Coal, O&M

Construction Cost Control – Some surprisingly simple strategies can help control many construction project costs.

Issue 9 and Volume 112.

By David Wagman, Chief Editor

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Power plant engineering construction costs have been rising much faster than core inflation for the last several years. All along the supply, build, commission chain pressures are growing to find ways to cut costs.

Construction cost run-ups are by no means limited to the power generation sector. All across the heavy industrial market (which includes power, oil and gas, chemicals and heavy manufacturing) prices for materials, labor and equipment have been rising. These markets rely on common equipment and materials such as piping, structural steel, large pumps and valves, large transformers, switchgear, tanks and wire and cable.

“History has shown each segment of the market is cyclical, often with one segment being busy while another was flat”, said Don Zabilansky, president of the Power Business Group at CH2M Hill. In the late 1990s, the power market was known to be in a “bubble”. During that period, power plants were relatively easy to finance and were being built all across the United States. During those same years, the oil and gas construction market was slow due to low oil prices.

In the last two years, owever, the heavy industrial market has seen a different dynamic. Not only have the power and oil and gas segments been busy, but for the first time, Zabilansky said, market costs have been further affected by extreme international demand for equipment and material. In particular, China, India, Brazil and the Middle East have increased demand significantly as they pursue big infrastructure projects of their own.

“Where once these countries had minimal impact on supply and demand of material and equipment, now their impact to availability and price is greater than the impact the United States has had,” he said.

As one indication of the scale of the price runup, Cambridge Energy Research Associates’ “Project Cost Control Index” rose from 100 in 2000 to 194 by the end of the first quarter of 2007. By the third quarter of 2007 the CERA index stood at 233, where it remained at the end of the first quarter of 2008.

Rapidly rising costs have overwhelmed previous metrics used to estimate cost escalation, said Candida Scott, senior director of research at CERA in a June conference call.

“It is unprecedented to see an era of high energy growth along with high industrial growth,” she said.

Several factors have driven the recent cost escalations, said Zabilansky. Among the factors are the availability of raw material, increased labor costs to convert raw materials to commodities and equipment, the cost of raw material and energy, increased profit demand from suppliers and speculative purchasing.

“When purchasers of the material and equipment have been required to predict escalation for future projects in this market, common escalation percentages have been 7 percent to 9 percent,” he said. In some cases, this has not been enough. For example, Zabilansky pointed to the 30 percent increase in steel pipe from May to July of 2008.

But power plant cost containment can take place all across the engineering, procurement and construction (EPC) spectrum, said Peter G. Hessler, president of Construction Business Associates.

Projects that are defined early and defined well are executed more effectively.
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“Althought ‘E’ is the smallest portion, it can create the largest cost through over-engineering,” Hessler said. Guarding against so-called gold-plating can be achieved through pursuing a strategy of project alliances, which allow the engineering firm to share in the project’s ultimate cost-containment success. A bonus/penalty arrangement can encourage the engineering firm to work within a targeted budget, Hessler said. Such incentives allow a firm to benefit financially by managing costs effectively to come in either at or under budget.

A second strategy involves assigning a dedicated staff member from the owner’s office and putting him or her in the engineer’s office. “It’s a small price to pay and it keeps the job from being engineered into a Cadillac,” Hessler said.

Adequate front-end planning and scope definition are also critical, said Lyle White vice president/director, Business Development for WorleyParsons. “As proven by the Construction Industry Institute’s Project Definition Rating Index, projects that are defined early and defined well are executed more effectively,” he said.

When it comes to procurement, the cost containment best practices some owners and contractors have been taking (particularly when firm pricing has been the contracting norm) starts with risk sharing, said Zabilansky. Many big pieces of equipment require long lead times due to market demand and supply bottlenecks. This means many owners are buying long-lead time equipment before they select a contractor and sometimes even before they have selected a construction site. This strategy is being used to minimize the inflationary impact of rising costs, as well as the issues associated with long lead items on major engineered equipment.

Hessler said one Southeastern utility bought all of its structural steel for a proposed project up front. Other project developers have bought alloy tubing and are storing it for future use.

“There is a risk the unit won’t be built, but the utility could resell the raw materials,” he said.

Still other power plant owners are asking for firm commitments from suppliers that commodities and equipment will be available when the owner is ready to move ahead with a project.

Some end users have received approval from their funding entity to allow certain percentages or all material and equipment pricing to float with the market as an “allowance”, Zabilansky said. Some have allowed the pricing to be “open book”, which means the owner pays the actual costs at the time the item is purchased. This approach can benefit owners by shielding them from paying projected high costs that often are attached to volatile items due to their unpredictability in current markets.

Other owners have “competed” the volatile items by requesting bidders to fix as much of the work as they can. Owners then award the work to the bidder that offers the best combination of a high percentage of fixed price scope with the fewest number of items that are volatile considered as “allowances.” When the bidders increase their percentage of firm scope they have to evaluate the risk/reward ratio. Given current price volatility, cases may exist where the risks and contingencies are so high that the owner feels he or she would be better off taking the commodity and escalation risk. This is also true with the availability and cost of skilled trade labor, Zabilansky said.

Some owners who are required to have a total firm fixed price contract select a contractor through various competitive approaches, but allow the volatile items to be treated as allowances until the notice to proceed is issued. Then they require the volatile items to be firmed up using indices or “price in effect” at the time the notice to proceed is issued. This allows a level of risk sharing with the bidder buying out as much of the equipment and material as soon they receive the full notice to proceed.

Once engineering and procurement addressed, Hessler said five key areas can be addressed to help manage the construction cost part of EPC: safety, quality, site purchasing, tools and consumables and supervision.

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Hessler said the cost of a job can be reduced by as much as a couple of percent if job site accidents are reduced or eliminated entirely. Time schedules can slip and labor productivity can be negatively affected by accidents. Both of these safety factors have a negative effect on overall project cost.

A second labor-related issue is quality. Efforts to keep workmanship at a high level can drive anywhere from 5 percent to 20 percent out of overall expenses as rework orders are reduced or eliminated.

“It’s amazing how few projects measure productivity,” Hessler said. In some instances, project owners may spend $1 million extra due to productivity lapses when a $75,000 budgeted position could help to measure and improve job site productivity.

Site purchasing can add as much as 15 percent if the common practice of getting three price quotations and selecting the lowest bidder is followed, Hessler said. A more cost-effective approach often is to negotiate supplier contracts early on, rather than after a project is underway.

As part of an “engaged materials management” program, consider including international procurement, said WorleyParsons’ Lyle White. “Manufacturing environments are constantly changing and in today’s global economy, companies must take advantage of highly qualified shops around the world.” He cautioned, however, that expediting, surveillance and quality assurance are even more important when working with international suppliers.

“An ounce of prevention in the shop is worth more than a pound of correction in the field,” he said.

Most construction sites have equipment on hand that isn’t being used but that is being paid for. Rental fees that are paid simply to keep equipment on hand can be expensive. By closely managing the delivery and removal of tools, equipment and consumables, costs can be further contained. Some third-party suppliers will put their own trailer on-site and take responsibility for managing materials and tools. Some contractors also have alliances with firms such as crane operators to move expensive construction machinery into and away from the job site in a cost-effective manner.

A final construction cost-containment strategy is supervision, Hessler said; in particular by adopting “coopertition” or a strategy that sees competing contractors share risk management and cost containment approaches. “Contractors working on the same project can learn from each other,” Hessler said.

White agreed. “‘Murphy’ is a part of every project; how he affects the outcome depends on how well the team plans and prepares for the unexpected.” A strong teambuilding environment helps to foster a project culture that identifies problems and potential problems early so that the team’s collective expertise can be put to work on solutions.

Not to be overlooked is the early involvement of plant operations and commissioning teams. After all, said White, it’s their plant and they will have to live with it for 30 years or more. Their early involvement can pay dividends by having experience and preferences built into the job from the beginning, avoiding sticker-shock and many change orders.

Worldwide demand for labor, material and equipment have exerted enormous pressure on owners, engineers and contractors alike. By implementing best practices such as these, the current difficult economic cycle can be weathered successfully and cost effectively.

A forest of cranes surrounds the Olkiluoto 3 nuclear station construction site in Finland. Photo courtesy of Areva.