Risk Pricing Approach
The approach to risk pricing varies with the organization. For the most part, there are a few basic methods:
- Risk pricing is an entirely separate activity that follows the base estimate completion,
- Risk pricing is an integral component of the base estimate preparation,
- Risk pricing takes place during and after the base estimate preparation.
Additional details are:
- The risk pricing is conducted by the same parties involved in the base estimate preparation,
- The risk pricing is done by separate individuals from the parties involved in the base estimate preparation.
While the literature suggests that risk pricing is a separate process that follows after the completion of the base estimate, practice shows that this process is contingent on preferences within each organization. Who is involved in the pricing of risk? This is dependent on the organization and the size and type of the project. Ultimately, risk pricing is a function of executive management.
Who is involved in the pricing of risk?
This is dependent on the organization and the size and type of the project. Ultimately, risk pricing is a function of executive management and occurs during the estimate review meeting. Varying with the size and type of project, the estimate review meeting is attended by those who played a significant part in the estimate preparation and senior management.
The approval of the final tender sum is always a function of senior management, regardless of project type and size. The value of the project usually affects the number of people involved in risk pricing. A typical cost estimate review group would be the cost estimator, contract manager, site manager and executive manager. For small construction firms, usually, the owner is very closely involved with the estimating process and the pricing of risk. For larger organizations, which bid on more major projects with increased risk, the tender is reviewed several times by people with increased levels of responsibility.
The risk is usually priced in individual components where the risk is a trade and non-trade related. The risk associated with non-trade elements of the project, such as preliminaries and contractual risk, is priced once the base cost of the project has been established.
Calculation of risk.
There is a widespread of methodologies for risk calculation. Some of the most common methods are:
- Micro. This method involves the identification and pricing of risk on a trade-by-trade basis. The contingency for risk is added as a separate line for each trade. The same approach is applied to calculating risk for all project indirect costs. The literature on the subject suggests that each major cost element should be assessed regarding uncertainty, and the appropriate risk value should be assigned. This method of pricing risk is considered more reliable than the simple application of one overall risk amount to the full base estimate.
- Macro. This risk calculation method involves using an overall sum for the whole project. The amount of contingency to cover the risk is derived from previous experience on similar projects and historical data. Some considerations should be included for adjustments based on current circumstances: the state of the economy, the location of a project, available skilled trades, etc.
- Micro+Macro. This method of risk calculation is a combination of micro and macro methodologies. Trade or elemental basis price is part of the risk, and some risk is added to the base estimate as a lump sum amount.
- Construction period. Using this methodology, the contractor assesses the feasibility of construction time stated in the tender documents. Then, if necessary, they make an allowance per week to cover the liquidated damages and multiply by the number of extra weeks considered to be required to complete the project reasonably.
- Monte Carlo simulation. This methodology uses a probabilistic estimating technique to determine an overall contingency amount. Contractors very rarely use this method. It is more common in capital cost estimating.
Above all, the most valuable asset when pricing risk is experience and intuition. Regardless of the method used to price risk, there is nothing that can replace experience.
Most common risks.
The literature identifies the following risks as most commonly accounted for when pricing tenders:
- Tender documentation errors.
- Availability of resources.
- Constructability issues.
- Incomplete design.
- Subcontractor/supplier availability and quality.
- Scope changes.
- Exchange rate.
- Possible estimating errors.
- Site access issues.
- Environmental issues.
- The complexity of the project team.
- Inclement weather.
- Subcontractor performance.
- Owner financial issues.
- Equipment failure.
- Unforeseen site conditions.
- Industrial relations actions.
- Deficiencies.
- Changes in regulations/legislation.
- Political uncertainty.
- Site safety requirements.
- Low labour productivity.
- Fire.
The significance of each risk is dependent on the type of project, contractor experience and availability of resources, project location, the design firm, project owner, project schedule, etc. There is a direct relationship between the risks the contractors most often encounter and the significance of risks considered when pricing risk. Some risks have a considerable difference between their importance and rankings by the contractor. For example, unforeseen site conditions, labour low productivity and scope changes are considered significant risks but ranked as low ranking. The reason can be attributed to the fact that, based on previous experience, contractors can mitigate these risks during the project execution.
What is your approach to pricing risk? Please leave your comments below.
