By Thomas Gueville (primary contributor), Robert Wells, Jay Carson, and Bill Canterbury (CEP Committee members of AACE’s Certification Board)

As described in the previous Part 1 article, published in the December 2021 edition of AACE’s Source, escalation calculations are part of the required skills and knowledge for a Certified Estimating Professional (CEP).

An estimator is to properly understand the differences among contingency, escalation, inflation, and currency variation. All these concepts contribute to cost change and in some circumstances can overlap each other.

Routine estimating cost data maintenance includes updating the costs of equipment, material, labor, etc., needed to estimate the future cost of a project or to bring historical costs to the present. This is because cost estimating, generally, is done in today’s dollars and then escalated to the time when the project will be executed.

Depending on the objective of the escalation calculation, various approaches and methodologies are available which may require different input data and calculation steps. The three main steps to properly escalate an estimate are as follows:

1. Define the purpose of the escalation calculation: Past escalation, that is, bringing a historical estimate up to today’s costs; or future escalation, which is taking a current cost estimate and adjusting costs to the future date of expenditure.

This first point will clarify the methodology to be used.

For past escalation, the Monte Carlo Simulation approach can be disregarded. Methods using indices, based on historical price data and/or input from historical price indices, are the most common practice.

Developing forecast future price index is much more complex and can be developed in different manner:

• Trends based on historical data
• Market survey and/or expert opinion (procurement department as an example)
• Third party providers who can produce databases of forecast indices (that can be built on complex models incorporating historical data, macro-economics, and market surveys).

A reliable forecast model requires effort and resources. Even with the valuable input from economists, estimators should be deeply involved in the model build-up to ensure that indices effectively represent the cost item, but also that the weight and combination of indices properly reflect the project/product.

2. Single Cost Item or Composite Price

This method will be used if you are escalating a cost account using a weighted indices calculation or if only a basic cost estimating relationship (CER) is applicable.

For the single cost item with single point in time and associated relevant index, the final total amount should be equal to the original amount multiplied by the ratio of the price index at the final time and at the initial time.

Final amount = Initial amount x [(Index for later date) / (Index for earlier date)].

For composite price, you should carefully read AACE’s Recommended Practice RP 58R-10, “Escalation Estimating Principles and Methods Using Indices” to perfectly understand various methods, tips, and all the steps to correctly addressing cost over time and cost account detail.

3. Indices or Monte Carlo approach

These two main approaches to escalation are based on similar principles based on the same key inputs:

• Cost estimate
• Schedule
• Spending expenditure within the schedule
• Indices

The Monte Carlo approach adds variability and probability distribution on these elements with potential dependencies and correlations. The main benefit of this approach is to provide more information related to uncertainty related to the escalation, but this requires a more sophisticated model and usually requires additional time and resources. AACE’s Recommended Practice RP 68R-11, “Escalation Estimating Using Indices and Monte Carlo Simulation” can provide guidance and references for these approaches.

The Certified Estimating Professional (CEP) certification ensures that an estimator has the appropriate knowledge of these topics, access to reliable technical resources, and that the calculation can be performed in accordance with AACE’s Recommended Practices.

REFERENCES

AACE International, “RP 58R-10,” AACE International Recommended Practices, May 25, 2011

AACE International, “RP 68R-11,” AACE International Recommended Practices, May 2, 2012