Guide for Adjustment of Prices in Construction Cost Estimates for Inflation and Changes in Market Conditions for Transport

Scotlands Major Rail Projects Programme

Date:

Q1 2006

Transport Scotland Major Projects Team Buchanan House 58 Port Dundas Road Glasgow Scotland G4 OHF

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Contents
Page Introduction Cost and Price Reason why adjustment of prices is required Impact of price inflators on estimates Recommendations Methodology
Appendices A B C D Suggested Price and Cost Adjustment Factors (at Nov 2005) The RICS BCIS indices Network Rail Suggested Inflation Allowances (Compared with RPI and BCIS TPI) Views of major construction cost consultants compared with other published data 6 7 9 10

1 1 1 2 2 4

Introduction
This guide has been prepared to provide a basis for implementing escalation adjustments to the estimated costs of projects in Transport Scotlands Major Rail Projects portfolio. There are two distinctly different adjustment aspects: 1. Adjustment to reflect the way in which prices move and 2. Adjustment to reflect the way costs move. We have summarised in Appendix A the annual adjustment rates for use on the Transport Scotland major projects. Cost and Price As a preface to this Guide, it is worth highlighting the difference between cost and price as both terms are used extensively throughout this paper:Cost in the context of the adjustment of estimates, the term cost is commonly used when in reality the focus is on the price likely to be paid for the work rather than how much the input resources may cost to use. Strictly speaking, cost is the cost of labour, plant, materials, etc before any addition of the supplier or contractor profit, overheads and risk margins. However, the term cost is also used in the context of the more global sense of prices paid for construction work aggregated across a part or whole of the construction industry. Price is the cost of the work in the marketplace after the addition of the supplier or contractor profit, overheads and risk margins. It is the amount likely to be paid for the work or item by the customer. Reason why adjustment of prices is required Estimates for construction work are produced at a specific point in time and the prices used therein are (unless other parameters are specifically set) relevant only for that date. This is because prices for items supplied and work undertaken are continually subject to market forces. These forces arise from two main directions: 1. inflation (and potentially and alternatively, deflation) and 2. the ever-changing relationship between supply and demand for construction in the market place The driver for price increases in respect of both of the above is primarily related to supply capacity relative to demand. In the case of inflation, the effect is at a macro level, generally affecting the whole economy. In an economists term, inflation is often described as too much money chasing too few goods demand itself being ineffectual unless the capacity to purchase is also present. In the case of basic supply and demand, this can have a significant affect on construction prices in various ways:

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on specific materials (a good example of this recently was in respect of steel prices which were being driven up by strong demand from China relative to world capacity) on specific components (lifts and escalators are a good example of where because of long lead-in periods supply is unable to flex easily to meet sudden peaking in demand and this can impact on prices) on trades (whilst prices can be affected by national wage agreements availability of skilled craftsmen in particular localities where there is a period of high construction activity can impact on prices) on tender prices (this can also be localised and or regionalised and may vary according to the type of construction work)

Impact of price inflators on estimates Estimates, if prepared months or possibly a year or more ago, will need to be rebased to current price levels to make the figures meaningful - not just in terms of the overall total price likely to be paid, but also in respect of the individual work items in the estimate. This is particularly important for processing adjustments that have arisen because of design or scope changes since the original estimate was prepared and also for when designs and implementation strategies for specific parts of the project are discussed and reviewed. In these instances recourse to the detailed breakdown of estimate figures is needed and these figures must also be at current price levels to ensure any subsequent adjustments are realistic. The adjustment factors in these instances can be assessed from actual historic information concerning how construction prices actually moved over the period since the estimate was originally prepared. Another category of cost assessment that is required is in respect of forward projecting scheme prices to either the date of tender or even further in time to the end completion date of the construction. These assessments are often needed for business case reviews and for planning cashflow and funding requirements. The calculations required in this type of assessment cannot rely on the analysis of actual historic prices tendered but instead must be based on trending and on the general economic and market factors emerging or likely to emerge in the future. Recommendations For major transport projects in the Transport Scotland portfolio, the following approach is to be taken: Apply adjustments separately to the following five work categories in estimates: 1. civils construction (permanent way, tunnels, embankments, bridges, localised road-works, ground stabilisation, etc) 2. building works (stations, depots, ancillary buildings, building engineering services (m&e, data and telecomms, etc) 3. signalling (including all associated plant and equipment) 4. electrification (traction power - including all associated plant and equipment)

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5. project organisation (promoter costs, project management cos ts, designer and other consultant costs, etc) Use the following indices/adjustment rates for the above categories (see Appendix A ):
Adjustment to later estimate date or to date of tender Adjustments for cost inflation during construction period

Work Category

Civils

Average of Tender Price adjustments from four of the leading construction cost consultants Average of Tender Price adjustments from four of the leading construction cost consultants %TP adjustments as calculated above + 1.2 %TP adjustments as calculated above + 1.0 %RPI + 1.5

Network Rail Civil, Structures and Pway suggested inflation allowances BCIS General Building Cost Index

Building

Signalling

Network Rail Signalling suggested inflation allowances Network Rail Electrification and Telecomms suggested inflation allowances %RPI/Government inflation forecast + 1.5

Electrical & traction power; telecomms Organisation/ Management

Reasons for the above strategy Adjustments to a later estimate date or to date of tender:Civil and Building works: tender price indices are to be used on the basis that these are a more realistic guide than cost indices for the movement of tender prices The four firms identified in Appendix D are highly experienced major UK cost consultant companies who continually assess the movement in tender prices on projects across their nationwide spread of offices. This assessment is undertaken in the full knowledge of what the DTI and BCIS forecasts are saying at any particular point in time. However, it is suggested that the cost consultant assessment better reflects movements in the private sector as well as the public sector and also takes better account of major projects in excess of 100m rather than the much smaller value public sector projects that form the primary data source to compile other published indices. Signalling, electrical/traction power and telecomms : it is probable that prices for work in these disciplines will reflect the increasing demand in London and Central Scotland as rail work grows in these two regions over the next few years. Because they are highly specialised, provision of these additional resources will be problematic and we feel will inevitably attract a premium perhaps more so in Scotland than in London because the base resource pool is smaller and the distance for redeployment of skilled labour from resources further south in the UK is greater. The addition of a of premium of 1.2 and 1.0 should therefore be made to the percentage adjustment for

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signalling and electrical works respectively, over and above the adjustment rates generated from the TP calculation for civils and building works. This percentage premium is in recognition of these additional pressures on specialist labour prices. Organisation and management prices: adjustment of these figures is related more to movement in salaries. Salary increases are at least partially linked to cost of living rises and it is considered that RPI/Government inflation projections are a reasonable basis for assessing adjustments to organisation and management prices. However, in a rising construction market, these rises are likely to run ahead of RPI/inflation and therefore an addition of 1.5 should be added to the adjustment rates calculated from the RPI/inflation forecasts. (Note: although the DTI does track salaries in the construction industry, it only does so historically i.e. no forecasts are provided. This is one of the reasons why the RPI/Government inflation projections are felt to be more suitable as a basis) Adjustments for cost inflation during construction period:Civil and Building works: Network Rails suggested inflation allowances for civil, structures and permanent way should be used. Signalling: Network Rails suggested inflation allowances for signalling should be used. Electrical/traction power and telecoms: Network Rails suggested inflation allowances for electrification and telecoms should be used. Organisation and management prices: as advised above, RPI/Government inflation forecasts plus 1.5 should also be used for adjustments during the construction period. Methodology for undertaking the adjustment calculations

Example - update prices from Estimate Base Date of 2Q04 to 4Q05: Electrical Estimate 135,000 at 2Q04 Average Tender Price increases from Appendix A:2004 5.83% 2005 5.30% Two quarters = 2.915% Four quarters = 5.300% Cumulative increase = 8.369%

135,000 + 8.37% = 146,299

Example update of costs for inflation effect during construction period: 4

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Update prices from estimated date of tender of 4Q05 to estimated date of end of construction of 4Q06: Building Estimate 150,000 at 4Q05 BCIS General Building Cost index change: 246.2 to 255.2; increase of 3.66% 150,000 + 3.66%/2 = 152,745 (on the basis of expenditure being a straight line we reduce the percentage uplift by half to, in effect, apply it at the mid point of the programme) Regular reviews Reviews of the assessment of movements in tender prices and in costs should be made regularly to ensure the indices and adjustment factors are kept up to date and remain realistic.

References: BCIS website and BCIS On-line DTI website Association of Cost Engineers The Cost Engineer dated September 2005. Network Rails The Calculation of Inflation Allowances for Capital Cost Estimates Guidance Notes 30.9.05 issued 13.10.05

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Appendix A Suggested Price and Cost Adjustment Factors (at Nov 2005)
Adjustment to later estimate date or to date of tender (expressed in %)
2001 Civils Building Signalling Electrical & Traction Power, Telecomms Organisation/Management * 4.08 4.08 5.28 5.08 3.30 2002 5.53 5.53 6.73 6.53 3.20 2003 3.15 3.15 4.35 4.15 4.40 2004 4.83 4.83 6.03 5.83 4.50 2005 4.30 4.30 5.50 5.30 4.30 2006 4.55 4.55 5.75 5.55 4.00 2007 4.53 4.53 5.73 5.53 3.90 2008 4.55 4.55 5.75 5.55 4.00 2009 4.48 4.48 5.68 5.48 4.10 2010 4.87 4.87 6.07 5.87 4.10

* O/M 2010 detail n/a; 2009 has been repeated

Adjustment for cost inflation during construction period expressed in %

2001 Civils Building * Signalling Electrical & Traction Power, Telecomms Organisation/Management 0.54 2.60 5.41 2.51 3.30 2002 9.59 4.60 4.13 3.92 3.20 2003 3.82 5.90 3.87 2.36 4.40 2004 6.82 5.60 4.76 7.37 4.50 2005 5.26 6.60 6.48 2.62 4.30 2006 5.55 4.50 4.87 4.15 4.00 2007 5.55 3.20 4.87 4.15 3.90 2008 5.57 3.80 4.88 4.16 4.00 2009 5.55 3.80 4.87 4.15 4.10 2010 5.55 3.80 4.87 4.15 4.10

* Building 2009 & 2010 detail n/a; 2008 has been repeated

Dec Dec annual index adjustment used

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Appendix B The RICS BCIS Indices The BCIS (Building Cost Information Service) prepares and publishes a large
number of cost and tender-price indices as follows: Cost indices Regional Tender Price indices Trade Price indices Construction Plant Hire Association indices Miscellaneous indices Retail Prices Output Price indices Tender Price indices BMI Maintenance Cost indices Measured Term Contract updating percentages Price Adjustment Formula indices

Indices are available monthly, quarterly and annually. BCIS, in its five year forecast, forward predicts its General Building Cost Index and its all-in TPI. The BCIS tender price index series measures the trend of contractors pricing levels in accepted tenders. The Tender Price index series includes: Index Series All-in TPI + Firm Price TPI Housing Refurbishment TPI Housing TPI Market Conditions Factor Non-housing Refurbishment TPI Public Sector TPI ++ Refurbishment TPI Rest of UK Sample TPI Southern and Eastern Sample TPI Fluctuating Price TPI Private Commercial TPI Private Industrial TPI Private Sector TPI Regional TPI +++ Base Inde x 100 date 1985 updated 25.4.2000 1985 updated 20.4.2000 1991 updated 27.1.2000 1985 updated 06.4.2000 1985 updated 20.4.2000 1991 updated 06.4.2000 1985 updated 20.4.2000 1991 updated 06.4.2000 1985 updated 20.4.2000 1985 updated 20.4.2000 1985 updated 25.3.2000 1985 updated 20.4.2000 1985 updated 25.3.2000 1985 updated 20.4.2000 1985 updated 20.4.2000

+ BCIS - All-in Tender Price Index The All-in Tender Price Index covers new building work across the UK and includes works from all construction sectors such as the public and private sectors and also housing construction. ++ BCIS - Public Sector Tender Price Index This is a sub-set of the all-in Tender Price Index and covers non-housing schemes for public sector clients including local and central governments, health trusts, etc. +++ BCIS - Regional Tender Price Indices This contains a separate index series for each UK economic planning region, Wales and Scotland.

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Appendix C Network Rail Suggested Inflation Allowances (Compared with RPI and BCIS TPI)

Network Rail Suggested Inflation Allowances (derived)

2001 BCIS All-in Tender Price Index Retail Price Index General Management & Design (incl. Professional Services) Signalling Electrification & Telecomms (inc plant) Civils, structures & pway General Building 6.59% 1.05% 4.60% 2002 6.74% 2.53% 3.18% 2003 3.16% 2.64% 2.45% 2004 14.29% 3.43% 4.16% 2005 0.00% 2.24% 4.16% 2006 4.91% 2.53% 3.78% 2007 7.44% 2.53% 3.78% 2008 6.02% 2.54% 3.80% 2009 6.00% 2.53% 3.78% 2010 6.00% 2.53% 3.78% 2011 6.00% 2.53% 3.78% 2012 6.02% 2.54% 3.80%

later years extrapolated on a straight line basis later years extrapolated on a straight line basis

5.41% 2.51%

4.13% 3.92%

3.87% 2.36%

4.76% 7.37%

6.48% 2.62%

4.87% 4.15%

4.87% 4.15%

4.88% 4.16%

4.87% 4.15%

4.87% 4.15%

4.87% 4.15%

4.88% 4.16%

0.54% 2.60%

9.59% 6.09%

3.82% 4.31%

6.82% 7.34%

5.26% 5.98%

5.55% 3.23%

5.55% 5.48%

5.57% 5.23%

5.55% 5.21%

5.55% 5.21%

5.55% 5.21%

5.57% 5.23%

Annual percentages calculated Dec index to Dec index

Network Rail Inflation Guides Compared with RPI and BCIS TPI

16.00% BCIS All-in Tender Price Index 14.00% Retail Price Index 12.00% General Management & Design (incl. Professional Services) Signalling Electrification & Telecomms (inc plant) Civils, structures & pway 6.00% General Building 4.00%

P e r c e n t a g eC h a n g e

10.00%

8.00%

2.00%

0.00% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Years

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Appendix D Views of major construction consultants compared with other published data

Tender Price Inflation - Comparison of Published Data - Year on Year PUBS BCIS % MIPS % Year Movement CS DLE % ECH % G&T % Average EC %
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 4.00 4.00 4.00 3.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 9.60 4.50 7.40 3.10 4.60 2.90 4.10 4.90 5.90 6.10 6.10 5.00 4.00 7.20 4.00 6.20 5.80 5.60 5.40 4.80 4.80 4.50 4.50 3.80 3.50 2.50 4.50 4.50 4.50 3.80 3.50 3.00 5.78 4.08 5.53 3.15 4.83 4.30 4.55 4.53 4.55 4.48 4.87
8.40 6.00 7.30 3.20 14.30 4.50 4.50 3.80 3.50 5.30 9.20 3.80 3.70 3.20 3.80 3.70 3.60 3.30 3.30 8.90 7.30 6.50 3.60 8.10 5.00 6.90 4.60 3.80

RPI % 3.00 1.80 1.70 2.90 3.00 2.80 2.50

CS DLE ECH G&T BCIS PUB SEC MIPS RPI

Cyril Sweett Davis, Langdon & Everest EC Harris Gardiner & Theobald Buidling Cost Information Service DTI Public Sector Index NHS extrapolation from Pub Sec Retail Price Index

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