Project Risk Management: Essential Methods for Project Teams and Decision Makers

CHAPTER ELEVEN

Cost Escalation Modeling

Questions Addressed in Chapter 11

• How average should an average really be?
• Why is consumer price index the worst possible macroeconomic index for evaluating project cost escalation?
• Why should first and second market transactions be delineated?
• How reliable can cost escalation modeling be?
• Should cost escalation modeling be probabilistic?

ONE OF THE KEY PROJECT cost uncertainties that should be managed through the procurement process is cost escalation. This standalone project general uncertainty is directly related to the development of adequate project cost estimates and reserves.

OVERVIEW OF THE COST ESCALATION APPROACH

Let’s assume that all quotes received by a project owner in 2014 for a construction package are firm and valid for the next several weeks or months. Does this help to predict real expenditures? The answer is no. One reason for this is very basic. A dollar in 2014 will have rather different purchasing power in three or four years over the course of the project execution. So, quite often project teams use an average annual inflation rate to escalate future expenditures from the base estimate. In North America it is around 2% these days. In a few years, a smaller amount of goods or services would be purchased using the ...