 1950s, the team had no historical basis to draw upon when estimating the length of time it would take to accomplish certain tasks. For each of the activities, the devel- opers of PERT estimated a best or shortest time, worst or longest time, and the most probable time to accomplish the tasks defined. Concurrent with the PERT network develop- ment, the team also developed computer software to run a probability analysis to arrive at a “most likely” duration for each activity and the overall project. PERT is considered an indeterminate process for activity and project durations, while CPM is considered a deterministic process. The network of activities developed for PERT are similar to the arrow diagramming method (ADM) and precedence dia- gramming method (PDM) networks. Because of the similari- ty and resemblance of a CPM network to PERT, the term PERT has been used as a synonym for CPM. Discussion of CPM The most commonly used scheduling method and the tech- nique that will meet your project objectives is CPM incorpo- rating overlapping logic. CPM is a scheduling technique using arrow or precedence diagrams (networks) to determine the length of a project and to identify the activities and constraints on the critical path. The critical path is defined as the longest chain or chains of activities, in terms of time or duration, through a network. Two basic methods of critical path scheduling are the following: • the arrow diagramming method (ADM) (also called activity-on-arrow, or the “i” - “j” method), and • the precedence diagramming method (PDM) (also called activity-on-node). 13.3 AACE INTERNATIONAL SCHEDULING GLOSSARY TERMS IN THIS CHAPTER activity ◆ activity description ◆ activity identification arrow diagramming method (ADM) ◆ backward pass bar chart ◆ calendar days ◆ constraints ◆critical path critical path method (CPM) ◆ early finish (EF) early start (ES) ◆ forward pass ◆ free float ◆ gantt chart late finish (LF) ◆ late start (LS) ◆ original duration (OD) overlapping scheduling technique ◆ PERT diagram planning ◆ precedence diagramming method (PDM) network ◆ milestone ◆ relationships; remaining duration schedule calendar ◆ schedule update ◆ scheduling scheduling levels ◆ status ◆ target schedule time scaled network ◆ total float work breakdown structure (WBS) ◆ work days (WD)
- 187. Arrow Diagramming Method (ADM) In arrow diagramming, the nodes in the network are the beginning and end of each activity. The activity beginning node is commonly referred to as the “i” node and the ending node as the “j” node. Each activity has a unique two number identification. This is referred to as the activity “i - j” number. The arrow diagramming method (ADM) is a method of con- structing a logical network of activities using arrows to rep- resent the activities and connecting them head to tail. This diagramming method shows the sequence, predecessor, and successor relationships of the activities. In ADM networks, project activities are shown on the arrows, with a node or event at each end. The tail of the arrow represents the begin- ning of the activity, and the head of the arrow represents completion of the activity. The activity number, or identifier, consists of tail and head numbers, which are commonly referred to as the “i” and “j” nodes. This node numbering system is used to number activities. Each node is uniquely numbered and is represented by a cir- cle. Nodes have no duration. A node represents a particular point in time during the course of a project. It is appropriate to have a convention, which is used to organize or track activ- ity data. Figure 13.2 shows how a typical arrow diagram network would look. The sequencing of activities in an ADM network must adhere to the following rules: • All activities that immediately precede other activities must be complete before the latter activity can be com- menced. No activity can start before its predecessors are complete. If this occurs, the activity must be subdivided • Neither the length of an arrow nor its direction in the network has any meaning—arrows imply logical rela- tionships only. • Each activity must have a different activity number. • Duplicate activity numbers are not permitted. A unique feature of ADM networks is the use of “dummy” activities. These are activities that have no time duration; they are used only to show relationships between activities that have more than one predecessor and/or to give each activity a unique “i - j” designator. Figure 13.2 also shows an ADM network using a dummy activity. Precedence Diagramming Method (PDM) In the precedence diagramming method (PDM), the logic network is constructed using nodes to represent the activities and connecting them by lines that show logic relationships. The nodes (activities) can be circles or boxes. Activities that precede other activities are known as predecessor activities. Activities that follow other activities are known as successor activities. Figure 13.3 shows a typical PDM network diagram. 13.4 SCHEDULING AACE INTERNATIONAL 1 2 4 5 3 Process Work Order Requisition Material Install Pump (Duration) (TF) ES LS EF LF y m m u D (Duration) (TF) ES LS EF LF (Duration) (TF) ES LS EF LF w e r C n g i s s A ) n o i t a r u D ( ) F T ( S E S L F E F L 1 1 2 2 4 4 5 5 3 3 Process Work Order Requisition Material Install Pump (Duration) (TF) ES LS EF LF y m m u D (Duration) (TF) ES LS EF LF (Duration) (TF) ES LS EF LF w e r C n g i s s A ) n o i t a r u D ( ) F T ( S E S L F E F L w e r C n g i s s A ) n o i t a r u D ( ) F T ( S E S L F E F L Figure 13.2—ADM Typical Activity Convention and Dummy Activity Activity A Activity B Figure 13.3—PDM Network • activity description (requisition material)—above the activity line. • activity duration—centered above the activity line. • activity number or ID—a unique “i– j” node number within node. The “i” node is 2, and the “j” node is 4. • TF (activity total float)—centered below the activity line. • ES (activity early start)—upper left side of the activity in question. (Note that this represents the largest value ES of all the activities preceding the node.) • EF (activity early finish)—upper right side of the activity line. • LS (activity late start)–left side below the activity line. • LF (activity late finish)—right side below the activity line.
- 188. In PDM, the activities are graphically represented by boxes that are assigned the properties of the activity they represent. The lines in the network represent the interrelationships between activities. These relationships are referred to as links, or constraints. Arrows are not needed; however, arrows are more descriptive than lines. The nodes are sketched large enough to include certain infor- mation about the activity. This practice follows a convention so that others may easily understand the network. It is common to show the following information for an activ- ity within the PDM node: • activity description. • activity ID—a unique activity number for identification and computer usage. • activity duration—number of work days required to accomplish the activity. Figure 13.4 refers to the OD, original duration. • activity schedule dates—typically both early and late dates are shown. • ES (early start)—earliest point in time that an activity can start based on the network relationships. • EF (early finish)—earliest point in time that an activity can finish based on the network relationships. • LS (late start)—latest point in time that an activity must start in order to avoid delaying the project’s completion. • LF (late finish)—latest point in time that an activity must finish in order to avoid delaying the project’s com- pletion. • activity float values—typically total float (TF) is shown as in Figure 13.4. Total float is the amount of time that the completion of an activity can be delayed without delay- ing the project’s completion. Total float is equal to the late finish minus the early finish or the late start minus the early start of the activity. Optional data that may be depicted within the node include resource requirements, codes, and percent complete. The development of the network involves the identification of the project activities and the relationship between these activities. It is recommended that an activity list be initially developed which identifies the intended relationships. The activity list serves as the tool to be used in the development of the network. Table 13.1 is a typical activity list identifying the project activities and the relationships between these activities. It is common to modify or expand upon this list as the network is developed. Development of a precedence network diagram represents a graphical depiction of the work plan. The network shown in Figure 13.5 is based on finish to start (FS) relationships. The successor cannot start until the predecessor is finished. For example, there are five activities, ASTART, AFINISH, B, C, and D. Activity ASTART is the first activity and can start any- time, Activity ASTART must be finished before Activity AFINISH and Activity B can start. Activity C cannot start until Activity AFINISH is complete. Activity D cannot start until Activity B and Activity C are finished. Figure 13.6 represents the network of this work plan. The benefit of using the PDM for networking and schedul- ing is the ease of applying overlapping techniques to the activity relationships. 13.5 AACE INTERNATIONAL SCHEDULING ACT ID OD TF ACTIVITY DESCRIPTION ES EF LS LF Figure 13.4—Typical Precedence Diagram Activity Activity ID Description Predecessor 100 Activity ASTART - 200 Activity B 100 300 Activity AFINISH 100 400 Activity C 300 500 Activity D 200, 400 Table 13.1—Precedence Network Activity List 100 ASTART 300 AFINISH 200 B 400 C 500 D 100 ASTART 100 ASTART 300 AFINISH 300 AFINISH 200 B 200 B 400 C 400 C 500 D 500 D Figure 13.5—Precedence Network Diagram
- 189. Overlapping Networks Techniques The use of overlapping network techniques is common in PDM applications. Overlapping network techniques allow activities to be grouped together, which reduces the number of activities in a network and can reduce the overall time of performance. The overlapping scheduling technique allows for the develop- ment of a schedule, which more closely represents how a plan- ner visualizes actual field conditions. For example, rather than wait for an activity to complete before starting the succeeding activity, it can be said that a successor activity can start a num- ber of days after the start of its predecessor, or that it can finish a number of days after the finish of its predecessor. Overlapping consists of two parts: a relationship and a lag value or constraint. Four types of overlapping relationships exist: 1. finish-to-start + lag (FS + N) Where “N” is lag, 2. finish-to-finish + lag (FF + N), 3. start-to-start + lag (SS +N), and 4. start-to-finish + lag (SF + N). In each case, a number of days (work periods) “N” are indi- cated that define the overlapped time frame, or the lead-time, between the activities in question. Lags can be either positive or negative, but are assumed to be zero if not specified. A finish-to-start + lag (FS + N) links the finish of the preceding activity with the start of the succeeding activity and indicates that the successor activity cannot begin until the preceding activity is complete. Alag “N” can be placed on the relationship to indicate that the succeeding activity cannot begin until a given time after the preceding activity has finished. A finish-to- start relationship with a lag value of zero is considered the default if no other value is specified. For example, in Figure 13.6, Activity 20 cannot start until “N” work periods after Activity 10 is complete. Typical applications include cure time between the place- ment of concrete and the stripping of formwork, queuing time between a request for action and when the action takes place, and time for the approval process after a report has been submitted and the action is taken following approval. The alternate approach to this problem would be to include an activity in the network called “concrete cure,” “review request,” or “review and approval,” and assign the added activity a duration of “N” days. A start-to-start + lag (SS+N) relationship links the start of the preceding activity with the start of the following or succeed- ing activity. It indicates that the successor activity cannot begin until the preceding activity has been started and the specified work periods (lag) or overlap time after the start of the preceding activity has elapsed. For example, in Figure 13.7, Activity 20 cannot start until “N” work periods after the start of activity. Typical applications include the relationship between the pulling wire and cable and wire terminations, or starting the report preparation before all the research information has been completed. These relationships assume that if the work can begin before the preceding activities are complete, an SS + N relationship between them can be utilized. The schedule com- putations will indicate that the start of the succeeding activities can begin “N” days after the preceding activity has started. The alternate approach to this problem would be to include additional activities in the network to show the start and fin- ish of both the predecessor and successor activities. A finish-to-finish + lag (FF + N) relationship links the finish of the preceding activity with the finish of the following or succeeding activity and indicates that the latter activity can- not be completed until the preceding activity has been com- pleted and the specified work periods (lag) or overlap time has elapsed. For example, in Figure 13.8, Activity 20 cannot finish until “N” work periods after Activity 10 is finished. Typical finish-to-finish applications include the relationship between the finish of wire terminations and the finish of test equipment, or between finish of research information and finishing the report preparation. These relationships assume that if the successor work can finish “N” work periods after 13.6 SCHEDULING AACE INTERNATIONAL 10 ES LS EF EF 20 ES LS EF EF FS + N Figure 13.6—Finish to Start + Lag Relationship 10 ES LS EF EF 20 ES LS EF EF SS + N Figure 13.7—Start-to-Start + Lag Relationship.
- 190. the finish of the preceding activities, an FF + N relationship between them can be utilized. The schedule computations will indicate that the finish of the succeeding activities requires “N” days after the finish of the preceding activity. The alternate approach to this problem would be to include additional activ- ities in the network to show the start and finish of both the predecessor and successor activities. A start-to-finish + lag (SF + N) relationship links the start of the preceding activity with the finish of the following or suc- ceeding activity and indicates that the successor activity cannot finish until the preceding activity has started and the specified work periods (lag) or overlap time has elapsed. For example, in Figure 13.9, Activity 20 cannot finish until “N” work periods after Activity 10 is started. This relationship is seldom used because of inherent problems associated with the start of the successor activity and the finish of the predecessor activity. Generally, computer software will not allow this relationship. The development of an overlapping network involves the same efforts as discussed previously for precedence net- works. The difference is that during the development of the activity list, overlapping relationships and lead time periods, where applicable, are shown. The activity list that illustrates overlapping is shown in Table 13.2. It is similar to the network previously used. The differ- ences are that certain activities have been combined and over- lapped and overlapping relationships are included. Note that where no overlapping relationship exists, a FS relationship with a lag of zero is assumed. Figure 13.10 demonstrates that by using overlapping network techniques, we can combine the two activities “ASTART” and “AFINISH” into one Activity “A” and show a relationship that Activity “B” can start 10 days after the start of Activity “A”. Other changes to the network include that Activity “D” can finish 3 days after the finish of Activity “C”. Figure 13.10—Overlapping Network Overlapping network techniques, in turn, reduce the number of schedule computations required. WORK BREAKDOWN STRUCTURE The most effective tool to use in ensuring that all work scope is planned is the work breakdown structure (WBS). The WBS is a valuable management tool for planning, organizing, implementing, and controlling projects. The WBS is a tree structure of successively further breakdowns of work scope into component parts for planning, assigning responsibility, managing, controlling, and reporting project progress. The top of the tree represents the whole. Subsequent levels repre- sent divisions of the whole on a level by level basis until the smallest element desired is defined. Defining Work Breakdown Structure The best approach to developing a WBS (Figure 13.11 on page 13.8) is to first choose the desired hierarchy (process, organiza- tion, or product) and represent the entire project by a specific “project” block. The next step is to branch out beneath the 13.7 AACE INTERNATIONAL SCHEDULING 10 ES LS EF EF 20 ES LS EF EF FF + N Figure 13.8—Finish-to-Finish + Lag Relationship. 10 ES LS EF EF 20 ES LS EF EF SF + N 100 A 200 B 300 C 400 D SS + 10 FF + 3 100 A 100 A 200 B 200 B 300 C 300 C 400 D 400 D SS + 10 FF + 3 Activity ID Description Predecessor 100 Activity A - 200 Activity B 100 (SS + 10) 300 Activity C 100 (FS) 400 Activity D 200, 300 (FF + 3) Figure 13.9—Start-to-Finish + Lag Relationship Table 13.2—Overlapping Network Activity List
- 191. “project” block into several levels and components, which are equivalent to the “project” block when combined. For example, structure and services define the second level of the process hierarchy for the project. All project process infor- mation can be further defined by these two classifications. For prototype development, other systems classifications may include research and manufacturing. WBS techniques are valuable tools because they allow project details to be summarized into different groupings for analysis and control purposes. It is not necessary that all WBS have the same number of lev- els. For example, the sample breakdown has five levels and a product based WBS may have four levels. Coding Techniques Most computer software provides a function for WBS coding that is based on the previously discussed hierarchical structure. The fundamental element of any WBS is the detailed work activity. What enables the WBS technique to function is prop- er coding of detailed work activities. Activity definition and coding is best accomplished by numbering from the highest level of each WBS to the lowest level. The project process-based WBS (Figure 13.11) is used for illus- tration purposes to demonstrate the method of developing a WBS and its coding structure in detail from top to bottom. As stated previously, the Level II breakdown, structure, and services is completely representative of the Level I total proj- ect process activity. For illustration purposes, the structure component of the project process is selected for further hier- archy definition, and the line through structure is darkened to show the breakdown process. Figure 13.11 shows that the Level II structure component is further defined by Level III. The Level III components are substructure and superstructure. This technique of WBS development is very important. Without utilizing it, the development process usually gets unnecessarily bogged down with efforts to achieve perfec- tion before proceeding to subsequent levels. The Level III substructure component is further defined by Level IV, consisting of specific processes related to the sub- structure. One of those, concrete, is selected for further defi- nition of the structure process. In Level IV, concrete is further defined by three Level V com- ponents: Foundations, Foundation Walls Area A, and Foundation Walls Area B. Once the levels and their components have been defined, it is best to begin numbering them. Count the number of levels and establish a code scheme with an equal number of digits. 13.8 SCHEDULING AACE INTERNATIONAL Structure 21000 Project 20000 Sub Structure 21100 Super Structure 21200 Services 22000 Electrical 22020 Electrical Rough-In 22021 Mechanical 22010 Foundations 21121 Earthwork 21110 Concrete 21120 Start Plumbing 22011 Fdn Wall Area B 21123 Fdn Wall Area A 21122 Excavate 21111 Interior Backfill 21112 Level V Level IV Level III Level II Level I Structure 21000 Structure 21000 Project 20000 Project 20000 Sub Structure 21100 Sub Structure 21100 Super Structure 21200 Super Structure 21200 Services 22000 Services 22000 Electrical 22020 Electrical 22020 Electrical Rough-In 22021 Electrical Rough-In 22021 Mechanical 22010 Mechanical 22010 Foundations 21121 Foundations 21121 Earthwork 21110 Earthwork 21110 Concrete 21120 Concrete 21120 Start Plumbing 22011 Start Plumbing 22011 Fdn Wall Area B 21123 Fdn Wall Area B 21123 Fdn Wall Area A 21122 Fdn Wall Area A 21122 Excavate 21111 Excavate 21111 Interior Backfill 21112 Interior Backfill 21112 Level V Level IV Level III Level II Level I Figure 13.11—Process WBS
- 192. For example, there are five levels to the process WBS, and, consequently, a five-digit number is used. The number 20000 is the highest level for the process WBS. Working downward and across in the WBS, the Level II components are num- bered 21000 and 22000. Summarizing on WBS 2, where the first digit is equal to 2, provides the total project process information. The lowest level of any WBS of the project constitutes the detailed work activities. Higher levels constitute summaries of the detailed activities. Activity Coding Table 13.3 illustrates a listing of detailed schedule activities. Included in Table 13.3 is the process WBS coding. The code for each WBS can be input into one of many activity code fields when using computer-based project management sys- tems. It is necessary that every activity have a unique alphanumeric identifier. It is generally better to use the process-based WBS since it is usually the most detailed WBS. The WBS for any particular project is usually prepared by proj- ect control personnel. However, project control personnel do not perform the actual work. Consequently, it is imperative that project control personnel and the project personnel who actually do the work reach an agreement concerning the WBS. In addition to the previous construction example, Figure 13.12 is provided to display a nonconstruction WBS example. SCHEDULING TECHNIQUES Making Time Calculations Once a network has been created and the duration of each activity has been established, both the total time required to reach project completion and the individual start and finish times for each activity can be calculated. The four time values as associated with each activity are Early Start (ES), Early Finish (EF), Late Start (LS), and Late Finish (LF). The computations required to calculate the above times involve simple addition and subtraction. Manual computa- tion is easy and logical, but it can become tedious and time consuming when done for large networks. Forward and Backward Pass The forward pass through the network determines each activity’s ES and EF and the project’s duration or the earliest date a project can finish. The backward pass through the net- work determines each activity’s LS and LF. The calculations 13.9 AACE INTERNATIONAL SCHEDULING ACTIVITY NUMBER ACTIVITY DESCRIPTION PROCESS WBS 10 EXCAVATE 21111 20 FOUNDATIONS 21121 40 FOUNDATION WALLS AREA A 21122 50 FOUNDATION WALLS AREA B 21123 70 BACKFILL INTERIOR OF WALLS 21112 80 START PLUMBING SLAB ROUGH-IN 22011 110 ELECTRICAL ROUGH-IN 22021 • Establish Vehicle Complexity • Make Requests • Submit Test Plan • Measure Tire RR • Measure Aero • Measure Parasitic Loss • Coastdown SPs • Provide data to engine calibrators Vehicle Class A Vehicle Class C Post-Cert Phase Confirmation Phase Definition Phase Structural Prototype Phase Level IV (Tasks) Level III Level II Level I Program Vehicle Class B Vehicle Center II Vehicles Automotive Operations Testing • Access Database • Establish Targets • P&E/Tire/Driveline • Make Projections • Select Competitive Vehicle • Analyze Selection • Chart Program Calibrations • Submit Test Plan • Break-in CPs / Tires • Measure Tire RR • Measure AERO • Measure Parasitic Loss • Coastdown CPs • Update Chart • Monitor 0 Mile Cert Tests • Resolve Quick Check Issues • Represent to EPA • Establish Vehicle Complexity • Make Requests • Submit Test Plan • Measure Tire RR • Measure Aero • Measure Parasitic Loss • Coastdown SPs • Provide data to engine calibrators Vehicle Class A Vehicle Class C Post-Cert Phase Confirmation Phase Definition Phase Structural Prototype Phase Level IV (Tasks) Level III Level II Level I Program Vehicle Class B Vehicle Center II Vehicles Automotive Operations Testing • Access Database • Establish Targets • P&E/Tire/Driveline • Make Projections • Select Competitive Vehicle • Analyze Selection • Chart Program Calibrations • Submit Test Plan • Break-in CPs / Tires • Measure Tire RR • Measure AERO • Measure Parasitic Loss • Coastdown CPs • Update Chart • Monitor 0 Mile Cert Tests • Resolve Quick Check Issues • Represent to EPA Table 13.3—Detailed Activity List with WBS Coding Figure 13.12—Nonconstruction WBS
- 193. assume that activities begin on the morning of the scheduled start date and end in the evening of the scheduled finish date and that an event or milestone occurs on the evening of the day its last predecessor finished. Before starting the network calculation, the precedence net- work list of activities is revisited to include the activity dura- tion as shown in Table 13.4. The activity duration is the length of time from start to finish of an activity, estimated or actual, generally quantified in working day or calendar day time units. Activity duration estimates are developed from historical experience or estimated time to perform the work. The durations are assigned to the activities as shown in Figure 13.14. In the forward pass, the earliest start and finish times for each activity are calculated, observing the following rules: • Day 1 is the earliest start date for Activity 100. • The ES of Activity 100 (ASTART) is equal to 1. • The EF of the activity is equal to the ES of that activity plus the duration minus 1. • The ES of any succeeding activity is the EF of the prede- cessor activity plus 1. • The ES of an activity is equal to the largest of the EF times of the activities merging to the activity in question plus 1. In Finish to Start relationships, the early start of an activity is equal to the largest of the early finish times of the activities merging to the activity in question plus 1. The early finish date for Activity ASTART is day 10 (ESASTART + D -1). Day 11 is the early start date for Activities B and AFINISH. The early start for Activity D is day 36 since Activity D’s early start is controlled by the largest early finish date of all prede- cessors (B and C), which is Activity C. The total project duration is forty-five days. If the total project duration exceeds the available time, plan- ners must reevaluate their work and take whatever action is needed to meet time objectives: perhaps optional activities can be dropped and others can be shortened by applying more resources or other schedule compression techniques. In the backward pass, the latest allowable start and finish times for each activity are calculated, observing the following rules: • The LF of the terminal activity in the network is either assigned as being equal to its EF or assigned the value established by the contract documents. • The LS of an activity is its LF minus its duration plus 1. • The LF for all other activities is equal to the numerically smallest LS of succeeding activities minus one day. Where two or more activities burst from or leave an activ- ity, the numerically smallest LS of the successor activities minus one day is the LF of the activity in question. Figure 13.14 depicts the results of the backward pass through the network. Note that Activity ASTART’s late start is con- trolled by Activity AFINISH’s late finish. 13.10 SCHEDULING AACE INTERNATIONAL Figure 13.18 Backward Pass LFD = EFD LSA = LFA - DA + 1 LFPRED = LSSUC - 1 For Finish to Start relationships, the late finish of an activity is equal to the smallest of the late start times of the activities bursting from the activity in question minus 1. 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 10 1 35 16 20 11 21 35 36 45 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 10 1 35 16 20 11 21 35 36 45 Figure 13.14—Backward Pass Precedence Network FS Relationships Figure 13.13—Forward-Pass Network FS Relationships Figure 13.17 Forward Pass 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 Activity ID Description Predecessor Duration 100 Activity ASTART - 10 200 Activity B 100 20 300 Activity AFINISH 100 10 400 Activity C 300 15 500 Activity D 200, 400 10 ESASTART = 1 EFA = ESA + DA - 1 ESSUC = EFPRED + 1 In finish to start relationships, the early start of an activity is equal to the largest of the early finish times of the activities merging to the activity in question plus 1. Table 13.4—Precedence Network Activity List with Durations
- 194. Work Days and Calendar Days The calculated dates are shown in consecutive calendar days. This calculation is used for all examples. However, it must be understood that most projects are worked on a five-day workweek with weekends and certain recognized holidays not worked. These nonworking days must be accounted for in the total project duration. Most contracts that stipulate contract time do so in total calendar days including weekend and holidays. Computerized scheduling applications allow for setting cal- endars and automatically accounting for weekends and holi- days. Also, the dates provided by computerized schedules may, by choice, be in calendar days or dates. Forward and Backward Passes for Overlapping Relationships The forward and backward passes for the Overlapping Relationships are shown in Figures 13.15 and 13.16 respec- tively. The rules discussed earlier are shown with each figure. In Figure 13.15, the total project duration is forty days, five days shorter than Figure 13.16. From Figure 13.13, Activity ASTART and AFINISH were com- bined into Activity A. To account for the overlapped time, the relationship between Activity A and Activity B was changed to SS+10. The FS relationship between Activity A and Activity C remained unchanged. These changes result in the same EF for Activities B and C in Figure 13.15 as in Figure 13.13. Changing the relationship between Activity C and Activity D from FS to FF + 3 allows Activity B to control the finish of Activity D, which results in a savings of 5 days. Note Activity A’s late start and late finish dates are controlled by the late start of Activity B. Float Free float is defined as the amount of time that the comple- tion of an activity can be delayed without delaying any other following or succeeding activity. Free float is equal to the difference between an activity’s EF and the ES of the following or succeeding activity minus 1. In the event that two or more activities succeed or follow an activity, the succeeding activity with the smallest ES is used to determine the activity free float amount. The free float of an activity is equal to the smallest value between the activity in question and all succeeding activities minus 1. Free float belongs solely to the activity. Due to the nature of the computations, free float is reserved for only the last activ- ity in a chain of activities. Custom or preference may dictate whether free float is shown on the network or included in computerized reports. Total float (TF) is defined as the amount of time that the com- pletion of an activity can be delayed without delaying the completion of the project’s terminal activity. Total float is equal to the difference between the activity’s LF and EF, or the difference between the activity’s LS and ES. Total float is shared by the activities in a chain. For this rea- son, it is a better indicator of the float time an activity pos- sesses. It is cautioned, however, that TF is shared. If a chain of activities possess 15 days of TF and there are four activities in the chain, each activity does not possess 15 days of TF independent of the other activities in the chain. If the first activity in the chain uses all 15 days, the TF along the chain is reduced to zero. Any further delays to any activities in this chain will result in a delay to the project’s completion. Figures 13.17 and 13.18 on page 13.12 depict the networks with the TF values shown. 13.11 AACE INTERNATIONAL SCHEDULING Figure 13.19 F d P ESSTART = 1 EFA = ESA + DA – 1 (SS) ESSUC = ESPRED + (SS + N) (FS) ESSUC = EFPRED + 1 + N (FF) EFSUC = EFPRED + N (FF) ESA = EFA – DA + 1 100 A 200 B 300 C 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 100 A 200 B 300 C 400 D SS + 10 FF + 3 100 A 100 A 200 B 200 B 300 C 300 C 400 D 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 In Finish to Start relationships, the early start of an activity is equal to the largest of the early finish times of the activities merging to the activity in question plus 1. Figure 13.20 Backward Pass The late finish of an activity is equal to the smallest of the late start times of the activities bursting from the activity in question, minus 1 for Finish Start relationships LFD = EFD LSD = LFD – DD + 1 (FF) LFPRED = LFSUC – N (FS) LFPRED = LSSUC - 1 (SS) LSPRED = LSSUC - N (SS) LFA = LSA + D - 1 100 A 200 B 300 C 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 1 20 11 30 23 37 31 40 100 A 200 B 300 C 400 D SS + 10 FF + 3 100 A 100 A 200 B 200 B 300 C 300 C 400 D 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 1 20 11 30 23 37 31 40 Figure 13.16—Backward-Pass Overlapping Technique Relationships Figure 13.15—Forward-Pass Overlapping Technique Relationships
- 195. SCHEDULING AACE INTERNATIONAL 13.12 Critical Path Total float defines the critical path of the project. The critical path is defined as the longest chain or chains of activities, in terms of time or duration, through a network. It is the chain or chains of activities through a network with the smallest total float value. If the network is continuous, there will be at least one continuous chain through the network. A discontin- uous network is one where an imposed activity time con- straint has disrupted the chain of activity date calculations. Figures 13.17 and 13.18 also depict the networks with the crit- ical path identified. It is shown as the heavier lined path. The late finish for Activity A is controlled by the late start of Activity A. The late start of Activity A is critical and con- trolled by the critical path coming from Activity B. Activity A’s late start is LSA = LSB†– SS: (LSA = 11 - 10. LSA = 1.) LFA = LSA + D - 1. Constraints The start and finish of certain activities, at times, must be con- strained in order to represent what will actually occur. For example, based on network logic, the installation of a pump is scheduled to begin on September 17, but the actual pump delivery from the vendor is not scheduled until October 23. Therefore, the installation of the pump is constrained by the delivery of the pump. There are six major types of constraints: 1. start-on, 2. start-no-earlier than, 3. start-no-later than, 4. finish-on, 5. finish-no-earlier-than, and 6. finish-no-later-than. Each of the above constraints affects the schedule differently. “No-earlier-than” (NET) constraints affect only the forward pass calculation in the network. “No-later-than” (NLT) affects only the backward pass calculation. “On” is a combination of NET and NLT and affects both the forward and backward pass. A constraint may or may not be upheld, depending on net- work logic. For example, a “Start NET April 7” constraint will control the network calculations if the early start time is before April 7. If, however, the network logic produces an early start time on or after April 7, the network logic will be observed and the constraint will be ignored. Similarly, if the constraint is “Start NLT April 7” and network logic dictates a late start on or before April 7, the network logic again will control and again the constraint will be ignored. If the network logic produces a late start date after April 7, then the constraint will be observed, and the activity will be scheduled to have a late start date of April 7. SCHEDULING LEVELS AND REPORTING Scheduling Levels are schedules used by various manage- ment echelons to manage the project. Senior management may require a very summary level referred to as a milestone schedule. Project management and key department interface may only require a summary level of the project activities while hands-on managers require detailed project schedules and short-interval schedules for day-to-day management. Each level is an integral subdivision of the previous level and presents more detailed activities and relationships. Level 1–Milestone Level Schedule Level 1 schedules comprise key events or major milestones selected as a result of coordination between the client’s and the contractor’s management. These events are generally critical accomplishments planned at time intervals throughout the project and used as a basis to monitor overall project perform- ance. The format may be a list, summary network, or bar chart and may contain minimal detail at a highly summarized level. Significant events may include begin program definition, 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 10 1 35 16 20 11 21 35 36 45 0 5 0 0 0 100 ASTART 300 AFINISH 200 B 400 C 500 D 10 20 10 15 10 1 10 11 30 11 20 21 35 36 45 10 1 35 16 20 11 21 35 36 45 0 5 0 0 0 100 A 200 B 300 C 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 1 20 11 30 23 37 31 40 0 0 2 0 100 A 100 A 200 B 200 B 300 C 300 C 400 D 400 D SS + 10 FF + 3 1 20 20 21 20 15 10 11 30 35 31 40 1 20 11 30 23 37 31 40 0 0 2 0 Figure 13.17—Precedence Network FS Relationships Total Float and Critical Path Shown Figure 13.18—Overlapping Technique Relationships Total Float and Critical Path Shown
- 196. AACE INTERNATIONAL SCHEDULING 13.13 preliminary design complete, purchase major equipment, mobilization, foundations complete, delivery of major equip- ment components, installation complete. Company manage- ment is usually apprised of the project’s implementation progress with milestone level schedules. Level 2—Project Summary Level Schedule Level 2 schedules are composed of summary project activi- ties depicting critical work and other management selected activities generally indicating the activities’ ES and EF dates. Key restraints and relationships between activities are identi- fied and defined. This level of planning is represented by level 2 schedules and provides an integral plan of the project activities for project management. Milestone schedule dates are compared to those derived from the project summary schedule. Upon review (making adjustments, if necessary) and acceptance, the dates from the project summary are used for the milestone schedule. When using a network-based schedule, the detailed activities can be rolled up to a summary level and milestone level schedule. As the detailed schedule is developed, it must be summarized to replace the independently developed project summary and milestone schedules. Typical summary level activities include engineering and design, procurement, major equipment fabrication and deliv- ery, major structures, installation, start-up, and commissioning. Figure 13.19 shows both a level 1 and 2 schedule. Level 3—Project Detailed Schedule Level 3 schedules (Figure 13.20) display the lowest level of detail necessary to control the project through job comple- tion. The intent of this schedule is to finalize remaining requirements for the total project. Detailed scheduling iden- tifies and defines activities that are more detailed than the project summary level. For example, an activity in the proj- ect summary level, such as structural steel engineering and design, would be represented by more meaningful detailed activities of shorter durations such as: define and collect loads, perform analysis, prepare drawings and specifications, and issue documents for procurement. This level of planning also provides better networking capabilities. This level 3 schedule supports the planning effort for determining and assigning resources. Figure 13.19—Level 1 and Level 2 Schedule
- 197. SCHEDULING AACE INTERNATIONAL 13.14 Level 4—Short-Interval Schedule A Level 4 schedule is a two-to-six week look-ahead schedule that shows resource assigned, detailed, and work activities, and is used for planning and progress reporting purposes, review and assignment of current week work plans, and advance planning for near-term future week work (Figure 13.21). This level is sometimes referred to as short-cycle schedule since the process for its use is a weekly cycle of col- lecting progress, working the current week, and planning future work assignments. Short-interval Level 4 schedules are derived from the detailed Level 3 schedule network. These schedules are usu- ally bar charts as they are best used for communicating infor- mation and are developed by masking the relationships. It is one of the best tools for conveying the planning requirements to those performing the work. Schedule Reporting The following discussion of reports is provided to familiarize planners and schedulers with selected types of computerized report products. These are basic reports. There are numerous other reports of interest to planners, supervisors, and project managers. Schedules comprised of hundreds or thousands of activities can be made manageable and meaningful. Schedules can be selected for each party involved in the proj- ect to minimize the number of pages for review that may seem to be overwhelming. Early Start Dates Report: A listing of activities sorted by early start dates. This listing provides the scheduler and management with the activities that are scheduled to start by ascending dates. Short interval planning uses these lists to prepare for current period and future look-ahead periods. The same report for the overlapping activity schedule identi- fies the lead time relationships. Figure 13.20—Level 3 Schedule
- 198. Total Float Report: The activities are sorted by total float in ascending value beginning with values of TF = 0. The report first lists all activities that are on the critical path (TF = 0), and then lists all other activities grouped by total float values. Precedence Report: This is a listing by activity early start dates. However, the significance is the identification of all predecessor and successor activities for each activity. This report is used by planners for debugging schedules and comparing relationships on the network diagrams to those in the schedule reports. Schedule Plots Logic Diagrams: These have been used in the sample problems. Time-scaled Logic Diagram: This type of plot shows activity relationships and displays the activities in their scheduled place in time. (See Figure 13.20) Early Start Date Schedule: Bar Chart: Bar charts without logic relationships shown. These types of charts are used more frequently by supervision and management to track work. An example of this is the six week look ahead in Figure 13.21. Also see Figure 13.22 on page 13.16. MANAGING CHANGES IN THE SCHEDULE A schedule is simply a time-phased plan for accomplishing all of the specific activities that have been defined for a project. The schedule is derived and developed from estimated activity durations and the logical relationships or working sequence between activities. Unfortunately, in the real world, the actual work does not always progress in accordance with the original plan and a schedule slippage is usually the outcome. Actual activity durations may be greater (and sometimes even less) than the original estimated durations. In addition, the working sequence of activities will not always follow the sequence from the schedule. The correction of these changes through schedule updating can forecast any schedule slip- page or delay, and, hence, project management personnel can then react to bring the project back on schedule. The updated schedule, when compared to the original sched- ule, becomes an indispensable management tool that can be used to assess the overall project impact of any change. For example, the owner or other party following the issuance of the original schedule may impose changes to the original work scope. This may include any engineering design 13.15 AACE INTERNATIONAL SCHEDULING Figure 13.21—Level 4 Schedule
- 199. changes, emergent or additional work scope activities, and any change orders that are issued during the performance of the project. Nearly all projects require special material or equipment to complete. The procurement of these items often accumulates and at times, becomes the critical path. The updating process assesses the impact of the procurement items against the schedule and allows management to expedite the critical items and/or resolve them through activity logic changes. In addition, owners and government agencies may be slow in issuing permits or approvals. Furthermore, labor strikes, legal disputes, resource availability, accidents and weather conditions are all real dilemmas that many times can only be solved by rescheduling the work. Updating never regains lost work, but it can minimize the overall negative impact. Consequently, the original schedule should be updated regu- larly to reflect current information. Updating is a control process, which implies that adjustments in the network may be necessary and forewarns of potential revisions of major consequences. Reasons for Updating There are four major reasons a schedule should be updated regularly: 1. to reflect current project status, 2. to keep the schedule as an effective management tool, 3. to document to support performance 4. Documentation to plan for changes and support delay analysis The contractor and owner need to be aware of the current sta- tus throughout the project duration. Contractors are con- cerned with status of their submittals, delivery of equipment and materials, resource availability, coordination and per- formance of subcontractors, and timely payment for progress completed. Owners are concerned with the status of work including quality and whether the contractor’s progress is adequate to meet “turnovers” and completion dates. Both parties need to be aware of changes or delays as they occur and how they affect the project completion date. This will minimize any “surprises” and allow the parties to take nec- essary actions to get the project back on schedule. An updated schedule is a tool that provides the project’s sta- tus at a given time and is used to assess the performance of the owner, designer, and contractor to meet schedule com- mitments. It provides a record of the accomplishments as to timeliness and completeness. Changes to the work scope or methods of performance need to be included in the schedule updates. This provides management the opportunity to assess impact and plan remedial measures if necessary. In developing a project history, the causes for delays can be identified and measured from the updated schedules to sup- port delay analysis and negotiations. 13.16 SCHEDULING AACE INTERNATIONAL Figure 13.22—Slab on Grade Project Schedule
- 200. Updating Intervals for Managing Changes Generally, project management requires updates to be per- formed at least monthly and it is not unusual to require weekly status and updates. Most projects facilitate the need to update somewhere between the two extremes. These inter- vals generally coincide with routine business reporting peri- ods such as monthly progress reports, loan payment sched- ules, and other fixed reporting requirements. The project sta- tus and progress should also be reported periodically with these update reports to provide complete decision making information. Although periodic updates may support busi- ness and financial needs, the project manager needs more fre- quent and routine updating to perform effective manage- ment of changes. Updating Procedures for Managing Changes Updating and revising a schedule may require several itera- tions before management and supervision decides on an acceptable plan for implementation. When status and progress are input to the schedule, an analy- sis is performed to determine the impact on remaining activ- ities and project completion. Adverse trends may have to be mitigated by adding resources or reviewing logic relation- ships. Reports, tabular and graphic, should be reviewed with supervision and management and adjustments, if necessary, should be made. When changes become known, planning sessions must be initiated to determine their impact. For example, how will the change affect current progress? What new activities are needed to define the change? What are their durations and relationships to existing activities? What additional or new resource requirements must be considered? This process may result in several alternate plans that may require schedules to be prepared. The schedules result in graphical depictions of the alternatives. These schedules assist management in making decisions in selecting optimum solutions. The following steps are generally performed during the update process: 1. Gather all current information in accordance with rou- tine priorities. 2. Identify and plan for any changes to the work which affect activity duration, logic, work scope, and any other significant information. 2. Input these changes into the project schedule (any addi- tional work or delay should be coded appropriately to reflect “unforeseen” or “delay” work activity). 3. Recalculate the project schedule. 4. Perform analysis and prepare reports for management review. 5. Evaluate and adjust the updated schedule according to management’s and supervision’s review and direction. 6. Issue updated schedule to all interested parties. These procedures are generally performed throughout the duration of the project. Standard updating may be performed monthly. Revisions to schedules may be required as they become known, or routinely required on a bi-monthly or quarterly basis. It is important that the updated schedule be issued to all parties in a timely fashion in order to plan and expedite the work effectively and minimize any future delay. As an example of managing changes and updating a sched- ule, the following schedule (Figure 13.22) has been generated for a slab on grade construction project. The planned start for the project is May 30 and it has a total project duration of 68 days, finishing on August 7. There are two bars shown for every activity. The scheduling software allows a target bar to be inserted under the sched- ule bar for each activity. The target bar does not move or change due to status or progress. Therefore, the target schedule is a static represen- tation of the approved project schedule. On July 1, a schedule update (Figure 13.23) was conducted to show the current status of the job. The following information was given and entered, and resulted in the following schedule: • Building Excavation started on June 4 and was complet- ed on June 18 (late start). • Foundations started on June 19 and are 25 percent com- plete (in-progress). • A correction was made to increase the duration of the waterproofing to 10 days (duration change) The update shows the project now finishing on August 18 with a total duration of 79 Days, eleven days later than the target. After reviewing the update, it was decided to make changes to durations and logic in an effort to regain some time in the schedule. This was done after management consulted the various subcontractors and discussed alternatives. The fol- lowing changes were made, which resulted in Figure 13.24. • Waterproof task will be changed to finish 5 days after foundation walls area B (revised relationship). • Backfill interior wall and backfill exterior walls will be shortened to 3 days each (revised duration). • Electrical rough-in will be changed to start the same day as finish plumbing: slab rough-in (revised relationship). The schedule now shows a total project duration of 73 days with a completion date of August 12. 13.17 AACE INTERNATIONAL SCHEDULING
- 201. 13.18 SCHEDULING AACE INTERNATIONAL Figure 13.24—Slab On Grade Schedule Update 2 Figure 13.23—Slab on Grade Schedule Update 1
- 202. CONCLUSION The project schedule represents a communication tool that pres- ents the project plan (complete work scope), the order in which it will be worked, and the length of time it will take to complete the activities and the project. The schedule represents the earli- est dates the activities and project can occur and the latest dates for activities and project completion that must occur. PRACTICE PROBLEMS AND QUESTIONS 1. What is meant by early and late start and finish? 2. Define the critical path of a project. 3. What is total float and what does negative total float mean? 4. What is a great tool for communicating the work and why? 5. What are the benefits of progress collection and sched- ule updates? REFERENCES 1. Callahan, Michael T., Daniel G. Quackenbush, and James E. Rowings. 1992. Construction Project Scheduling. New York: McGraw-Hill, 1992. 2. Werderitsch, Anthony, PE, CCE. 1992. Planning … Scheduling. Ann Arbor, Michigan: Administrative Controls Management, Inc. 3. Lewis, James. 2000. Project Manager’s Desk Reference, 2nd Edition. New York: McGraw Hill. Portions of this chapter are from previous editions authored by Dr. Brisbane H. Brown, Jr.; Dr. James M. Neil, PE, CCE; and Jennifer Bates, CCE. 13.19 AACE INTERNATIONAL SCHEDULING Activity # Description Duration Relationship 1 Define Plan / Design Project 30 days No other activity can start until after Activity 1 has begun 2 Procure, Manufacture, and Deliver Major Equipment 60 days Can begin 15 days after Activity 1 starts 3 Bids / Select Installation Contractor 20 days Cannot start until Activity 1 is completed 4 Procure, Manufacture and Deliver Controls 40 days Starts 20 days after plan definition and project design has begun 5 Construct Equipment Foundations and Structure 30 days Must follow contractor selection 6 Set Major Equipment 15 days The first piece of major equipment must be received 40 days after procurement has begun, but cannot finish until 10 days after the last piece of major equipment is received. Setting equipment can start 20 days after the foundations and structures have begun 7 Install Controls 20 days Contractor cannot begin until 15 days after foundations and structures have begun, contractor cannot finish until 5 days after the last of the controls are delivered 8 Start Up & Test Major Equipment 10 days Occurs after controls are installed and equipment is set 9 Commission Equipment 10 days Can begin 2 days after start- up and test has begun, but cannot finish until 5 days after start up and test is completed Activity # Description Duration Relationship 1 Define Plan / Design Project 30 days No other activity can start until activity 1 is finished 2 Procure, Manufacture, and Deliver Major Equipment 60 days Succeeds the finish of Activity 1 3 Bids / Select Installation Contractor 20 days Cannot start until Activity 1 is completed 4 Procure, Manufacture and Deliver Controls 40 days Starts after project design is complete 5 Construct Equipment Foundations and Structure 30 days Must follow contractor selection 6 Set Major Equipment 10 days Before the contractor can set major equipment, the equipment must be received and foundation and structure must be completed 7 Install Controls 20 days Must occur after equipment foundations and structures are completed and controls have been delivered 8 Start Up & Test Major Equipment 10 days Occurs after controls are installed and equipment is set 9 Commission Equipment 10 days Starts after start up and test major equipment is complete Problem 1—Draw a Precedence Diagram Network, and calculate early dates, late dates, and total float for each activity based on the information in the table below. Problem 2—Draw a precedence diagram network, and cal- culate early dates, late dates, and total float for each activ- ity based on the information in the following table:
- 204. Section 4 Progress & Cost Control
- 206. INTRODUCTION The work tasks needed to complete a construction project range from designing the foundations to clearing and grad- ing a site, to startup and turnover of the completed facility. During the course of the project, the individuals executing it must periodically report their progress on each task. Since the nature of each task varies, no single reporting method is suitable, and several methods of measuring progress are required. The six most common methods are presented in this chapter. Other topics discussed include earned value, how to evaluate worker productivity, and the use of fixed budget systems. LEARNING OBJECTIVES After completing this chapter, readers should be able to • identify the six methods used for measuring work progress, • understand the concept of earned value and how to use it in fixed budgets to analyze cost and schedule per- formance, and • understand how to evaluate worker productivity. MEASURING WORK PROGRESS Method 1—Units Completed—This method is applicable to tasks that involve repeated production of easily measured pieces of work, when each piece requires approximately the same level of effort. In most cases, subtasks are not mixed, but if so, they are accomplished simultaneously, and one of the subtasks can be used as the reference task. Wire pulling is a task where accomplishment is easily meas- ured in terms of linear meters of wire pulled. If the work for pulling a certain type of wire is contained in a single control account, the units completed method can be applied. For example, if 10,000 linear meters (LM) of wire is to be pulled, and 4000 LM have been pulled, the percent complete is found by dividing 4000 LM by 10000 LM to show 40 percent complete. Placing and finishing a reinforced concrete slab is a type of work with multiple tasks handled simultaneously (placing and finishing), but progress would normally be reported on the basis of cubic meters (or yards) of concrete placed and finished, or on the number of square meters (or feet) of fin- ished surface. Method 2—Incremental Milestone—This method is applica- ble to any control account that includes subtasks that must be handled in sequence. For example, installing a major vessel in an industrial facility includes the sequential tasks or oper- ations listed in Table 14.1. Segmenting a task into subtasks and assigning each an increment of progress for the entire task is called developing “rules of credit [1].” Completing any subtask or operation is considered to be the achievement of a milestone, and each incremental milestone completed represents a certain percentage of the total installation. The percentage chosen to represent each milestone is normally based on the number of workhours estimated to be required to that point in relation to the total. 14.1 AACE INTERNATIONAL PROGRESS MEASUREMENT AND EARNED VALUE Chapter 14 Progress Measurement and Earned Value Dr. Joseph J. Orczyk, PE CCE TASK Received/inspected Setting complete Alignment complete Internals installed Testing complete Accepted by owner INCREMENTAL PROGRESS 15% 20% 15% 25% 15% 10% CUMULATIVE PROGRESS 15% 35% 50% 75% 90% 100% Table 14.1—Rules of Credit for Drums and Tanks
- 207. Method 3—Start/Finish—This method is applicable to tasks that lack readily definable intermediate milestones or those for which the effort/time required is very difficult to esti- mate. To illustrate, millwright alignment work usually falls into this category. Aligning a major fan and motor may take a few hours or a few days, depending on the situation. Workers know when this work starts and when it is finished, but they never know the percentage completion in between. Other examples include planning activities, flushing and cleaning, testing, and major rigging operations. In the start/finish approach, a percent complete is arbitrarily assigned to the start of a task, and 100 percent is recorded when the task is finished. A starting percentage of 50 percent is equivalent to a task completed at a constant rate over time, and is reasonable for short duration, lower-value tasks. For tasks with a longer duration or a higher value, a lesser per- centage (20-30 percent) would probably be used. This is because the percentage directly affects progress payments, and an owner will hesitate to recognize too much completion in advance. For very short tasks, the start/finish percentages are usually 0 percent/100 percent. Method 4—Supervisor Opinion—In this method, the super- visor simply makes a judgment of percent complete. The major problem with this approach is that some supervisors are optimists and some are pessimists; thus, there could be major differences of opinion as to the progress reported for the same or similar tasks. This is a subjective approach and should be used only for relatively minor tasks and only where developing a more discrete status is not feasible. Dewatering, temporary construction, architectural trim, and landscaping are candidates for application of this approach. Method 5—Cost Ratio—This method is applicable to tasks that involve a long period of time or that are continuous dur- ing the life of a project, and which are estimated and budget- ed on bulk allocations of dollars and workhours rather than on the basis of production. Project management, quality assurance, contract administration, and project controls are areas where the cost ratio method may be applied. With the cost ratio method, percent complete is found as follows: Method 6—Weighted or Equivalent Units—This method is applicable when the task being controlled involves a long period of time and is composed of two or more overlapping subtasks, each with a different unit of work measurement. Structural steel erection provides a good example of where this method may be applied. Structural steel is normally esti- mated and controlled by using tons as the unit of measure. However, as illustrated in Table 14.2, the subtasks included in steel erection each have a different unit of measure. To han- dle this, each subtask is weighted according to the estimated level of effort (usually workhours) that will be dedicated to that subtask. These weights are called “rules of credit.” As quantities of work are completed for each subtask, the quan- tities are converted into equivalent tons as illustrated in Table 14.2. The total weight of structural steel in this account is 520 tons. See equation 2. EARNED VALUE FOR FIXED BUDGETS Introduction—The discussion above pointed out that numerous ways exist for measuring work progress on a sin- gle work item. Having done this, the next challenge is to develop a method for determining overall percent complete for a combination of unlike work tasks or an entire project. The system for accomplishing this is called earned value, although the terms achieved value and accomplished value are occasionally used. A project's budget is expressed in both workhours and dol- lars, which are the only common denominators of the many accounts within a project. Earned value is keyed to the project budget. Many projects are constrained by fixed budgets; others have floating, or variable, budgets. Earned value techniques can be applied in both situations, although there are differences in the detail of application. In the following paragraphs, the basics of earned value will be explained, first by assuming the fixed budget situation and then by advancing to the variable budg- et situation. A comparison of the two methods will then be made. The System—When developing a control system for any project, the project must be segmented into its controllable parts. To control the work, a work breakdown structure (WBS) is developed, which includes all work tasks that must be controlled for purposes of determining project progress. Each task will have its own dollar and workhour budget. A project cost breakdown structure is created by adding to the WBS all other project accounts that have either a cost or a cost and workhour budget, but which are not used to measure progress (e.g., management, quality control, administration). In other words, the WBS is incorporated within the CBS. Under earned value, a direct relationship is established between percent complete of an account and the budget for that account. This relationship is expressed by the following formula: 14.2 PROGRESS MEASUREMENT AND EARNED VALUE AACE INTERNATIONAL percent complete = actual cost or workhours to date forecast at completion (equation 1)
- 208. earned value = (percent completed) *(budget for that account) (equation 3) As can be seen from this equation, a portion of the budgeted amount is earned as a task is completed, up to the total amount in that account. One cannot earn more than has been budgeted. For example, assume that $10,000 and 60 work- hours have been budgeted for a given account and that account is now 25 percent complete, as measured by one of the methods previously described. In other words, $2,500 and 15 workhours have been earned to date. Since progress in all accounts can be reduced to earned work- hours and dollars, this provides a way to summarize multi- ple accounts and calculating overall progress. The formula for this is: percent complete = (earned workhours or dollars all accounts) (budgeted workhours or dollars all accounts) (equation 4) COST AND SCHEDULE PERFORMANCE The concepts discussed thus far provide a system for deter- mining the percent complete of single work tasks or combi- nations of tasks. The next challenge is to analyze the results and to determine how well things are proceeding according to plan. Fortunately, the earned value system lends itself very well to such an analysis. The System—Budgeted and earned workhours or dollars have been the earned value factors considered to this point, but to these must be added actual workhours or dollars, since it is a combination of the three measures that are needed for the analysis. The earned value system defines these terms as follows: Budgeted workhours or $ to date represent what is planned to be done. This is called budgeted cost for work scheduled (BCWS). Earned workhours or $ to date represent what was done. This is called budgeted cost for work performed (BCWP). 14.3 AACE INTERNATIONAL PROGRESS MEASUREMENT AND EARNED VALUE Table 14.2—Rules of Credit Example for Structural Steel Private Allowed Credit 0.02 0.02 0.05 0.06 0.11 0.10 0.20 0.09 0.30 0.05 1.00 Subtask run foundation bolts shim shakeout columns beams cross braces girts and sag rods plumb and align connection punch list Steel Totals Total U/M each % % each each each bay % each % ton Total Quantity 200 100 100 87 859 837 38 100 2,977 100 520 To-Date Quantity 200 100 100 74 45 0 0 5 74 0 Earned Tons 10.4 10.4 26.0 27.5 3.0 0.0 0.0 2.3 3.9 0.0 83.5 earned quantity = (allowed credit) * (summary quantity) *(quantity to date) (total quantity) earned tons beams = (0.11) * (520 tons) * (45 each) = 3.0 tons (859 each) percent complete = 83.5 tons = 16.1% 520 tons A variation of this approach uses equivalent units for each subtask. In the example above, each subtask item would be given a unit of measure that is an equivalent ton. For example, each beam would have an equivalent ton value determined as follows: beam equivalent ton = (0.11 allowed credit) (520 tons) = 0.666 tons/beam (859 beams) GLOSSARY TERMS IN THIS CHAPTER earned value ◆ fixed cost ◆ productivity
- 209. Actual workhours or $ to date represent the cost incurred. This is called actual cost of work performed (ACWP). Schedule performance is a comparison of what was planned to what was done. In other words, workhours were budget- ed and earned. If the budgeted workhours are less than the earned workhours, it means more was done than planned, and the project is ahead of schedule. The reverse would place the project behind schedule. Cost performance is measured by comparing what was done to the cost incurred. To do this, earned workhours are com- pared to actual workhours. If the cost incurred were greater than what was done, the project has overrun its budget. The above relationships are expressed by the formulas listed as equation 5, equation 6, equation 7, and equation 8. A positive variance and an index of 1.0 or greater denotes favorable performance. See Figure 14.1 for a plot showing the relationships between BCWS, BCWP, and ACWP. PRODUCTIVITY Project managers are always interested in knowing how well actual productivity (workhours/unit) compares with the fig- ures used in planning and budgeting the work. While a com- parison of earned to actual workhours may appear to provide an evaluation of productivity, it does so only if actual quantities of work exactly equal those budgeted. Since this is rarely the case, another mechanism is needed to evaluate productivity. Credit Workhours—Credit workhours (CWH), like earned Workhours (EWH), are a derived quantity that provides a vehi- cle for handling work quantity variations between budgeted 14.4 PROGRESS MEASUREMENT AND EARNED VALUE AACE INTERNATIONAL Figure 14.1—Relationships Between BCWS, BCWP, and ACWP $ or Work-hours Budgeted—BCWS SV CV SV = Schedule Variance CV = Cost Variance ∆T = Time Variance ∆Τ Time, Days E a r n e d - B C W P Actual - ACW P Schedule variance (SV) = (earned workhours or $) - (budgeted workhours or $) = BCWP BCWS (equation 5) Schedule performance index (SPI) = (earned workhours or $ to date)/(budgeted workhours or $ to date) (equation 6) = BCWP/BCWS Cost variance (CV) = (earned workhours or $) - (actual workhours or $) (equation 7) = BCWP - ACWP Cost performance index (CPI) = (earned workhours or $ to date)/(actual workhours or $ to date) (equation 8) = BCWP/ACWP } }
- 210. and actual without distorting crew productivity figures. CWH equals the budgeted productivity workhour unit rate (WH/unit) for a given task multiplied by the number of units completed. Since the actual units of work in a work package may vary from the budgeted (estimated) number of units, CWH may be either greater or less than the EWH. CWH equals EWH only if budgeted and actual quantities of work are equal. If any work task is omitted during the planning/estimating phase (i.e., no workhour budget exists), CWH is not calculated for that package; calculations are confined to work packages for which workhours were allocated. A Productivity Index (PI) may be calculated for a single work package or a combination of work packages (or the total project) using the following for- mula: (see equation 9 and equation 10). SAMPLE PROBLEMS 1. Given the rules of credit and work completed for fabri- cated pipe spools in Table 14.3, find the equivalent linear feet of pipe in place. This pipe spool account is estimat- ed and controlled by using linear feet of pipe as the sum- mary unit of measure. 2. Given in Table 14.4 are data from a project's status reports at the end of a reporting period. Complete the worksheet, determine the percent complete for slabs at grade, elevated slabs, and the summary account, con- crete. 3. You have summarized all control accounts in area A of a project to the end of the reporting period. You note that you had scheduled 28,000 workhours, have earned 26,000 workhours, and have paid for 25,000 workhours. Analyze the cost and schedule status in area A at the end of the reporting period by calculating SV, SPI, CV, and CPI. 4. In planning and budgeting a fixed price project, a given work package was estimated to include 200 units of work. Estimators further utilized a unit rate of 4 work- hours per unit of work, so they budgeted for 800 work- hours in this account. In the field, it was subsequently determined that there were really 240 units of work to be 14.5 AACE INTERNATIONAL PROGRESS MEASUREMENT AND EARNED VALUE Allowed Credit 0.40 0.40 0.10 0.10 Subtask erect pipe end connections pipe hangers supports pipe trimmed U/M LF each each % Total Quantity 3030 180 290 100 To-Date Quantity 1800 75 116 30 Earned Quantity Table 14.3—Rules of Credit Private Credit Workhours (CWH) = (budget unit rate) * (actual quantity) (equation 9) Productivity Index (PI) = (sum of credit workhours) (sum of actual workhours) (equation10) Code 03110 03210 03310 Subtotal slabs at grade 03120 03220 03320 Subtotal elevated slabs TOTAL CONCRETE U/M SM CWT CM XXX SM CWT CM XXX XXX Quantity Total 500 10 1,000 XXX 550 10 2,500 XXX XXX Quantity To-Date 500 9 750 XXX 55 2 0 XXX XXX Budget WH 5,000 1,000 10,000 6,000 1,000 15,000 Table 14.4 —Data From Project Start Reports Earned WH
- 211. performed. This was strictly an estimating error, and, with no contingency fund available, the budget remained at 800 workhours. At the end of the latest reporting period, work was 50 percent complete (120 units), and 432 workhours had been paid for. Is this package overrunning or underrunning cost, and is pro- ductivity better or worse than planned? 5. A project is composed of two work packages, form and pour. From the weekly report data given in Table 14.5, calculate BCWS, ACWP, BCWP, CWH, SPI, CPI, and PI per period and cumulative. The original budget rates are 2.0 WHS/SM for forming and 1.8 WHS/CM for pouring. Portions of this chapter are from previous editions authored by Dr. James M. Neil, PE CCE FORM FORM FORM POUR POUR POUR SCHED. ACT. ACT. SCHED. ACT. ACT. Week QTY. QTY. WHS QTY. QTY. WHS 1 120 80 200 10 - - 2 220 160 330 30 10 25 3 240 240 430 30 35 70 4 160 240 410 30 40 64 5 60 120 280 20 30 50 6 - - - - 15 35 Table 14.5—Data From Weekly Reports PROGRESS MEASUREMENT AND EARNED VALUE AACE INTERNATIONAL 14.6
- 212. INTRODUCTION The concepts discussed in chapter 11 are based on a fixed budg- et scenario, which is most often the case in fixed-price work. However, in the case of cost reimbursable contracts and other situations where the budget is subject to considerable variation, the fixed budget system will not be appropriate for making judgments on cost and schedule performance. In those cases, earned value determinations should be based on a variable budget system. This chapter examines variable budget systems and when to use them. LEARNING OBJECTIVES After completing this chapter, readers should be able to • understand variable budget systems, and • determine when to use a fixed versus a variable budget. EARNED VALUE—VARIABLE BUDGETS The System—The variable budget system is particularly suited for a project that is initiated on the basis of an incom- plete definition and that has a floating budget. Each identi- fied work package is assigned a budget (workhours and/or dollars) based on the best available work quantity informa- tion at that point in time. Then, as each work package is fully defined, its budget is adjusted to reflect final work quantities. What Is a Quantity Adjusted Budget?—A quantity adjusted budget (QAB) varies directly with the quantity of work and is calculated by multiplying the budgeted workhour rates (and/or dollar rates) by the actual work quantities. For example, assume that the initial budget for constructing a foundation estimated 1,000 cubic yards of concrete at 10 workhours (WH) per cubic yard for a total of 10,000 work- hours. However, if the actual design quantity were only 950 cubic yards, the quantity adjusted budget would be equal to 950 cubic yards times the 10 workhours, or 9,500 workhours. In a sense, this is not really a new budget, but is rather a fore- cast reflecting the latest designed material quantities to be installed at budgeted productivity. The forecast then becomes the yardstick for measuring project achievement. The real budgets under this system are the unit rates. The project's final quantity adjusted budget cannot be estab- lished until design engineering is complete, which is usually well after the start of construction. The initial quantity adjust- ed budget must therefore be based on forecasted quantities from sampling and early takeoffs. The quantity adjusted budg- et is adjusted as better quantity data are supplied from the engineering office, and the adjustments impact project progress measurement. Since frequent quantity adjusted budget adjustments can cause fluctuations in progress meas- urement, it is advisable to use the initial budget as the quanti- ty adjusted budget until such time as reasonably firm quantity information becomes available. Quantity data is developed in a code by code sequence as engineering progresses and final commodity reviews are completed: earthwork is normally first, followed by concrete, structural steel, and so on. If the quantity adjusted budget is developed code by code in the same sequence as the final commodity reviews, the transition from budget to quantity adjusted budget becomes a smooth and gradual process. See Tables 15.1 and 15.2 for examples of calculating quantity adjusted budget and progress. Cost and Schedule Performance—The methods previously discussed for calculating percent complete, schedule variance (SV), schedule performance index (SPI), cost variance (CV), and cost performance index (CPI), as described under the fixed budget system, are fully applicable in the variable budget sys- tem. Earned workhours may be calculated by multiplying per- cent complete by the quantity adjusted budget, or, for those activities tracked under the units completed method, by multi- plying the units completed by the budgeted unit rate. Productivity Analysis—Under the variable budget system, the cost performance index is equal to the productivity index because the quantity adjusted budget automatically accounts 15.1 AACE INTERNATIONAL EARNED VALUE FOR VARIABLE BUDGETS Chapter 15 Earned Value for Variable Budgets Dr. Joseph J. Orczyk, PE CCE
- 213. 15.2 EARNED VALUE FOR VARIABLE BUDGETS AACE INTERNATIONAL QAB Job-to-Date Design Quantity Work Item UOM WH Quantity Percentage Complete Earned WH total percent complete = total earned workhours = 1,311 = 36.0% (equation 1) total QAB 3,640 Table 15.2—Calculating Percentage Complete Using QAB CY CY TN EA LF LF (000) 257 102 2.2 1.3 210 79 (000) 212 2,388 105 180 548 207 3,640 (000) 100 42 0.85 0.4 35 22 38.9 41.2 38.6 30.8 16.7 27.8 (000) 82 984 40 55 92 58 1,311 Earthwork Concrete Steel erection Mechanical equip. Piping Electrical systems TOTAL for quantity variations. A separate calculation of a productiv- ity index using credit workhours is unnecessary. Cautionary Notes—Reimbursable projects (those on which construction commences before complete design drawings are available) will tend to experience significant rework as a consequence of design changes. The rework in turn increases the budgets of the affected work packages. When determin- ing percent complete, it is incorrect to include in the calcula- tions either the reworked portion of the budgets or the hours earned when doing the replacement work, even though these may be paid for by the client. To get around this, it is neces- sary to purge such hours from the accounts as rework occurs. Quantity adjusted budgets and actual hours wasted as a result of rework should be transferred to separate accounts outside the basic control structure so that they may later show the extent and cost of rework. It must also be kept in mind that, when using the quantity adjusted budget method, the percent complete changes with every change in the forecasted quantities and workhours for individual accounts. A change of this type is completely inde- pendent of work accomplished, so it confuses people and tends to undermine the credibility of a performance tracking system. As with the fixed budget system, when setting up databases and algorithms for manipulating data, it is important that earned workhours not be totaled by adding the workhours earned during the current period to those accumulated dur- ing prior periods. Instead, to-date calculations should be made for each account, and the totals should be generated by adding the earned workhours of all accounts to-date in which hours or dollars have been earned. Original budget unit rates must represent realistic, achievable objectives, or the quantity adjusted budget will be invalid for all purposes. Another factor that can invalidate the quantity adjusted budget is a failure to keep change orders up to date. The whole premise of cost control is that it requires the budget to be realistic and current. If this is the case, the quantity adjusted budget provides a firm, fair basis for calculating per- cent complete. Work Item Earthwork Concrete Steel erection Mechanical equip. Piping Electrical systems TOTAL UOM CY CY TN EA LF LF Quan. (000) 234 94 2.5 1.1 180 84 WH (000) 193 2,201 119 152 470 220 3,355 Budgeted Unit Rate 0.825 23.41 47.6 138.2 2.61 2.62 Design Quantity 257 102 2.2 1.3 210 79 QAB WH (000) 212 2,388 105 180 548 207 3,640 *Note: The same approach would be used for calculating QAB $ Table 15.1—Calculating QAB (Using WH)* Original Budget
- 214. WHICH BUDGET SYSTEM: FIXED OR VARIABLE? In some instances, the budget system to be used on a project is dictated by the project itself; in other cases, choices exist. For a project started on the basis of incomplete design, the variable budget system should be used, since it is the only one responsive to the inevitable quantity variations that arise as the project becomes fully defined. On well-defined proj- ects, a choice can be made on the basis of characteristics desired in the control system. The Fixed Budget System Has These Characteristics: • It provides a direct evaluation of cost and schedule per- formance. • It requires a supplementary system for productivity evaluation. • Bookkeeping is simplified, and there is less potential for operator-caused errors. • The fixed budgets provide a constant target for manage- ment to see, which is ideal for fixed-price work or other work with target budgets. Fixed budgets provide an incentive for working smarter. • The cost performance index (CPI) and productivity index (PI) are not necessarily the same. Having the two separate indices provides more tools for analysis. • Performance data is susceptible to distortions if the proj- ect budget is not realistically distributed. The Variable Budget System Has These Characteristics: • It provides direct evaluation of productivity and sched- ule performance (cost performance index and productiv- ity index are the same when using workhours; this is also true when using cost if there are no wage rate variances). • It requires a supplementary system for evaluating cost per- formance if operating against a fixed or target budget. • It provides a moving budget that varies directly with both actual quantities of work and budgeted productivi- ty rates for included tasks. This is ideal for projects with open budgets. If applied to projects with a fixed or tar- get budget, a quantity variance account will be required to balance additions and deletions in the work accounts. • It requires more operator attention to database manage- ment because of continually changing baseline information. Summary Examples—Following is an example illustrating the application of the fixed and variable budget systems to a sim- ple project. Note that when a variable budget system is applied to projects with a fixed budget, a quantity variance account will be required to balance additions and deletions in the work accounts. This example includes calculations for schedule per- formance index (SPI), cost performance index (CPI), and pro- ductivity index (PI) to further illustrate differences among the approaches. A project is composed of three work packages. The original estimate is shown in Table 15.3. Work was scheduled during the initial planning as shown in Table 15.4. After the design was completed, two work package quantities had changed. Work package A had 12 units, and work package B had 22 units. As a result, work was rescheduled (see Table 15.5, since the schedule target completion date remains). 15.3 AACE INTERNATIONAL EARNED VALUE FOR VARIABLE BUDGETS Package Quantity Unit Rate Total WH A 10 15 150 B 15 10 150 C 20 5 100 Total 400 Table 15.3—Original Estimate Week A B C 1 2 2 2 3 2 4 2 5 5 2 5 6 5 7 5 8 5 9 5 10 5 Table 15.4—Initial Schedule Table 15.5—Revised Schedule Week A B C 1 2 2 3 3 3 4 2 5 5 2 5 6 5 7 5 8 6 9 6 10 5 GLOSSARY TERMS IN THIS CHAPTER earned value ◆ productivity
- 215. Case #1—Fixed Budget Approach for Fixed Price Contract The budgeted workhours were redistributed within the available budget as shown in Table 15.6. Redistribution was based on the needed workhours for the actual quantities, but spread within the 400-workhour budget using a factor of 400/440 = 0.909. To meet the original budget of 400 work- hours, the field performance must be substantially better than originally estimated. The data contained in Table 15.7 was taken from weekly reports. The quantity column reflects the planned units/actu- al units. The workhour column shows the scheduled work- hours (using the required unit rate)/actual workhours (also known as BCWS/ACWP). The weekly performance meas- ures were calculated from the data contained in Table 15.7. These are shown in Table 15.8. The cumulative performance measures are shown in Table 15.9. 15.4 EARNED VALUE FOR VARIABLE BUDGETS AACE INTERNATIONAL Table 15.6—Case #1 Redistributed Budget Workhours Budget Needed Allocated Required Package Quantity Unit Rate WH WH Unit Rate A 12 15 180 164 13.6 B 15 10 150 136 9.1 C 22 5 110 100 4.5 Total 440 400 Table 15.7—Case #1 Weekly Data A A B B C C TOTAL Week QTY WH QTY WH QTY WH WH 1 2/1 28/16 28/16 2 3/2 41/31 41/31 3 3/3 41/40 0/2 0/22 41/62 4 2/3 27/38 5/4 46/40 73/78 5 2/2 27/24 5/4 45/42 72/66 6 0/1 0/15 5/4 45/36 45/51 7 0/1 0/12 5/3 23/18 23/30 8 6/5 27/30 27/30 9 6/6 27/33 27/33 10 5/5 23/28 23/28 11 0/3 0/14 0/14 Table 15.8—Case #1 Weekly Performance Measures BCWS ACWP BCWP CWH Sched. Actual Earned Credit Week WH WH WH1 WH2 SPI3 CPI4 PI5 1 28 16 14 15 0.50 0.88 0.94 2 41 31 27 30 0.66 0.87 0.97 3 41 62 59 65 1.44 0.95 1.05 4 73 78 77 85 1.05 0.99 1.09 5 72 66 64 70 0.89 0.97 1.06 6 45 51 50 55 1.11 0.98 1.08 7 23 30 23 25 1.00 0.77 0.83 8 27 30 23 25 0.85 0.77 0.83 9 27 33 26 30 0.96 0.79 0.91 10 23 28 23 25 1.00 0.82 0.89 11 0 14 14 15 N/A 1.00 1.07 Notes: 1. Earned WH = (percentage complete) (budget in WH) 2. Credit WH = (original budgeted unit rate) (units complete) 3. SPI = (earned WH) divided by (scheduled WH) 4. CPI = (earned WH) divided by (actual WH) 5.PI = (credit WH) divided by (actual WH)
- 216. Case #2—Variable Budget Approach for Fixed Price Contract The work package budgets were adjusted to reflect the addi- tional work using the original unit rates. A quantity variance account was established to balance the budget to account for the fact that only 400 WH were really in the project's control budget. These facts are shown in Table 15.10. The data contained in Table 15.11 was taken from the weekly reports. The quantity column shows the planned units/actu- al units. The workhour column reflects the scheduled work- hours (using the budget unit rate)/actual workhours (also known as BCWS/ACWP). The weekly performance measures were calculated from the data in Table 15.11. They are shown in Table 15.12. The cumulative performance measures are shown in Table 12.14. 15.5 AACE INTERNATIONAL EARNED VALUE FOR VARIABLE BUDGETS BCWS ACWP BCWP CWH Sched. Actual Earned Credit Week WH WH WH WH SPI CPI PI 1 28 16 14 15 0.50 0.88 0.94 2 69 47 41 45 0.59 0.87 0.96 3 110 109 100 110 0.91 0.92 1.01 4 183 187 177 195 0.96 0.95 1.04 5 255 253 241 265 0.94 0.95 1.05 6 300 304 291 320 0.97 0.96 1.05 7 323 334 314 345 0.97 0.94 1.03 8 350 364 337 370 0.96 0.93 1.02 9 377 397 363 400 0.96 0.91 1.01 10 400 425 386 425 0.97 0.91 1.00 11 400 439 400 440 N/A 0.91 1.00 Table 15.9—Case #1 Cumulative Performance Measures Table 15.10—Case #2 Adjusted Budget Budget Needed Package Quantity Unit Rate WH A 12 15 180 B 15 10 150 C 22 5 110 Control budget 440 Quantity variance account -40 Real budget 400 A A B B C C TOTAL Week QTY WH QTY WH QTY WH WH 1 2/1 30/16 30/16 2 3/2 45/31 45/31 3 3/3 45/40 0/2 0/22 45/62 4 2/3 30/38 5/4 50/40 80/78 5 2/2 30/24 5/4 50/42 80/66 6 0/1 0/15 5/4 50/36 50/51 7 0/1 0/12 5/3 25/18 25/30 8 6/5 30/30 30/30 9 6/6 30/33 30/33 10 5/5 25/28 25/28 11 0/3 0/14 0/14 Table 15.11—Case #2 Weekly Data
- 217. 15.6 EARNED VALUE FOR VARIABLE BUDGETS AACE INTERNATIONAL Table 15.12—Case #2 Weekly Performance Measures BCWS ACWP BCWP Sched. Actual Earned WH Week WH WH WH1 SPI2 CPI3 Deficit4 1 30 16 15 0.50 0.94 2 45 31 30 0.67 0.97 3 45 62 65 1.44 1.05 4 80 78 85 1.06 1.09 5 50 66 70 0.88 1.06 6 50 51 55 1.10 1.08 -14 Pkg A 7 25 30 25 1.00 0.83 -2 Pkg B 8 30 30 25 0.83 0.83 9 30 33 30 1.00 0.91 10 25 28 25 1.00 0.89 11 0 14 15 n/a 1.07 -23 Pkg C Notes: 1. Earned WH = (Budgeted Unit Rate) (Units Completed) 2. SPI = (Earned WH divided by (Scheduled WH) 3. CPI = (Earned WH) divided by (Actual WH) 4. Deficit calculated at completion of package = (original budget) (actual WH) Table 15.13—Cumulative Performance Measures BCWS ACWP BCWP Sched. Actual Earned WH Week WH WH WH1 SPI2 CPI3 Deficit4 1 30 16 15 0.50 0.94 2 75 47 45 0.60 .096 3 120 109 110 0.92 1.01 4 200 187 195 0.98 1.04 5 280 253 265 0.95 1.05 6 330 304 320 0.97 1.05 -14 7 355 334 345 0.97 1.03 -16 8 385 364 370 0.96 1.02 9 415 397 400 0.96 1.01 10 440 425 425 0.97 1.00 11 440 439 440 N/A 1.00 -39 Note that the budgeted cost for work performed (BCWP) in the variable budget system is the same as the credit workhours (CWH) in the fixed budget system. Therefore, the cost performance index (CPI) in the variable budget system is the same as the produc- tivity index (PI) in the fixed budget system.
- 218. Case #3—Variable Approach With Variable Budget This would be handled the same as for the fixed budget, except that both the real and the control project budet would be 440 workhours to reflect the increased quantities. Budget variance would then be as followss: Portions of this chapter are from previous editions authored by T. Lynn Hyvonen and Dr. James M. Neil, PE CCE 15.7 AACE INTERNATIONAL SCHEDULING budget variance = (budget WH) - (actual WH): Package A = (180 WH) - (164 WH) = +16 WH Package B = (150 WH) - (152 WH) = -2 WH Package C = (110 WH) - (123 WH) = -13 WH total project = +1 WH
- 220. INTRODUCTION To achieve control of an operation, a plan for conducting that operation must exist, since it is the plan that forms the basis for control. Actually, the plan for the project consists of numerous interrelated planning documents such as sched- ules, budgets, a materials management plan, a subcontract- ing plan, and so forth. These documents also comprise the project baselines. A number of formal control structures included in the overall management of the project are collectively grouped under the term project control. These include cost control, schedule control, materials control, and quality control. This chapter is concerned primarily with cost and schedule control, tracking project statusand techniques for analyzing project reports. LEARNING OBJECTIVES After completing this chapter, readers should be able to • understand project control baselines and how to track proj- ect costs and schedule performance from reports, and • understand how to analyze project reports to identify trends and forecast potential problems. BASELINES Cost Control Versus Financial Control—Cost control is obviously important on any project, but it is important to dis- tinguish between cost control and financial control. Financial control is concerned with receipts and expenditures, which are important to good bookkeeping and accepted accounting practice. The financial control structure must be in accor- dance with generally accepted rules of accounting, and must serve the requirements that relate to contract payment provi- sions, taxation, regulations, or project capitalization. Financial accounting also reflects the pricing of a contract, which may differ significantly from its costing (because of unbalancing and the tracking of indirect accounts such as profit and distributable). Project managers, on the other hand, are concerned with cost— what specific operations should cost and what they do cost. Budget (cost) control should be approached as an application of Pareto's law, which essentially states that 80 percent of the out- come of a project is determined by only 20 percent of the included elements. Thus, in establishing a cost control system, the idea is to isolate and control in detail those elements with the greatest potential impact on final cost, with only summary- level control on the remaining elements. Most project cost ele- ments (materials, equipment, and overhead) can be predicted or established with reasonable accuracy if the project is proper- ly planned and estimated. The greatest variable in the final cost of a construction project is usually the labor cost. Labor cost is a function of worker hourly cost and worker productivity, but although hourly rates are relatively easy to predict, productivi- ty is the real variable. Thus, a contractor must monitor both worker hours expended and productivity as major elements in the cost control program. Of course, the element of quantity control is also included as a basis for progress reporting, as well as estimate verification. Budget Baselines—The budget baselines for a project are generated through the estimating process. Whether or not the design documents are complete, planners must develop a cost estimate for the project using the most appropriate meth- ods, as discussed in previous chapters. If the project has yet to be fully defined, this estimate is approximate and subject to some variation, but as the project becomes better defined, the estimate is updated to reflect the new definition. For a fixed price project, good estimating is critical because the estimate establishes the bid price, which must incorpo- rate all elements of cost while providing a reasonable profit to the contractor. The estimate also generates all quantity, cost, and productivity targets to be used for detailed control. 16.1 AACE INTERNATIONAL TRACKING COST AND SCHEDULE PERFORMANCE Chapter 16 Tracking Cost and Schedule Performance Dr. Joseph J. Orczyk, PE CCE
- 221. 16.2 TRACKING COST AND SCHEDULE PERFORMANCE AACE INTERNATIONAL Ideally, the estimate will have been prepared using the same work breakdown structure as that used for the control schedule, since doing so directly enables the quantity, cost, and produc- tivity targets to be developed for each control work package. Schedule Baselines—A major effort during the planning process is developing the work breakdown structure, which is the basis for the schedule. There are multiple levels of schedules and various forms of schedules. The control schedule is, as its name implies, the schedule used for master control of the project. It can be in bar chart format, but on larger projects is best presented in critical path method (CPM) format, particularly a time-scaled CPM. It is impor- tant that the control schedule be at a level of detail that can be intelligently reviewed by the planners—too great a level of detail gets beyond human comprehension and can contain illogical and arbitrary constraints. Detailed schedule control is best handled using bar charts to display the schedule data. The Control Account Baseline—Figure 16.1 shows a control account baseline and illustrates how a planner moves within a work package (in this case service water piping) from the control schedule level to the detailed level. The piping sys- tem is first segmented into the work tasks required for its completion (large pipe, valves, etc.), and the tasks are then scheduled in bar chart format with restraints, as shown. As is so often the case, the tasks are overlapping, and some flex- ibility exists in their sequencing (soft logic). Use of the bar chart format with float shown for each bar gives field per- sonnel the flexibility needed to accomplish the work. Other information included on the baseline document provides the basis for earned value control and progress payments. STATUSING Having established the basis for control, project controllers are then in a position to exercise that control. They do this by Figure 16.1—Control Account for Service Water Piping ABC1234 EFG7234 KKR3862 EYW4483 S W P 0 0 0 0 Account Code Control Account Baseline Description Weight 0.25 0.30 Large Hangers Large Pipe Large Valves Latest Estimate 0.10 0.15 0.20 Large Pipe Weld Small Pipe LF D J F M A M J J A S O 1999 Service Water Piping Project Date Rev. Total Control 1.00 Control Item Large Pipe U/M LF Qty 2000 WH WH % 360 660 510 580 660 230 Total 360 1040 1550 2110 2770 3000 Cumulative Cumulative 13 35 52 70 92 100 EA EA LF U/M EA 1500 150 10 2000 100 Activity . . . . . . . . . . . . . . . . . . . . . . . . .
- 222. 16.3 AACE INTERNATIONAL TRACKING COST AND SCHEDULE PERFORMANCE receiving reports of actual progress and costs and comparing them to the plan. Work Status—In chapter 14, various methods of measuring work progress were explained. On the control account base- line, the methods to be used are established under the unit of measure (U/M) column for each task. These can be rolled up using earned value to show the overall percent complete of the control account. Figure 16.2 represents a reporting format that uses the service water piping of Figure 16.1 as an example. The many control accounts can, in turn, be summarized both at various levels, and for the entire project using earned value. Cost Status—As noted earlier, the contractor will surely be interested in employing the project's workhour statistics as a major cost-tracking tool, and will use the cost performance index (CPI), productivity index (PI), and cost variance (CV) for workhours as indicators. Cost in terms of dollars also should be statused. Certain costs, particularly materials furnished and installed by the contractor and labor, are tracked on a control-account-by- control-account basis. Equipment costs and the cost of con- struction materials and supplies (materials consumed, but not incorporated, in the final product) may be tracked as part of the work control account, but are more likely to be tracked in separate accounts. The CPI and CV for dollars can be cal- culated for whatever cost items are tracked. Tabular reports are appropriate for summarizing cost status in various ways. Typical summaries are as follows: • A cost summary for each account showing the original con- trol workhours/dollars, current control workhours/dollars, this period workhours/dollars, job-to-date workhours/dol- lars, remaining to-completed workhours/dollars, estimate- at-completion workhours/dollars, and variance. • Alabor rate report for each craft and control account show- ing the original control figures for dollars, workhours, and dollars per workhour, and providing for each category the current control, experience this period, job-to-date experi- ence, estimate-at-completion, and variances. Figure 16.2—Monthly Quantity Report Control Account Baseline Project Date Rev. S W P 0 0 0 0 Account Code Description Service Water Piping This Period To Date Weight 0.25 0.30 0.20 0.15 0.10 Activity Large Pipe Weld Large Valves Large Pipe Large Hangers Control Item Large Pipe Small Pipe Total Control 1.00 U/ M LF U/M LF EA EA LF EA Latest Estimate Control Quantity 2000 Week Ending 1/3 1/10 1/24 1/17 5 5 15 20 15 35 15 50 50 50 90 75 75 25 265 175 100 25 Field Engineer 100 2000 1500 150 10 GLOSSARY TERMS IN THIS CHAPTER cost control ◆ scheduling ◆ status
- 223. 16.4 TRACKING COST AND SCHEDULE PERFORMANCE AACE INTERNATIONAL • A quantity and workhour report showing the original control work quantities, workhours, and the workhours per unit of work for each control account, and providing comparable information under the headings of current control, current period, job-to-date, and estimate-at-com- pletion. This report also can show the earned workhours this period, earned workhours to date, and the labor CPI. Schedule Status—Schedule status is best displayed using a bar chart. Figure 16.3 contains a sample of an excellent format for summary-level reporting to management. Note that serv- ice water piping is summarized as a single line in this figure. The weight column shows the ratio of the total workhours for the activity to the total workhours on the schedule. The number shown in the earned percentage column is the prod- uct of the weight column and the actual percent complete of the activity (shown at the end of the actual bar). ANALYSIS, TRENDING, AND FORECASTING While it is important to know the exact status of a project at any given point in time, it is equally important to analyze the situation so that appropriate corrective action can be taken if Aug Portable Water Oil, Chemicals, Vents Millwater & Misc. Steam and Condensate Air and Vacuum Process Liquors Service Water Deaerated B.F.W. Totals 502 0.6% P A 19085 9.5% 7362 0.0% 23525 16.9% 3000 1.6% 6587 6.6% 2407 2.0% P A P A P A P A P A P A 0.8% 29.7% 3.8% 10.2% 4.7% 39.4% 11.4% Weight Workhours Earned % 64268 37.2% 100% Legend Planned Actual Update: June 5, 1992 100 90 80 70 60 50 40 30 20 10 0 43 74 32 52 65 34 48 0 16 49 49 100 0 4 8 18 30 41 68 86 96 100 0 8 14 22 40 67 100 0 18 50 85 100 0 13 35 52 70 92 100 0 8 11 31 45 56 83 92 98 100 0 5 8 21 33 53 66 81 91 97 0 0 0 0 9 18 26 44 79 85 92 100 30 P A Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep % Figure 16.3—Monitoring Schedule
- 224. 16.5 AACE INTERNATIONAL TRACKING COST AND SCHEDULE PERFORMANCE needed. This analysis, as well as trending and forecasting, is discussed in the following paragraphs. The Cost and Schedule Performance Curves—One of the handiest formats for quickly presenting a project's cost and schedule status is shown in chapter 14 (Figure 14.1). This type of graph shows a plot of the planned budget cumulative expenditure budgeted cost for work scheduled (BCWS) curves (in terms of either $ or workhours) plus the cumula- tive actual cost of work performed (ACWP) and the cumula- tive earned budgeted cost of work performed (BCWP) to the date of the report. The viewer can quickly see the cost and schedule variances and approximately how far the project is ahead of or behind schedule. Index Tracking—Figure 16.4 contains a graph for tracking the types of indices described in chapter 11. It tracks the produc- tivity index on a cumulative basis, and uses a projected pro- ductivity curve, which does not coincide with the 1.0 datum curve. This curve recognizes that productivity is usually expected to be lower during the early stages of a project, reach a peak about midway in the project, and decrease toward closeout. The projected productivity curve allows the actual productivity plot to be more meaningfully evaluated. As shown in the figure, a productivity index of 1.06, which is nor- mally assumed to be favorable, is actually low compared to what it should be for that point in time. Other Tracking—Figure 16.5 is a variation of figure 16.4. The vertical axis is workhours per percent complete. On this graph, the cumulative plan curve is an upside down image of the projected curve in Figure 16.4 because of the different choice of units on the vertical axis. The graph also includes the plan for period and actual period plots to give it more usability. The point identified as (1) shows actual period performance equal to planned performance. But, when actu- al cumulative performance is examined, it shows that the project still has a problem because of the poor performance during earlier periods; thus, performance must become bet- ter than planned if the project is to recover. Figures 16.6 and 16.7 track a project's building steel erection workhour rates and unit wage rates, respectively. They are self- explanatory. Figure 16.8 presents a format for tracking bulk quantity items—in this case, wire pulling and terminations. The two curves shown represent the plan. By superimposing actual performance on the graph, the current situation and trends are readily shown. The graph also indicates that terminations were not scheduled to begin until 15 percent of the wire was pulled, which helps ensure that the wire termination crews will have work available to them at all times. This series of curves can be extended to include conduit installation and electrical design as well. Analysis Techniques—Each report item has significance in itself, but it usually takes a combination of items for the total situation to be shown. For example, poor labor cost performance (cost performance index CPI less than 1.0) is certainly a problem, but the CPI does not point to the cause 0 100 90 80 70 60 50 40 30 20 10 Physical Completion (%) Actual Projected 1.06 Productivity Index 0.2 0.4 0.6 0.8 1.0 1.2 0.0 1.3 Figure 16.4—Productivity Profile • • • •
- 225. 16.6 TRACKING COST AND SCHEDULE PERFORMANCE AACE INTERNATIONAL A M J M A M F J D N O S A J Figure 16.6—Building Structural Steel Erection 1993 % Progress Based on Quantity Installed Estimated 30.0 WH/Unit Cumulative Period Unit Rates and Progress % Complete 100% 25% 50% 75% 90 10 20 30 40 50 60 70 80 0% 1992 100 0 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 Workhour(s)/% Complete 100 0 50 40 30 20 10 90 80 70 60 Actual Cumulative Actual Period Plan for Period Percent Complete Cumulative Plan Figure 16.5—Workhour Productivity Trend Chart
- 226. 16.7 AACE INTERNATIONAL TRACKING COST AND SCHEDULE PERFORMANCE Figure 16.7—Unit Wage Rate Actual Planned 21.00 20.00 19.00 1992 1993 Jul May Apr Mar Feb Jan Dec Nov Oct Sep Aug DOLLARS/UNIT of that problem, which could be low productivity, a bad quantity estimate, excessive staffing, higher crew rates, or any combination of these. Thus, report data must be available in each of those areas to enable the manager to isolate the problem and take remedial action. Figure 16.9 shows an analysis tree involving just two report items: schedule performance index (SPI) and total float. Many possible combinations exist. Other analysis trees using other report items can be readily developed. Forecasting—There are three basic forecasting approaches. 1. This method is used for forecasting costs and workhours. It assumes that work from a particular point forward will progress at planned rates, whether or not those rates have prevailed to this point. EAC = (ACWP) + (BAC - BCWP) (equation 1) where: EAC = estimate at completion ACWP = actual cost of work performed to date Figure 16.8—Bulk Quantity Curves Wire Pulling Actual Terminations Time Now 100 15 Actual 25 50 75 % Complete 0
- 227. BAC = original budget at completion BCWP= budgeted cost of work performed to date 2. This method assumes that the rate of progress prevailing to date will continue to prevail. EAC = (BAC) divided by (CPI) (equation 2) where: CPI = cost performance index Other terms as above 3. This method uses curves, and is useful for forecasting any piece of data represented by those curves. The fore- caster makes the best extrapolation possible using the typical shapes of the curves and whatever other infor- mation may be available to make the projection. No single forecasting method is recommended. Rather, a forecast by each of the above methods should be performed, since this will provide a range of possibilities. Portions of this chapter are from previous editions authored by Dr. James M. Neil, PE CCE 16.8 TRACKING COST AND SCHEDULE PERFORMANCE AACE INTERNATIONAL SPI > 1.0—ahead of schedule on critical path; more work being done than planned TF > 0 SPI = 1.0—ahead of schedule on critical path; some shortfall in work on non-critical activities SPI < 1.0—ahead of schedule on critical path; significant shortfall in work on non-critical activities SPI > 1.0—critical path on schedule; more work being done on non-critical activities TF = 0 SPI = 1.0—critical path on schedule; total work volume is as planned SPI < 1.0—critical path on schedule; shortfall in work on non-critical activities SPI > 1.0—critical path activities behind schedule; total work more than planned indicating excess attention to non-critical activities TF < 0 SPI = 1.0—critical path activities behind schedule; total work volume as planned meaning too much attention to non-critical activities SPI < 1.0—critical path activities behind schedule; total work less than planned; need more overall effort Figure 16.9—Analysis Tree—Total Float and Schedule Performance Index (SPI)
- 228. INTRODUCTION Companies in the business world are constantly concerned with improving their bottom line—increasing their rate of return on investment, increasing the ratio of profit to rev- enues, or simply increasing total profit. Using programs with buzzword titles such as productivity improvement, total quality management, re-engineering, time-based competi- tion, horizontal management, down-sizing, and right-sizing, they reorganize, trim staffs, invest in training, automate, computerize, and otherwise do whatever is considered nec- essary to optimize or maximize the company's performance and beat the competition. But, whatever the name of the pro- gram, the goal is the same—spend less to make more money or spend less to provide the same or better service. For pro- duction-type activities, this translates into reducing worker and equipment hours per unit of output—i.e., improving productivity. For support and professional activities it means improving efficiency. For all activities, it includes reducing waste of time, materials, and equipment. Altogether it means improving the outcome of the total organization. LEARNING OBJECTIVES After completing this chapter, readers should be able to • analyze worker productivity and performance, and • identify ways to increase productivity, improve per- formance, and minimize waste in the workplace. SUCCESS INDEX Numerical evaluation of total organizational performance is possible using the success index (SI). It could be called the performance index, but doing so might cause it to be con- fused with the productivity index (PI) to be described and used later. Equation 1 is the formula for the success index for a profit-oriented business. Equation 2 is for a service organi- zation, such as a government. success index = net profit (equation 1) total costs success index = value of services rendered (equation 2) costs of providing services It should be noted that the success index is really an expres- sion of organizational productivity because it relates a form of output (profit or value) to a form of input (cost). To continue the discussion, the denominators of equations 1 and 2 can be re-expressed as shown in equations 3 and 4: success index = net profit (equation 3) essential costs + cost of waste success index = value of services rendered (equation 4) essential costs + cost of waste The denominators in both equations now divide total costs into two broad categories—essential costs and cost of waste. Essential costs are those personnel, material, equipment, tax, and other costs that would be incurred if the organization were efficiently organized and running perfectly.As for waste, these are the major categories: • inefficiencies inherent in the design and operation of the work place; • individual inefficiencies; • non-contributing (wasted) time by individuals; • waste of materials, supplies, and services (misuse, overuse, loss); • waste of equipment (abuse, misuse, loss); and • functions that no longer add value to the output of the organization. In the past, management tended to focus on productivity improvement as the key to reducing costs and/or improving 17.1 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT Chapter 17 Performance and Productivity Management Dr. James M. Neil, PE CCE
- 229. the bottom line, and that subject was and still is given signifi- cant attention in technical literature. This is to be expected, since production activity can be readily measured, it can be expressed in hard numbers, its trends are easily noted, and it lends itself to detailed analysis and improvement studies. The problem is that there are many people and much equipment within a company performing functions whose effectiveness and contributions are not properly measured on the basis of output per unit of input. Personnel in this category include most support and professional staff—secretaries, design engi- neers, managers, etc. Equipment types include word proces- sors, tower cranes, and administrative vehicles. True, there are outputs associated with many of these indi- viduals and pieces of equipment, but productivity is not the basis for their selection. For example, a receptionist or a secu- rity guard must be present to handle whatever comes up; their performances would not be evaluated on the basis of quantity output. Similarly, a tower crane at a building con- struction site is selected on the basis of lifting capacity at var- ious boom radii—one does not think in terms of tons per hour. There have been efforts to apply productivity measure- ment concepts to individuals in this category who do have products (e.g., secretaries and design engineers), but with lit- tle or no success. In fact, doing so may create stress and cause quality to be compromised as individual goals shift from quality to quantity production of the item designated for measurement (e.g., correspondence processed or drawings produced). To expand on the above, within an organization's population are people who produce things and people who perform things. Most individuals do both to some degree. Performance may be associated with units of output, but the real performance standard is something other than quantity (e.g., engineering drawing quality, ability to write, or respon- siveness in an emergency). Performance is evaluated subjec- tively (e.g., above average or 7 on a scale of 10). One would like to assume that every organization seeks to do everything possible to promote performance and productivi- ty. Unfortunately, the real-life situation tends to be as depict- ed in Figure 17.1. It shows that an individual has a basic capa- bility resulting from many factors. What that individual can produce becomes restricted by organizational constraints. What should an organization do? To borrow an expression from a US Armed Forces recruiting commercial, the organiza- tion should do whatever is necessary to make each individual “the best that he/she can be.” That is done by eliminating or minimizing conditions within an organization that limit per- formance and productivity and by creating conditions that pro- mote them. Remaining sections of this chapter provide guid- ance for doing this. The first section will focus on the challenge of improving performance of a total organization. That will be followed by a discussion relating specifically to those personnel in the workforce involved in production activity. Finally, the role of incentives in performance and productivity manage- ment will be reviewed. 17.2 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL Figure 17.1—Performance Expectancy Model Experience Confidence Developed Skills Innate Ability Pride and Motivation Constraints Working Conditions Mgmt. Attitudes Personalities Policies Procedures Resource Limits etc. Outcome Capability
- 230. 17.3 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT THE OVERALL PERFORMANCE ISSUE The Challenge An organization's success index always will be less than that potentially available had perfection prevailed, because human beings are involved and Murphy's Law (If anything can go wrong, it will!) has yet to be repealed. The problem is illustrated in Figure 17.2, which illustrates how performance potential is lost through inefficiency and waste. The goal must be to eliminate or minimize the factors contributing to that degradation. Losses Through Inefficiency Inefficiencies are both organizational and individual. Inconvenient positioning of office reproduction equipment, shortages of equipment or materials, lack of procedures, excessive management layering, and poor lighting are typical organizational inefficiencies. Failure to plan, refusing to use labor-saving equipment (such as a word processor), and sloppy filing are typical individual inefficiencies. All of these translate into time loss and higher costs. The problem with inefficiencies is that the losses tend to be hidden—an observ- er watching a individual doing what appears to be contribut- ing work may not realize that the work is being done very inefficiently. Waste Through Interruptions Everyone acknowledges that interruptions are disruptive, but interruptions are seldom treated as a subject area with significant potential for improving productivity and per- formance. Take the typical office situation shown in Figure 17.3 where an individual is trying to write a report: a series of interruptions in the form of telephone calls and visitors reduces the individual's average productivity significantly. If something could be done to reduce these interruptions (e.g., an electronic mailbox, visitor screening, providing bet- ter office privacy), the individuals potential output would be improved. The lesson to be learned is simple: review work practices in an organization to determine where avoidable interruptions occur and then take corrective action. Other Time-Wasters Interruptions are but one form of time waste; there are many more. First is a list of events or situations that are accepted parts of life in most organizations, but each causes interrup- tions, and some result in wasted time. The Performance Problem Potential Performance Lost Because of Time Wasted Potential Performance Lost Because of Inefficiencies Actual Performance Training, Other Necessary Functions Potential Performance per Unit of Time 100% Non-Contributing Activity or Non-Activity Contributing Work Activity Non-Work Essentials Figure 17.2—The Performance Problem GLOSSARY TERMS IN THIS CHAPTER ◆ productivity ◆
- 231. 17.4 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL • official meetings and appointments; • telephone calls; • personal breaks and lunch breaks; • official visitors; • a need to interrupt current activity to make a copy of some- thing, send a fax, or coordinate with another worker; • fire drills, hazard alarms, or other emergencies; • adverse weather; • power outages; • equipment breakdowns; • holds for quality checks or coordination; • absentees whose work must be absorbed by others; • turnover of key personnel—new ones must be brought up to speed; • higher headquarters or outside agency inspections, audits, and reviews; • secretaries/clerks delivering mail and messages; • noise and conversations from adjacent work areas; • unusual activity outside office windows; • running out of something—paper, staples, etc.; • misplacing something; and • forgetting something. Certain actions or policies may minimize the disruption and time loss effect of some of the above items, but the potential is not significant. The next list contains more events and situations that create time loss in an office setting. In this case, all of them have sig- nificant potential for elimination or reduction through better planning and management: • unnecessary and unstructured meetings; • people late for meetings; • social visits or greetings from passing fellow employees; • sales calls without appointments; • waiting for engineering and vendor information; • errors or omissions on engineering drawings; • lack of communication—somebody didn't “get the word,” • too many people or organizations involved in getting an answer, approval, or decision; • excessive time taken to make decisions, or approve/coor- dinate something; • too few support personnel available (e.g., clerical) so professional staff must perform own support; and • inadequate support equipment (e.g., copy machines) causes waiting. In the case of construction field sites, these are controllable time-wasters: • ill-defined scope forces constant reworking of schedule; • contractual disputes; Figure 17.3—Impact of Disturbance on Performance Average Office Example—Writing a Report PRODUCTIVITY LEVEL Peak Telephone Rings Again Co-worker drops by Telephone Call Your Day Starts Co-worker leaves Call ends Call ends Time
- 232. • labor disputes and adverse union activity; • arbitrary work rules; • personality problems among key personnel on owner, engineer, and contractor staffs; • late materials or installed equipment deliveries; • materials and equipment for installation do not meet specifications or have fabrication errors; • materials and equipment allowed to deteriorate in stor- age so as to not be usable; • materials and equipment listed on warehouse inventory cannot be found; • failure to pick up all needed materials the first time; • excessive distances between work areas and tool rooms, warehouses, and laydown areas; • wrong or defective tools issued; • waiting for support equipment (e.g., crane); • waiting for an approval to do something; • lack of information or waiting for instructions; • issuing instructions after work has started; • waiting for other crews to get out of way; • individuals don't understand their roles or responsibili- ties—must always ask questions; • limited availability of a critical skill that must be shared among crews (e.g., competent person required by OSHA for certain operations); • late starts/early quits; • absentees—work must be reorganized; • discipline problems; • permits (such as hot work permits) not available; • daily renewal of permits; • conflicts with operating plant personnel on revamp work; • operating personnel, having not been consulted during development of the project, make changes on the fly; • changes are issued—both formal and constructive; • unexpected conditions require work reorganization; • waiting for access or removal of lockouts; • over-inspections; • outdated policies or procedures that must be interpreted to fit current needs; • work is started before being fully planned and without all resources needed; • safety incidents; and • construction mistakes. Many actions can be taken to eliminate or minimize the time- wasters listed above. For many, the nature of the problem makes the solution obvious. However, to provide several ideas with respect to one major time waster, consider the problem of meetings—too many, too big, too unstructured. Following are some ideas that have worked for others to cor- rect the situation. • Prepare and implement a written policy/procedure for conduct of meetings. • Train meeting sponsors on the policy. • Prepare and work from an agenda for all meetings. Establish a limit of time and start promptly. • Prepare minutes of meetings to include all decisions made, items remaining open, and actions assigned to individuals (with target dates for completion). • As an occasional attention-getter, require meeting spon- sors to prepare a timesheet for each meeting that lists individuals attending, time spent, and their hourly billing rates (wages + fringes). The sponsor must extend and total the cost figures and submit the summary to his/her supervisor. This makes meeting sponsors think twice about scheduling questionable meetings, encour- ages them to better plan the meeting, and forces them to think in terms of benefits and costs. • For any individual late to a meeting, fine them $5 and put it in the coffee or flower fund. • Arrange the tables and chairs with respect to the entrance so that a latecomer cannot “sneak in.” He/she must walk by the chairman and everyone else so that he/she will be totally embarrassed. • Schedule meetings at beginning of day, just before lunch, just after lunch, or just before quitting time. Scheduling them in the middle of the work day creates a major inter- ruption. Waste Through Rework Rework is a special form of waste. One tends to apply the term only to redoing work because the work is flawed or changed. But, one will find countless other forms of rework going on within organizations every day when you use the more general definition of rework: the repeating of an activ- ity (and consequent expenditure of resources) with no value added to the final output. Because activity during rework usually looks the same as when work is done the first time, it is easily overlooked as an area of waste with tremendous potential for reducing costs. Following are common exam- ples of rework in an organization. • Marketing rework: Constantly looking for new work because the organization cannot attract significant repeat business. • Management/Supervision Layering—Maintaining exces- sive levels of supervision—a higher level essentially repeats the work of the lower level. • Materials Management—Double (or more) handling of materials before use. • Reorganizations—Reconfiguring an organization with no significant change in missions or workload. • Physical Relocations—Moving personnel and equipment to accommodate a new organizational structure or other- wise. • Lack of Electronic Data Links—Receiving data in hard copy and reentering it into another computer system instead of electronically linking computer systems. 17.5 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT
- 233. • Computer Illiteracy—A manager or other professional staff member who is computer averse still does every- thing long-hand and turns it over to a clerk for entry into a computer. • Excessive Administrative Review—Requiring excessive numbers of approvals on documents such as purchase orders or travel claims. • Failure to Provide Management Guidance—A manager failing to provide guidance when tasks are assigned and then rejecting the output as not being what he/she was looking for. • Excessive Quality Control—Maintaining separate contrac- tor and owner quality control operations on a project site. • Post-Production Engineering Review—Performing a review of engineering deliverables after the deliverables have been fully drafted by the engineering staff. After being marked up, drawings must be redone. • Reinventing the Wheel—Failing to conduct post-project reviews to develop experience data and lessons learned that can be used in future planning. • Scope Revision During Detailed Engineering—Failing to completely define scope during conceptual engineering. Detailed designs must be reworked with each scope change. May create construction rework. • Claims—Expending significant resources in the pursuit of claims, particularly the research and reconstruction of records to find out what really happened. • Estimating Formats—Developing an estimate against one format and then reconfiguring it for project control. • Continual Hiring and Training of New Personnel— Experiencing high turnover because the organization is unable to retain trained personnel. • Misuse of Fax—Using a fax to transmit a copy of some- thing that also is being transmitted in hard copy. • Not Invented Here—Refusing to acknowledge good ideas that have been demonstrated by others, and, as a matter of hard-headedness, doing it another way. • Using Second Shift to Continue Work of First Shift— Passing work from one crew to another at a shift change results in lost time as the new shift determines the status of work in place. They also may redo some work. • Out-of-Date or Incorrect Specifications—Designing against out-of-date or incorrect specifications results in design rework and can create field rework or delays. • Resolution of Time-Card Discrepancies—Resolving time-card discrepancies because of wrong coding, wrong totaling, etc. • Untimely Input on Design—Introducing additional design requirements after design development is under way. The Solution As one reads through the lists of time and cost wasters above, potential corrective actions are almost obvious. The first step in waste elimination or minimization is to acknowledge that these conditions exist. Through surveys or group discus- sions, lists of negative conditions can be identified. Usually the list will be too long to attack in total at one time, so the list should be narrowed down to those with the greatest poten- tial for improvement. Specific solutions can be generated through group problem-solving sessions using the various problem-solving tools associated with total quality manage- ment (TQM)—flow charts, cause and effect diagrams, force- field analysis, and various statistical analyses. As problems from the original list are solved, return to the list and deter- mine if others should be added, and select new targets for improvement. The result of these efforts will be continuous improvement, the ultimate goal of any TQM program. Of course, a proactive approach to waste control is always better than a reactive one. The following specific guidelines are appropriate: • Plan! Plan! Plan!—this is universal guidance for any operation. • Establish written policies and procedures—these become the standard references for how things are to be done. • Involve users (e.g., operators) and constructors in design decisions. • Control changes —changes degrade performance because they delay and demoralize. • Give priority emphasis to safety and quality—many claim that performance is directly related to quality and safety. • Control disturbances and interruptions—examples have already been given. This should be an area of major emphasis. • Take advantage of modern technology—most productiv- ity gains in the industrial world result from use of better technology. • Employ partnering and team building—the team approach is always better. • Communicate—an essential element within a true team. • Involve employees in planning—this establishes their commitment. • Use employee group problem-solving techniques. • Make your work place a good place to work—this pro- motes employee loyalty and stability, and limits distrac- tions and inefficiency. • Recognize employee achievements—let them know you appreciate their contributions; this will stimulate contin- ued achievement (see later discussion of incentives). • Promote first-level quality control—this is the best way to minimize rework. • Train managers, supervisors, and workers—this pro- motes professionalism and consistency within the organ- ization while also showing you care. One major indus- trial firm claims that they get $30 in benefits from every dollar spent on training. • Be selective in hiring—quality control of personnel can- not be overemphasized. 17.6 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL
- 234. THE PRODUCTIVITY ISSUE The Challenge For any business involved in producing goods or providing services, the productivity of its production personnel and equipment directly influences that business’ competitiveness and profitability. It follows that these businesses continually seek ways to improve their productivity. Usually, production is dependent upon some combination of machines and per- sonnel so both must be examined when seeking productivity improvements. In some situations, a company’s production potential is totally constrained by the machines being used— they can produce only so may items per unit of time. If so, the solution is to either add more machines or find higher output machines. If human beings are a factor in the rate of production, improving their productivity is more complex. The construction industry has a somewhat unique challenge when it comes to productivity. It is a fact that a large per- centage of construction work is awarded on a fixed-price, tar- get-price or target-workhour basis. In this arena, competing contractors must base their bids or proposals on productivi- ty assumptions for all crafts involved. Then, once the con- tract is awarded, the contractor has the challenge of meeting or beating the productivity assumptions in order to make a profit or at least not lose money. With labor costs often being 40 percent or more of the total installed cost and with profit margins in construction often being less than 5 percent, it is easy to see how errors in productivity estimation and man- agement can ruin a contractor. Remaining discussion in this section will be examples on recognizing the particular chal- lenges of the construction industry. A major point to be made and emphasized is that productiv- ity on the same type of work varies significantly from loca- tion to location within a country and from country to coun- try. That variation is caused by many factors, which may be grouped as follows. Variability—Sociological (Area) Factors Some variation can be attributed to differences in the socio- logical makeup of the local population, local work ethic, level of mechanization, the education and training levels of work- ers, the climate, the organized labor situation, and urban vs. rural factors. Recognizing this, most major construction con- tractors and some owners maintain proprietary data on area productivity differences to be accounted for in their estimat- ing of construction costs. Typically, they will select one area as the base area and give it an index of 1.00. Other areas are given indices that relate their general productivity to the base area, with indices less than 1.00 being less productive and those with indices greater than 1.00 being more productive. For example, these are extracts from an index register used at one time by one owner company: Houston (base area) 1.00 Baton Rouge 0.85 Corpus Christi 1.10 Chicago 0.80 Denver 0.95 Internationally, the variation is even greater. An article, International Labor Productivity, in the January 1993 issue of AACE International's Cost Engineering magazine by J.K. Yates and Swagata Guhathakurta, provides relative produc- tivity data for many countries. Its indices use a format that is the inverse of the above and it provides ranges for each coun- try. Examples: Washington, D.C. (base area) 1.00 Belgium 1.25-1.52* Jamaica 1.49-3.05 China 2.60-4.50* *Interpretation—Comparable work in Belgium will require 25-52 percent more workhours than in Washington, D.C. Variability—Location Factors As location varies, so do these factors: • weather patterns; • altitude; • access; • availability of skills; • availability of logistical support; • trafficability of site; • attitude of nearby communities; • transportation network; and • local economy. Variability—Project and Contract Characteristics No two projects or contracts are exactly alike. These differ- ences definitely influence productivity potential. • project size; single craft size; • schedule constraints; • adequacy of scope definition; • constructability of design; • exposure to hazards; • environmental requirements; • height or depth of work; • form of contract; • budget constraints; • quality of engineering; • degree of congestion or confinement; • relationship to existing facilities; and • relationship to other construction. 17.7 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT
- 235. Variability—Human Factors The ultimate determinants of project performance are the human beings doing the managing and building. Overall performance is a function of these human factors: • management competence; • supervisor competence; • individual worker skills; • work rules; • personal pride; • stability of employment; • overtime; • experience/ point on learning curve; • worker attitudes; • crew stability/ key personnel turnover; • owner/contractor relationships; • value system; and • personalities. Variability—Field Organization and Management Factors Finally, these are those factors which are most completely in the hands of management to control: • site layout for construction; • support equipment availability; • project controls system; • quality management program; • technology/methodology used; • subcontractor performance; • degree of communication; • crew balance; • materials availability and quality; • tool availability and quality; • safety program; • adequacy of support facilities; • degree of planning; • vendor performance; and • control of interruptions. Accounting for Variability in Estimates Acknowledging that there are many variables that influence overall productivity on a project, contractors bidding on fixed-price or target-price work must somehow determine how these variables will interact to affect worker productivi- ty on that project. Ideally, a contractor will maintain histori- cal data files containing actual productivity data from past projects. For this data to be useful on future projects, several criteria apply: • a standard chart of accounts for crew tasks must be used for all projects so that data from one project realistically can be compared to data from another; • the breakdown of crew tasks for purposes of estimating must be the same as that used for reporting so that esti- mated and actual performance can be truly compared; and • in addition to the numerical data collected on each proj- ect, the conditions under which work was performed (e.g., weather, congestion, materials shortages) should be described, since those conditions affect the outcome. When preparing bids for a new project, estimators will research the historical files to find productivity data on simi- lar work performed under similar conditions. Unfortunately, such efforts will be only partially successful, so judgment decisions must be made to adapt data on hand to the new project. Fortunately, there are some tools available to facili- tate this process. • Range Estimating—Range estimating is a generic term applied to several commercial and company-developed computer programs that use a Monte Carlo statistical modeling technique to deal with events where the out- come of each event can occur over a range represented by a frequency curve. It is particularly useful for evalu- ating the combined effect of multiple independent vari- ables on measures of performance such as productivity. The point to be made is that range estimating can be used to quantify the risk associated with productivity variability on a number of different work tasks. • Checklists and Worksheets— Some individuals and companies have developed structured approaches in the form of checklists or worksheets to help them in coming up with productivity estimates. As an example, appen- dix A to this chapter is a description and sample of a Productivity Index Evaluation Worksheet developed by the author. Promoting Productivity To promote productivity on a project, managers must first be aware of the many factors that can affect it. These have been listed in previous paragraphs. During the pre-mobilization stage and using these lists as checklists, managers can identi- fy those factors with potential to adversely affect productivi- ty. From this list, they can identify those factors that cannot be controlled, those that can be partially controlled, and those that can be completely controlled. It is then a matter of pri- oritizing the controllable factors and developing positive programs to eliminate or minimize the effects of these fac- tors. As implied in the previous paragraph, a proactive approach to promoting productivity will yield the greatest return. If, during the course of a project, productivity is not what man- agers feel it should be, reactive action is required, but it will follow the same steps. 17.8 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL
- 236. Additionally, since productivity is but a subset of perform- ance, the guidance contained in the solution sub-section of the overall performance issue section, above, is fully applica- ble to productivity management programs. PRODUCTIVITY ANALYSIS Determining Percent Complete The primary purpose of this section is to explain methods for measuring and analyzing productivity. However, use of these methods requires an understanding of the methods for measuring percent complete of work activities, so these will be described first. There are six methods: • Units completed—This method is suitable when the total scope of an activity consists of a number of equal or nearly equal parts, and status is logically determined by counting parts completed and comparing that to the total number of parts in the total activity. Ideally, each unit is of relatively short duration. In engineering, a pos- sible application is in the writing of a number of specifi- cations of a given type where all specifications are con- sidered to have essentially equal weight. In construction it is useful in activities such as earthwork, concrete work, and wire pulling. • Incremental Milestone—This method is appropriate for activities of significant duration that are composed of easily recognized, sequential subactivities. Percentage completion values are established based on the effort estimated to be required at each milestone point relative to the total for the activity. This method is ideal for con- trol of engineering drawings and can be used in pro- curement. A typical example for drawing control is: Start drafting 0 percent Drawn, not checked 20 percent Complete for office check 35 percent To owner for approval 70 percent First issue 90 percent Final issue100 percent Vessel installation and assembly is a classic example in construction. For example: Received and inspected 15 percent Setting complete 35 percent Alignment complete 50 percent Internals installed 75 percent Testing complete 90 percent Accepted by owner 100 percent • Start/Finish Percentages—This method is applicable to activities that lack readily definable intermediate mile- stones and/or the effort/time required is very difficult to estimate. For these tasks, controllers credit 20-50 percent when the activity is started and 100 percent when fin- ished. The reason that a percentage is assigned for start- ing is to compensate for the period between start and fin- ish when no credit is being given. In engineering, this method is appropriate for work such as planning, designing, manual writing, model building, and studies. It also can be used for specification writing. In construc- tion it is appropriate in any situation where scheduling is detailed with multiple, short-term tasks. • Ratio—This method is applicable to tasks such as project management, constructability studies, project controls, and comparable activity that involve a long period of time, have no particular end product, and are estimat- ed and budgeted on a bulk allocation basis rather than on some measure of production. It also can be used on some tasks for which the start/finish method is appro- priate. Percent complete at any point in time is found by dividing hours (or dollars) spent to date by the current estimate of hours (or dollars) at completion. This method is useful on any project where non-production accounts (such as overhead) must be statused individu- ally and summarized with production accounts to deter- mine the overall percent complete. • Supervisor Opinion—This is a subjective evaluation of percent complete and should be used only where more discrete methods cannot be used. There is a natural ten- dency to over-estimate the level of completion of an activity in its early stages. • Weighted or Equivalent Units—This method is applica- ble where the task is a major effort involving a long peri- od of time and composed of two or more overlapping subtasks, each with a different unit of measurement (e.g., each, yd3). To set this up all subtasks are listed along with their respective units of measure and quantities. The subtasks are then weighted using relative work- hours as weighting standards—the total of all weights equals 1.00 or 100 percent. The progress of each subtask is reported using one of the five measurement tech- niques described previously. When this percentage is multiplied by that subtask's weighting factor, its contri- bution to overall task completion is calculated. Those for all subtasks are added to give the overall percent com- pletion of the major activity. A classic example is con- crete placement, which is frequently estimated and reported in terms of cubic yards in place; it can be broken up into the subtasks of base preparation, forming, resteel installation, concrete placement, curing, form stripping, and patching. Another example is steel erection, which 17.9 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT
- 237. is traditionally estimated and controlled in terms of tons of steel. The process is illustrated in Table 17.1. Productivity Measurement of Individual Work Tasks Owners and contractors are always interested in comparing actual field productivity to that estimated and budgeted. When dealing with a single work activity, the calculation of productivity is very simple: productivity = (number of units completed) ÷ (work- hours consumed) What is more difficult is the calculation of productivity at a summary level or for an entire project. Productivity Analysis at a Summary Level While a comparison of earned to actual workhours is used by some practitioners to provide an evaluation of productivity at a summary level, that approach is valid only if actual quantities of work are exactly equal to those budgeted. This is not always true, particularly on fixed-price, lump-sum con- tracts, so another tool is needed to evaluate productivity. That tool is credit work-hours. Credit workhours (CWH) are derived quantities and are found using this formula for work items completed: CWH = (budgeted unit rate*) x (units completed to date) * budgeted unit rate = budgeted hours per unit of work For individual work packages in progress (not yet complete), this formula is appropriate: CWH = (percent complete) x (budgeted unit rate) The productivity index (PI) for a single work package is found by this formula: productivity index = (CWH to date) ÷ (actual WH to date) The productivity index (PI) for a combination of work packages or for a total project uses this formula: productivity index = (∑ CWH ÷ ∑ actual workhours). The format of these equations is such that an index of less than 1.0 is unfavorable, while one equal to or greater than 1.0 is favorable. Use of Productivity Data It is a waste of time to collect data that is not used for the benefit of the project or the company. Recalling that project estimates include pro- ductivity assumptions for the vari- ous work tasks, a very important use of the field data is to compare estimated with actual productivi- ties. It is unlikely that estimated and actual productivities associated with a single work task will ever be exactly equal, but significant varia- tions should be cause for concern— the difference may be attributable to a poor estimate and/or it may be attributable to field performance. In any event, significant variations should be investigated and the results shared with the estimators, since their databases may need updating. 17.10 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL Wt. 0.02 0.02 0.05 0.06 0.10 0.11 0.20 0.09 0.30 0.05 1.00 Subtask Run fdn bolts Shim Shakeout Columns Beams Cross braces Girts/sag rods Plumb and align Connections Punch list STEEL UM each percent percent each each each bay percent each percent TON Quantity Total 200 100 .100 84 859 837 38 100 2977 100 Equiv. Steel TN* 10.4 10.4 26.0 31.2 52.0 57.2 104.0 46.8 156.0 26.0 520.0 Quantity To Date 200 100 100 74 0 0 0 5 74 0 Earned Tons ** 10.4 10.4 26.0 27.5 0.0 0.0 0.0 2.3 3.9 0.0 80.5 Table 17.1—Steel Erection as Traditionally Estimated and Controlled in Terms of Tons of Steel * Equiv. Steel TN = (Wt.) (520 Ton) ** Earned Tons = (% complete) (Equiv. Steel Tons) percent complete = (earned tons) ÷ (total tons) = (80.5 tons) ÷ (520.0 tons) = 15.5 percent Notice in this example how tons of steel is the account's unit of measure, and all subtasks are converted to equivalent tons. It also may be noted that percent complete could have been calculated by this formula: percent complete = ∑ [ (weight) x (percent complete each subtask) ]
- 238. Significant variations in the productivity index at the project level may or may not be of concern, depending on the phase of the project. Figure 17.4 shows example plots of a produc- tivity index on both a period and cumulative basis. A pro- ductivity index of 1.0 is the datum line. Also shown is the expected cumulative plot. As drawn, that curve reflects the typical course of the cumulative productivity index over the life of an activity or total project—typically it runs below 1.0 during the early reporting periods, increases gradually to a peak of 1.15-1.20 about the 50 percent complete point and then decreases, ideally becoming 1.0 at the 100 percent com- plete point. On this example, the actual cumulative produc- tivity index has been running consistently below the expect- ed cumulative curve, meaning that, in spite of the fact that at some points the period PI was above 1.0, the cumulative pro- ductivity index probably will be less than 1.0 when the proj- ect or activity is complete. INCENTIVES Why Incentives? Incentive programs must be included in any discussion of performance and productivity. Such programs have the potential to: • increase performance and productivity; • reduce waste; • reduce absenteeism; • improve employee morale; • promote teamwork; • identify more cost-effective work procedures; • improve equipment design; • improve quality; and • share business risks with employees. In doing this the profitability of the organization is certainly improved, but, increasing profitability is not the only poten- tial benefit. Users have found incentive programs to be excel- lent tools for opening lines of communication between man- agers and employees and for committing employees to the goals of the organization. The Stimuli If incentives are intended to stimulate employees to support management goals, it is important that management under- stand the stimuli that can be mobilized. These may be grouped into two categories from the perspective of the employee. • Possibility of winning: • excitement of winning something; • personal satisfaction in achieving a goal; • euphoria of being singled out for recognition; • financial gain; • career enhancement; 17.11 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT Figure 17.4—Productivity Index PERCENT COMPLETE PI 1.4 100 75 50 25 0 0.6 0.8 1.0 1.2 0.4 0.2 0 • • • • • • • ◊ ◊ ◊ ◊ ◊ ◊ Expected Cumulative ◊ Period PI • •Cumulative PI
- 239. • pride of association with a winning team; and • a chance to do something different • Fear of losing: • potential embarrassment; and • potential loss of status, job, potential for promotion, etc. Certainly the best incentive programs are based on the con- cept of win-win; i.e., both the employer and employee are potential winners. Those that capitalize on the employee's fear of losing are more fragile and can be counterproductive. Rewards Within the Winning Scenario Each incentive program in the win category has some reward associated with the achievement of some objective. In design- ing incentive programs and incentive awards it is important to realize that rewards have two values—intrinsic and extrinsic. The intrinsic value is essentially the exchange or cash value of the reward. The extrinsic value is that value above and beyond the cash value that accrues to the recipient because of what the award means to him or her—some might call this esteem value. It is essential that every reward have some value—it may have either or both intrinsic and extrinsic value, but it is not neces- sary that it have both. A medal for heroism and the Eagle badge in scouting have little intrinsic value but tremendous extrinsic value to the awardees. If an employer gives a Rolex watch to every employee completing 25 years of service as an incentive to reduce turnover, that watch has considerable intrinsic value but minimal extrinsic value because the quality of an employee's performance during those 25 years is not a factor. Achievement of professional registration has high extrinsic value and also can have significant intrinsic value if it means a raise in pay or chance for promotion. Rewards whose value is almost totally extrinsic are certainly the most cost effective. The fact that such rewards also can be effective stimuli puts incentive programs within reach of every employer. Specific examples of rewards in both cate- gories will be incorporated within the following discussion of specific programs. Example Incentive Programs The following summaries of programs or activities that have been or are being used successfully illustrate the range of incentive program options that may be considered. • Open-Book Management—This incentive program is really a revolutionary way of doing business and might be considered an advanced form of total quality man- agement. As the name suggests, the company’s books, strategies, good news and bad news are fully shared with employees, the theory being that employees will make better decisions and perform better if they know exactly how the company operates and what contributes to profits and losses. The incentive involved is a sharing of annual profits among employees, typically 25 percent. For this management form to work, the following condi- tions must prevail: • The Green Stamp Program—Under this program, employees earn credits (or green stamps) for achieve- ment of various objectives. Typical objectives are zero defects, no accidents, no late starts/early quits, or no absenteeism during a given period; achievement of a production or productivity goal; approval of a sugges- tion; etc. The number of credits awarded are commen- surate with the achievement. Credits are allowed to accumulate in the employee's account for conversion to gift certificates at his/her convenience. Each credit is usually worth $1. This program has several advantages: (1) the employee can pick the reward; (2) the accumula- tion feature stimulates continuing achievement; (3) it brings in the influence of an employee's family (they cheer the employee on), since awards can be significant and of the type the whole family chooses; and (4) it is open to all employees. • Suggestion Program—These programs have been around a long time. Employees make suggestions that are reviewed by selected committees for possible adop- tion. Adopted suggestions usually result in a cash award that is based on anticipated savings. If a suggestion is not adopted, or the benefits are other than cash savings, the reward is usually a letter of appreciation but may include some token merchandise item. Suggestion pro- grams have enjoyed mixed success. A high rate of sug- gestion rejection or excessively complex and time-con- suming submission and processing procedures can quickly dim employee enthusiasm. • Sharing Savings—On fixed-price or target-price con- tracts, an incentive program can be established whereby field personnel will share in any savings realized. These are usually distributed based on salaries or wages paid during the life of the contract. An interesting form of this has been used by an open shop contractor to keep fixed- price projects within budget. First, all budgeted direct costs within the control of construction crews were allo- cated to their individual work packages. Then, as crews completed the work, actual costs were accumulated. These costs included labor costs, materials costs, equip- ment and tool costs, costs of accidents, and any other costs attributable to the crew's assigned work. At well- defined milestone points in the project, a tally was made of budgeted and actual costs in the covered period. Any savings were distributed totally to the workers, the dis- tribution being proportional to worker hours or earnings during the period involved. There were no penalties for overruns—these are assumed to be a result of bad esti- 17.12 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL
- 240. mates and budgets. This program promotes teamwork and crew balancing, safety, conservation of materials and improved productivity, all while preserving company profit. • Target Bonuses—Often an owner will establish a target completion date or a target cost for a project, knowing those targets can be met only with exceptional effort. To stimulate this effort, they will set aside a sum of money to be divided among the field personnel if the target is met. • Honoraria—These are given to individuals for specific achievements relating to professional development, such as professional registration/certification, writing and publishing a professional paper, or representing the com- pany in a professional forum. • Service Awards—These are usually a combination of a certificate and a merchandise prize to recognize years of service with a company. The value of the merchandise increases with length of service. Often, a special lunch- eon or dinner is held to distribute these awards. • Merit Raises—Either a portion or all salary increases in a given year are tied to performance evaluations. It is very difficult to create an impartial system for these since evaluations are very dependent upon subjective judg- ments of individual managers and these can be influ- enced by politics and prejudices. A selection board approach can minimize this problem. • Cross-Training—An employer who provides cross- training for workers provides a measure of job security for those workers, and this is motivating for the employ- ees. • Special Training—If a limited number of individuals are selected each year for some special training, competition for selection becomes a strong motivator for excellent performance. Many successful incentive programs capitalize on the extrin- sic value of the rewards involved and, in so doing, achieve results at low cost. Examples: • The Simple “Atta Boy!”—A simple pat on the back or word of appreciation, particularly when given in front of everyone in a work unit, can do wonders to motivate many people. • Management by Walking Around—It is good manage- ment practice to maintain visibility with employees through frequent visits to work areas during which they chat with employees. By showing sincere interest in the individuals and their work, a manager effectively moti- vates employees. • Letter or Certificates of Appreciation and Achievement—A document that commends an individ- ual for an accomplishment has high, long-term value since it is written proof of special capability and may be the document needed in some future job search. • Certificates of Completion—These recognize comple- tion of some training program. They have significant value only if the participants in the program had to pass some meaningful test to graduate. • Decals—These are usually used in conjunction with other awards. For example, someone completing a first aid or CPR course would receive both a certificate of completion and a decal to put on their hard hat. • Token Awards—Awards in this category include inexpen- sive items such as t-shirts, coffee cups, baseball caps, cal- culators, and pen knives. These are appropriate for indi- vidual or crew minor achievements such as short-term safety, quality, or attendance records. Slightly higher-cost items, such as a wind breaker jacket, engraved desk sets, and clocks are suitable for more significant achievements, such as long-term safety or quality records. • “Exclusive Clubs” on the Job—Individuals take pride in being part of a group whose membership criteria is exclusive. A group of earth movers had a “Million Yard Club” on their project. Production, safety, and quality goals can be set to qualify for membership in comparable clubs. Achievement of membership in the club is recog- nized through certificates, decals on the hard hat, t- shirts, bumper stickers, etc. • Employee or Crew of Month—This program is very common in the service industry. A committee selects the recipients based on recommendations from managers, customer comment forms, or other criteria. The reward is usually a picture of the individual or crew displayed in a prominent location, plus a certificate. It can include a cash award or special luncheon/dinner. This program must be carefully managed so it does not degenerate into a popularity contest or “whose turn is it this month?” form of selection. • Problem-Solving Teams—These are similar to quality circles except they are ad hoc and are given a specific problem to solve by management. Their work can result in cash or credit awards; however, a letter of appreciation or commendation may be adequate. These teams are motivators since they are another form of participative management. 17.13 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT
- 241. • Team Builders—There are a number of relatively inex- pensive actions that can be taken to stimulate group morale and team spirit (and thus productivity and qual- ity) on a project or in other workplaces. • Creating a project logo and using this logo on signage, hard hat decals, bumper stickers, stationery, etc. It is rec- ommended that a project-wide contest be held to design the logo. • Publish a newsletter. Have a contest to name the newsletter. • Use the newsletter or bulletin boards for publication of “Hats Off” type notices to recognize accomplishments of individuals. • Occasionally put out coffee for workers as they check in for work or cool beverages as they leave work on a hot day. • Have the project photographer take pictures of individu- als and crews on the job. Display these pictures on a bul- letin board near the check-in area. Perhaps make copies available to pictured individuals. • An alternate to the above is to provide video coverage of the project with the product being a weekly tape of about 15-30 minutes in length. On this tape review project sta- tus, show crews at work, etc. Show the tape during lunch in protected break areas. • Use a special message board in a prominent location on which the project status is displayed, special accom- plishments are announced, and human interest stories told about project participants. • Sponsor charity work by the workers—food and toy drives, painting or repairing homes for the needy, build- ing playgrounds, etc. • When a major project milestone is reached, allow an extra hour for lunch and have a catered lunch for the workers. Use this opportunity to give out safety and other awards. • Sponsor “family day” at the project, plant, or nearby park with a picnic lunch, tours of the project/plant, and games. • Put first names of workers on their hard hats. • Sponsor bowling, softball, and other teams in local leagues. • Issue press releases on project and employee accom- plishments. • Recognize birthdays or other events with a congratulato- ry letter. • Do whatever you can to provide job security for employ- ees—cross-training, information on upcoming jobs, out- placement service, etc. • If the project receives some cash award for safety or other achievement, divide the award up into $50 packages and give them away in a raffle. All workers who contributed to the achievement are included in the drawing. • Anything to make the site “a good place to work”—a strong safety program, decent worker facilities, good layout, dust control, etc. Incentive Program Guidelines In analyzing the many individual and team incentive programs that have enjoyed success, a number of guidelines evolve. • Learn from the experiences of others. • Program must balance both employer and employee goals. • Get workforce into the planning of program if possible— if union personnel are involved, the union must be involved. • Keep each program element as simple as possible. • Criteria for awards must be specific and understandable. • Performance criteria must be achievable. • Successful achievement of goals must be within control of target individual or group. • Programs based on subjective rather than objective crite- ria are more difficult to manage impartially. • The program will be most effective if the awards result- ing from an accomplishment directly accrue to the indi- vidual or team making the accomplishment. • Mobilize as many of the stimuli as possible in establish- ing the reward structure. • Avoid any potential for discrimination in determining award recipients. • Make certain your program is well publicized. • Publicize achievements by individuals and teams. • Ensure that the program is continuously well managed. • Incorporate potential for many winners. • Provide opportunities for the entire workforce. • Don't turn off non-winners—”maybe next time.” • What works in one environment won't necessarily work in another. An example can be cited where a contractor used preferential parking as a reward and the program was very successful. Another contractor tried it and the rewarded workers found their tires slashed. • Be aware of the tax implications of awards. Merchandise awards of nominal value (example: turkeys, coffee cups, etc.) are not taxable. Cash awards or awards equivalent to cash (example: gift certificates) or costly merchandise awards (example: TV, pickup truck) are taxable. • Proceed with caution when launching an incentive pro- gram. Start small and work up to more ambitious pro- grams that build on the success of early programs. A failed incentive program can have totally negative effects. Incentive programs have established a place for themselves in the business world. A variety of programs already have been successful. Companies can learn from these programs and design adaptations of them to fit their particular envi- ronments. The question is inevitably asked, “What is the benefit:cost ratio for incentive programs?” Unfortunately, the author is 17.14 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL
- 242. not aware of any research on the subject and such data would be difficult to compile. However, several individuals with experience with incentive programs have expressed the opin- ion that the payoff is in the range of 4:1 to 10:1. Whatever the benefit:cost ratio, the results so far have shown that well- managed incentive programs can positively influence team- work, safety, quality, and overall performance. CONCLUSION The ultimate performance index for an organization is the one that relates its net profit or value of services to the costs of achieving that profit or providing those services. An organiza- tion seeking to maximize that index must examine the opera- tions of its total workforce, not just those of its production units. It must target waste in all forms—not only materials or equip- ment waste, but the waste associated with inefficiencies, inter- ruptions, rework, and an assortment of other time-wasters, all of which effectively constrain their employees' ability to pro- duce, perform, and achieve. And, most of all, that organization must provide a workplace with the facilities, procedures, atmosphere, and attitudes that stimulate performance. PRODUCTIVITY INDEX EVALUATION WORKSHEET Purpose This worksheet, Figure 17.5 on page 17.16, is intended to facilitate a comparison of the productivity potential of a pro- posed project with respect to a completed project. For this purpose, a productivity index of 1.0 is average, a productivi- ty index less than 1.0 is less than average (unfavorable), and a productivity index greater than 1.0 is better than average (favorable). Evaluating productivity variation among projects is not an exact science. This worksheet serves only to force planners to seriously consider many conditions that can affect productiv- ity and to evaluate their individual effects as well as their cumulative effect. The productivity elements and the weighting factors used are not fixed—users should adjust them to reflect experience over time. Use of Worksheet 1. For a reference (completed) project, complete an evalua- tion of each of the 7 categories of productivity elements. This is best done by several individuals familiar with the project so that the results represents group consensus. Note that each category is made up of 2 or more subcat- egories so that evaluations can be made at the subcate- gory level to yield the category score. For example, note that the first category, general area economy, has three subelements. Assume that the group makes the follow- ing analysis of a completed project: a. Construction volume in the area at the time of the project was somewhat low compared to previous years when several major plants were built. Now, most construction activity involves homes and small commercial projects. This subcategory is given an index of 110. b. The unemployment rate in the area was about average for the state, but better than the national average. There were jobs available, but most were of the minimum wage category. This subcategory is given an index of 100. c. The local business situation was basically healthy, nei- ther robust or depressed. This subcategory is given an index of 100. d. The resultant score for category 1, general area economy, is: 110 x 4 = 440 100 x 4 = 400 100 x 2 = 200 1,040 ÷ 10 = 104 2. Continue the evaluation of the remaining categories to develop the score for the completed project. 3. Make a similar evaluation for the proposed project. Then compare the scores to determine a multiplying fac- tor to use in estimating productivities on the new project using productivities for similar work on the completed project as a reference. (productivity multiplying factor for proposed project) = (PI proposed project) ÷ (PI completed project) 4. The above does not consider regional differences in gen- eral workforce productivity due to sociological and other differences among worker populations. If planners believe such differences exist, they must further modify the multiplier obtained in paragraph 3 by multiplying it by a factor found by dividing the area productivity index of the proposed project by the area productivity index of the reference project. 5. Use the resultant productivity multiplier in conjunction with relative wage rates to determine relative labor costs for the same volume of work. 6. This worksheet also can be used to normalize data from past projects for entry into the historical database. Since the raw data from each project is distorted because of numerous project-unique conditions, normalizing it has the effect of bringing the data down to a baseline not affected by those conditions. 17.15 AACE INTERNATIONAL PERFORMANCE AND PRODUCTIVITY MANAGEMENT
- 243. 17.16 PERFORMANCE AND PRODUCTIVITY MANAGEMENT AACE INTERNATIONAL PRODUCTIVITY INDEX EVALUATION WORKSHEET 75-99 100 101-125 Productivity Element Weight Low Average High Score Product 1. General Area Economy 10 Prosperous Normal Depressed ______ ______ construction volume in area 4 high average low unemployment situation 4 low average high local business situation 2 stimulated normal dead 2. Project Character 25 Complex Average Favorable ______ ______ schedule 6 compressed normal ample slack complexity of work 6 complex average simple contract form 5 reimbursable fixed-price incentive project type 5 revamp new work repeat work size 3 mega average small 3. Craft Workers and Foremen 25 Poor Average Good ______ ______ quality and availability 8 poor average excellent distance to project 5 more than 60 min 30-60 min less than 30 min substance abuse program 5 none policy only full program use of overtime and multiple shifts 4 much some exception rate of force build-up 3 fast comfortable (not used) 4. Project Operating Conditions 20 Poor Average Good ______ ______ congestion and hazards 6 considerable average little management quality 6 inexperienced average highly qualified materials and tools availability 3 shortages average adequate required workmanship 3 exceptional normal (not used) site access 2 restricted normal open 5. Weather 10 Poor Average Good ______ ______ amount of protected work 2 limited normal significant precipitation days 2 frequent normal occasional cold and wind days 2 often average rare days of extreme heat 2 many average rare days of extreme humidity 2 many average rare 6. Construction Equipment 5 Poor Average Good ______ ______ condition 3 poor average excellent maintenance/repair availability 2 remote nearby onsite 7. Delays and Interruptions 35 Numerous Some Minimum ______ ______ rate of changes expected 10 high normal low materials deliveries 6 uncertain normal timely operating plant/other interferences 6 frequent a few none possible site work permits 6 frequent occasional not applicable labor unrest potential 5 could happen none expected (not used) public protest potential 2 could happen none expected (not used) TOTALS 130 ______ PRODUCTIVITY INDEX = ( ∑ PRODUCT) ÷ (13,000) = _______________ Figure 17.5—Productivity Index Evaluation Worksheet
- 246. INTRODUCTION In today's difficult and challenging business environment, it is vital that the management of projects results in: • identifying risks, • maximizing cost savings, • minimizing time delays, and • improving economic return. These results can only be achieved through: • effective management of people, • tough but fair project objectives, • efficient business techniques, and • outstanding leadership skills. The following project management chapters cover these sub- jects in considerable detail. The roles, functions, and interfaces of company management, project management, engineering management, construction management, and support-service groups are explored. Overall relationships and personnel rela- tionships, essential for successful project execution, are out- lined. Throughout, the emphasis is on practical approaches and the relationships of personnel in the project team. The emphasis is on the need for and substance of early proj- ect planning and the related scheduling of time and develop- ment of costs. It is essential that all project leaders be effective professional project managers—they need to be organizers, planners, motivators, communicators, and business-persons. Current studies by the Construction Industry Institute (CII) of state-of-the-art project management methodology have shown that the top category for successful project execution is front-end planning/project organization. The studies have concluded with the following simple but true premise. If we get it right at the front end, we have a chance of success, though not guaranteed.If we don’t get it right, then we have no chance of success. The following material, mostly flowcharts, illustrates the major factors, functions, and project phases of the project life cycle. Full understanding of all these elements can ensure effective communication channels, tight schedules, low cost, and a clear path for efficient decision-making and economic actions. But it is in these very elements where many problems develop and become impossible to solve or reduce as the project pro- gresses. The result is more money is spent than necessary, more time is consumed than needed, and there is a constant recycling of options and alternatives that should have been eliminated at an earlier stage. Project ignorance, lack of skill, poor coopera- tion, and refusal/reluctance to participate properly are com- monplace. Biases, prejudices, and personal interests are also part of the equation. All of these elements are compounded by industry-wide lack of up-to-date project training. LEARNING OBJECTIVES After completing this chapter, readers should be able to • understand the roles and responsibilities of project man- agement. THE CHANGING ROLE OF MANAGING PROJECTS Over the past 40 years there have been major improvements in project execution, but surprisingly, the most significant developments can be narrowed to less than ten. These devel- opments are the following: • design quality assurance—value engineering; • project management performance measurement; • critical path method (CPM) scheduling; • fast track scheduling program; • fast track trapezoidal technique; 18.1 AACE INTERNATIONAL PROJECT MANAGEMENT FUNDAMENTALS Chapter 18 Project Management Fundamentals James A. Bent, CCC
- 247. 18.2 PROJECT MANAGEMENT FUNDAMENTALS AACE INTERNATIONAL Figure 18.1—The Changing Role of Project Management Old C. Mgt 1950—1970 • Complete Engineering • Complete Purchasing • Install • Inspect - Fix • Commission • Start Up New Programs (major) 1. 1968 CPM 2. 1970 FAST TRACK 3. 1982 F.T. TRAPEZOIDAL TECH. 4. 1985 INDEPENDENT C.M. 5. 1990 PARTNERING 6a. 1990 - T.Q.M. 6b. "Participative" Mgt. "Open Book" Mgt. 7. 1990 DESIGN Q.A.-V.E. 8. P. MGT. PERF, MEAS. New C. Mgt 1975—NOW PREPLANNING CONSTRUCTABILITY CONTRACT ADMINISTRATION BUSINESS ($) MANAGEMENT $ $ $ $ $ $ NEW ELEMENTS, impacting on Construction 1955—1975 GROWTH +400% 1984 C.I.I. ESTABLISHED R&D in Total Project Skills $ $ $ $ $ $ 1975 on . . . . GROWTH OF UNDEVELOPED AREAS YEAR 2000+ • DEVELOPMENT OF EASTERN EUROPEAN STATES (C.I.S) • DEVELOPMENT OF CHINA; to WORLD'S LARGEST ECONOMY • By Year 2000—300 percent in Energy; Equals . . . . $30 per BBL (1994, 5 bbl/day versus US @ 55) . . . . 10 Million BPSD • By Year 2010, +300 percent Energy; Only Equals 50 percent US Level REACTIVE PROACTIVE
- 248. • independent construction management; • partnering; contracting arrangement • total quality management (TQM); and • participative and “open book” management. Project Execution, Old Versus New Figure 18.1 on page 18.2 is a flowchart that highlights the major changes in project management from the mid-1950s to the present. The old program of sequential completion of the individual phases of engineering, procurement, and construc- tion, where construction management rarely got involved until 4 weeks prior to opening the site, has been replaced by the very challenging, but very efficient, fast track program. Fast tracking, critical path method (CPM) scheduling, and the trapezoidal technique program are the greatest advances in methodology that have occurred in the past 30 years and followed the explosion of work that took place after World War II. Today’s computer systems, while not of the same fun- damental importance, greatly assist in the collection and col- lation of data for these three programs. This data, in turn, is developed into specific cost and schedule project baselines and essential information. The development of the fast track—trapezoidal technique (F.T.—T.T.) for plant projects, which was first published in 1982, was of particular importance. This technique is used in conjunction with construction complexity and labor density. Construction complexity and labor density are essential in developing or verifying the quality of a conceptual estimate and planning schedule for process plant projects. When the appropriate factors are properly developed, the resulting cost and schedule numbers can have a probability of 90 to 95 percent. A Proactive Role The best of today’s construction management now take a proactive role through the newly developed programs of construction preplanning and constructability. This results in a strong construction involvement at the early stage of the project to ensure that engineering design and early planning fully recognize the requirements of an economic construction program. An example of construction preplanning is back- wards scheduling, where the overall project schedule is structured around the construction schedule, with design drawing issues and material deliveries being matched to con- struction needs. If this is done early in the design stage, there is no cost impact on design engineering or purchasing, and the construction cost savings can be considerable, even with the added cost of early construction involvement. Business management is now considered of greater value than the old standard of aggressively pushing the work, with cost and contractual considerations of lesser consequence Note: The timing of new major programs and elements, as shown in Figure 18.1, represents the approximate date when the individual categories were widely used (proven), not when they were first developed. Project Performance Measurement—Company The development of a program to measure project perform- ance and personnel skills is essential for any quality pro- gram. By the same token, a full benchmarking evaluation is also essential. The real value or added value of a benchmark- ing program is to provide a state-of-the-art skills base, which is then used to constantly measure the total project perform- ance of the group over time. With a good technical program, the correct balance/mix of skilled personnel, and effective training, there should be a steadily improving project per- formance that directly results in lower cost/higher quality of a company’s capital projects. The measurement program needs to be simple, but effective, utilizing existing informa- tion and being directed by the projects quality assurance group. The overall performance goal is to reach a rating of 80 percent, as compared to the current international standard of 55 percent. DEFINITION OF A PROJECT A project can be defined loosely as an item of work that requires planning, organizing, dedication of resources, and expenditure of funds in order to produce a concept, a prod- uct, or a plant. This chapter focuses on plant projects, all of which require design engineering, the purchase of material, and the installation of that material to the previously com- pleted design engineering. PROJECT MANAGEMENT FUNCTION Almost all companies have personnel who are trained, skilled, and dedicated to the execution of the companies' projects. The individuals who lead these efforts are called project engineers and/or project managers. Supporting these project managers are such personnel as design engineers, procurement personnel, contracts officers, estimators, cost engineers, planners, construction managers, and a variety of technical specialists. In many cases, the type, size, and com- plexity of projects vary greatly, and therefore, the skills and experience of project engineers, project managers, and sup- port personnel can, similarly vary in capability. 18.3 AACE INTERNATIONAL PROJECT MANAGEMENT FUNDAMENTALS GLOSSARY TERMS IN THIS CHAPTER life cycle ◆ project management
- 249. The flowchart in Figure 18.2 above shows the major factors that are essential for the successful execution of projects. Cost Management Many projects have project cost as the top objective, and this requires the project to be completed at, or less than, the bud- geted cost. Significant business skills are essential to meet this objective. There is an industry-wide company policy that the approved project budget can be exceeded by 10 percent, without there being a supplemental funds request. Time Management To meet the cost objective, it is necessary to manage time effi- ciently. This means the predetermined schedule, upon which the cost was based, must be met and met economically. Some projects may have schedule as the top objective. In such cases, acceleration programs are planned and it is probable that there will be corresponding cost increases to the eco- nomic-based project. Human Resources Of all the resources required for plant projects, the people resources are the most difficult to manage. Interpersonal skills and the effective motivation of people, at all levels, are essential for successful project execution. Lack of human resources, plus a corresponding lack of the correct mix of people skills, are becoming an increasing feature of the proj- ect business. One of the most abused people resource concepts is the “lean and mean” program. The management intent is that a reduced group of people, through advanced skills, can exe- cute as effectively as a larger group, and therefore, save the cost of the people reduction. There is some merit in this con- cept, but in many cases it is a “device” used by poor man- agement to cut costs. If there is a significant lack of people, there is almost certain to be a corresponding inefficiency in project execution, coupled with an increase in costs. 18.4 PROJECT MANAGEMENT FUNDAMENTALS AACE INTERNATIONAL Figure 18.2—Major Factors That Are Essential for the Successful Execution of Projects Cost Management Budget Variance Dollars Time Today Time Variance 1991 J F M A M Human Resources Time People Communications = Time Management Critical Path
- 250. 18.5 AACE INTERNATIONAL PROJECT MANAGEMENT FUNDAMENTALS Figure 18.3—Overall Company "Projects" Life Cycle Functions Flowchart COMPANY PLANNING ENGINEERING DEPARTMENT PROJECT DEVELOPMENT ENGINEERING REQUEST PROJECT EXECUTION Small Projects • COST PLUS ENGINEERING • L.S. CONSTRUCTION Larger Projects • E.P.C. • L.S. or COST PLUS (See Detail) (See Detail) Affiliate Operations Maintenance (See Detail) BUDGETING and MANAGEMENT APPROVAL FIVE YEAR ANNUAL PLANT CENTRAL Communications A formal and informal structure of effective communications is absolutely essential for successful project execution. In addition to weak people skills, many company organizations and cultures have poor administrative practices that also form barriers to project success. These barriers are common to all companies and are generally referred to as matrix inter- face conflicts (MICs). The conflicts or barriers are caused by departmental jealousies, rivalries, and failures by manage- ment to create a culture where project consciousness and esprit-de-corps are common to all personnel. The total quali- ty management programs sweeping the industry are an attempt to solve these problems. OVERALL COMPANY PROJECTS LIFE CYCLE The flowchart in Figure 18.3 shows the general steps com- mon to all plant projects. Experience in this process, recogni- tion of each company program's individualities, and the skills of bridging the matrix interface conflicts, are necessary for project success. Getting the front-end planning right is the key to success. ENGINEERING REQUEST The flowchart in Figure 18.4 illustrates the major factors that generate the capital project work. Timely and quality assess- ments of plant requirements are difficult to achieve but are essential for company profitability. Such assessments result in formal engineering requests for the project work. PROJECT DEVELOPMENT The flowchart in Figure 18.5 shows the major components for developing the scope of each project. Each of these compo-
- 251. 18.6 PROJECT MANAGEMENT FUNDAMENTALS AACE INTERNATIONAL Figure 18.4—Engineering Request—Functions Flowchart "STAY—IN— BUSINESS" ENVIRONMENTAL ADDITION— QUANTITY UPGRADE— QUALITY ENGINEERING REQUEST ENGINEERING DEPARTMENT SOLVE PROBLEMS Figure 18.5—Project Development; Functions Flowchart ECONOMICS CONCEPTUAL COST ESTIMATE REGULATORY PROJECT CONDITIONS PROJECT DEVELOPMENT BUDGETING AND MANAGEMENT APPROVAL TECHNICAL
- 252. 18.7 AACE INTERNATIONAL PROJECT MANAGEMENT FUNDAMENTALS Figure 18.6—Budgeting and Management; Functions Flowchart PROJECT RESOURCES EXECUTION STRATEGY ESTIMATE QUALITY PARTIAL—FULL FUNDING BUDGETING AND MANAGEMENT APPROVAL PROJECT EXECUTION PHASED APPROACH nents, technical, project conditions, regulatory, cost, and eco- nomic, is then further defined and prioritized and it is vital that the priority be clearly established. BUDGETING AND MANAGEMENT Development of the scope in terms of risk, cost, time, and resources is followed by approval, partial approval, or rejec- tion of each proposed project. Figure 18.6 shows the budget- ing and management process, closely followed by the devel- opment of the project strategy and project organization. The correct assessment of the people resources, especially the key people, is essential at this early stage. TYPICAL PROJECT PHASES AND LIFE CYCLE The time and interface relationship of major project phases is shown in Figure 18.7. Assuming a fast track program, most of these phases will overlap, and the degree of overlapping will depend on the work content of each phase and the efficiency of decision-making present in the project. PROJECT TEAM CULTURE Finally, there is the question of company personnel working as a team. Without question, this matter has become the vital issue to profitability, especially as companies downsize and reduce the core. Greater personnel efficiency and increased operational quality are essential requirements in today's dif- ficult business environment. The bean-counter syndrome is a dangerous and unacceptable practice. The “Bean-Counter” Syndrome This is a wide spread practice, where effective cost control is absent or greatly diminished. This practice has two major contributing factors. First, the project manager does not want an aggressive, creative, analytical function for the cost engi- neer and, therefore, relegates the work to a retro-active, record keeping function. Hence the term, bean-counter. Second, the cost engineer can be directly responsible for this practice; as the individual does not possess the essential ana- lytical skills, or does not believe in an aggressive trending approach and/or does not possess the essential people/com- munication skills. They are, in fact, content with a bean- counting role. There is a much wider acceptance today of the need for dynamic, proactive cost engineering-trending and it is to be hoped that the function will become a pivotal project
- 253. role, as effective cost trending is essential for project success. After a lifetime of project work this author has learned this fundamental truth: “Projects are designed and built by people, not companies. People do it singly, or in multiple groups; and if there are skilled people and good relationships, there is a chance of success. If the people and relationships are poor, there is lit- tle chance of success.” This chapter is based upon, or portions are excerpted by permission from, Effective Project Management Through Applied Cost and Schedule Control, by James A. Bent, CCC, Marcel Dekker, Inc., New York, 1996. 18.8 PROJECT MANAGEMENT FUNDAMENTALS AACE INTERNATIONAL Figure 18.7—Major Phases Flowchart Company and Market Strategy DEVELOPMENT PLANNING 1 Design Options and Cases FEASIBILITY STUDY 2 Case Selection and Optimization CONCEPTUAL STUDY 3 Project Execution and Contracting PROJECT PLANNING 4 Workscope Definition BASIC DESIGN 5 DETAIL DESIGN AND PROCUREMENT 6 CONSTRUCTION 7 MAJOR PROJECT PHASES COMMISSION and START UP 8
- 254. INTRODUCTION In today’s difficult, global business environment it is vital that the management of projects identifies risks, maximizes cost savings, minimizes schedule delays, and improves eco- nomic return. This only can be achieved with a quality pro- gram of project planning and project organization. The most comprehensive study, done to date, of the con- struction industry was carried out by the Construction Industry Institute (CII), and they concluded that the number one category of project management methodology is project planning and project organization (note that the Construction Industry Institute refers to it as strategic project organizing). Very simply: If we get it right at the front end we have a chance of suc- cess, though not guaranteed. If we do not get it right, then we have no chance of success. The following are the major constituents of project planning and project organization: • project organization; • establishing objectives; • scope definition control; • communication and information utilization; and • constructability planning. Careful attention to the following details of these con- stituents will provide a good start to any project. LEARNING OBJECTIVES After completing this chapter, readers should • understand the role of the project manager in project planning, and • be familiar with project organization and planning. BACKGROUND TO PAST ORGANIZATIONAL STRUCTURE The Matrix Structure Over the past 30 years, the most widely used organization structure has been, and still is, the matrix organization. Most projects are executed with the “matrix,” where multiple proj- ects are executed by many departments carrying out the work at the same time, resulting in the project manager hav- ing inadequate decision-making authority. Both academics and professional project managers agree that the “matrix organization” is the most complex form of organization structure. Matrix structures were developed to more effi- ciently use common resources and work many projects at the same time, with the same staff. This provided effective infor- mation exchange and allowed for efficient management coor- dination of the total project workload. Matrixes achieve this by having the working personnel be simultaneously accountable to both the project manager and the departmental manager. In the “matrix,” both project managers and departmental managers have authority and responsibility over the work, albeit, there is an agreed divi- sion of responsibility. The departmental manager is general- ly responsible for the technical content and working resources, and the project manager decides on the cost and time baselines. Unfortunately, the person who comes off worst in the “matrix” is the individual who is actually doing the work. He/she reports to two bosses: the project and departmental managers. This leads to divisions of responsi- bility, problems of loyalty, differences over priorities, poor communications, and lack of single and direct “line authori- ty.” The management of personnel and departmental inter- faces is a demanding task, and in the “matrix,” is often referred to as “conflict management.” The fundamental of “matrix theory” in a protect environ- ment, requires the project execution plan to be clearly defined, so that all working groups would then accept, com- 19.1 AACE INTERNATIONAL PROJECT ORGANIZATION STRUCTURE Chapter 19 Project Organization Structure James A. Bent, CCC
- 255. mit to, and work to the agreed execution plan. There would be unanimous support from all and all would be working to the same “plan.” With a strong project management culture and effective com- pany leadership, it was anticipated that the “matrix” would be effective. Initially it was, but as time passed, the “matrix” failed and the research carried out by Peters and Waterman (in their book, In Search of Excellence [1]) and many other man- agement experts, has clearly demonstrated this failure. The answer, agreed by all, was a new approach, called quality management. This new approach was spearheaded by Dr. Edward Deming, working in Japan, in the 1960s and1970s. Demingism and Total Quality Management (TQM) This made its debut in the US in 1981, at the Ford Motor Corporation. Yet the transformation of the US industry to Demingism has been slow, even though there is wide accept- ance that his quality management approach is essential. TQM, a version of Demingism, has been implemented in the manufacturing industries since the late 1980s and in the engi- neering/construction industry in the early 1990s. Dr. Deming has developed 14-key sets of criteria for developing a quality management program. This criteria is referred to as “Demingism” and is summarized as follows. • Client Satisfaction—For the services provided or for the product sold. • Understanding and Reducing Variation—Every manage- ment process, practice, procedure, policy must be evalu- ated for its effectiveness in allowing the company’s indi- viduals to work at maximum effectiveness. • “Top-Down” Management Leadership and Commitment—Improvement cannot come merely from middle managers and workers “trying harder.” There must be full understanding of, and total commitment to, the necessary systematic change and the planned improvements. • Change and Improvement Must Be Continuous—It must be all-encompassing, involving every “process,” individ- ual and outside services and suppliers. • Ongoing Training and Education is Essential for all employees, and it must be of a high technical quality so that high standards of skills and practices can be imple- mented by all personnel. • A Culture of Personnel Pride and Job Satisfaction—At all levels; this requires leadership, program champions, the development of trust and loyalty, personnel empower- ment, and the elimination of inadequate performance measurement schemes that can create more losers than winners, resulting in lowering of morale. Such schemes, says Deming, do not account for the “variations” and weaknesses in the company process and can be inaccu- rate and unfair; and are perceived as such by the employees. Performance measurement is essential, but it should be of the system or process, and individuals should be paid for their experience and responsibilities. Not all personnel will be “star” performers, and the con- tribution of the company janitor can be equal to that of the chief engineer, when there is a commitment to excel- lence from both. However, most companies do not agree with Deming on this particular issue and use a “person- nel performance” awards program that gives individuals recognition and awards for superior performance. Such a program is Fluor Corporation’s “MVP” (most valuable player) program, which was developed through an extensive personnel survey where the staff stated that the company salary program did not properly reward superior performance and that individual awards would be a viable program. Thus the practice of employee empowerment showed a major “need,” and Fluor insti- tuted the program in 1994. They currently report that the program is successful and is a key feature of their con- tinuous improvement program (CIP). Fluor Corporation is an international contractor, with headquarters located in Annaheim, CA. GENERAL It is an obvious, but not well-understood fact, that it is peo- ple in single, medium, or large size groups who design and build projects, not companies. If there are people available, if they have the required skills, if they have a positive working environment, then success is possible. If none of these condi- tions pertain or only partially, then success is very question- able. Therefore, there must be a consistent and long-term interest in people needs, their development and their train- ing. When there is little interest, or the interest is not genuine, the long term success of the company is unlikely. The entire total quality management (TQM) program is built around the needs and development of people, and there is unanimous acceptance by industry that total quality management is the key to success. In essence, develop the people, and in turn, the people will develop the profits. IS THE OWNER COMPANY QUALIFIED TO BE ITS OWN PROJECT MANAGER? A very fundamental consideration in today’s world of com- pany reengineering is the question of the owner functioning as its own project manager. Too often, owners arrive at an affirmative answer through poor analysis. It is a matter of previous experience of the specific project (particularly size), having adequate in-house or consulting resources (skills and numbers), a good project management program and costs. This is, currently, a major consideration with many operating companies as they downsize their operations. Many companies 19.2 PROJECT ORGANIZATION STRUCTURE AACE INTERNATIONAL
- 256. confuse the issue due to technical/engineering considerations. Having competent engineering personnel, they take on the project management responsibility, but without adequate proj- ect experience or project resources. Engineering design compe- tence does not necessarily translate into project capability. Note: This question was a major issue during the early devel- opment of the North Sea Oil and Gas industry (1972-1977). The “answer” at that time, was an emphatic no, from all the large oil companies (as all had limited resources), except for the rare case where contractors declined to bid due to lack of capacity. This problem of limited contractor resources and inadequate technical and engineering expertise was resolved with a project services contract (PSC), and ultimately, partnering and inte- grated project teams. With a project service contract or reim- bursable FOC, owners can “direct” engineering. DOES THE ORGANIZATION STRUCTURE PROPERLY FIT CONTRACTING ARRANGEMENTS? Different skills and different numbers of personnel are direct- ly related to contracting arrangements; i.e., lump sum, reim- bursable, unit price, project services contract, agent, and independent contractor. From an owner’s perspective, reimbursable contracts can require three times as many owner people as a lump sum contract, and would require personnel with extensive analyt- ical skills. For lump sum, a good design package and strong project discipline (no/little design changes) are essential. Often, there is a mismatch of people resources, in relation to contract arrangements. Having both the wrong contract and the wrong organization/people is a recipe for disaster. Also, a poor management application of the lean and mean princi- ple will result in a serious lack of resources, leading to poor project execution and cost over-runs/schedule slippage. IS THE PROJECT MANAGER QUALIFIED? The answer should address technical expertise, project experi- ence, business capability, leadership ability, and people skills. Project, business, and people expertise should have greater con- sideration, especially for larger projects. On smaller projects and feasibility studies, technical skills would be more important. DOES THE OWNER PROJECT MANAGER REPORT TO THE CLIENT OR PROJECTS/ENGINEERING? In contractor groups this is not normally a problem. In owner organizations it is often a problem because the owner project manager normally reports to both groups. My recommenda- tion would be to report to the internal company client so as to “follow” the financial responsibility and to projects/engi- neering for direction on technical methods. SHOULD THE PROJECT TASK FORCE (PTF) APPROACH BE UTILIZED? Significant experience has now shown that the project task force is more efficient for larger projects. The close working relationships allow more efficient communication channels and a more efficient decision-making process. The challenge of welding together many individuals from many parts of the company is a substantial task. The organization structure should follow the current state-of the-art, which has added the new function of a business manager. BUSINESS MANAGEMENT MUST RECEIVE THE CORRECT EMPHASIS On economically based projects, the emphasis should be on business considerations. There has to be a correct “balance” of technical versus business (estimating, cost control, scheduling, purchasing, contract preparation, contact/construction admin- istration), with emphasis on business considerations. EFFICIENCY AND EFFECTIVENESS OF THE PROJECT TEAM There is often the conflict of quality versus quantity. On large projects it is easy to make the mistake of “over-substi- tution” of numbers of people to satisfy lack of skill. It is a question of degree, as some “substitution” is common- place. In most cases, lack of good contracting personnel is a major problem. Personnel planning needs to be early, resulting in effective scheduling of all required personnel. Careful consideration should be given to the timing of all key managers and supervisors. PROJECT ORGANIZATION STRUCTURE— OWNER TEAM (REIMBURSABLE CONTRACT) On a reimbursable project, the owner should have a “direct- ing position” in order to contain the risk of a contractor tak- 19.3 AACE INTERNATIONAL PROJECT ORGANIZATION STRUCTURE GLOSSARY TERMS IN THIS CHAPTER planning ◆ project management
- 257. ing advantage of “the reimbursable” and manipulating day- to-day execution to enhance profitability. This risk has been well documented by owners and its practice is a key tech- nique of large, international contractors. The balancing force to contain this risk is the quality and skill of the owner’s proj- ect team, both in the pre-contract activities and the post-con- tract work execution program. An equal partner relationship (EPR) is an essential requirement and should be built in to the agreement with the appropriate contract clause. These pre-contract activities should be undertaken by the project team to ensure that the contractor provides competent personnel. It is a contractor practice to train new/inexperi- enced personnel on their client’s reimbursable projects, since the major cost risk is to the client. Pre-Contract Activities for Contractor Evaluation • An effective proposal evaluation program should evalu- ate the quality of the contractor’s program, with individ- ual criteria for technical, project management, commer- cial/pricing, project control, contractual, and construc- tion. • If the project is of a substantial size, interviews should be carried out with key personnel (previously nominated). • Ensure that correct contracting arrangement/conditions are in the contractor’s proposal, especially the equal partner relationship clause. Assess the required liability of agent or independent contractor. • Evaluate contractor proposal program/execution plan and key interfaces of local, corporate, and government. PROJECT ORGANIZATION CHARTS These should be dynamic, up-to-date documents, used to identify owner and contractor positions, and during execu- tion of the work, will be the current and future personnel plan, as generally agreed in pre-contract meetings. These charts need to be properly recognized and the organization clearly understood by all project team members. The use of formal job descriptions and duties is recommended. PROJECT MANAGER AUTHORITY This individual has full authority to make both design and cost decisions, with appropriate limits of authority and man- agement reporting requirements. On reimbursable projects, the authority of the contractor project manager must be ade- quate to allow efficient day-to-day operations. PROJECT CONTROL FUNCTION REPORTS DIRECTLY TO PROJECT OR BUSINESS MANAGER Many hold the concept that cost control should be an audit function of the project, and therefore report to higher/senior management. I do not support that concept, since it can lead to an adversary relationship and dilute the trust and cooper- ation that is absolutely essential in the cost effort in the proj- ect. There are always independent, periodic cost reviews by senior home office personnel that should be more than ade- quate for a management audit . REFERENCES 1. Peters and Waterman. 1984. In Search of Excellence. Warner Books, Inc. This chapter is based upon, or portions are excerpted by permission from, Effective Project Management Through Applied Cost and Schedule Control, by James A. Bent, CCC, Marcel Dekker, Inc., New York, 1996. 19.4 PROJECT ORGANIZATION STRUCTURE AACE INTERNATIONAL
- 258. INTRODUCTION In today’s difficult, global business environment, it is vital that the management of projects results in identifying risks, maxi- mizing cost savings, minimizing schedule delays, and improv- ing economic return. This only can be achieved with a quality program of project planning and project organization. The most comprehensive study, done to date, of the con- struction industry was carried out by the Construction Industry Institute (CII) and they concluded that the number 1 category of project management methodology is project planning and project organization (note that CII refers to it as strategic project organizing). Very simply, If we get it right at the front end we have a chance of success, though not guaranteed. If we do not get it right, then we have no chance of success. Note: project organization is covered in chapter 19. The following are the major constituents of project planning: • establishing objectives; • scope definition control; • communication and information utilization; and • constructability planning. Careful attention to the following details of these con- stituents will provide a good start to any project. LEARNING OBJECTIVES After completing this chapter, readers should • understand the role of the project manager in project planning, and • understand planning strategies. ESTABLISHING OBJECTIVES General In many cases, the process of developing objectives also can assist in building team commitment and understanding. Objectives always will be a compromise between quality, cost, and schedule and are used as a guide to make decisions. These major objectives then guide development of more detailed goals, procedures, technical criteria, cost targets, and individ- ual milestones. Ideally, a common set of objectives should guide the owner, engineer, and constructor. These objectives provide the work direction to all parties, and as such, would have to be compatible and acceptable. The key to successful acceptance, by all, is a set of well-defined objectives. Client Satisfaction Criteria and a measurement program, acceptable to the client, should be developed to produce a periodic and timely report. Client satisfaction should be the single most impor- tant objective, and reports, showing poor performance against this objective, should receive top management atten- tion and immediate resolution. Scope Objective That the technical and project scope, as identified in the approved project budget appropriation, will be achieved; a well-written, but brief scope definition is developed for issue to all (see scope definition in following section). Cost and Schedule Baselines The required quality and formats of the estimating and scheduling programs should be identified in conjunction with the associated databases and computer systems. All internal and external constraints, interfaces, and influences should be carefully evaluated for both cost and schedule baselines. A critical path method (CPM) computer schedul- ing system is recommended. Levels of schedule detail, codes of accounts, and work breakdown structures for the cost/estimating program, require careful consideration. 20.1 AACE INTERNATIONAL PROJECT PLANNING Chapter 20 Project Planning James A. Bent, CCC
- 259. Overall and intermediate milestone objectives should be developed. A risk analysis program should identify the ranges of risk for both cost and schedule. The responsibility and management of contingency should be clear and precise. It is the author’s judgment that project contingency should be the project manager’s responsibility and not treated as a management reserve, as is the practice of some companies. Quality Clear and unambiguous criteria should be developed and be fully acceptable to all project parties. The criteria need to be measurable so that a status/progress report can be issued on a regular basis. Quality of project operations, as well as qual- ity of design and construction, need to be covered. Other Training, technology transfer, etc., must be fully defined. Project Objectives Are Prioritized, Documented, and Communicated to Project Team If this is not done and constantly maintained, then accept- ance leading to commitment will be lacking. Establishing clear priorities, with each objective having its relative priori- ty, will allow the multiple groups to work in harmony with each other. Thereafter, a constant effort (part of team build- ing) must be made to keep the project objectives viable. Effective Project Team Building Assembling a group of individuals, especially on large proj- ects with large companies, does not make a team. Personnel can come from different locations (worldwide) and different cultures. Time is needed for individuals to recognize and control their individualities, as appropriate, and learn to work together. Individuals usually accept project assign- ments with little or no knowledge of the individuals with whom they will be working and people accept project assign- ments hopefully and without full knowledge. It is therefore essential that management and project leaders (all groups) develop a team building program and maintain it through- out the life of the project. Working togetherness, project com- mitment, cost consciousness, personnel satisfaction, etc., are the deliverables. The cost for this activity should be a recog- nized budget item. Effective Community Relations—Local and/or Overseas There is an ever-increasing opposition from local communi- ties to process projects, due in part to the hazardous nature of many of these projects. An effective and positive public rela- tions effort, in conjunction with direct financial investment in local matters, is necessary and essential. SCOPE DEFINITION CONTROL General This is a matter of project discipline and design control to prevent or identify scope changes that are all too common on fast track projects. A Construction Industry Institute study, “More Construction for the Money,” published in January 1983, reports, “. . . Poor scope definition and loss of control of the project scope rank as the most frequent contributing fac- tors to cost overruns.” Effective Interface With Stakeholders, Operations, and Maintenance for Scope Approval Achieving a proper input for the design from all project par- ties is a formidable task. This work is usually the direct responsibility of the project engineering manager, and strongly supported by the project manager. If there is no proj- ect team, then it would be the responsibility of the project manager. There must be consensus and full understanding, as well as approval, of all parties to the design basis and especially from the design decision-makers. The design basis must be shared openly and with all participating parties. When the design basis is sensitive or proprietary, security procedures must be established. In addition to design, the project execution plan and financial program must be part of the approval process. Scope Is Well Defined Before Start of Detailed Engineering This is the purpose of the feasibility study. However, the qual- ity and extent of the early design and project work are a mat- ter of management decision and can vary widely. A poor design package at the start of detailed engineering will result in significant change, rework, and a substantial cost increase. The major deliverable of the feasibility study is the basic design package—statement of requirements (SOR). These should be well-written documents that properly define the technical requirements and have sufficient depth to provide clear direction for all major design issues. They should clearly communicate the intent to the designers and set appropriate boundaries on the project design for detailed decision-making. The scope document should cover: • Project description project justification, project objectives, economic justification, and if pertinent, facilities description • Design basis and specs process definition • description of process • process flow diagrams • tabular heat and material balance • process conditions, special conditions 20.2 PROJECT PLANNING AACE INTERNATIONAL
- 260. • construction of materials • startup and shutdown requirements mechanical definition • p&id drawings—preliminary sizing and piping tie-ins • preliminary plot plan • preliminary general arrangement • preliminary equipment list instrument definition • define primary control points and purpose • define instrument set points, low level alarms, etc. safety system • hazards analysis (hazops) • list of safety devices and their design criteria • interlock logic description and diagram • Project location—elements engineering and construction productivity factors (versus database) logistics reviews, delivery to and at-site infrastructure requirements, at-site weather concerns and impacts • Project conditions offshore installations-suppliers prefabrication and modules operational restraints-conditions site and access problems • Estimate—definition work quantities and takeoffs engineering, labor, staff hours contingency and budget limitations risk analysis and identification • Schedule—definition difficulty of proposed completion all constraints, restraints and critical relationships appropriate levels of detail Decisions on Scope Are Made in a Timely Manner This can only be achieved if there is a cohesive, dynamic trending program. Effective communication channels and working togetherness are direct contributors. Management approval process is also a factor. Dynamic Design Change Control—Formal Program Project trending and reporting systems, such as the design change order log, are essential. The weekly trend meeting and regular progress meetings provide much of the early identification of change. An effective design control program is centered around an engineering milestone, called the design control point (DCP). If the feasibility study is extensive, the design control point could be operational at the end of the study, and thereafter, all changes would be formally docu- mented. If the feasibility work were minimal, then the design control point would be established at the early part of the proj- ect engineering phase. The design control point is reached when the project’s original scope is properly defined, agreed to, and approved by all parties. As this approval is reached, the project manager will inform all appropriate parties that the design control point has now been implemented. On very large projects there can be multiple design control points. It is emphasized that the design control point is not a design freeze, as viable design changes should always be an option. COMMUNICATIONS INFORMATION UTILIZATION General The requirement is to turn data into useful and usable information. Current computers and software systems make the gathering and collation of data a relatively simple task. Thus, correctly establishing the available input data results in obtaining the required output and information. With the establishment of effective communication channels, the information is then directed to the correct recipient. Execution Plan Formal, Written Program This should be a dynamic document, being revised and updated as conditions/scope change, with proper/timely inputs from all parties. Commitment to “the plan” must then be achieved with all project parties, and especially from management. These are the three major categories of a good execution plan: • What is the scope of work? (see information in earlier paragraph) • How is the work to be executed? • When is the work to be carried out? • How is the work to be executed? • Statement of project objectives • Proposed division of work • in-house, by company • work contracted out • development of work packages 20.3 AACE INTERNATIONAL PROJECT PLANNING GLOSSARY TERMS IN THIS CHAPTER planning ◆ project management ◆ scope ◆ schedule
- 261. • Contract strategy • required scopes and degree of definition • forms of contract • risk allocation versus. cost of liability • Detailed engineering • third-party licensers • environmental and regulatory; permits • Procurement program • competitive bidding • domestic and international • single source; negotiated • plant compatibility and spares requirements • Construction • preplanning program-critical highlights • prefabrication, modules • pre-commissioning and testing program • Commissioning and startup • Quality assurance—control and inspection • Project organization (see earlier chapter) • Project coordination procedure (as follows) • When is the work to be carried out? • Schedule and probability • economic versus acceleration • critical path and float analysis • Resource analysis • engineering, construction availability • skills and trade union climate • Marketing Interface • limitations or constraints • Cash flow limitations • Access problems • weather windows, traffic limitations • Shutdown—retrofit program All Scope-Cost Matters Are Routed Through the Project Manager This is to ensure project consciousness and dynamic trend- ing; this presupposes that the project manager has appropri- ate authority and decision-making ability for all scope and cost matters. A Team and Cost Culture Is Developed on the Project The project manager is directly responsible for creating an environment that will enable project control to be properly exercised. The project manager must be a cost leader, encour- age project cost consciousness, seek counsel from all appro- priate sources, accept sound advice, and stretch cost/sched- ule personnel to the extent of their capability. Team building and team stretching are key elements of successful project management. On smaller projects, where the project manager is also the project control engineer, it is essential that the project manag- er possess project control skills and/or motivate the support- ing/service groups to provide the quality information that is needed for creative analysis and effective decision-making. Effective project control requires the timely evaluation of potential cost and schedule hazards and the presentation of recommended solutions to project management. Thus the cost/schedule specialist must be a skilled technician and also be able to effectively communicate at the management level. Sometimes, an experienced project control engineer’s per- formance is not adequate because of poor communication skills. Technical expertise will rarely compensate for this lack. As in all staff functions, the ability to “sell” a service can be as important as the ability to perform the service. On larger projects, project teams are usually brought togeth- er from a variety of “melting pots,” and the difficulty of establishing effective and appropriate communications at all levels should not be underestimated. In such cases, the proj- ect manager must quickly establish a positive working envi- ronment where the separate functions of design, procure- ment, construction, and project control are welded into a uni- fied, cost-conscious team. Internal Project Charter Program This is a newly-developing method to motivate working togetherness by reducing the large coordination procedure to just the key objectives. It is a one or two page document that lists all major parties and their responsibility/accountability and the project objectives. All parties sign the charter, thus demonstrating their commitment to the project plan. Open Communication Lines at All Times Between All Project Parties A question of an effective organization, project commitment, working togetherness, and leadership. Project Coordination Procedure (PCP)—Clearly Defines Communication Channels to All This would include: • limits of authority; • responsibilities of parties; • correspondence procedures; • filing and reporting codes; • document and action schedule 20.4 PROJECT PLANNING AACE INTERNATIONAL
- 262. (for all drawings, documents, reports); • public relations procedures; • security and safety procedures; and • project close-out report. Trend and Progress Meetings Are Held on Weekly Basis These meetings are a vital communications tool, and the trend meeting should be a “must” for the project manager. Of the many meetings held during the execution of a project, the weekly trend meeting is probably the most important. This is not a decision-making meeting, but is where information is gathered and shared by key technical/services specialists. The project manager leads the meeting, and the project cost engineer serves as secretary. All current and potential influ- ences, changes, extras, and trends are reviewed and dis- cussed. The key meeting objective is the common sharing, gathering, communicating, and coordinating of all project influences that are developing at the time. Each party to the contract should hold its own weekly trend meeting, followed up by a joint meeting of the main parties, i.e., the owner, engi- neer, and general contractor. The Project Management Information System (M.I.S.) Has Effective Levels of Detail The development of reporting levels of detail must ensure that the information is necessary by management—supervi- sory function, is accurate, and is timely. Unnecessary detail can be generated easily with today’s computer programs, so a vigorous screening effort is therefore, necessary. CONSTRUCTABILITY PLANNING General Constructability and construction pre-planning are often used, interchangeably, to describe the function of each cate- gory. They can be considered as functions of “value engi- neering.” Constructability is largely concerned with the tech- nology, methods of installation, and the associated cost. Pre- planning is largely to do with the scheduling of resources, organization, site access, and infrastructure. The purpose of constructability is to reduce costs by considering alternative design and/or installation methods. Typical examples would be steel or precast concrete for a building and for process plants, greater prefabrication and pre-assembly, or even modularization. Early Economic “Path of Construction” Program This is an evaluation of the physical sequence of construction work to produce the lowest cost. Many factors are involved, such as: • physical site conditions, weather; • restraints of drawings, material delivery, schedule critical path sequences; • economics of crew sizes and supporting resources; and • plant operations, safety regulations, etc. With such early planning, design or material alternatives can be considered at little or no additional cost. The data that is developed is then used in the project scheduling program. Formal Constructability Programs Are an Integral Part of Project Execution This is to ensure that the early initiative, as outlined above, is maintained to project completion. Front-End Planning Actively Incorporates Construction Input It is essential that capable and experienced construction per- sonnel are assigned to the project at this early stage and that their constructability and preplanning evaluations are a proper part of project development. Sometimes, owners are not prepared to pay for this service and do not appreciate the cost benefit of this early work. “Construction Driven” Scheduling as Key to CPM Program This is also known as “backwards” scheduling, meaning that the project CPM schedule is structured around the construction schedule, assuming that the construction schedule has been developed on a “best economic” basis. Engineering and mate- rial deliveries then can be matched to the economic construc- tion program, at no cost penalty. Research has clearly shown that the cost benefits of this approach are considerable. CONCLUSION It is again emphasized that project planning and project organization structure, as reported by the Construction Industry Institute, make up the number 1 activity on any project, and when this work is properly executed, the finan- cial payout is immediate and substantial. If we start a project with a good scope definition, have a good organization, and all parties are committed to working togetherness, then project success is a reality. This chapter is based upon, or portions are excerpted by permission from, Effective Project Management Through Applied Cost and Schedule Control, by James A. Bent, CCC, Marcel Dekker, Inc., New York, 1996. 20.5 AACE INTERNATIONAL PROJECT PLANNING
- 264. INTRODUCTION Construction labor costs are the most variable element of the project construction budget. Therefore, labor cost control is paramount to profitability for all contractors. Owners also need to control labor costs for work performed in-house and for work performed by contractors on a reimbursable basis. In order to control costs, project management must first develop a realistic budget. Just as a yardstick that is not exactly 36 inches long is of little use for measuring distances, an inaccurate budget is useless for measuring labor cost per- formance. Secondly, in order to maintain an accurate budget, project management must continually compare the actual dollars and workhours to the budget dollars and workhours to identify deviations. Once deviations are identified, project management must take swift corrective action to minimize cost overruns. Creating realistic budgets and maintaining them requires choosing an excellent and efficient cost control system for controlling construction labor costs. Good construction labor cost control methods utilize the feed- back and corrective action elements of the control cycle. The two prevalent construction labor cost control reporting systems are the earned value method and the unit rates method. Each method has the following elements: measuring inputs, meas- uring outputs, and report processing. The discussions in this chapter are illustrated using data from the concrete accounts of a pre-engineered warehouse project. The labor cost estimate for the concrete accounts is shown in Table 21.1 on page 21.2. LEARNING OBJECTIVES After completing this chapter, the reader should be able to: • calculate installed quantities (progress) for construction activities; • define how actual labor workhours are collected using time cards; • analyze labor cost performance using earned value; • analyze labor cost performance using unit rates; • define the three components of labor costs—quantities installed, production rates, and wage rates; and • Analyze labor cost performance using variance analysis. LABOR COSTS AND PRODUCTIVITY Every construction project incorporates a large amount of skilled and unskilled craft labor. The greatest variable in the final cost of a construction project is the labor cost. Labor cost is a function of worker hourly wage rate and worker produc- tivity, but although hourly rates are relatively easy to predict, productivity is the real variable (see list below). Thus, a con- tractor must monitor both worker hours expended and pro- ductivity as major elements in the cost control program. Of course, the element of quantity control is also included as a basis for progress reporting as well as for estimate verifica- tion. The craft labor cost may be paid directly by the project owner, the prime contractor, or the subcontractor. If the craft labor is paid by the subcontractor, the prime contractor expe- riences the craft labor cost as a subcontract cost. Depending upon whether the subcontract is cost plus or lump sum, the prime contractor may or may not be at risk for labor ineffi- ciencies. A similar relationship exists between the prime con- tractor and the project owner. The labor cost control methods included in this chapter are applicable to those organizations at risk (financial or otherwise) due to labor inefficiencies. Some factors affecting construction craft productivity include the following: • crew sizes and craft composition; • craft density (area per worker); • interference with other crews; • scheduling; • material availability; • equipment and tool availability; • information availability, 21.1 AACE INTERNATIONAL PROJECT LABOR COST CONTROL Chapter 21 Project Labor Cost Control Dr. Joseph J. Orczyk, PE CCE
- 265. • rework due to design, fabrication, and field errors; • site layout; • weather; and • constructability. Implementing the labor cost control methods included in this chapter can be costly. A cardinal rule of cost control is that the cost of the control techniques be less than the money saved by using the cost control techniques. Cost control should be approached as an application of Pareto’s Law, which essen- tially states that 80 percent of the outcome of a project is determined by only 20 percent of the included elements. Thus, in establishing a cost control system, the idea is to iso- late and control in detail those elements with the greatest potential impact on final cost, with only summary-level con- trol on the remaining elements. The methods presented in this chapter utilize two-dimen- sional tables or spreadsheets to present data. These spread- sheets lend themselves to computerization. In fact, many job cost control and project management software will perform the calculations described in this chapter. MEASURING INPUTS AND OUTPUTS In the example of a home heating system, only one measure- ment, temperature, is required to control the system. Controlling construction labor costs requires many measure- ments. The ultimate goal of labor cost control is to expend the fewest dollars to complete the project. In order to achieve this goal, project management must measure the efficiency or cost-effectiveness of each dollar spent. This requires hun- dreds of measurements of labor dollars and workhours expended and quantities produced. Labor cost efficiencies are measured as a ratio of inputs (workhours or dollars) and outputs (quantities produced). A construction project is complex and must be broken into controllable parts. This is accomplished using a work break- down structure (WBS). The WBS is the classification of each project element along activity levels where the activity out- puts can be measured and then compared to the resources expended for that activity. Each classification is assigned a cost code for identification. A construction project has hun- dreds of cost codes. A study of 30 building contractors in Atlanta showed that for a two-million-dollar project, the median number of line items was 400 [2]. This translates into approximately the same number of cost accounts. The WBS must be carefully constructed and documented so that all members of the project team consistently use the correct cost codes for inputs and outputs. Labor input is measured by workhours expended or by labor dollars spent. Workhours are measured directly using cost codes and time cards. Dollars are calculated by multiplying each workhour expended by the appropriate wage rate (i.e., dol- lars per workhour). Unlike construction inputs that have the common unit of measurement (i.e., dollars and workhours), the output cannot be measured with a common unit of measure. Consequently, a large number of measures are used for construction outputs. Examples of these measures include cubic yards of excavation, square feet of concrete formwork, tons of structur- al steel, lineal feet of pipe, and number of electri- cal terminations. Cost control requires matching each unit of output to the input (resources) that was required to produce it. Each category of output requires a separate cost account. The input is separated into the appropriate cost account in order to match each unit of output to the resources (inputs) that produced the output. The breakdown of the inputs into the individual cost accounts is accomplished by observing and record- ing the number of workhours expended each day by cost account. If workhours are not accurately 21.2 PROJECT LABOR COST CONTROL AACE INTERNATIONAL Table 21.1—Original Estimate
- 266. recorded in the correct cost account, the cost control system will be ineffective. The accuracy of cost coding workhours is improved by the following: • training all personnel in the use of company cost accounts to correctly code time cards; • checking time cards for correct cost codes before record- ing in the cost control system; and • developing and maintaining a well documented WBS. A major consideration for measuring construction quantities is to determine if an item (such as cubic yards of concrete placed or lineal feet of wire pulled) is installed in one step or several steps. Quantities installed in one step are the easiest to measure. The item is either installed or it is not installed. The project management team can physically measure the output for the reporting period. It is more difficult to meas- ure progress when quantities are installed in several steps. One method to measure progress is to assign each sequential step its own cost account. However, this would burden the labor cost control system with too many cost accounts. A bet- ter way to handle this situation is to use the equivalent units method to report the partially completed units as equivalent units completed. In the equivalent units method, each step is assigned a weight based upon the percentage of the activity’s budget dollars or workhours required to complete that step. The breakdown of the effort that is required for each step is called the “rules of credit.” Following is an example of piping rules of credit [3]. • pipe placed in the permanent location—60 percent of the work; • pipe end connections are welded or bolted—20 percent of the work: • pipe trim installed and pipe is ready for hydrotest—20 percent of the work. An example of a daily production report that measures work progress by cost account using the equivalent units (rules of credit) method can be found in Table 21.2. The detailed description of each field in the daily production report for cost account 03140 appears below. The description column lists all subtasks for account 03140. The field engineer or superintendent records the quantity completed each day for each of the following subtasks: erect forms, wreck forms, and clean and oil forms. The subtask quantities are totaled through the report cut-off date. Each subtask is weighted according to the estimated level of effort required for that subtask. These weights are the “rules of credit” and are listed for each subtask. The actual quantity for the subtask is multiplied by the sub- task’s weight in order to obtain the subtotal of quantity 21.3 AACE INTERNATIONAL PROJECT LABOR COST CONTROL Table 21.2–Daily Production Report. GLOSSARY TERMS IN THIS CHAPTER earned value ◆ schedule variance work breakdown structure (WBS)
- 267. completed for the account. For this example, 767 linear feet (LF) of edge form was erected by day 30. This amount is mul- tiplied by 0.6, the weight for erecting edge forms, to obtain the equivalent completed units for the account of 460 LF. The subtotal for each subtask is totaled to obtain the equiva- lent actual quantity for the account. The total of 608 lf is the sum of 460 LF (erect form) plus 111 LF (wreck forms) plus 37 lf (clean and oil forms). Earned Value Method Once the actual inputs and outputs are measured, the project management team compares the actual inputs and outputs to the project budget inputs and outputs. This comparison occurs at both the cost code and project levels (or at any level in the WBS). The dollars and workhours cost cannot be com- pared directly to the budget dollars and workhours because the actual is only for completed work, whereas the budget dollars and workhours are for the entire project. In the earned value labor cost control system, the budget dol- lars or workhours is multiplied by the percent of work com- pleted to calculate the earned value. The percent complete for the cost account is the actual quantity divided by the fore- casted total quantity (see equation 1). The forecasted total quantity is the project management team’s current assess- ment of the total quantity included in the cost account. The earned value is compared directly to the actual cost to evalu- ate project cost performance. Earned value is measured by either workhours or labor dollars. Earned value is also referred to as the budgeted cost of work performed (BCWP). (equation 1) Percent complete (single account) = (actual quantity) (forecasted total quantity) The relationship between the earned value and the budget is expressed in equation 2: (equation 2) Earned value (BCWP) = (actual percent complete) x (budget for the account) As can be seen from this equation, a portion of the budget dollars or workhours is earned as a task is completed up to the total budget in that account. One cannot earn more than has been budgeted. If an account has a budget of $3,200 and 100 workhours and the account is now 25 percent complete, then $800 and 25 workhours have been earned. Cost per- formance is measured by comparing the earned value to the actual cost. Earned value and actual cost can be measured in either dollars or workhours. Also, earned value and actual cost can be for a period or the total to-date. The actual cost comparison can be a ratio or a variance as illustrated in equa- tions 3 and 4. (equation 3) Cost Variance (CV) = (earned value) - (actual cost) (equation 4) Cost Performance Index (CPI) = (earned value) (actual cost) Note that a positive variance and an index of 1.0 or greater indicate a favorable performance. Since progress in all accounts can be reduced to earned work- hours and dollars as illustrated, then multiple accounts can be summarized and overall progress calculated as shown in equation 5. (equation 5) Percent Complete (multiple accounts) = (earned value all accounts) (budget cost all accounts) The estimated total dollars or workhours at completion (EAC) is determined by predicting the overall cost perform- ance index at the completion of the cost account. There are several sophisticated forecasting techniques that are explained in management science texts, but few constructors are comfortable with them and their reliability appear no bet- ter than utilizing a few simple approaches. One fact is certain. No two methods, sophisticated or otherwise, produce the same answer. Three basic approaches are provided here [1]. Method 1: assumes that work from this point forward will progress at the budget (CPI = 1) whether or not this perform- ance has prevailed to this point. (See Equation 6.) (equation 6) Estimate at Completion (EAC) = (actual cost to-date) + (budget - earned value) Method 2: assumes that the performance to-date will contin- ue. (See Equation 7.) (equation 7) Estimate at Completion (EAC) =(budget) / (CPI) Method 3: Utilizes historical curves that show the normal vari- ation in the CPI as the cost account progresses. The forecaster simply makes the best extrapolation possible using the typical shapes of such curves and whatever other information may be available to the forecaster to make the projection. 21.4 PROJECT LABOR COST CONTROL AACE INTERNATIONAL
- 268. It is recommended that no single forecasting method be used. Rather, include a forecast by each of the above methods in order to provide a range of possibilities. Both the quantities installed and the labor unit rate deter- mine labor dollars or workhours. The labor unit rate is expressed in either dollars per unit or in workhours per unit. Multiplying the workhours per unit yields the dollars per unit. Overall cost performance depends on both quantity variances and unit rate variances. As can be seen from the calculation of earned value, cost overruns occur when actual quantities installed total more than the budget quantities. This occurs when the budget quantities is based upon an inadequate scope, when there are mistakes in the estimate takeoff, when scope creep occurs after the budget is prepared, when the field force installs more quantities than what was required, and when there is rework due to poor workmanship. Cost overruns also occur when the actual unit rate (dollars per unit or workhours per unit) is greater than the budget unit rates. The credit value is the budget unit rate multiplied by the actu- al quantities of work installed [1, p. 11-4]. The credit value rep- resents what the cost would have been if the actual quantities were installed at the budget unit rate. The credit value is computed using equation 8a or 8b, and the unit of measure can be dollars or workhours. Comparing the credit value to the actual cost measures the performance of the unit rate alone without the confounding effect of changes in quanti- ties. Use the unit cost (dollars per unit) for the budget unit rate to calculate credit dollars (C$). For an analysis by work- hours, use the production rate (workhours per unit) to calcu- late credit workhours (CWH). The unit cost index is the ratio of the credit dollars (C$) to the actual dollars. (See equation 9.) The productivity index is the ratio of the credit work- hours (CWH) to the actual workhours. (See equation 10.) (equation 8a) Credit dollars = (actual quantity) x (budget unit cost) (equation 8b) Credit workhours = (actual quantity) x (budget production rate) (equation 9) Unit Cost Index (UCI) = (credit dollars) (actual dollars) (equation 10) Productivity Index (PI) = (credit workhours) (actual workhours) A significant feature of an earned value analysis is that the cal- culated earned value can be compared to the scheduled value to measure schedule performance. The scheduled value is the value in dollars or workhours of work scheduled. It is also known as the budgeted cost of work scheduled (BCWS). The BCWS is computed using either equation 11 or 12. (equation 11) Scheduled value (BCWS) = (scheduled percent complete) x (budget dollars or workhours) (equation 12) Scheduled value (BCWS) = (quantity scheduled) x (budget unit cost or production rate) Schedule performance is measured by comparing the earned value to the scheduled value. This comparison can be a vari- ance, as in equation 13, or a ratio, as in equation 14. (equation 13) Schedule Variance (SV) = (earned value) - (scheduled value) (equation 14) Schedule Performance Index (SPI) = (earned value) (scheduled value) Note that a positive variance and an index of one or greater is a favorable performance. In Table 3, the scheduled value (BCWS) is calculated at the end of day 30 of the project. Day 30 is the cut-off date for the example used in this chapter. The detailed description of each field in the schedule report for cost account 03140 appears below. • The budget labor dollars are listed for each account. This is $1,440 for account 03140. • The start date is expressed as the beginning of the day. The slab edge forms are scheduled to start at the begin- ning of day 26. • The number of workdays scheduled by the cut-off date, day 30, is 5 for account 03140. The five days are days 26 through 30 inclusive (26, 27, 28, 29, and 30). • The BCWS is calculated by multiplying the budget labor dollars or workhours by the percentage of work that should have been accomplished by the cut-off date. For this example, the assumption is that an equal amount of work is scheduled for each day. Therefore, the scheduled percentage complete is equal to the scheduled days at day 30 divided by the total duration. The scheduled per- 21.5 AACE INTERNATIONAL PROJECT LABOR COST CONTROL
- 269. cent complete for account 03140 is 5 days divided by 20 days, or 25 percent. The BCWS is 25 percent mul- tiplied by $1,440, or $360. In Table 4, labor cost and schedule performance is analyzed using the earned value method. The detailed description of each field in the labor cost report using earned value for cost account 03140 appears below: • The actual quantity is transferred to this report from the actual quantities provided in Table 21.1 or from the quantities calculated on the daily production report, Table 21.2. Note that some cost accounts appear in more than one work package. The cost account total on this report is the summary of all work packages. For cost account 03140, the actual quantity is calculated at 608 LF. See the daily production report in Table 21.2. • The budget quantity is transferred to this report from the labor estimate. For cost account 03140, the budget quantity is 2,880 LF. • The estimate at completion (EAC) quantity is the budget quantity plus or minus any changes or corrections. There are no changes or correc- tions for cost account 03140. • The labor budget in dollars is transferred from the labor estimate. For cost account 03140, the labor budget is $1,440. 21.6 PROJECT LABOR COST CONTROL AACE INTERNATIONAL Table 21.3—Schedule Report Table 21.4—Labor Cost Report Using Earned Value
- 270. • The actual cost of work performed (ACWP) is gathered from the daily time cards. For cost account 03140, the ACWP is $288. • The budgeted cost of work performed (BCWP) is also known as the earned value. The BCWP is calculated by multiplying the budget labor dollars by the percentage of work actually completed. The actual percent complete is the actual quantity divided by the forecast quantity. For account 03140, the actual percent complete is 608 lf divided by 2,880 LF, or 21.11 percent. The BCWP is $1,440 multiplied by 21.11 percent, or $304. • The credit dollar (C$) is equal to the budgeted unit cost multiplied by the actual quantity. This is the amount that would have been spent to produce the actual quantity at the budget unit cost. The budget unit cost is the budget dollars divided by the budget quantity. For cost account 03140, the budget unit cost is $1,440 divided by 2,880 LF, or $0.50 per LF. The C$ is $0.50 per lf multiplied by 608 LF, or $304. Note that the C$ is equal to the BCWP. This will always be the case when the forecast quantity is equal to the budget quantity. • The cost performance index (CPI) is a measure of the cost performance. It is calculated by dividing the BCWP by the ACWP. Indexes greater than one indicate good cost performance. Indexes of less than one point towards poor cost performance. For cost account 03410, the CPI is equal to $304 divided by $288, or 1.056, which indicates good performance. • In Table 4, the estimated total dollars or workhours at completion (EAC) is computed assuming that the cost performance to-date will continue until the cost account is completed. The EAC is calculated by dividing the budget labor dollars by the CPI. The CPI is equal to 1.00 for accounts that have no actual data. For cost account 03410, the EAC is equal to $1,440 divided by 1.056, or $1,364. • The schedule performance index (SPI) is a measure of schedule performance. The SPI is the ratio of the BCWP to the BCWS. Indexes greater than one indicate good schedule performance and indexes of less than one point towards poor schedule performance. For cost account 03410, the SPI is equal to $304 divided by $360, or 0.844, which indicates poor schedule performances; i.e., the edge forms are behind schedule. • The unit cost index (UCI) is a measure of unit cost per- formance. The labor unit cost is a combination of both labor productivity and wage rates. Variances between the budget unit cost and actual unit cost are generally caused by differences in productivity. Therefore, the UCI is an indirect measure of labor productivity. The UCI is the ratio of the C$ to the ACWP. Indexes greater than one indicate good unit cost performance and indexes of less than one point towards poor unit cost performance. For cost account 03410, the UCI is equal to $304 divided by $288, or 1.056. Note that the UCI is equal to the CPI for this account. Since there is no variance between the budget quantities and actual quantities, the overall cost performance is deter- mined solely by the unit cost variance. UNIT RATES METHOD The unit rates labor cost control system is another method for the project management team to compare the actual inputs and outputs to the project budget inputs and outputs. This method makes comparisons at the cost code level, total proj- ect level, or at any level in the WBS. In the unit rates labor cost control system, actual dollars or workhours to-date are used to calculate actual unit rates (dollars per unit or work- hours per unit). The actual unit rates are then analyzed to forecast the unit rates at the completion of the account. The estimated total dollars or workhours at completion (EAC) is calculated by multiplying the estimate at completion unit rates by the forecasted quantities. The EAC is then compared to the budget dollars or workhours to determine cost per- formance. Note that at the account level, to-date unit rates can be compared directly to the budget unit rates to deter- mine performance. The estimated total dollars or workhours at completion (EAC) is analogous to finding the EAC in the earned value method. It is determined by predicting the overall unit rates at the completion of the cost account. The three basic approaches for determining EAC are restated here for the unit rates method. Method 1: assumes that work from this point forward will progress at budget unit rates whether or not these rates have prevailed to this point. (See Equation 15.) (equation 15) Estimate at Completion (EAC) = (actual dollars or work- hours to-date) + [(to go quantity) (budget unit rate)] Method 2: assumes that the unit rate prevailing to-date will continue to prevail. (See Equation 16.) Estimate at Completion (EAC) = (total quantity) x (actual unit rate) Method 3: utilizes historical curves that show the normal variation in unit rates as the cost account progresses. The 21.7 AACE INTERNATIONAL PROJECT LABOR COST CONTROL
- 271. forecaster simply makes the best extrapolation possible using the typical shapes of such curves and whatever other informa- tion may be available to the forecaster to make the projection. As with the earned value method, it is recommended that no single forecasting method be used. Rather, include a forecast by each of the above methods in order to provide a range of possibilities. The labor cost report using forecasted unit rates, which ana- lyzes labor cost performance using the forecasting unit cost method, can be found in Table 23.5. The detailed description of each field in the labor cost report using forecasted unit rates for cost account 03140 follow: • The actual quantity is transferred to this report from the actual quantities provided in Table 21.1, or from the quantities calculated on the daily production report, Table 21.2. Note that some cost accounts appear in more than one work package. The cost account total on this report is the summary of all work packages. For cost account 03140, the actual quantity is calculated at 608 LF. See the daily production report in Table 21.2. • The budget quantity is transferred to this report from the labor estimate. For cost account 03140, the budget quan- tity is 2,880 LF. • The forecasted quantity is the budget quantity plus or minus changes or corrections. There are no changes or corrections for cost account 03140. • The percent complete is the actual quantity divided by the forecast quantity. For account 03140, the actual percent complete is 608 lf divided by 2,880 LF, or 21.1 percent. • The actual cost of work performed is gathered from the daily time cards. For cost account 03140, the actual cost of work performed is $288. • The budget labor dollars is transferred from the labor esti- mate. For cost account 03140, the labor budget is $1,440. • The actual unit cost is the actual dollars divided by the actual quantity. For cost account 03140, the actual unit cost is $288 divided by 608 LF, or $0.4737 per LF. Note that the report is formatted to show only two decimal places. • The budget unit cost is the budget dollars divided by the budget quantity. For cost account 03140, the budget unit cost is $1,440 divided by 2,880 LF, or $0.5000 per LF . By comparing the budget unit cost to the actual unit cost, the project management team can determine the cost performance of the account. The project management team has to take into account that cumulative to-date unit rates at the beginning of an account are typically higher than the unit rate at completion. • In Table 21.5, the estimated total dollars or workhours at completion (EAC) is computed assuming that the actual unit cost to-date will continue until the cost account is completed (Method 2). Therefore, the forecasted unit cost is equal to the actual unit cost. For cost account 03410, the forecasted unit cost is $0.4737 per LF. Method 2 is just one of the methods used to forecast the final unit cost. The accuracy of the forecast generally improves as more information is used in the forecast. • The EAC is calculated by multiplying the forecast quantity by the forecast unit cost. For cost account 03410, the EAC is equal to 2,880 lf multiplied by $0.4737 per LF, or $1,364. 21.8 PROJECT LABOR COST CONTROL AACE INTERNATIONAL Table 23.5—Labor Cost Report Using Unit Rates
- 272. TWO-WAY VARIANCE ANALYSIS A frequent question is what or who is responsible for the total difference between the budget and the EAC? Variance analy- sis is one method for answering this question. The project manager allocates the total difference between the budget and the EAC to the appropriate variance category, quantity, or rate. This is an important step in determining the appro- priate corrective action for attaining budget performance for the account. Corrective actions to correct quantity variances are different than the corrective actions to correct rate (dollars per unit or workhours per unit) variances. Table 21.6 contains the necessary formulas to carry out the variance analysis. The following example illustrates a variance analysis of a pipe installation account. Table 21.6—Variance Analysis Formulas—Two-Way Variance Analysis Example SUMMARY Which method, earned value or unit rates, is best for control- ling construction labor dollars or workhours? Each method analyzes the construction project and identifies the devia- tions from the budget for corrective action by the project management team. Using the assumptions stated in this chapter yields identical estimates at completion for each method. While both methods, when diligently applied, will control project costs and produce identical estimated total at completion, each one has a unique advantage. The earned values in the earned value method can be compared to the value of work scheduled as part of an integrated project con- trol system. The advantage of the unit rates method is that the unit costs and production rates are used for estimating and are therefore familiar to most managers. Labor cost control is best achieved by using a feedback loop. As construction activities proceed, both actual dollars or workhours and actual progress are measured. The actual per- formance is compared to the budgeted or planned perform- ance. The project manager concentrates corrective efforts on those activities whose actual performance deviate from the budget. The effectiveness of the corrective action is moni- tored by the feedback loop. This chapter presented an inte- grated system for implementing a feedback loop control sys- tem for labor cost control. 21.9 AACE INTERNATIONAL PROJECT LABOR COST CONTROL Estimated Total at Completion (EAC) QF x PF Budget QB x PB Quantity Variance C Q x PB Rate Variance (Production Rate or Unit Cost) QF x C P LEGEND QB Budget Quantity QF Forecast Quantity PB Budget Production Rate or Unit Cost PF Forecast Production Rate or Unit Cost C Q Change in quantity = QB – QF C P Change in production rate or unit cost = PB - PF ACTUAL BUDGET FORECAST LABOR COST QUANTITY QUANTITY QUANTITY BUDGET ACWP CODE DESCRIPTION LF LF LF WH WH 15170-20 Chilled Water, large 221 365 395 256 140 bore welded Quantity WH/LF Workhours Budget 365 LF 0.701 WH/LF 256.0 WH EAC 395 LF 0.633 WH/LF 250.2 WH Change - 30 LF 0.068 WH/LF 5.8 WH Quantity Variance = -30 LF 0.701 WH/LF - 21.0 WH Production Rate Variance Check = 395 LF 0.068 WH/LF 26.8 WH Check 5.8 WH OK
- 273. PRACTICE PROBLEMS AND QUESTIONS 1 You have summarized all control accounts in Area A of a project to the end of the reporting period. You note that you had scheduled 28,000 work hours, have earned 26,000 work hours, and have paid for 25,000 work hours. Analyze the cost and schedule status in Area A at the end of the reporting period by calculating SV, SPI, CV, and CPI. 2. Given the data below in Practice Table 1, complete the worksheet from a project’s status reports at the end of a reporting period. Refer to the text for the method to cal- culate earned value (BCWP) and percent complete for multiple accounts. 3. In planning and budgeting a fixed price project, a given work package was estimated to include 200 units of work. Estimators further utilized a unit rate of 4 work hours per unit of work so they budgeted for 800 work hours in this account. In the field, it was subsequently determined that there were really 240 units of work to be performed. This was strictly an estimating error, and, with no contingency fund available, the budget remained at 800 work hours. At the end of the latest reporting period, work was 50 percent complete (120 units) and 432 work hours had been paid for. Is this package overrunning or under running cost, and is pro- ductivity better or worse than planned? 4. Find the ACWP, BCWP, BCWS, CWH, CPI, SPI, PI, and EAC in Practice Table 2. Estimate the cost of this account at completion (EAC) assuming that the cost performance to-date will continue until the end of the project. Monday through Friday are the project work- days. 5. Given the rules of credit and work completed for fabri- cated pipe spools below in Practice Table 3, find the equivalent linear feet of pipe in place. This pipe spool account is estimated and controlled using the total lineal feet of pipe as the summary unit of measure. The sum- mary unit of measure is the characteristic that represents the total of all subtasks. For the formwork example in the text the summary quantity is the total square feet of all of the formwork. Note that for the formwork example the subtask total quantity is equal to summary quantity. 21.10 PROJECT LABOR COST CONTROL AACE INTERNATIONAL Practice Table 1 Practice Table 2
- 274. 6. See the quantity take-off for four hydronic piping accounts. The estimator made two errors in taking off the length of the hydronic piping. To correct these errors, add 30 LF to the chilled water large bore pipe (also, 12 joints & 4 hangers) and add 32 LF to the heat- ing hot water large bore pipe (also, 12 joints & 3 hang- ers). Use the forecasted quantities for the hydronic pip- ing daily production report. Complete the hydronic piping daily production report for the Hydronic piping for the project to-date as of day 30. Account 15170-20, chilled water, large bore welded steel has been completed for you. Use the following rules of credit: Subtask Large Bore Small Bore —————————————————————————— Erect pipe 0.25 0.10 Connect pipe, joints 0.65 0.70 Pipe hangers 0.10 0.20 Practice Table 4—Hydronic Piping Take-off Example: Chilled water large bore pipe The forecast quantity is equal to the budget quantity +/- any adjustments Pipe forecast quantity = 365 LF + 30 LF = 395 LF Hangers forecast quantity = 34 ea + 4 ea = 38 ea Joints forecast quantity = 112 ea + 12 ea = 124 ea Use the forecast quantity for both the subtask total quantity and the summary quantity. Equivalent Quantity = Allowed Credit x (Subtask to-date quantity/Subtask total quantity) x Summary quantity Pipe equivalent quantity = 0.25 x 230 lf/395 LF x 395 LF = Pipe equivalent quantity = 0.25 x 0.58 x 395 LF = 57.3 LF Joints equivalent quantity = 0.65 x 68 ea/124 ea x 395 LF = Joints equivalent quantity = 0.65 x 0.55 x 395 LF = 141.2 LF Hanger equivalent quantity = 0.10 x 22 ea/38 ea x 395 LF = Hanger equivalent quantity = 0.10 x 0.58 x 395 LF = 22.9 LF Total 221 LF 7. Complete the BCWS report on page 21.22, and earned value labor cost report for the hydronic piping project to-date as of day 30. Assume that performance to-date will contin- ue. Account 15170-20, chilled water, large bore welded steel has been completed for you. You need to use some of the data and the solution for Problem 6 to complete Problem 7. 8. Complete the BCWS report, and earned value labor cost report for the formwork project to-date as of day 30. Assume that performance to-date will continue. Refer to the text for directions on completing these worksheets. For some accounts you must add work packages together to get the account totals. 21.11 AACE INTERNATIONAL PROJECT LABOR COST CONTROL
- 275. REFERENCES 1. Halpin, Daniel W. 1985. Financial and Cost Concepts for Construction Management. New York: Wiley. 21.12 PROJECT LABOR COST CONTROL AACE INTERNATIONAL Practice Table 5—BCWS Report
- 276. INTRODUCTION It has been recognized for some time that cost professionals, and other professionals, are faced with an unprecedented rate of technological change and growing competitiveness in the marketplace. However, it also is recognized that technol- ogy and competition can be more easily managed than the human element of the enterprise. Some have noted that the managing change would present few problems if it were not for the people who create and are affected by the change (Conference Board, 1969). This presents even greater chal- lenges for today’s leaders. This chapter examines different approaches to leadership—one of the most important aspects of project management. LEARNING OBJECTIVES After completing this chapter, readers should be able to • recognize some of the key contributions to the field of leadership and management, • describe the challenges of working with multicultural teams and identify advantages they afford, • recognize some theories of motivation and some critical motivation mistakes to avoid, and • appreciate the challenges associated with business ethics at the individual and organizational levels. LEADERSHIP STYLES Today’s leaders must work to promote a team culture and establish partnerships with customers and suppliers. This is done through communication and information sharing among all stakeholders. Leaders now are considered team players. The leader does not work to control team members, but instead works to obtain commitment from them to support goals and objectives by fostering open communication, increased productivity through group efforts, and participato- ry decision making. The leader may not be necessarily a tech- nical expert, as his or her expertise is in leading the team to reach success on each endeavor as measured by its goals and objectives. A number of theories and writings of behavioral scientists have influenced the development of leadership styles. Five key contributions are discussed in this section. Douglas McGregor In The Human Side of Enterprise [19], Douglas McGregor was an early proponent of management as a profession. McGregor stated that management demands a scientific base of research and application to make it a successful profession. He said that to develop the professional manager, first the manager should examine how he or she saw himself or herself in relation to the job of managing human resources. The starting point is a set of fundamental beliefs or assumptions of what people are like. He developed two theoretical constructs of the nature of man in relation to his work, known as Theory X and Theory Y. Theory X includes the following assumptions: • The average person has an inherent dislike of work and will avoid it if possible. • The average person must be coerced, controlled, direct- ed, or threatened with punishment to put forth adequate effort toward achievement of organizational objectives. • The average person prefers to be directed, wishes to avoid responsibility, has relatively little ambition, and wants security. • Control should be externally imposed. Theory Y assumptions include the following: • People are self-motivated and will exercise self-direction and self-control toward achieving objectives to which they are committed. 22.1 Chapter 22 Leadership and Management of Project People1 Dr. Ginger Levin AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE 1This chapter includes modified excerpts from Flannes, Steven W., and Ginger Levin. 2001. People Skills for Project Managers. 2001. Management Concepts, Inc. Reprinted with permission.
- 277. • Average people learn to not only accept but also seek responsibility. • People are capable of a high degree of imagination, inge- nuity, and creativity in solving organizational problems. • The average person’s intellectual potential is only par- tially used. Central to a discussion of McGregor’s two theories is the matter of control. Under Theory X, control is externally imposed, while Theory Y emphasizes self-control or an inter- nal control. Theory Y implies that within a climate of trust and respect, the employee is capable of putting forth willing effort and controlling work habits. Theory Y presented a flex- ible view and opened up a wide range of possibilities for new managerial policies and practices. Frederick Herzberg Frederick Herzberg [12] studied the relationship between the role of work and working conditions. He developed a moti- vation-hygiene theory based on the concepts of satisfiers and dissatisfiers. He found that real motivation resulted from the worker’s involvement in accomplishing an interesting task, not from the working conditions or environmental factors that are peripheral to the job. The hygiene factors, though, must be adequately provided if a person is to rise above them and be able to involve oneself in meaningful tasks. Managers need to recognize the disparate nature of hygiene factors and motivators and increase the challenging content of the job. Herzberg’s emphasis on job enrichment stated that increas- ing the challenging content of the job would cause the employee to grow both in skill and in a feeling of accom- plishment. Chris Argyris Chris Argyris [2] advanced some of McGregor’s theories and said that the organization may be the source and cause of human problems. He felt that individual needs and orga- nizational needs were not met effectively in most organiza- tions, as he described the dichotomy between these two sets of needs. Part of the problem, Argyris noted, was due to the bureaucratic nature of organizations and their hierarchical structures; he was an early proponent of the concept of ad hoc work groups, or project teams, that cross-cut organiza- tional lines. Argyris felt that the organization must change to conform to human needs, and that the organization should offer meaningful challenges and opportunities for responsibilities. A climate of open communication and trust is needed in all interpersonal relationships. Argyris advo- cated the development of interpersonal competence and authenticity in relationships as the first step in dealing with any personal differences that may block information flow and understanding of objectives at the individual, unit, and organizational levels. Rensis Likert Well-known for the development of an attitude measurement approach known as the Likert-type scale, Rensis Likert [15] also developed the concept of the linking pin—a person who belongs to two groups in the organization. The linking pin shows that the entire organization is viewed as a set of over- lapping and interacting groups. Likert advocated open com- munication within groups, development of mutual trust, con- sensus decision-making, group goal setting, definition of roles, and shared responsibility. He said that real authority is not just official or formal authority, but is dependent on how much authority a manager’s subordinates allow the manager to exert over them, regardless of formal authority position. As Likert stated, the amount of influence a manager exerts over subordi- nates is determined by how the manager allows himself or her- self to be influenced by them. The degree of group commitment and involvement is based on the extent to which the manager considers the opinions of subordinates in reaching a decision whose outcome has impact upon the group. Likert [16] further developed four basic styles of leadership related to a wide range of organizational variables: • exploitive-authoritative, • benevolent-authoritative, • consultative, and • participative group. These four styles exist in everyday practice, but he directed his attention toward the participative group, which he felt was ideal for a human-concerned organization. Robert Blake and Jane Mouton In 1962, Dr. Robert Blake and Dr. Jane Mouton developed a con- cept called the managerial grid [4]. They felt there was an unnecessary dichotomy in the minds of most managers between concern for people problems and concern for produc- tion problems. These concerns are complementary. They said that each manager has a discernible style of management based on the degree of concern for production and people. At one end is the manager who is only concerned with production; at the other end is the manager who coddles people at the cost of lost production. There are 81 possible positions on their manageri- al grid representing leadership styles; of these, though, there are five key styles. Ideally, on the grid, a manager should be a 9,9. This manager stresses team management. Concern for peo- ple and production are interdependent. The manager’s job is one of a coach, an advisor, or a consultant. TEAMS It has long been recognized that teams out-perform individ- uals acting alone, especially when performance involves multiple skills and areas of expertise. However, groups of people do not become a team merely because they are 22.2 LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL
- 278. assigned to one. They must be collectively committed to each other and mutually accountable. As noted by Katzenbach and Smith [13], “the wisdom of teams comes with a focus on collective work products, personal growth, and performance results. However meaningful, ‘team’ is always a result of pursing a demanding performance challenge.” A team begins as a group of individuals with different moti- vations and expectations. Some people are pleased to be part of the team; others are not. Some people want to have signif- icant responsibility on the team and want to lead it, while others want to follow. People also bring views as to how teams should operate and stereotypes that reflect one’s views and attributes toward members of various groups. Not everyone will view the project with the same attitudes. These conditions create an environment in which individuals determine the conditions on the team. Individual accountabili- ty must be merged with mutual accountability. Team members must be committed to a common approach as to how they might best work together. Performance challenges should ener- gize teams, as a team’s performance goals must always relate to its overall purpose [13]. Clear goals can help reduce the poten- tial for future disruptive conflicts and minimize any past dif- ferences among the various people represented on the team. As Parker [22] notes, the people who come together to be part of the team will be effective to the extent that they agree on a com- mon goal, set aside their individual priorities and agendas, develop a plan to reach that goal, and then commit to work together to attain it. CROSS-CULTURAL CONCERNS Culture, as defined by the American Heritage Dictionary [1], is “The totality of socially transmitted behavior patterns, arts, beliefs, institutions, and all other products of human work and thought.” It includes political, economic, demographic, educational, ethical, ethnic, religious, and other areas, includ- ing practices, beliefs, and attitudes, that affect the way people and organizations interact [24]. All organizations are becoming more culturally diverse with each passing business day. People working on teams in the field of cost management, for example, often consist of mem- bers representing many different nationalities, languages, and cultures. This cultural richness brings many advantages to a team in the form of different backgrounds, values, norms, and perspectives. However, the characteristics that add richness to a team also increase its complexity. With mul- ticultural teams, the team leader must create vehicles to bridge the cultural gap and bring the team together. A man- ager working with a multicultural team needs to be aware of these cultural differences and take special care to avoid the potential risks associated with them. Culture affects our work in many ways. Research has shown that birth culture has a greater effect on a worker’s frame of mind than does organizational culture. A worker, no matter how well he or she adopts the organization’s culture, is still motivated primarily by the cultural environment in which he or she was raised. In such a multicultural world, the manager or team leader faces a variety of issues, such as managing the team member who may be bicultural and dealing with a culture that may be different from that of the organization. This includes a wide range of challenges from language barriers and time differences to religious diversity and differences in food pref- erences. For example, in some cultures that value harmony, indirectness, and shared identify, conflict is seen as a loss of face. Open discussion and resolution of conflict is viewed as negative, and a direct approach to conflict resolution, such as a confrontational style, is considered threatening. Here, con- flict is best handled behind the scenes, using a smoothing or compromising method. Other cultures that value confronta- tion see conflict as a positive force as it allows ideas to be aired and insights to be shared in an open fashion. As anoth- er example, some cultures view risks as only the responsibil- ity of the executives in the organization, while others view it as the team’s responsibility. For a manager working in settings that involve multicultural issues, it is important to recognize the effect of cultural fac- tors. In the area of communications, the manager must be aware of verbal and nonverbal differences, and recognize that cultural differences can result in misunderstandings. The manager should remain conscious of the fact that cultur- al differences do exist and try to accommodate these differ- ences if possible. Diversity itself, although a challenge, is also the source of many creative issues. A multicultural team does have greater potential for higher productivity and innova- tion. Cultural differences should not be ignored or mini- mized, and if a cultural difference does cause a problem, it should be addressed. Awareness of cultural differences among team members may even make the difference between success and failure. 22.3 AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE GLOSSARY TERMS IN THIS CHAPTER culture ◆ empowerment ◆ ethics hierarchy of needs ◆ leadership ◆ management motivation ◆ motivation-hygiene theory ◆ team Theory X management ◆ Theory Y management
- 279. LEADING, MANAGING, FACILITATING, AND MENTORING Similar to many leaders, cost engineers and other profession- als are often promoted into leadership roles for reasons relat- ed to technical competency, not demonstrated leadership and management skills. This technical professional then must acquire functional knowledge of basic leadership and man- agement skills, because ultimately the success and failure of all projects can be traced to the “people” component. Carr, Hard, and Trahant [6] and Fitz-Enz [8] offer resources related to generic managerial and leadership skills. The importance of this elusive, people component remains constant in today’s complex world in which sophisticated technology and software resources are available to manage the intricate processes of any project. Working with a team of people, the manager faces many challenges. These include the following: • uncertain organizational resource support for the project, • extreme time pressures, • first-time challenges to solve unique and complicated problems, • a wide variety of personnel and other resource interde- pendencies, and • challenges of obtaining resources from senior managers who may not totally support the project. As a result, the successful manager must bring special skills and abilities to the organization. He or she must be able to • apply both technical and managerial skills in addition to operating as a generalist; • motivate the team toward the goals and objectives of the project while still attempting to meet each individual’s professional goals; • create group cohesion without succumbing to “group think;” • think and thrive under pressure while integrating and resolving conflicting priorities and goals of other stake- holders; • drive the team toward excellence; • work with the emotional, intellectual, and physical chal- lenges in the start-up and close-out phases of the project; • think in terms of three dimensions– timely delivery, cost compliance, and task performance; and • create mechanisms within the team that encourage the discussion of conflict and balance the process through methods that motivate the team toward decisive action. The role of the project manager is multifaceted. During a proj- ect, the project manager then must be able to assume four dif- ferent roles: that of leader, manager, facilitator, and mentor. Leadership Being a leader of a project is a more subtle, complicated role than simply being the person who is in charge of the project and is supposed to deliver it on time and within budget. True leadership involves the ability to conceptualize the vision and direction of the project and then be able to com- municate and sell this vision to the team members and other stakeholders. In this context, vision is not an idealistic, amor- phous concept of the project, but involves identifying the purpose of the project. This involves listening to the cus- tomer to determine the added value the project will bring and recognizing what the customer is not saying. Once the project manager has discussed the purpose of the project, the next step is to create a personal vision of its pur- pose. The key point is to create a personal representation of the true purpose of the project, noting subtle goals and the customer’s true requirements. This then enables the project manager to be confident and motivated to begin the project and to determine how to best sell this process to the team and required stakeholders. The next step is to begin a dialogue with the team members on the subject of the project’s purpose. The project manager must create an atmosphere in which all team members are encour- aged to ask questions about the purpose of the project and to offer opinions and clarification. Additionally, the project man- ager must gain credibility and must demonstrate managerial actions and behaviors that are consistent with verbally espoused values. Congruence in actions and stated values is crucial because it creates a state of comfort and trust for team members that enables the person to take the leader at face value and become involved in the task without holding any reservations, doubts, or hesitation. Leadership also involves an active role in being the team’s voice to the outside world. The leader needs to communicate actively with outside partic- ipants who affect the success of the project to address stake- holders in terms of supporting and buying into the project goals, obtaining needed project resources, providing updates and progress reports, and addressing conflict in a productive and forthright manner. Active communication between the project manager and various stakeholders maintains sponsor support, creates needed ongoing liaisons, and helps reduce the risk of unexpected obstacles hindering the project. Management The manager role ensures the project is completed on time, within budget, and at acceptable levels of performance. It involves creating the administrative procedures and structure to monitor completion of the work. The manager role, viewed from the perspective of people challenges, involves creating an administrative system with enough structure and discipline to complete the project without the structure stretching into the realm of excessive bureaucracy. It is important to balance the need for structure and the need for autonomy and flexibility. 22.4 LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL
- 280. Facilitation Facilitation is one of the more subtle, yet profound roles for the project manager. Facilitation is those behaviors and atti- tudes that help others get their work done and is often achieved through the art of influencing others. It involves communication abilities, conflict resolution, the ability to actively procure necessary supplies and resources for the team as a hole, and the ability to motivate both individual team members and the team ass a unit. Team-focused moti- vation involves the creation of strategies that unite the team in common action and rewards that are realistic. The goal is to provide team members with choices, options, and a con- ductive setting and then trust that the team members will cre- ate the desired outcome. A project manager who is adept at helping team members address and resolve conflict in a pro- ductive manner promotes facilitation. Mentor or Coach The roles of mentoring and coaching are becoming increas- ingly important areas in the workplace. They can be defined as those processes in which one person (the mentor or coach) assists another person, either formally or informally, in vari- ous tasks related to the general purposes of professional growth and development. This assistance takes the form of guidance and encouragement, which may or may not be directly tied to an actual project issue being faced by the indi- vidual but instead may be directed at assisting the individual in attaining a broader view of future career directions or advancement. The role of mentoring and coaching involves the following: • being a role model who demonstrates desired skills, behavior, and attitudes whose adoption may benefit team members; • demonstrating a genuine, personal interest in the welfare and professional growth of team members; • offering suggestions, possibilities, resources, problem- solving approaches, and opportunities to think-out-loud with team members regarding current or future issues; • providing feedback that is supportive and also frank and accurate; and • offering motivation directed toward assisting team members in identifying and achieving long-term profes- sional goals. The Four Key Roles Thus, the most effective project manager is able to assume these four roles—leader, manager, facilitator and mentor— throughout the project and has competency in each of the four areas. Additionally, the project manager needs the skill of timing to determine when to move from one role to anoth- er, since projects have different needs at different times. MOTIVATORS AND DEMOTIVATORS What is Motivation? Used in the context of this chapter, motivation is defined as “That process, action, or intervention that serves as an incen- tive for a project team member to take the necessary action to complete a task within the appropriate confines and scope of performance, time, and cost”[10]. The impetus for taking action may come from either intrinsic or extrinsic sources of motivation. Intrinsic motivation is that which arises from a source within a team member, such as a desire to obtain new skills or the need to confront a stimulating personal challenge. Extrinsic sources of motivation involve a force outside of the individual, such as recognition from one’s peers in a professional association or at a conference or a man- ager providing a sizeable pay increase for a job well done. Members of a high-performance team tend to be motivated by both sources. The manager or leader, working with his or her team, should strive to search for both intrinsic and extrinsic sources of motivation when working with each team member. Motivational Challenges Motivation is particularly difficult because of three strong forces and trends: the continuing ongoing reductions in force; the unspoken contract between the employee and employer, which has changed dramatically over the past 20 years; and the increase in the number of team members that are from different backgrounds and viewpoints. Organizations in both the public and private sectors continue to downsize. Even organizations that are experiencing growth in one sector of their operations may downsize in other sectors. Nearly all downsizing results in situations in which those who survive are required to do more with less. Frequently, the survivors have experienced feelings of anger and guilt that clearly decrease motivation [21]. It is not unusual to find pervasive cynicism and skepticism among the surviving employees, which creates an environment that makes motivation difficult at best. The contract between the employer and the employee in today’s operating environment primarily focuses on the organization owning the job with the employee owning the career. This differs from the era before the 1970s, in which employees often perceived an unspoken contract between themselves and their employer, grounded in the belief that quality job performance and loyalty would be in turn rewarded by job security. In today’s environment, the man- ager must instead be creative in developing motivational approaches and processes that are part of the current reality. The richness of team members from different backgrounds, as noted in the previous section, brings many positive contribu- tions to the work environment. However, it can be a richness 22.5 AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE
- 281. that also complicates the process of motivating team mem- bers, since the “norms” for what is viewed as motivating can be so different across the different cultural groups and loca- tions involved. Greater sensitivity is required of the manager who is responsible for motivating people from different cul- tural backgrounds. Knowledge must be acquired as to what is motivating for each individual, while at the same time avoiding the pitfall of generalizing as to what will be moti- vating for specific cultural groups. Other Motivational Considerations It is important to recognize that people bring with them a cer- tain amount of “baggage” that will affect their motivation. This baggage can be feelings, attitudes, or expectations that have a negative tone and are the result of previous negative personal or professional experiences of the individual involved. The baggage then becomes an impediment to the person’s positive engagement with the work to be done. Sources of such baggage include the following: • previous or ongoing organizational problems, • industry changes, • health issues, • career stalling, and • personal problems. It is also important to be aware of some motivational mis- takes. The following are some examples: • what motivates me will probably motivate others, • people are primarily motivated by money, • everyone wants to receive a formal award, • team members are motivated by quotas, • each person needs a rally slogan, • the best leader is a strong cheerleader, • people who are professionals do not need motivating, • people only need to be motivated if there is a problem, • everyone should be treated the same, and • just find one thing that motivates each person and then stay with it. Motivation of project team members is one of the most chal- lenging tasks of managers. It must address individual issues as well as organizational issues. Sources of motivation are both fluid and dynamic. As a manager, a good practice to fol- low is to ask each person what he or she finds to be particu- larly motivating. This practice, although simplistic, will pro- vide the manager with a wealth of current and specific infor- mation that cannot be obtained through any other method. Theories of Motivation Traditionally, theories of motivation have characterized the subject from the perspective of evolution, biology, drives, needs, and social influence. Each of these perspectives is in agreement that individuals display a wide range of motives. An overview of these theories of motivation begins with the premise that motivation involves goal-directed behavior. • Biological perspective is considered an evolutionary approach. It asserts that actions or behaviors that con- tribute favorably to the preservation and expansion of the species will produce motivation. It is appropriate when confined to the more basic aspects of human behavior, such as hunger and thirst, reproduction, and the need for affiliation for the goal of basic survival. • Drive theories state that certain behaviors are the result of individuals meeting the requirements of specific drives. Drives are considered complex combinations of internal stages of tension that cause the individual to take action to reduce the level of tension. The goal of reducing tension is to achieve an internal state of equi- librium or balance or “homeostasis.” Individuals in this model are believed to desire homeostatic states in their lives, and behavior is motivated because of attempts to maintain this balance. Similar to evolutionary theories, these drive theories work best when applied to the most basic human behaviors. They are often insufficient when trying to explain the complex behavior and skills involved in management. • Incentive theories state that individual behavior is pulled in certain directions based on the external condi- tions in the specific setting. Much of the field of learning theory and instrumental learning work conducted by the noted psychologist, B.F. Skinner, is based on the incen- tive type of motivation. These approaches can work in settings when the manager and team member have the ability and the resources to identify a desired behavior that can be awarded by providing the identified incen- tive. The incentives must be valued by the group and may need to come directly from the group members. The incentives also need to be appropriate to the culture of the organization. • Theory of needs is another approach to motivation pri- marily based on work done by David McClelland [18], who developed the concept that people who value the need for achievement are often those people who are the leaders in the areas of creativity and economic growth. This approach is based on premises that, as humans, challenging environments provide us with an opportu- nity to achieve excellence, or to compete against others successfully will provide motivation. The need to achieve and compete within one’s own professional dis- cipline can self-motivate many individuals. • Fear of failure can describe another motivational basis to act and succeed. This approach can be a strong motiva- tor in situations when the consequences for failure are 22.6 LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL
- 282. especially distasteful or catastrophic. However, it should be employed only in unusual circumstances, such as if a project is headed for crisis, and immediate action is required. If it is employed too frequently, it may create a crisis management, disaster-avoiding environment, which will easily lead to employee burn out and dissatisfaction. • Hierarchical theory of motivation was set forth by Abraham Maslow [17]. It adopts the premise that the basic physical needs and more subtle social or psycho- logical needs will motivate people. Maslow states that people are motivated by the desire to satisfy these vari- ous needs according to a hierarchy, with the most basic needs placed at the bottom of a “needs pyramid.” When one need is satisfied, the individual will then move upward to the next need. Maslow’s hierarchy of needs can be described as follows: -Level 1—physiological needs (food, thirst), -Level 2—security and safety needs (stability, survival), -Level 3—belonging needs (affiliation, love), -Level 4—esteem needs (achievement and the acquisi- tion of recognition), -Level 5—cognitive needs (knowledge), -Level 6—aesthetic needs (beauty, order), and -Level 7—self-actualization needs (the realization of one’s personal potential). • Career stages is a different approach presented by Schein [25] through a model that describes major stages in a per- son’s career. An understanding of an individual’s current career stage by the leader can be used in developing tan- gible approaches to individual motivation. This model has 10 career stages. -Stage one and stage two occur in the person’s life before entering the world of work and involve early years of career exploration followed by formalized career prepa- ration, such as higher education and specialized train- ing. -Stage three is the first formal entry into the workplace where real world sills of the profession are acquired. -Stage four refers to training in the concrete application of skills and professional socialization, which occur as the identity of being a professional is becoming established. -Stage five occurs when the individual is observed as having gained full admission into the profession based on competency and performance. -Stage six is the point at which the individual gains a more permanent membership in the profession. -Stage seven is the natural mid-career assessment or cri- sis period during which questions are asked as to the value of the career and what has been accomplished. -Stage eight is the challenge of maintaining momentum as the career starts to move into its final chapters. -Stage nine is when the individual beginning to disen- gage from the profession and the world of work. -Stage ten is the retirement stage in which the individual must come to some form of closure of employment with a specific organization or membership in a certain profession. Schein also stated that our personal values affect our enjoyment and pursuit of various tasks in the workplace, and, as a result, the more we understand our own values in specific areas, the better we are able to achieve work satisfaction. Therefore, our motivation will be greatest when we pursue tasks and functions consistent with our values. Schein identified eight of these values, which he describes as career anchors; the word anchor suggesting a person’s self-image of what is important for them as they consider the aggregate of their skills, motives, and values. These eight values are as follows: -technical-functional, -general managerial, -autonomy and independence, -security and stability, -entrepreneurial creativity, -service and dedication to a cause, -pure challenge, and -lifestyle. • Empowerment is another approach suggested by Meredith and Mantel [20] in which a team environment be established in which the members experience a strong sense of empowerment through the use of participatory management methods. Empowerment is defined as an approach that stresses individual initiative, solution cre- ation, and accountability. The team is then motivated by the opportunity to be self-determinative in creating the structure and methods to achieve its goals. ETHICAL THEORIES AND APPLICATIONS For any professional, in any discipline, ethics is an emotion- ally and intellectually charged word. It prompts images of moral responsibility and obligation, scholars debating the intricacies of profound issues, and arguments between pro- fessionals and social commentators about right and wrong behavior. Other images are those such as a professional over- sight board ruling on professional conduct or misconduct; discussions about financial or corporate malfeasance, and the like [9]. Business ethics is considered a management discipline because of the social responsibility movement that began in the 1960s. During the 1960s, social awareness movements emphasized the expectations of businesses to use their influ- ence to address social problems. People asserted that since 22.7 AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE
- 283. businesses were making profits, it was also their responsibil- ity to work to improve society. Many replaced the word “stockholder” with “stakeholder,” including employees, cus- tomers, suppliers, and the wider community. By the 21st cen- tury, 90 percent of business schools provide some type of training in business ethics. However, philosophers, academ- ics, and social critics traditionally have handled the field of business ethics. Much of the literature that is available is not geared to the practical requirements for the behavior of lead- ers and managers. And, while there is no shortage of differ- ing opinions about what businesses should do in various sit- uations, there is little information on ways to actually imple- ment ethical practices. One definition is that ethics “is the science of judging specif- ically human ends and the relationship of means to those ends” or “the art of controlling means so that they will serve specifically human ends.” It, therefore, involves techniques of judging and decision making, as well as tools of social con- trol and personal development. Accordingly, it is or should be involved in all human activities. In terms of business, ethics is concerned with the relationship of business goals and techniques to human ends. It studies the impacts of acts on the good of the individual, the organization, the business community, and society as a whole [11]. Another definition is that it is “the guidelines or rules of conduct by which we aim to live” [5]. As Cadbury explains, while it is difficult enough to resolve dilemmas when one’s personal rules of conduct conflict, the real difficulties arise when one must make deci- sions affecting the interests of others. Often it is necessary to balance the interests of employees against those of share- holders and the differing views that exist among the share- holders. What matters most is how one behaves when faced with decisions that involve combining ethical and commer- cial judgments. Most organizations have ethics programs, but many are unaware of them. These ethics programs typically are com- posed of values, policies, and activities that affect the propri- ety of organization behavior. Ethics is a matter of values and associated behavior. Several principles have been set forth for highly ethical organizations: • They easily interact with diverse internal and external stakeholder groups. The ground rules of these firms make the good of the stakeholder groups part of the organizations’ own good. • They are obsessed with fairness. The ground rules emphasize that other peoples’ interests count as much as their own. • Responsibility is individual, not collective; individuals assume personal responsibility for the actions of the organization. The ground rules state that individuals are responsible to themselves. • Activities are viewed in terms of purpose; this purpose is a way of operating that members of the organization value highly. The purpose ties the organization to its environment [23]. There are few, if any, ethical truths or standards that can be memorized and applied in a concrete fashion in all settings applicable to cost and project management. Ethical behavior is difficult to qualify and operationalize. It can be viewed as a process that one goes through, a method to consider the conflicting and often contentious agendas of those involved. It is not an action taken after the consideration of memorized rules of conduct. It is, instead, the actions that are taken as a result of the individual having engaged in a process of con- sidering the needs of the various stakeholders, thinking through the consequences of various actions, and arriving at an action that is grounded in a good faith approach to respect the rights of those involved [10]. The difficulty of establishing sound ethical norms for an organization cannot be underestimated, as the ethical climate of an organization is extremely fragile. The task requires unremitting effort, and ethical codes can be helpful, although not decisive [3]. In the end, society sets the ethical framework within which those who run companies must work out their own codes of conduct. Business must take into account its responsibilities to society in reaching its decisions, but socie- ty must accept its responsibilities for setting the standards against which decisions are made [5]. SUMMARY The challenges associated with management of project peo- ple are numerous and complex. But as a leader or manager, one must establish direction, communicate this direction to others, and motivate and inspire people to achieve goals and objectives. This involves the necessity of developing a lead- ership style that is appropriate to the specific organizational situation, working more frequently with diverse groups of people representing many different cultures, using the most appropriate motivational approaches, and also taking profes- sional responsibility for one’s actions. REFERENCES 1. American Heritage Dictionary of the English Language. Third Edition. 1992. Boston: Houghton Mifflin. 2. Argyris, C. 1964. Integrating the Individual and the Organization. New York: Wiley. 3. Badaracco, J. L., and A. P. Webb. 1995. Business Ethics: A View from the Trenches. California Management Review. Winter. 22.8 LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE AACE INTERNATIONAL
- 284. 4. Blake, R., and J. Mouton. 1964. Corporate Excellence Through Grid Organization Development. Houston: Gulf Publishing Co. 5. Cadbury, A. 1987. Ethical Managers Make Their Own Rules. Harvard Business Review. September–October. 6. Carr, D. K., K. J. Hard, and W. J. Trahant. 1996. Managing the Change Process: A Field Book for Change Agents, Consultants, Team Leaders, and Reengineering Managers. New York: McGraw-Hill. 7. The Conference Board. 1969. Behavioral Science Concepts and Management Applications. New York. 8. Fitz-Enj, J. 1997. The 8 Practices of Exceptional Companies: How Great Organizations Make the Most of Their Human Assets. New York: American Management Association. 9. Flannes, S. 2001. Ethics and Professional Responsibility. Unpublished paper. 10. Flannes, S. and Levin, G. 2001. People Skills for Project Managers. Vienna, Virginia: Management Concepts. 11. Garrett, T. 1996. Business Ethics. New York: Meredith Publishing Company. 12. Herzberg, F. 1968. “One More Time: How Do You Motivate Employees?” Harvard Business Review. January- February. 13. Katzenbach, J. R, and D. K. Smith. 1994. The Wisdom on Teams. New York: HarperBusiness. 14. Kotter, J. P. 1990. A Force for Change: How Leadership Differs From Management. New York: The Free Press. 15. Likert, R. 1961. Patterns of Management. New York, 1961, McGraw-Hill Book Company. 16. Likert, R. 1967. The Human Organization. New York: McGraw-Hill Book Company. 17. Maslow, A. 1970. Motivation and Personality. New York: Harper & Row. 18. McClelland, D. 1961. The Achieving Society. New York: The Free Press. 19. McGregor, D. 1960. The Human Side of Enterprise. New York: McGraw-Hill. 20. Meredith, J. R. and Mantel S. J. 2003. Project Management: A Managerial Approach. New York: John Wiley & Sons. 21. Noer, D. 1993. Healing the Wounds: Overcoming the Trauma of Lay-Offs and Revitalizing Downsized Organizations. San Francisco: Jossey-Bass. 22. Parker, G. M. 1994. Cross-Functional Teams. Working with Allies, Enemies, and Other Strangers. San Francisco: Jossey- Bass. 23. Pastin, M. 1986. The Hard Problems of Management: Gaining the Ethics Edge. San Francisco: Jossey-Bass. 24. Project Management Institute. 2000. A Guide to the Project Management Body of Knowledge. PMBOK® Guide. Newtown Square, Pennsylvania: Project Management Institute. 25. Schein, E. 1990. Career Anchors: Discovering Your Real Values. San Francisco: Jossey-Bass/Pfeiffer. 22.9 AACE INTERNATIONAL LEADERSHIP AND MANAGEMENT OF PROJECT PEOPLE
- 286. INTRODUCTION The quality management movement has evolved consider- ably over the past two decades. This chapter introduces qual- ity management concepts and current trends (such as Six Sigma) and their implications for cost professionals. LEARNING OBJECTIVES After completing this chapter, readers should be able to • understand a brief history of the quality management, continuous improvement, and benchmarking move- ments; • appreciate why there is renewed interest in quality man- agement now emerging as Six Sigma; • learn why traditional managerial accounting has failed the quality management movement; • get oriented to the COQ categories—error-free, confor- mance related, and nonconformance related; • understand how activity-based cost management (ABC/M) provides a foundation for repetitively and reli- ably computing COQ; and • appreciate the goals and uses of COQ and benchmarking data. WAS THE TOTAL QUALITY MANAGEMENT MOVEMENT A FAD? In the 1980s, the total quality management (TQM) move- ment—-a vast collection of philosophies, concepts, methods, and tools—grew increasingly popular. It received substantial business media attention and was intellectually appealing. At an operational level, TQM was effective at identifying waste and accelerating problem solving for tactical issues. However, at a more strategic level, it was felt by many that TQM was not the magic pill for which senior executives always seem to be searching. TQM usually did not double or triple an organization’s prof- its. In many cases, implementation of TQM probably pre- vented greater financial losses from customer defections caused by quality problems or from waste and inefficiencies. Unfortunately, the avoidance of reduced profits is not meas- ured or reported by the financial accounting system. No one could easily assess TQM’s benefits. As a result, in the 1990s, TQM was regarded by senior management of some organi- zations as another check-in-the-box improvement program that they needed to have in place along with other programs. But TQM was not viewed as foundational. What led to the initial interest in TQM? By the 1980s it had become evident to senior executives and the federal govern- ment that Japan was winning market share with better quali- ty. What began as a competitive nuisance quickly became feared as a serious threat. Japan’s economy had miraculously transitioned from a low- to high-quality reputation. In hind- sight, we now realize it was not miraculous but a result of plain commonsense business practices. What had occurred was that consumers began to recognize Japanese products as either superior or a bargain. Consumers realized they did not need to resign themselves to accepting shoddy workmanship. North American executives countered this threat and began to realize that quality management initiatives improve pro- ductivity while concurrently defending their market share position—a win-win. Executives were learning that there is no trade-off of extra cost for greater market share. In the 1980s, TQM got its opportunity to shine as a leading change initiative. Popular quality management consultants raised awareness and educated businesses. Joseph M. Juran, 23.1 AACE INTERNATIONAL QUALITY MANAGEMENT Chapter 23 Quality Management Gary Cokins 1This chapter includes modified excerpts from Cokins, Gary. 2001. Activity-Based Cost Management: An Executive’s Guide. New York: John Wiley and Sons.
- 287. W. Edwards Deming, Phillip Crosby, and others became lead- ing experts and guides for organizations struggling with how to turn themselves around. Quality management programs became prevalent and often institutionalized via accepted standards such as the ISO 9000 Quality System Standard. In 1987, the U.S. Congress passed a law establishing the Malcolm Baldrige National Quality Award. In 1988, the European Foundation for Quality Management (EFQM) was founded, and in 1992, it introduced the European Quality Award. It appeared as if industry was solving its “quality crisis.” In the early 1990s, skepticism about TQM began to take the bloom off the TQM rose. A disappointing pattern from past TQM projects had emerged. Results from TQM were below possibly inflated expectations. Regardless of the explanation, after initial improvements from TQM, executives began to question if there were enough results. In October 1991, Business Week ran a “Return on Quality” cover article ques- tioning the payback from TQM. In short, there was an omi- nous disconnection between quality and the bottom line, as increasingly more companies adopted quality programs yet few could validate much favorable impact on profitability. At about this same time, other change initiatives, such as just- in-time production management and business process reengineering (BPR), began capturing management’s atten- tion. TQM settled in as a necessary-but-not-sufficient back- seat program. Renewed Emphasis on Quality Management A historical perspective on the role of quality in business and commerce may be helpful. During the Middle Ages many guilds of craftsmen were established to guarantee the quality of workmanship and to define standards by the pur- chaser. During the Industrial Revolution, many of the tech- nological advances, such as the development of the steam engine, were made possible through developments in metrology and the standardization of engineering compo- nents such as screw threads. The advent of mass production during the twentieth century increased the demands for control of product quality. During the 1940s and 1950s, the techniques of quality control became an increasingly important element of business management as organizations sought to gain competitive advantages. The success of Japanese manufacturers during the 1960s and 1970s changed the emphasis from a quality control approach to a quality assurance approach that involved more of an organization’s functions. Organizations worldwide began recognizing that quality management need not operate in isolation from other change initiative programs. Managements admitted to themselves that there had been drawbacks that had harmed quality man- agement’s reputation, such as nonverifiable measures, claimed but unrealized cost savings, and small projects that were too local and tactical. However, these same executives realized that with corrections, what was earlier referred to as TQM could be repositioned with new branding. In the face of increasing pressures, organizations have often launched massive, but usually uncoordinated, change initia- tives that may or may not achieve their goals. Each effort in isolation may have shown results, but collectively, the initia- tives can fall well short of their potential. Despite the temp- tation for management to continue this search for that special improvement program, system, or change initiative to cure their ills, pragmatic executives realized that there is no single program. Multiple concurrent change initiatives are needed, and they require integration. A variety of programs and management systems began to emerge. Balanced scorecards became accepted as a solution to aligning organizational execution with strategy. Information systems such as ERP and advanced planning and scheduling (APS) improved execution, compressed lead times, and reduced unused capacity. Customer relationship management (CRM) systems connected the sales force to cus- tomer needs, value, and satisfaction. Activity-based cost management (ABC/M) systems improved the visibility and understanding for management to infer things, understand and believe their profit margins, draw conclusions, and make better decisions. The rate of change began to accelerate. The strong force of recognizing customer satisfaction as being essential moved organizations from hierarchical structures toward process- based thinking. The reengineering message was to worry about the outputs, not the functions: Do not get entangled in the politics of the hierarchical organization chart. Power was shifting from sellers to buyers, and organizations had to shift their orientation. Quality management qualified as one of the essentials in the new suite of management tools and methodologies. Corporate role models emerged. Six Sigma programs with “black belt” quality training at General Electric and Motorola were heralded as keys to their successful performance. To validate an organization’s claim to having achieved high quality, quality assessment mechanisms have been devel- oped. The Malcolm Baldrige Award, established in 1987, has become coveted as a sign of excellence in the U.S. Europe honors its winners of the European Quality Award (EQA), and Japan has honored winners of the Deming Application Prize. Figure 23.1 illustrates the stages of maturity that qual- ity programs have progressed through. The figure empha- sizes that the benefits for any program stem from when cus- tomer and/or shareholder value are created. 23.2 QUALITY MANAGEMENT AACE INTERNATIONAL
- 288. There have been and will continue to be endless debates about which management techniques matter and are effec- tive—and which don’t matter. There is an increasingly pre- vailing consensus that strategy and mission are essential; after strategy and mission are defined by senior manage- ment, the core business processes take over to execute the strategy. The core business processes are now accepted as the mechanism to deliver the value (both customer and stock- holder value) defined by the strategy. Time, flexibility, quali- ty, service, and cost are all derivatives of the business process. They are inextricably braided together and should not be addressed in isolation from each other. (Programs such as “core competencies,” “organizational learning,” and cycle time compression are considered to be important enablers.) At the same time that management tools and methodologies were being blended, new thinking about how to achieve competitive advantage began displacing old thinking. Quality management has a golden opportunity to be part of this new managerial thinking. As an example, at some com- panies the Michael Porter “competitive advantage” strategy model is being abandoned. Companies can no longer com- pete by concentrating on “low price versus high product or service-line differentiation.” This is because companies that are successfully sustaining their competitiveness have achieved competencies in new product development. Those “first-to-market” suppliers are quickly met by competitors with rapid “me-too” capabilities—and with lean cost struc- tures. There is no place left to stake out a competitive edge. The only option that competitors have is to adopt aggressive, confrontational management styles. This is a major challenge for executives, and it involves increas- ing value. Value is an ambiguous term and can be highly sub- jective. Aprimary responsibility for executives is to create value for the customer while increasing economic wealth for employ- ees and shareholders—all at the same time! The capability of producing value is a prerequisite to growth, and pressure is mounting to increase the rate of value creation. A simple equation for value is value = performance/cost, where performance loosely refers to the right type of results aligned with the organization’s strategy. With this math, value increases if the numerator goes up or the denominator goes down. In some ways, executives feel boxed-in given that pricing is market-driven. They are realizing that profit margin manage- ment will require visibility and relentless management of costs. Quality management will be essential for managing costs. 23.3 AACE INTERNATIONAL QUALITY MANAGEMENT GLOSSARY TERMS IN THIS CHAPTER benchmark indexes ◆ benefit cost analysis chart of accounts ◆ cost ◆ cost of quality cost of quality conformance ◆ cost of quality nonconformance ◆ cost of lost business advantage ◆ functional worth indirect costs ◆ overhead ◆ prevention ◆ quality quality performance tracking aystem ◆ total quality management (TQM) ◆ value activity Figure 23.1—Evolution of Value Realization
- 289. PRODUCTIVITY PARADOX To complicate matters, some companies that have been “reengineered” may have become leaner and smaller from downsizing, but not necessarily fitter. It may have helped them to survive, but they may still not have a distinct com- petitive or quality advantage. In many cases, you cannot sim- ply remove bodies if you do not also reduce the work; other- wise, service levels erode and deteriorate. In addition, the old methods and old systems usually remain in place. Management may have met some short-term objectives, but the surviving workforce is hopefully operating with the long term in mind. As a result of these types of changes, so-called improvements in productivity do not always translate into a more profitable business. This has been referred to as the productivity paradox. Some organizations have invested in improving processes that were not critical to their strategic success. Such processes may have been improved, sometimes dramatically, but they did not turn out to be sufficiently relevant to the organization’s long- term performance and success. Process performance improve- ment, cost reduction, and the like are managerial terms, but they are not necessarily indicative of value added. Value is an economic concept. However, with an advanced managerial accounting system, increases or decreases to shareholder wealth can be traced to the changes in features, functions, and processes aimed at altering customer satisfaction. In addition, simply being lean and agile will no longer be suf- ficient for success. Companies’ success will depend on all the trading partners in their supply chains behaving similarly. Waste and redundancy created by interorganizational mis- trust must be removed via collaboration. Ideally quality man- agement can be a shared experience among trading partners and a basis for communications. THE ROLE OF CONTINUOUS IMPROVEMENT PROGRAMS Quality management encompasses many tools and tech- niques under the umbrella of what is popularly referred to as continuous improvement, including statistical process con- trol (SPC), quality control, quality improvement, quality assurance, and benchmarking. The emphasis in this chapter is on measuring the financial accounting aspects, because Six Sigma’s key differentiator is its emphasis on financial returns justification (in contrast to its predecessor quality manage- ment programs) and because AACE International is an organization that approaches problem solving and manage- ment from a cost viewpoint. There are substantial materials about continuous improvement tools and techniques at the Web site of the American Society for Quality at www.asq.org. WHY IS TRADITIONAL ACCOUNTING FAILING QUALITY MANAGEMENT? One of the obstacles affecting quality management initia- tives, and other initiatives as well, has been the shortcomings of the financial accounting field. Part of the problem is the traditional emphasis of accounting on external reporting. A significant reason why traditional accounting fails quality managers is that the initial way in which the financial data are captured is not in a format that lends itself to decision making. It is always risky to invest in improving processes for which the true cost is not well established, because man- agement lacks a valid cost base against which to compare the expected benefits of improving or reengineering the process. Gabe Pall, in The Process-Centered Enterprise, states: Historically, process management has always suf- fered from the lack of an obvious and reliable method of measurement that consistently indicates the level of resource consumption (expenses) by the business processes at any given time—an indicator which always interests executive management and is easily understood. The bottom line is that most businesses have no clue about the costs of their processes nor their processes various outputs [5]. Another part of the problem involves attitudes. For some qual- ity professionals, using quality to connect with the bottom line or with executive thinking may seem irrelevant or, worse yet, destructive. These quality professionals fear the danger of managers who myopically focus on short-term results. In short, understanding the economic contribution toward increasing shareholder wealth from individual business processes is a significant concern for management. When the costs of processes and their outputs can be adequately meas- ured financially, two things can happen: 1. The data can gain management’s attention and confi- dence that they can depend on these managerial account- ing data as reliable business indicators. 2. Management can more reliably assess the different worth of processes and how they contribute to the overall per- formance of the business. Finally, another part of the problem is accountants and defi- ciencies with their financial accounting system. The account- ants’ traditional general ledger is a wonderful instrument for what it is designed to do: post and bucketize (i.e., categorize) transactions into their specific account balances. But the cost data in this format (e.g., salaries, supplies, depreciation) are structurally deficient for decision support, including measur- ing cost of quality (COQ). The accounting community has been slow to understand and accept this problem. 23.4 QUALITY MANAGEMENT AACE INTERNATIONAL
- 290. The quality professional’s focus should be on the quality of cost as well as the COQ. That is, focusing on the quality of cost ensures that any money spent on the business produces its equivalent in value for the customer and the supplier’s employees and shareholders. The COQ measures how much cost is caused by poor quality. Both are important. This is a before-investment view in contrast to an after-the-fact view. The next section discusses the issues related to measuring the financial dimensions of quality. BRING FACTS, NOT HUNCHES To some people, it is obvious that better management of qual- ity ultimately leads to goodness that, in turn, should lead to improved financial health of an organization. Perhaps some of these same people have difficulty imagining a bridge of linkages that can equate quality improvements with exactly measured costs or profits. However, for them this does not matter very much. These types of people operate under the belief that if you simply improve quality, good things, such as happier customers and higher profits, will automatically fall into place. Other types of people prefer having fact-based data and rea- sonable estimates with which to evaluate decisions and pri- oritize spending. These types of people do believe in quality programs, but in complex organizations with scarce idle resources, they prefer to be more certain they know where it is best to spend the organization’s discretionary money. Some quality managers have become skeptical about measur- ing the COQ. They have seen increasing regulations and stan- dards, such as the ISO 9000 series, where installing any form of COQ measurement was perceived as more of a compliance exercise to satisfy documentation requirements to become “reg- istered” rather than a benefit to improve performance. Some perceive quality and cost as an investment choice, implying that there is a trade-off decision. This thinking assumes that achieving better quality somehow costs more and requires more effort. This is not necessarily true. If qual- ity programs are properly installed, productivity can be improved while also raising customer satisfaction. These two combined eventually lead to increased sales, market penetra- tion, and higher profits and returns. Managers in the quality field have seen a number of quality programs and tools come along. Some have fallen short of their initial promise. The ISO 9000 series is the popular inter- national standard. It addresses not only products and service lines but also the processes and policies of an organization. The benefits of the ISO 9000 accreditation included relieving buyers of redundant supplier assessments, expansion of assessments to the suppliers’ suppliers, protection against product liability litigation, and a firm foundation upon which organizations could potentially further develop their quality development. However, a disadvantage of ISO 9000 is that it represents only a minimum standard, perhaps insufficient to induce competitive-advantage behavior. Also, due to its being written in general terms, with a manufacturing origin, it is open to interpretation with ambiguities for service sector organiza- tions. Some complain that ISO 9000 serves as a documentation tool with little extension to apply as a managerial tool. Now, Six Sigma is vying to exhibit staying power as a quality management program. Will it succeed, or is there an inherent flaw? Six Sigma is viewed as a paradigm shift in the quality arena. Veterans of quality management believe that quality just for quality’s sake—meaning conformance to standard—is not good. This sounds paradoxical. Quality is obviously need- ed to capture and retain customers, but quality must also be applied to the business itself. Six Sigma ensures that there is emphasis on the conversion and the paperwork-related trans- action processes as well. But Six Sigma goes much farther and also suggests consideration of the business’ financial health. A popular definition of quality preferred by Six Sigma advo- cates is quality is a state in which value entitlement is real- ized for the customer and the supplier (i.e., employees and shareholders) in every aspect of the relationship. It is pre- dictable that there will be debates about trade-offs among shareholders, customers, employees, taxpayers, and the envi- ronment. The methods of COQ measurement will be useful to convert debates into agreements [3]. This new perspective acknowledges that investing addition- al capital intended to reduce defect rates will not be sus- tained unless shareholders and lenders feel assured of high- quality financial returns to them. In Six Sigma, financial data to support manager proposals for projects are absolutely required. So, just like customers who demand utility-value, owners, investors, and lenders have a rightful expectation of profit-value and wealth creation. This broader notion of quality is well beyond the more narrow TQM of the 1990s. For producers, it is no longer enough to just make and deliver quality goods and services. A quality busi- ness must exist as well. The intent of Six Sigma is to refocus on business economics as the driver of quality improvements. WHAT IS QUALITY? Before discussing the various costs of quality and how to measure them, one should have a definition of quality itself. To some the term quality might mean durability or richness in a product or a pleasurable experience. This is a “fitness for use” definition that relates to a customer’s needs. In the 1980s, a predominant supplier-oriented view defined quality 23.5 AACE INTERNATIONAL QUALITY MANAGEMENT
- 291. as being a high conformance to the buyer’s requirements or specifications, usually measured at the time of final product test. One of the risks of limiting the definition of quality to a supplier “doing things right” is that it can miss the cus- tomers’ real needs and preferences. More recently, quality has been considered from a customer satisfaction orientation to meet or exceed customer require- ments and expectations. This shifts the view from the sell side to the buy side. There has been substantial research about cus- tomer preferences, both stated and subconscious, with elabo- rate survey questionnaires, diagnostics, and conjoint statisti- cal analysis. For example, “food” may be a customer’s stated need, but “nourishment” or a “pleasant taste” are the real pri- mary needs. A customer’s ultimate perception of quality involves many factors. In short, the universally accepted goals of quality management are lower costs, higher revenues, delighted customers, and empowered employees. IMPACT OF POOR QUALITY Almost every organization now realizes that not having the highest quality is not even an option. High quality is simply an entry ticket for the opportunity to compete. Attaining high quality is now a must. Anything less than high quality will lead to an organization’s terminal collapse. In short, high quality is now a prerequisite for an organization to continue to exist. The stakes are much higher. The quality techniques that have been applied in the past, however, are still relevant. One of leaders in the quality movement, Joseph M. Juran, has described managing for quality by using three managerial steps, called the Juran Trilogy [4, p. 2–7]: 1. Quality planning—translating customer needs into characteristics of products and service lines (e.g., quality function deployment analysis). 2. Quality control: measuring quality levels and compar- ing them against desired levels (i.e., removing sporadic deficiencies). 3. Quality improvement: implementing incremental improvements to attain better levels of control (i.e., removing chronic deficiencies). Figure 23.2 shows that each step leads to a result used in the next step. In the figure, sporadic problems are those that periodically occur and are dealt with shortly after they happen. In effect, the problem is quickly corrected until the process or off-spec output is returned to an acceptable level. Sporadic problems will likely continue to recur because the solution is usually more a bandage than a real cure. Chronic problems, in contrast, have usually existed for an extended period of time and may be accepted or tolerated by 23.6 QUALITY MANAGEMENT AACE INTERNATIONAL Figure 23.2—Juran’s Trilogy
- 292. the organization as known but unresolvable. Examples include poor communications or inad- equate tools for workers. Employees are often resigned to the existence of chronic problems. They are undesirable but expected to persist because they have been subconsciously designed and planned into the processes and procedures. Organizations tend to concentrate on sporadic problems because when they occur there is usu- ally an adverse consequence, such as a customer complaint or a missed delivery date. But the fix may not necessarily be lasting. In contrast, the elimination of chronic problems requires greater effort. The solution may be the result of forming a project team that produces an innovative solu- tion. The problem analysis will likely be more intent on truly understanding the root cause. When root causes of chronic problems are removed, improvements in performance and costs can be substantial. In Figure 23.2, sporadic problems can spike from an unplanned event, such as a power failure. Immediately fol- lowing these events teams troubleshoot and “put out the fire,” which restores the error level back to the status quo— the planned chronic level. The figure also reveals that after a quality improvement initiative addresses the process, the level of error is driven downward. Another leader in the quality movement, W. Edwards Deming, advocated a similar and now well-accepted set of steps with his “Plan-Do-Check-Act” (PDCA) cycle, an itera- tive approach to achieving preventive and corrective solu- tions [4, p. 41.3–41.5]. Some now have reduced PDCA to a more simple “Do-and-Reflect.” Regardless of the quality techniques applied, financial measures will be increasingly relevant as organizations move from decisions based on instinct and intuition toward fact-based decisions. CATEGORIZING QUALITY COSTS To some people quality costs are very visible and obvious. To others, quality costs are understated; and they believe that much of the quality-related costs are hidden and go unreported. There are several levels of non-error-free quality costs, as illustrated in Figure 23.3. The following discussion of scope is restricted to the inner concentric circles, although there are additional quality costs. Figure 23.3 begins to reveal that there are other hidden finan- cial costs and lost income opportunities beyond those associ- ated with traditional obvious quality costs. Examples of obvi- ous quality-related costs are rework costs, excess scrap mate- rial costs, warranty costs, and field repair expenses. These typically result from errors. Error-related costs are easily measured directly from the financial system. Spending amounts are recorded in the accountant’s general ledger sys- tem using the “chart-of-accounts.” Sometimes the quality- related costs include the expenses of an entire department, such as an inspection department that arguably exists solely as being quality-related. However, as organizations flatten and de-layer, and employees multitask more, it is rare that an entire department will focus exclusively on quality. The hidden poor quality costs, represented in the figure’s outer circle, are less obvious and are more difficult to meas- ure. For example, a hidden cost would be those hours of a few employees’ time sorting through paperwork resulting from a billing error. Although these employees do not work in a quality department that is dedicated to quality-related activities, such as inspection or rework, that portion of their workday was definitely quality-related. These costs are not reflected in the chart-of-accounts of the accounting system. That is why they are referred to hidden costs. The lack of widespread tracking of the COQ in practice is surprising because the tools, methods, and technologies exist to accomplish reporting COQ. A research study [6] investi- gating the maturity of COQ revealed that the major reason for not tracking COQ was lack of management interest and sup- port in tracking COQ and their belief that quality costing is “paperwork” that does not have enough value to do. Other major reasons for not tracking COQ were a lack of knowledge 23.7 AACE INTERNATIONAL QUALITY MANAGEMENT Figure 23.3—Levels and Scope of Quality Costs
- 293. of how to track costs and benefits of COQ as well as a lack of adequate accounting and computer systems. Given the advances in today’s data collection, data warehousing, data mining, and ABC/M system implementations, these reasons begin to appear as lame excuses—the technology is no longer the impediment for reporting COQ that it once was. Providing employee teams with visibility of both obvious and hidden quality-related costs can be valuable for per- formance improvement. Using the data, employees can gain insights into causes of problems. The hidden and traditional costs can be broadly categorized as follows: • Error-free costs are costs unrelated to planning of, con- trolling of, correcting of, or improving of quality. These are the did-it-right-the-first-time (nicknamed “dirtfoot”) costs. • COQ are costs that could disappear if all processes were error-free and if all products and services were defect- free. COQ can be subcategorized as -costs of conformance—the costs related to prevention and predictive appraisal to meet requirements. -costs of noncomformance—the costs related to internal or external failure, including detective appraisal work, from not meeting requirements. The distinction between internal versus external is that internal failure costs are detected prior to the shipment or receipt of service by the customer. In contrast, external failure costs result usually from discovery by a customer. An oversimplified definition of COQ is the costs associated with avoiding, finding, making, and repairing defects and errors (assuming that all defects and errors are detected). COQ represents the difference between the actual costs and what the reduced cost would be if there were no substandard service levels, failures, or defects. Simple examples of these categories for a magazine or book publisher might be as follows: • Error-free—“first time through” work without a flaw; • Prevention—training courses for the proofreaders, and preventive maintenance on the printing presses; • Appraisal—proofreading; • Internal failure—unplanned printing press downtime, and correction of typographical errors; and • External failure—rework resulting from a customer complaint. There are other quality-related costs depicted in the outer levels that are somewhat more difficult to measure but may be relevant in decision analysis. These additional concentric rings of costs are supply chain-related: • Postponed profits (current)—profits that could not be formally recognized during a specific financial account- ing period because the goods and services did not satis- fy all of the customer’s requirements. The impact is deferred cash inflow. • Lost profits (permanent)—the sales and profit opportu- nity permanently lost when a customer elects to switch to a competitor or substitute or no longer purchase due to a bad experience. • Customer incurred costs—all of a customer’s COQ (plus postponed and lost profits from the customer’s customers) caused by the supplier’s nonconformance. Examples include the customer’s own rework, its equipment repair, or its tarnished name due to reduced service levels. Some people may argue that an additional level of socioe- conomic costs exists where the public and community are affected, such as when an oil spill or pollution occur. This is represented in Figure 23.3 as the most outside concentric ring of costs. Figure 23.4 uses a pie chart to portray, in financial terms, how an organization’s sales, profits, purchased materials, and COQ expenses might exist. In principle, as the COQ expens- es are reduced, they can be converted into higher bottom line profits. Figure 23.5, titled “ABC/M’s Attributes Can Score and Tag Costs,” illustrates how “attributes” can be tagged or scored into increasingly finer segments of the error-free and COQ subcategories. Attributes are tagged to individual activities 23.8 QUALITY MANAGEMENT AACE INTERNATIONAL Figure 23.4—Sales, Costs, and Profits
- 294. for which the activities will already have been costed using activity-based cost management (ABC/M). Hence, the subcat- egory costs can be reported with an audit trail back to which resources they came from. Each of the subattributes can be fur- ther subdivided with deeper “indented” classifications. Because 100 percent of the resource costs can be assigned to activities, 100 percent of the activities can be tagged with one of the COQ attributes, since the activities have already been costed by ABC/M. The attribute groupings and summary roll-ups are automatically costed as well. Life would be nice in an error-free world, and an organiza- tion’s overall costs would be substantially lower relative to where they are today. But all organizations will always make mistakes and errors. They will always experience some level of errors. However, the goal is to manage mistakes and their impact. Cost quality serves to communicate fact-based data—in terms of money—to enable focusing and prioritiz- ing to manage mistakes. As previously mentioned, unless an entire department’s exis- tence is fully dedicated to one of the COQ subcategories, or an isolated chart-of-account expense account fully applies to a COQ category, most of the COQ spending is hidden. That is, the financial system cannot report those costs. A danger exists if only a fraction of the quality-related costs are measured and their amount is represented as the total quality costs—this is a significant understating of the actual costs. Unfortunately, there are as many ways of hiding qual- ity costs as there are people with imagination. Organizations that hide their complete COQ from themselves continue to risk deceiving themselves with an illusion that they have effective management. ABC/M is an obvious approach to making visible the missing COQ amount of spending. WHERE DO QUALITY COSTS RESIDE IN THE ACCOUNTANT’S FINANCIAL STATEMENT? It may make it easier to think of the sum total of all of the cost categories (i.e., error-free or COQ) as equating to the total expenditures during a time period, less purchased material costs, that make up a company’s budget state- ment. For any nonprofit organization, their budget-funded expenditures “equals” error-free costs “plus” COQ. (If there are fees or revenues, then these are simply added to the budget-funded amount.) One hundred percent of the total expenditures can be accounted for and included. Figure 23.6 illustrates the distri- bution of quality costs using the subcategories that were described in Figure 23.5. An example of a commercial com- pany will be used to demonstrate how quality can be meas- ured financially. The parallels to a government or nonprofit organization are high. 23.9 AACE INTERNATIONAL QUALITY MANAGEMENT Figure 23.5—ABC/M’s Attributes Can Score and Tag Costs
- 295. In this example, a fictitious manufacturer with revenues of $200,000 enjoys a healthy 5 percent profit-to-sales rate and purchases roughly half of its expenditures, $90,000, from its suppliers. The remaining expenses of $100,000 were not directly purchased from external suppliers; 80 percent of these were error-free, but 20 percent involved quality-related work. (In advanced COQ analysis, portions of the external purchases, such as for contract labor, can also be included for segmentation as error-free versus COQ. Externally pur- chased services are rarely perfect.) Sales $200,000 Expenses Purchased direct material < 90,000> Labor, supplies, and overhead <100,000> this equates to the total expenses not purchased from suppliers (i.e., error-free + COQ) ________ Profit $10 ,000 (5% of sales) In Figure 23.6, the majority of the costs of $20,000 quality-relat- ed costs are classified as external failure ($12,000). That is, the product or service-line was unsuccessful after being received by the end-customer. In theory, if half of that type of COQ expense (i.e., $6,000) could be eliminated, and presuming the freed-up capacity can be redeployed elsewhere, then the profits would rise by $6,000 from $10,000 to $16,000—a 60 percent jump! The profit rate would increase from 5 to 8 percent of sales. Figure 23.7 displays how the COQ histogram from Figure 23.6 could ideally appear after both prevention and appraisal spending is initially increased, and then process efficiencies are applied to drive all of the COQ costs down. BENEFITS FROM INCLUDING TOTAL EXPENDITURES WHEN MEASURING QUALITY Starting the measurement by assuming a 100 percent inclu- sion of the total expenditures, then subsequently segmenting those expenses between the error-free costs and the COQ has the following results: • reduces debate—With traditional COQ measures, peo- ple can endlessly debate whether a borderline activity is a true COQ, such as scrap produced during product development that may arguably be expected. Including such a cost as COQ may inflate a measure that is of high interest. By excluding it, that expense melts away with- out any visibility into all the other total expenditures of the organization. It can be tempting for controversial costs to be excluded as a quality-related cost category. By starting with the 100 percent expenditure pool, every cost will fall into some category and always be visible. Each type of cost can always be reclassified later on, as people better understand how to use the data. • increases employee focus—By developing classifica- tions into which all costs can be slotted, organizations will hopefully focus much less on their methods of meas- urement and focus much more on their organization’s problems and how to overcome them. • integrates with the same data used in the boardroom— When traditional and obvious COQ information is used, only portions of the total expenditures are selected for 23.10 QUALITY MANAGEMENT AACE INTERNATIONAL Figure 23.6—COQ Histogram Figure 23.7—Getting Efficient with Conformance-Related COQ
- 296. inclusion. This invites debate about arbitrariness or ambiguity. However, when 100 percent of expenditures are included, the COQ plus error-free costs exactly rec- oncile with the same data used by executive manage- ment and the board of directors. There is no longer any suspicion that some COQ has been left out or that the COQ data are not anchored in reality. By starting with 100 percent expenditures, the only debate can be about misclassification, not omission. The capture of COQ can be further refined if it is worthwhile for the organization. When making decisions, the universally popular costs-ver- sus-benefits test can be applied with COQ data. If either sub- category of COQ is excessive, it draws down profits for com- mercial companies or draws down resources in government agencies that could have been better deployed on higher- value-added activities elsewhere. GOALS AND USES FOR THE COQ INFORMATION If an organization makes the effort to collect data, validate the information, and report it, it might as well use the infor- mation. In fact, to state the obvious, the amount of use of and utility in the information will be proportional to the length of life of the COQ measurement system. In short, the uses of a COQ measurement system can range from favorably influ- encing employee attitudes toward quality management by quantifying the financial impact of changes to assisting in prioritizing improvement opportunities. The rationale for implementing COQ is based on the follow- ing logic: • For any failure, there is a root cause. • Causes for failure are preventable. • Prevention is cheaper than fixing problems after they occur. If you accept the logic that it is always less expensive to do the job right the first time than to do it over, the rationale and goal for quality management and using COQ to provide a quality program with concrete and fact-based data should be apparent. Implementation involves the following steps: • Directly attack failure costs with the goal to drive them to zero. • Invest in the appropriate prevention activities, not fads, to effect improvements. • Reduce appraisal costs according to results that are achieved. • Continuously evaluate and redirect prevention efforts to gain further improvement. Figure 23.8 on page 23.12 illustrates the direction in which qual- ity-related costs can ideally be managed. Ideally, all four COQ cost categories should be reduced, but one may initially need to prudently increase the cost of prevention to dramatically decrease the costs of and reduced penalties paid for nonconfor- mance. This makes COQ more than just an accounting scheme; it becomes a financial investment justification tool. A general corrective operating principle is that as failures are revealed, for example via customer complaints, the root caus- es should be eliminated with corrective actions. A general rule-of-thumb is that the nearer the failure is to it being used by the customer, the more expensive it is to correct. The flip side is that it is less expensive—overall—to fix problems ear- lier in the business process. As failure costs are reduced, appraisal efforts can also be reduced in a rationale manner. QUANTIFYING THE MAGNITUDE OF THE COSTS OF QUALITY The formal COQ measurement system provides continuous results. In contrast to a one-time assessment, it requires involvement by employees who participate in the business processes. More important, these employees must be moti- vated to spend the energy and time, apart from their regular responsibilities, to submit and use the data. Commercial ABC/M software products were designed for frequent repeated updating. For such a COQ system to be sustained longer-term, the system requires senior manage- ment’s support and interest as well as genuinely perceived utility by users of the data to solve problems. Regardless of the collection system selected, it is imperative to focus analytical and corrective time and energy on the area of failure costs. As Dr. Joseph Juran discussed in his highly popular article, “Gold in the Mine,” there is still much “min- ing” that can be performed [4, p. 8.1–8.11]. This mining should be considered a long-term investment, because failure costs, when starting a quality management program, usually constitute 65 to 70 percent of a corporation’s quality costs. Appraisal costs are normally 20 to 25 percent, and prevention costs are 5 percent. CONTINUOUS IMPROVEMENT WITH BENCHMARKING AND UNIT COSTS Tagging attributes onto costs is obviously a secondary pur- pose for measuring costs. The primary purpose for costing is to simply know what something costs. This data allows you 23.11 AACE INTERNATIONAL QUALITY MANAGEMENT
- 297. QUALITY MANAGEMENT AACE INTERNATIONAL 23.12 to measure profit margins, to focus on where the larger costs are that may be impacted, or to estimate future costs to justi- fy future spending decisions (e.g. ROI). In short, managerial accounting transforms expenses into calculated costs. That is, expenses are postings to the general ledger bookkeeping sys- tem to recognize exchanges of money to vendors and employees. Expenses are purchases of resources. In contrast, costs are the uses of that spending. Costs are always calculat- ed. Many organizations arbitrarily “allocate” costs based on broadly-averaged volume factors, but the proper rule is to trace and assign the expense based on a one-to-one cause- and-effect relationship. When an organization has good costing, then it can use cal- culated costs, such as the cost per processed invoice, as a basis for comparison. In short, the unit cost per each output of work is computed and then this data is usable for bench- marking—either internally or with other organizations. The use of ABC/M data is becoming more popular as a met- ric for benchmarking. Often in benchmarking studies, there can be a bad case of apples-to-Oreo’s. That is, there is lack of unrecognized comparability amongst the participating organizations. There is lack of consistency among what work activities or outputs are to be included or excluded in the study. An ABC/M methodology and system introduces rigor and is sufficiently codified and leveled for relevancy as to remove this nagging shortcoming of benchmarking. In practice, the vast majority of ABC/M is applied to subsets of the organization for process improvement rather than rev- enue enhancement and profit margin increases. An example of a subset is an order processing center or equipment mainte- nance function. These ABC/M models and systems are designed to reveal the cost structure to the participants in the main department and related areas. In ABC/M’s cost assign- ment view, the cost structure is seen from the orientation of how the diversity and variation of the function’s outputs cause various work to happen, and how much. The costs of the work activities that belong to the processes are also revealed in the ABC/M model as they relate in time and sequence. However, it is ABC/M’s powerful revealing of the costs of various types of outputs that serves as a great stimulant to spark discussion and discovery. For example, if an order processing center learns that the cost per each adjusted order is roughly eight times more costly than for each error-free or adjustment-free entered order, that would get people’s attention. This result happens even if the order entry process has been meticulously diagrammed, flowcharted, and documented. DECONSTRUCTING COQ CATEGORIES In effect, the technique to calculate a reasonably accurate COQ is to apply ABC/M and ABC/M’s attribute capability. Figure 23.9 shows categories for work activities that are one additional level below the four major categories of COQ. This Figure 23.8—Driving Cost-of-Quality Downward
- 298. figure reveals how each of these subcategories can be tagged against the ABC/M costs. This provides far greater and reli- able visibility of COQ without the great effort required by traditional cost accounting methods. The quality movement has been a loud advocate for measur- ing things rather than relying on opinions. It would make sense that measuring the financial implications of quality will become an increasingly larger part of the quality man- agement domain. SUMMARY The reputation of quality management movement has expe- rienced a few waves of ups and downs. It has become almost religious-like for some years and then ridiculed. Hopefully, the addition of valid costing data will give the quality move- ment more legitimacy. In a recent publication from one of the key sanctioning quality societies, The American Society for Quality (ASQ), there was a key definition. ANSI/ISO/ASQ Q9004-2000 suggests financial measurement as an appropri- ate way to assess “the organization’s performance in order to determine whether planned objectives have been achieved [1]. Hopefully there will be increased coordination amongst the quality, managerial accounting, and operations system. REFERENCES 1. American Society for Quality. 2000. ANSI/ISO/ASQ 9004-2000. Milwaukee, Wisconsin: ASQ Quality Press. 2. Cokins, Gary. 2001. Activity-Based Cost Management: An Executive’s Guide. New York: John Wiley & Sons. 3. Harry, Mickel J. 2000. New Definition Aims to Connect Quality with Financial Performance. Quality Progress. January. p. 65. 4. Juran, Joseph M. 1999. Juran’s Quality Handbook. New York: McGraw-Hill. 5. Pall, Gabe. 2000. The Process-Centered Enterprise. New York: St. Lucie Press. p. 40. 6. Sower, Victor E., and Ross Quarles. 2002. Cost of Quality Usage and Its Relationship to Quality Systems Maturity. Working Paper series. Center for Business and Economic Development at Sam Houston State University. Lucie Press, 2000), p. 40. 23.13 AACE INTERNATIONAL QUALITY MANAGEMENT Figure 23.9—Typical Cost-of-Quality Components
- 300. INTRODUCTION The objective of the value analysis (VA) study is to improve the value for the intended project objectives. This VA practice chapter covers a procedure for defining and satisfying the requirements of the user/owner’s project. A multidiscipli- nary team uses the procedure to convert design criteria and specifications into descriptions of project functions and then relates these functions to revenues and costs. All examples of costs presented are relevant costs over a des- ignated study period, including the costs of obtaining funds, designing, purchasing/leasing, constructing/installing, operating, maintaining, repairing, and replacing and dispos- ing of the particular item, design or system. While not the only criteria, cost is an important basis for comparison in a VA study of a building. Therefore, accurate and comprehen- sive cost data is an important element of the analysis. The following are guidelines for developing alternatives that meet the project’s required functions: • Estimate the costs for each alternative. • Provide the user/owner with specific, technically accu- rate alternatives, appropriate to the stage of project development, which can be implemented. • The user/owner then selects the alternative(s) that best satisfies the needs and requirements. This methodology can be applied to an entire project or to any subsystem. The user/owner can utilize the VA methodology to improve the element or scope of the project to be studied. LEARNING OBJECTIVES After completing this chapter, the reader should be able to • develop alternatives to a proposed design that best ful- fills the needs and requirements of the user/owner of the project or system. • identify the functions of the project and its systems; • develop alternatives to fulfill the user’s/owner’s needs and requirements; and • evaluate the alternatives in their ability to meet defined criteria. VALUE ANALYSIS SIGNIFICANCE AND USE Perform VA during the planning, design, and final phases of a project, product, program, system or technique. The most effective application of VA is early in the design phase of a project. Changes or redirection in the design can be accom- modated without extensive redesign at this point, thereby saving the user/owner time and money. During the earliest stages of design, refer to VA as value plan- ning. Use the procedure to analyze predesign documents— for example, program documents and planning documents. At the predesign stage, perform VA to define the project’s functions, and to achieve consensus on the project’s direction and approach by the project team. By participating in this early VA exercise, members of the project team communicate their needs to other team members and identify those needs in the common language of functions. By expressing the proj- ect in these terms early in the design process, the project team minimizes miscommunication and redesign, which are cost- ly in both labor expenditures and potential schedule delays. Also, perform VA during schematic design (up to 15 percent design completion), design development (up to 45 percent design completion), and completion documents (up to 100 percent design completion). Conduct VA studies at several stages of design completion to define or confirm project func- tions, to verify technical and management approaches, to analyze selection of equipment and materials, and to assess the project’s economics and technical feasibility. Perform VA studies concurrently with the user/owner’s design review schedules to maintain the project schedule. Through the schematic design and design development stages, the VA 24.1 AACE INTERNATIONAL VALUE ANALYSIS Chapter 24 Value Analysis Del L. Younker, CCC
- 301. team analyzes the drawings and specifications from each technical discipline. During the completion (such as con- struction or manufacturing) documents stage, the VA team analyzes the design drawings and specifications, as well as the details and equipment selection, which are more clearly defined at this later stage. A VA study performed at a 90 to 100 percent completion stage, just prior to bidding, concentrates on buildability, eco- nomics and technical feasibility. Consider methods of con- struction, phasing of construction, and procurement. The goals at this stage of design are to minimize costs and maxi- mize value; reduce the potential for claims; analyze manage- ment and administration; and review the design, equipment and materials used. During construction or other completion means, analyze value analysis change proposals (VACPs) of the contractor. VACPs reduce the cost or duration of construction or present alterna- tive methods of construction, without reducing performance, acceptance, or quality. At this stage, the alternatives presented to the user/owner are VACPs. To encourage the contractor to propose worthwhile VACPs, the owner and the contractor share the resultant savings when permitted by contract. The numbering and timing of VA studies varies for every project. The user/owner, the design professional, and the value analyst determine the best approach jointly. A complex or expensive facility or a design that will be used repeatedly warrants a minimum of two VA studies performed at the pre- design and design development stages. VALUE METHODOLOGY STANDARD FORWARD Since 1947, the methods, technology, and application of the value methodology (VM) has greatly increased and expand- ed. VM includes the processes known as value analysis, value engineering, and value management. It is sometimes also referred to as value control, value improvement, or value assurance. This standard defines common terminology, offers a standardized job plan (while allowing the great diversity of individual practices that have been successfully developed), and is offered to reduce confusion to those being introduced to VM. The standard includes the approved job plan, the body of knowledge as developed by the SAVE International professional ccertification board, typical profiles of the value specialist and value manager, duties of a value organization, a glossary, and an appendix of references. Learn more about the VM by reviewing the SAVE International Web site www.value-eng.org. VM Applicability The VM can be applied wherever cost and/or performance improvement is desired. That improvement can be measured in terms of monetary aspects and/or other critical factors such as productivity, quality, time, energy, environmental impact, and durability. VM can beneficially be applied to vir- tually all areas of human endeavor. The VM is applicable to hardware, building or other con- struction projects, and to “soft” areas such as manufacturing and construction processes, healthcare and environment al services, programming, management systems, and organiza- tion structure. The prestudy efforts for these soft types of projects utilizes standard industrial engineering techniques, such as flow charting, yield analysis, and value added task analysis to gather essential data. For civil, commercial and military engineering works such as buildings, highways, factory construction, and water/sewage treatment plants, which tend to be one-time applications, VM is applied on a project-by-project basis. Since these are one- time capital projects, VM must be applied as early in the design cycle as feasible to achieve maximum benefits. Changes or redirection of design can be accomplished with- out extensive redesign, large implementation cost, and schedule impacts. Typically for large construction projects, specific value studies are conducted during the schematic stage and then again at the design development (up to 45 percent) stage. Additional value studies may be conducted during the final completion stages. For large or unique products and systems such as military electronics or specially designed capital equipment, VM is applied during the design cycle to assure meeting of goals and objectives. Typically, a formalized value study is per- formed after preliminary design approval but before release to the build/manufacture cycle. VM may also be applied during the build/manufacture cycle to assure that the latest materials and technology are utilized. VM can also be applied during planning stages and for proj- ect/program management control by developing function models with assigned cost and performance parameters. If specific functions show trends moving toward or beyond control limits, value studies are performed to assure the func- tion’s performance remains within the control limits. VALUE STUDY TEAM A key to the successful application of a value study is the skills and experience of those applying the methodology. While the methodology can, and often is, used by individu- als, it has been proven that a well-organized team obtains the best value for effort performed for significant projects . 24.2 VALUE ANALYSIS AACE INTERNATIONAL
- 302. The team leader performs a key role and is a significant fac- tor in the degree of success. The team leader must have thor- ough training in both the VM and team facilitation. The requirements include strong leadership, communication skills, and experience working with users/clients. The size and composition of the team is project dependent. The members should represent a diverse background and experience that incorporates all the knowledge required to fully cover the issues and objectives of the project. Typically, these include cost, estimating, procurement/materials, and those technical disciplines unique to the project such as design, manufacturing, construction, environmental, and marketing, etc. It is most advantageous for the team leader, or a team mem- ber, to implement the approved value proposals at study completion. Decisions based primarily upon one technical discipline will often have significant effects on other disciplines within the project. In addition to being technically competent, team member selection should include individuals who represent the range of disciplines and end users the study results will impact. They must be individuals who generate positive atti- tudes and are willing to investigate new ideas and then rationally evaluate them. THE VALUE METHODOLOGY JOB PLAN The VM uses a systematic job plan (Table 24.1). The job plan outlines specific steps to effectively analyze a product or service in order to develop the maximum number of alterna- tives to achieve the product’s or service’s required functions. Adherence to the job plan will better assure maximum bene- fits while offering greater flexibility. 24.3 AACE INTERNATIONAL VALUE ANALYSIS GLOSSARY TERMS IN THIS CHAPTER agenda ◆ constructability reviews ◆ cost ◆ cost-design cost-life cycle ◆ cost model ◆ cost/worth ratio Function ◆ function-basic ◆ function-secondary function models ◆ hierarchy ◆ function analysis system technique (fast) ◆ job plan ◆ performance ◆ price product ◆ scope ◆ value ◆ value-monetary value methodology ◆ value methodology proposal value study ◆ value methodology training ◆ value analyst value engineer ◆ value engineering change proposal (VECP) value specialist ◆ worth PRESTUDY collect user/customer attitudes complete data file determine evaluation factors scope the study build data models determine team composition VALUE STUDY Information Phase complete data package modify scope Function Analysis Phase identify functions classify functions develop function models establish function worth cost functions establish value index select functions for study Creative Phase create quantity of ideas by function Evaluation Phase rank and rate alternative ideas select ideas for development Development Phase conduct benefit analysis complete technical data package create implementation plan prepare final proposals Presentation Phase Present Oral Report Prepare Written Report Obtain Commitments for Implementation POST-STUDY complete changes implement changes monitor status *The VM Job Plan covers three major periods of activity: prestudy, the value study, and post-study. All phases and steps are performed sequentially. As a value study progresses new data and information may cause the study team to return to earlier phases or steps with- in a phase on an iterative basis. Conversely, phases or steps within phases are not skipped. Table 24.1—The VM Job Plan
- 303. PRESTUDY Preparation tasks involve six areas: (a) collecting/defining user/customer wants and needs, (b) gathering a complete data file of the project, (c) determining evaluation factors, (d) scoping the specific study, (e) building appropriate models, and (f) determining the team composition. a. Collect User/Customer Attitudes—The user/customer attitudes are compiled via an in-house focus group and/or external market surveys. The objectives are to 1. determine the prime buying influence; 2. define and rate the importance of features and charac- teristics of the product or project; 3. determine and rate the seriousness of user-perceived faults and complaints of the product or project; 4. compare the product or project with competition or through direct analogy with similar products or projects. For first time projects such as a new product or new construc- tion, the analysis may be tied to project goals and objectives. The results of this task will be used to establish value mis- matches in the information phase. b.Gather a Complete Data File—There are both primary and secondary sources of information. Primary sources are of two varieties: people and documentation. People sources include marketing (or the user), original designer, archi- tect, cost or estimating group, maintenance or field service, the builders (manufacturing, constructors, or systems designers), and consultants. Documentation sources include drawings, project specifications, bid documents and project plans. Secondary sources include suppliers of similar products, literature such as engineering and design standards, regu- lations, test results, failure reports, and trade journals. Another major source is like or similar projects. Quantitative data is desired. Another secondary source is a site visitation by the value study team. “Site” includes actual construction location, manufacturing line, or office location for a new/improved system. If the actual “site” is not available, facilities with comparable functions and activities may prove to be a valuable source of usable information. c. Determine Evaluation Factors—The team, as an impor- tant step in the process, determines what will be the crite- ria for evaluation of ideas and the relative importance of each criteria to final recommendations and decisions for change. These criteria and their importance are discussed with the user/customer and management and concur- rence obtained d.Scope the Study—The team develops the scope statement for the specific study. This statement defines the limits of the study based on the data-gathering tasks. The limits are the starting point and the completion point of the study. Just as important, the scope statement defines what is not included in the study. The study sponsor must verify the scope statement. e. Build Models—Based on the completion and agreement of the scope statement, the team may compile models for fur- ther understanding of the study. These include such mod- els as cost, time, energy, flow charts, and distribution, as appropriate for each study. f. Determine Team Composition, Wrap-Up—The value study team leader confirms the actual study schedule, loca- tion and need for any support personnel. The study team composition is reviewed to assure all necessary customer, technical, and management areas are represented. The team leader assigns data gathering tasks to team members so all pertinent data will be available for the study. Value Study The value study is where the primary VM is applied. The effort is composed of six phases: (a) information, (b) function analysis, (c) creativity, (d) evaluation, (e) development, and (f) presentation. a. Information Phase—The objective of the information phase is to complete the value study data package started in the prestudy work. If not done during the pre-study activities, the project sponsor and/or designer brief the value study team, providing an opportunity for the team to ask questions based on their data research. If a “site” visi- tation was not possible during prestudy, it should be com- pleted during this phase. The study team agrees to the most appropriate targets for improvement such as value, cost, performance, and sched- ule factors. These are reviewed with appropriate manage- ment, such as the project manager, value study sponsor, and designer, to obtain concurrence. Finally, the scope statement is reviewed for any adjust- ments due to additional information gathered during the Information Phase. b.Function Analysis Phase—Function definition and analysis is the heart of VM. It is the primary activity that separates VM from all other “improvement” practices. The objective of this phase is to develop the most beneficial areas for contin- uing study. The team performs the following steps: 1. Identify and define both work and sell functions of the product, project, or process under study using active 24.4 VALUE ANALYSIS AACE INTERNATIONAL
- 304. verbs and measurable nouns. This is often referred to as random function definition. 2. Classify the functions as basic or secondary. 3. Expand the functions identified in step 1 (optional). 4. Build a function model—function hierarchy/logic or function analysis system technique (FAST) diagram (see Figure 24.1). 5. Assign cost and/or other measurement criteria to functions. 6. Establish worth of functions by assigning the previous- ly established user/customer attitudes to the functions. 7. Compare cost to worth of functions to establish the best opportunities for improvement. 8. Assess functions for performance/schedule consider- ations. 9. Select functions for continued analysis 10. Refine study scope c. Creative Phase—The objective of the creative phase (some- times referred to as speculation phase) is to develop a large quantity of ideas for performing each function selected for study. This is a creative type of effort, totally unconstrained by habit, tradition, negative attitudes, assumed restric- tions, and specific criteria. No judgment or discussion occurs during this activity. The quality of each idea will be developed in the next phase, from the quantity generated in this phase. There are two keys to successful speculation: first, the pur- pose of this phase is not to conceive ways to design a prod- uct or service, but to develop ways to perform the func- tions selected for study. Secondly, creativity is a mental process in which past experience is combined and recom- bined to form new combinations. The purpose is to create new combinations which will perform the desired function at less total cost and improved performance than was pre- viously attainable. 24.5 AACE INTERNATIONAL VALUE ANALYSIS Design Objective Design Objective Basic Function Required Secondary Function Required Secondary Function Required Secondary Function Causative Function Higher Order Function SCOPE OF PROBLEM UNDER STUDY Functions that happen "At the Same Time" and/or "Are Caused By" some other function E N I L E P O C S Critical Path Functions Functions that happen "All the Time" WHEN? WHY? HOW? GROUND RULES FUNCTION ANALYSIS SYSTEMS TECHNIQUE Technically-Oriented FAST Figure 24.1—FAST Diagram Example (other examples are found at SAVE International’s Web site www.value-eng.org
- 305. There are numerous well-accepted idea generation tech- niques. The guiding principle in all of them is that judg- ment/evaluation is suspended. Free flow of thoughts and ideas—without criticism—is required. d. Evaluation Phase—The objectives of the evaluation phase are to synthesize ideas and concepts generated in the cre- ative phase and to select feasible ideas for development into specific value improvement. Using the evaluation criteria established during the pre- study effort, ideas are sorted and rated as to how well they meet those criteria. The process typically involves several steps: 1. Eliminate nonsense or “thought-provoker” ideas. 2. Group similar ideas by category within long-term and short-term implications. Examples of groupings are electrical, mechanical, structural, materials, special processes, etc. 3. Have one team member agree to “champion” each idea during further discussions and evaluations. If no team member so volunteers, the idea or concept is dropped. 4. List the advantages and disadvantages of each idea. 5. Rank the ideas within each category according to the prioritized evaluation criteria using such techniques as indexing, numerical evaluation, and team consensus. 6. If competing combinations still exist, use matrix analysis to rank mutually exclusive ideas satisfying the same function. 7. Select ideas for development of value improvement. If none of the final combinations appear to satisfactorily meet the criteria, the value study team returns to the cre- ative phase. e. Development Phase—The objective of the development phase is to select and prepare the “best” alternative(s) for improving value. The data package prepared by the cham- pion of each of the alternatives should provide as much technical, cost, and schedule information as is practical, so the designer and project sponsor(s) may make an initial assessment concerning their feasibility for implementa- tion. The following steps are included: 1. Beginning with the highest ranked value alternatives, develop a benefit analysis and implementation requirements, including estimated initial costs, life cycle costs, and implementation costs, taking into account risk and uncertainty. 2. Conduct performance benefit analysis. 3. Compile technical data package for each proposed alternative. 4. Write descriptions of original design and proposed alternative(s). 5. Include sketches of original design and proposed alternative(s). 6. Calculate cost and performance data, clearly showing the differences between the original design and pro- posed alternative(s). 7. Provide technical back-up data, such as information sources, calculations, and literature. 8. Assess Schedule impact. 9. Prepare an implementation plan, including a pro- posed schedule of all implementation activities, team assignments, and management requirements. 10. Complete recommendations, including any unique conditions to the project under study, such as emerg- ing technology, political concerns, impact on other ongoing projects, marketing plans, etc. f. Presentation Phase—The objective of the presentation phase is to obtain concurrence and a commitment from the designer, project sponsor, and other management to pro- ceed with implementation of the recommendations. This involves an initial oral presentation followed by a complete written report. As the last task within a value study, the VM study team presents its recommendations to the decision making body. Through the presentation and its interactive discussions, the team obtains either approval to proceed with imple- mentation, or direction for additional information needed. The written report documents the alternatives proposed with supporting data and confirms the implementation plan accepted by management. Specific organization of the report is unique to each study and organization requirements. POST STUDY The objective during post-study activities is to assure the implementation of the approved value study change recom- mendations. Assignments are made either to individuals within the VM study team, or by management to other indi- viduals, to complete the tasks associated with the approved implementation plan. While the VM team leader may track the progress of imple- mentation, in all cases the design professional is responsible for the implementation. Each alternative must be independ- ently designed and confirmed, including contractual changes if required, before its implementation into the product, proj- ect, process or procedure. Further, it is recommended that appropriate financial departments (accounting, auditing, etc.) conduct a post audit to verify to management the full benefits resulting from the value methodology study. 24.6 VALUE ANALYSIS AACE INTERNATIONAL
- 306. SUMMARY In conclusion, value analysis is an important part of competing in today’s marketplace. The value improvement process takes shape by following the SAVE International recommended job plan, consisting of information, function analysis, creative, evaluation, development, and presentation/reporting. The main benefit from conducting such VA studies on a pro- gram, project, product, process, system, or technique is that the managers of value improvement programs have a valu- able tool in value analysis for managing the value objectives for which they have control and are expected to produce. The managers’ goals are to produce the best product with the greatest amount of value improvement in the timeframe, allowed and within or under budget according to the cus- tomer’s expectations. VA is only one effective tool to help the manager meet and exceed the project goals. Side benefits from conducting the study are numerous, including better team relations and better project identification and under- standing of the customer’s goals, as well as more improved group dynamics and cohesiveness focused on managing value objectives. REFERENCES 1. Dell’Isola, Alphonse J. 1988. Value Engineering in the Construction Industry. Construction Publishing Co. Van Nostrand Reinhold Co. 2. Miles, Lawrence D. Techniques of Value Analysis and Engineering. Eleanor Miles Walker (publisher). 3. SAVE International Web site. www.value-eng.org. 4. Younker, Del L. Value Engineering, Analysis and Methodology. New York: Marcel Dekker, Inc. 24.7 AACE INTERNATIONAL VALUE ANALYSIS
- 308. INTRODUCTION The purpose of this chapter is to discuss the elements of a contract, various contracting arrangements, changes to con- tracts, and disputes arising under contracts. Cost manage- ment is an integral part of good contract administration. Thus, practicing cost professionals must learn fundamentals of contracts in order to fulfill their role properly. LEARNING OBJECTIVES After completing this chapter, readers should be able to • understand the basic requirements of a contract; • understand how contracts may become defective and, possibly, unenforceable; • understand the types of contracts typically employed in capital projects, their requirements, and the potential advantages and disadvantages of each; • understand typical project delivery methods and how contracts are employed in each method; • understand various key clauses in contracts; • understand what sorts of claims may arise on contracts for capital projects; and • understand how disputes arising under contracts may be resolved. DEFINITION OF CONTRACT A contract is simply an agreement between two or more per- sons that is enforceable at law. It is a business agreement (as opposed to a social transaction), whereby one party agrees to perform work or services for the other party for some con- sideration. Depending upon the nature of the business to be transacted and the jurisdiction in which the work or services are to be performed, contracts may be either written or oral. That is, in some jurisdictions certain types of contracts must be in writing, otherwise they are not enforceable (for exam- ple, in California all contracts for sales of property must be in writing by statute). The difference between a contract and an agreement is the element of legal enforceability. Whenever two parties have a meeting of the minds on a subject, there exists an agreement. It is only when the two parties agree and intend to be legally obligated to perform to the terms and conditions of an agree- ment, does a contract arise. REQUIREMENTS OF A CONTRACT Regardless of the type of contract or the nature of the con- tractual arrangements, to be enforceable, the following basic elements of contract formation must be met: • Offer—To be enforceable, there must be a clear, unequiv- ocal offer to perform the work or services by one party. The offer to perform must be definite, seriously intended and communicated to the other party. • Acceptance—Once an offer has been clearly communi- cated to a party, and that party, or someone authorized to act on their behalf, accepts the offer, a contract can be formed. As with the offer, the acceptance must be com- municated to the party making the offer. Counteroffers do not constitute acceptance. If a party receives an offer and agrees to accept the offer with a condition not included in the original offer, this is a rejection of the original offer and a counteroffer. In such a case, the offer has not been accepted and no contract exists. Of course, the party receiving the counteroffer may accept the coun- teroffer and thus form a contract. • Legality of Purpose—To be an enforceable contract, the work or service to be performed must involve legal activities. For example, a contract to design and con- struct a laboratory to manufacture illegal drugs is likely 25.1 AACE INTERNATIONAL CONTRACTING FOR CAPITAL PROJECTS Chapter 25 Contracting for Capital Projects James G. Zack, Jr.
- 309. to be considered unenforceable, even if it’s in writing and meets all other conditions. • Competent Parties—In order to have an enforceable contract, all parties to the contract must be competent – that is, possess the legal and mental capacity to form a contract. Typically contracts with minors, insane individ- uals, intoxicated persons, convicts (in some states in the U.S.) and enemy aliens are not legally binding. These are, however, fairly rare situations. What is more common is the issue of whether both parties executing a contract have the legal authority to do so. In private contracts, the person asking for an offer is presumed to have the legal authority to contract (apparent authority). A party deal- ing with such an individual has the legal right to assume authority and competency to contract on the part of that individual. In public contract, however, the risk is shift- ed by statute to the party making the offer. That is, there is no apparent authority doctrine applicable to public contracts. The party making the offer has an affirmative obligation to determine whether the public official ask- ing for the offer has the authority to execute a contract and legally bind their public agency to the terms and conditions of the contract. • Consideration—Courts will enforce contracts only when there is consideration. Consideration is another differen- tiating factor between mere agreements and contracts. Consideration, under the law, is whatever one party demands and receives in exchange for the work or serv- ices performed. Typically, of course, consideration for most contracts is monetary in nature. That is, “We will design and construct the specified processing facility for $205,000,000.” However, consideration may be anything the receiving party perceives as having sufficient value to warrant performing the work or services offered. MISTAKES THAT MAKE CONTRACTS DEFECTIVE Despite all of the above, certain mistakes may occur during the contract formation stage that will render a contract unen- forceable. These mistakes include the following: • Mistakes as to the Nature of the Transaction—A mis- take as to the nature of the transaction will render a con- tract void if the mistake was brought about by fraud by one of the contracting parties (e.g., express misrepresen- tation or concealment of material facts). For example, if the parties agree to the design and construction of a facil- ity at a specific location, and it turns out that the proper- ty is not zoned for such a facility, then a mistake as to the transaction has arisen. However, to raise this defense, the party asserting fraud must demonstrate that they, them- selves, were not negligent during contract formation (e.g., never read the terms and conditions of the contract). • Mistakes as to the Identity of a Party—Freedom to con- tract brings with it the right to refuse to contract with some parties. The law cannot compel any party to con- tract with another party they have chosen not to do busi- ness with. If one party is mistaken as to the identity of the party they are contracting with, then the contract is unenforceable. It is, however, incumbent upon contract- ing parties to perform some due diligence during the contract formation stage to determine who they are deal- ing with and deciding whether they will, in fact, execute a contract. • Mutual Mistakes as to the Identity of the Subject Matter—Unlike the mistakes set forth above (which were unilateral mistakes or mistakes on the part of only one party), mistakes as to the identity of the subject mat- ter must be mutual—made by both parties. For example, a party may plan to design, construct, and operate two similar facilities in two different locations. During the bidding process, engineering drawings may be inadver- tently switched such that drawings for facility A may be substituted for those of facility B, a location at which facility A cannot be constructed. Any contract arising under these circumstances will be unenforceable. • Mutual Mistakes as to the Existence of the Subject Matter—If two parties contract for the remod