Escalation in the cost estimate for increases in various categories
Escalation is used to estimate the future cost of a project or to bring historical costs to the present.
Escalation is caused by many factors such as inflation, market conditions, risk allocation clauses in the contract, interest rate and taxes. It is a risk that can account for a substantial part of construction cost, especially in long term projects where the variability and uncertainty is greater. Therefore there is a need to assess the risk of cost escalation in construction programs.
Escalation, therefore, comes from the interplay of changes real or anticipated, in input costs, perceptions of risk, and perceptions of the competition.
In some cases it comes from real information, such as actual changes in the cost of critical materials like steel or copper. More often than not, however, it comes from the formation of market opinions, which may or may not have a basis in fact.
Increase in contract cost through increase in quantities or variations should not be confused with cost escalation incident to inflation. Estimate must accompany the depreciation, interest on capital and the cost of repairs at future escalated prices.
Expenditures for labour are subject to statutory increase of minimum wages and 'social' charges (insurance, benefits, etc,)
Provide estimates which allow for price increases during the period of construction. As these cannot be accurately predicted under the variable inflationary conditions, there is a tendency to allow for more than thought necessary for such escalation effect. Contractor will experience financial difficulties if underestimated.
The use of suitable escalation formulae linked ideally to a system of independent cost indices allows prices to be adjusted at determined intervals, limits both the Client's and the Contractor's levels of risk, and ensures a fair and equitable return.
Escalation Relationships:
Escalation in cost estimating has two main uses:
to convert historical costs to current costs (historical escalation index) and to escalate current costs into the future (predictive escalation index) for planning and budgeting.
The historical escalation index is used to bring the historical cost to the present and then a predictive escalation index is used to move the cost to the future.
APPLICATION OF A PRICE ADJUSTMENT FORMULA for Escalation
In various countries, during the periods of steep price rises sophisticated systems for 'recording' and 'monthly publishing' of cost indices were developed.
These permit contract prices to be regularly modified using suitable formulae with invoices adjusted by comparing the updated indices to the indices applicable at the time of bidding.
In overall terms, this system allows the contract prices to be adjusted at a rate probably slightly ahead of the retail price index and inflation.
Price adjustments to contracts can be any of the following:
a)Fixed (no escalation) for a contract of a stipulated length of time (variations and claims excepted)
b) Variation of price allowed if the contract period exceeds a pre-set time from a pre-set time
c) Variation of price by an agreed formula, if the 'change' in any constituent ,of the formula is greater than a certain percentage (e.g., 5%) wrt its value at time of tender
d) As per a contract that allows for periodic adjustments of rates changed according to published indices over the base indices. The period of adjustment may vary from one month to one year after the date of tender and then every agreed period thereafter.
A Simple And Compact Method
R = Total value of work done during the month. It would include the amount of secured advance granted, if any, during the month, less the amount of secured advance recovered, if any, during the month. It will exclude value of works executed under variations for which price adjustment will be worked out separately based on the terms mutually agreed.
Adjustment for 'labour' component: .
Price adjustment due to an increase or decrease in the cost of labour shall be paid in accordance with the following formula:
VL = 0.85 x P1/100 x R x (Li –Lo/Lo)
VL =Increase or decrease in the cost of work during the month under consideration due to change in rates for local labour.
Lo =The consumer price index for industrial workers for the State on the day 28 days preceding the date of opening of bids, as published by Labour Bureau, Ministry of Labour, Government of….
Li = The average consumer price index for industrial workers for the State for the month under consideration as published by Labour Bureau, Ministry of Labour, Government of. ....
P1 =Percentage value of labour component of the work.
Adjustment for ‘Cement’ component:
Price adjustment due to an increase or decrease in the cost of cement procured by the Contractor, shall be paid in accordance with the following formula:
Vc= 0.85 x Pc/100 x Rx (Ci -Co)Co
Vc= Increase or decrease in the cost of work during the month under I consideration due to change in rate. of cement.
Co = The countrywide wholesale price index for cement on the day 28 days preceding the date of opening of bids, as published by the Ministry of Industrial Development, Government of. ….
Ci=The countrywide average wholesale price index for cement for the month under consideration, as published by the Ministry of Industrial Development, Government of.
Pc= Percentage value of cement component of the work.
Adjustment for ‘Steel' component:
Price adjustment due to an increase or decrease in the cost of steel procured by the Contractor shall be paid in accordance with the following formula:
Vs=0.85 x Ps/100 x R x (Si – So)/ So
Vs= Increase or decrease in the cost of work during the month under consideration due to change in rate of steel.
So =The country-wide wholesale price index for steel (Bars and rods) on the day 28 days preceding the date of opening of Bids, as published by the Ministry of Industrial Development, Government of. ..,
Si = The countrywide average wholesale price index for steel (Bars and rods) for the month under consideration, as published by Ministry of Industrial Development, Government of......
P s = Percentage value of steel component of the work
Note: For application of this clause, the index of Bars and Rods may be. chosen to represent the Steel group .
Adjustment for 'Bitumen' component:
(Unlike indices for other components, adjustment for bitumen is made directly on a retail price basis since 'indices' may not be available for an item like bitumen.)
Price adjustment due to an increase or decrease in the cost of bitumen procured by the Contractor shall be paid in accordance with the following formula:
Vb = 0.85 x Pt/100 x R x (Bi -Bo/Bo)
Vb =Increase or decrease in the cost of work during the month under consideration due to change in rate of bitumen.
Bo =The official retail price of bitumen at the nearest depot centre on the day 28 days prior to date of opening of bids.
Bi = The official retail price of bitumen at the nearest depot centre for the 15th day of the month under consideration.
Pb = Percentage value of bitumen component of the work
Adjustment for 'POL' (fuel and lubricant) component:
(… based directly on price of (HSD) , for same reason as for Bitumen). Price adjustment due to increase or decrease in the cost of POL (fuel and lubricant) shall be in accordance with the following formula:
Vf = 0.85 x Pf/100 x R x (Fi –Fo)/Fo
Vf =Increase or decrease in the cost of work during the month under consideration due to change in rates for fuel and lubricants.
Fo =The official retail price of HSD at the existing consumer pumps at nearest Depot centre on the day 28 days prior to the date of opening of bids.
Fi = The official retail price of HSD at the existing Consumer pumps at nearest depot centre oil the 15th day of the month under consideration.
Pf = Percentage value of fuel and lubricants component of the work
Note: For application of this clause, the price of HSD oil may be chosen to represent the fuel and Lubricants group.
Adjustment for ‘Plant and Machinery /Spares’ Component:
Price adjustment due to an increase or decrease in the cost of plant and machinery /spares procured by the Contractor shall be paid in accordance with the following formula:
Vp = 0.85 x Pp/100 x R x (Pi –Po)/Po
Vp =Increase or decrease in the cost of work during the month under consideration due to change in rates of plant and machinery/Spares.
Po =The country wide wholesale price index for heavy machinery and parts on the day 28 days preceding the date of opening of Bids as published by the Ministry of Industrial Development, Government of….
Pi=The country wide average wholesale price index for heavy machinery and parts for the month under consideration as published by the Ministry of Industrial Development, Government of…
Pp = Percentage value of plant and machinery/spares component of the work
Note: For application of this clause, the index of Heavy Machinery and Parts may be chosen to represent the Plant and Machinery/Spares group.
Adjustment for 'Other Materials' Component:
Price adjustment due to an increase or decrease in the cost of local materials other than cement, steel, bitumen and POL procured by the Contractor, shall be paid in accordance with the following formula:
Vm = 0.85 x Pm/.100 x R x (Mi –Mo)/Mo
Vm =Increase or decrease in the cost of work during the month under. consideration due to changes in rates of local materials other than cement, steel, bitumen and POL.
Mo =The countrywide wholesale price index (all commodities) on the day 28 days preceding the date of opening of bids, as published by the Ministry of Industrial Development, Government of ….
Mi =The countrywide average wholesale price index (all commodities) for the month under consideration as published by the Ministry of Industrial Development, Government of….
Pm= Percentage value of local material component (other than cement, steel, bitumen, and POL) of the work
Percentage Values:
The following percentage values may be assumed for the price adjustment, for example, an entire Highway contract:
Labour -PL 25%
Cement -Pc 15%
Steel -Ps 25%
POL -Pf 5%
Plant & Machinery Spares -Pp 5%
Other Materials –Pm 10%
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Total 85%
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Factors affecting ambiguities in Escalation formula
The methodology for allocating % for M, L and POL are not very accurate because these constants are meagerly derived by the clients .
For material escalation the WPI index is considered which includes food items and many materials like fertilizers, tobacco, papers etc which actually do not relate to construction activity.
For the labour component the formula refers to the CPI for industrial workers . Though in many projects the clause is related to MWA so lack of uniformity of approach.
For fuel normally the price of HSD is considered for calculations
The material supplied by the client are deducted from the running bills before paying escalation. But since the materials also undergo the construction process, they should be excluded while calculating escalation on labour and fuel.
Profit margin is generally excluded while paying escalation which is assumed to be between 10-25% of every running bill.
No escalation for P and M though in international projects price variation clause on P an M is also included.
Escalation is used to estimate the future cost of a project or to bring historical costs to the present.
Escalation is caused by many factors such as inflation, market conditions, risk allocation clauses in the contract, interest rate and taxes. It is a risk that can account for a substantial part of construction cost, especially in long term projects where the variability and uncertainty is greater. Therefore there is a need to assess the risk of cost escalation in construction programs.
Escalation, therefore, comes from the interplay of changes real or anticipated, in input costs, perceptions of risk, and perceptions of the competition.
In some cases it comes from real information, such as actual changes in the cost of critical materials like steel or copper. More often than not, however, it comes from the formation of market opinions, which may or may not have a basis in fact.
Increase in contract cost through increase in quantities or variations should not be confused with cost escalation incident to inflation. Estimate must accompany the depreciation, interest on capital and the cost of repairs at future escalated prices.
Expenditures for labour are subject to statutory increase of minimum wages and 'social' charges (insurance, benefits, etc,)
Provide estimates which allow for price increases during the period of construction. As these cannot be accurately predicted under the variable inflationary conditions, there is a tendency to allow for more than thought necessary for such escalation effect. Contractor will experience financial difficulties if underestimated.
The use of suitable escalation formulae linked ideally to a system of independent cost indices allows prices to be adjusted at determined intervals, limits both the Client's and the Contractor's levels of risk, and ensures a fair and equitable return.
Escalation Relationships:
Escalation in cost estimating has two main uses:
to convert historical costs to current costs (historical escalation index) and to escalate current costs into the future (predictive escalation index) for planning and budgeting.
The historical escalation index is used to bring the historical cost to the present and then a predictive escalation index is used to move the cost to the future.
APPLICATION OF A PRICE ADJUSTMENT FORMULA for Escalation
In various countries, during the periods of steep price rises sophisticated systems for 'recording' and 'monthly publishing' of cost indices were developed.
These permit contract prices to be regularly modified using suitable formulae with invoices adjusted by comparing the updated indices to the indices applicable at the time of bidding.
In overall terms, this system allows the contract prices to be adjusted at a rate probably slightly ahead of the retail price index and inflation.
Price adjustments to contracts can be any of the following:
a)Fixed (no escalation) for a contract of a stipulated length of time (variations and claims excepted)
b) Variation of price allowed if the contract period exceeds a pre-set time from a pre-set time
c) Variation of price by an agreed formula, if the 'change' in any constituent ,of the formula is greater than a certain percentage (e.g., 5%) wrt its value at time of tender
d) As per a contract that allows for periodic adjustments of rates changed according to published indices over the base indices. The period of adjustment may vary from one month to one year after the date of tender and then every agreed period thereafter.
A Simple And Compact Method
R = Total value of work done during the month. It would include the amount of secured advance granted, if any, during the month, less the amount of secured advance recovered, if any, during the month. It will exclude value of works executed under variations for which price adjustment will be worked out separately based on the terms mutually agreed.
Adjustment for 'labour' component: .
Price adjustment due to an increase or decrease in the cost of labour shall be paid in accordance with the following formula:
VL = 0.85 x P1/100 x R x (Li –Lo/Lo)
VL =Increase or decrease in the cost of work during the month under consideration due to change in rates for local labour.
Lo =The consumer price index for industrial workers for the State on the day 28 days preceding the date of opening of bids, as published by Labour Bureau, Ministry of Labour, Government of….
Li = The average consumer price index for industrial workers for the State for the month under consideration as published by Labour Bureau, Ministry of Labour, Government of. ....
P1 =Percentage value of labour component of the work.
Adjustment for ‘Cement’ component:
Price adjustment due to an increase or decrease in the cost of cement procured by the Contractor, shall be paid in accordance with the following formula:
Vc= 0.85 x Pc/100 x Rx (Ci -Co)Co
Vc= Increase or decrease in the cost of work during the month under I consideration due to change in rate. of cement.
Co = The countrywide wholesale price index for cement on the day 28 days preceding the date of opening of bids, as published by the Ministry of Industrial Development, Government of. ….
Ci=The countrywide average wholesale price index for cement for the month under consideration, as published by the Ministry of Industrial Development, Government of.
Pc= Percentage value of cement component of the work.
Adjustment for ‘Steel' component:
Price adjustment due to an increase or decrease in the cost of steel procured by the Contractor shall be paid in accordance with the following formula:
Vs=0.85 x Ps/100 x R x (Si – So)/ So
Vs= Increase or decrease in the cost of work during the month under consideration due to change in rate of steel.
So =The country-wide wholesale price index for steel (Bars and rods) on the day 28 days preceding the date of opening of Bids, as published by the Ministry of Industrial Development, Government of. ..,
Si = The countrywide average wholesale price index for steel (Bars and rods) for the month under consideration, as published by Ministry of Industrial Development, Government of......
P s = Percentage value of steel component of the work
Note: For application of this clause, the index of Bars and Rods may be. chosen to represent the Steel group .
Adjustment for 'Bitumen' component:
(Unlike indices for other components, adjustment for bitumen is made directly on a retail price basis since 'indices' may not be available for an item like bitumen.)
Price adjustment due to an increase or decrease in the cost of bitumen procured by the Contractor shall be paid in accordance with the following formula:
Vb = 0.85 x Pt/100 x R x (Bi -Bo/Bo)
Vb =Increase or decrease in the cost of work during the month under consideration due to change in rate of bitumen.
Bo =The official retail price of bitumen at the nearest depot centre on the day 28 days prior to date of opening of bids.
Bi = The official retail price of bitumen at the nearest depot centre for the 15th day of the month under consideration.
Pb = Percentage value of bitumen component of the work
Adjustment for 'POL' (fuel and lubricant) component:
(… based directly on price of (HSD) , for same reason as for Bitumen). Price adjustment due to increase or decrease in the cost of POL (fuel and lubricant) shall be in accordance with the following formula:
Vf = 0.85 x Pf/100 x R x (Fi –Fo)/Fo
Vf =Increase or decrease in the cost of work during the month under consideration due to change in rates for fuel and lubricants.
Fo =The official retail price of HSD at the existing consumer pumps at nearest Depot centre on the day 28 days prior to the date of opening of bids.
Fi = The official retail price of HSD at the existing Consumer pumps at nearest depot centre oil the 15th day of the month under consideration.
Pf = Percentage value of fuel and lubricants component of the work
Note: For application of this clause, the price of HSD oil may be chosen to represent the fuel and Lubricants group.
Adjustment for ‘Plant and Machinery /Spares’ Component:
Price adjustment due to an increase or decrease in the cost of plant and machinery /spares procured by the Contractor shall be paid in accordance with the following formula:
Vp = 0.85 x Pp/100 x R x (Pi –Po)/Po
Vp =Increase or decrease in the cost of work during the month under consideration due to change in rates of plant and machinery/Spares.
Po =The country wide wholesale price index for heavy machinery and parts on the day 28 days preceding the date of opening of Bids as published by the Ministry of Industrial Development, Government of….
Pi=The country wide average wholesale price index for heavy machinery and parts for the month under consideration as published by the Ministry of Industrial Development, Government of…
Pp = Percentage value of plant and machinery/spares component of the work
Note: For application of this clause, the index of Heavy Machinery and Parts may be chosen to represent the Plant and Machinery/Spares group.
Adjustment for 'Other Materials' Component:
Price adjustment due to an increase or decrease in the cost of local materials other than cement, steel, bitumen and POL procured by the Contractor, shall be paid in accordance with the following formula:
Vm = 0.85 x Pm/.100 x R x (Mi –Mo)/Mo
Vm =Increase or decrease in the cost of work during the month under. consideration due to changes in rates of local materials other than cement, steel, bitumen and POL.
Mo =The countrywide wholesale price index (all commodities) on the day 28 days preceding the date of opening of bids, as published by the Ministry of Industrial Development, Government of ….
Mi =The countrywide average wholesale price index (all commodities) for the month under consideration as published by the Ministry of Industrial Development, Government of….
Pm= Percentage value of local material component (other than cement, steel, bitumen, and POL) of the work
Percentage Values:
The following percentage values may be assumed for the price adjustment, for example, an entire Highway contract:
Labour -PL 25%
Cement -Pc 15%
Steel -Ps 25%
POL -Pf 5%
Plant & Machinery Spares -Pp 5%
Other Materials –Pm 10%
---------------------------------------------------------------------------
Total 85%
---------------------------------------------------------------------------
Factors affecting ambiguities in Escalation formula
The methodology for allocating % for M, L and POL are not very accurate because these constants are meagerly derived by the clients .
For material escalation the WPI index is considered which includes food items and many materials like fertilizers, tobacco, papers etc which actually do not relate to construction activity.
For the labour component the formula refers to the CPI for industrial workers . Though in many projects the clause is related to MWA so lack of uniformity of approach.
For fuel normally the price of HSD is considered for calculations
The material supplied by the client are deducted from the running bills before paying escalation. But since the materials also undergo the construction process, they should be excluded while calculating escalation on labour and fuel.
Profit margin is generally excluded while paying escalation which is assumed to be between 10-25% of every running bill.
No escalation for P and M though in international projects price variation clause on P an M is also included.
