Cost Estimation in Construction Projects: How to Get it Right

Sydney Opera House is prominent for its architectural wonder and state-of-the-art design. And it holds a Guinness World Record for being the largest proportional cost overrun in a building project. 

The initial estimate was AUS$7 million, but in the end, the actual cost was AUS$102 million — a gigantic 1,400% increase. The main issues were engineering challenges, labor disputes, design changes, rising material costs, and, ultimately, an improper cost estimate. 

Although the Sydney Opera House is an extreme case, cost overruns are common in construction projects. PMI reports that a staggering 90% of projects suffer from cost overruns, with improper estimates being the main culprit.

What is a cost estimate, and why is it important?

A cost estimate is an approximation of the total financial cost to complete a project, from the project initiation to the end of the project. 

Cost estimates impact the project by way of:

• Supporting project approval
• Preventing cost overrun 
• Establishing ROI projections

The Sydney Opera House example illustrates the importance of an accurate cost estimate in a construction project. In a large and complex project, costs may skyrocket beyond expectations. In some extreme cases, the cost overrun may put the company in a dire financial situation or even lead to bankruptcy.

What are the types of construction cost estimates?

In construction projects, there are four types of cost estimates: factor estimates, parametric estimates, unit-rate estimates, and 3-point estimates.

Factor estimate

A factor estimate happens in the very early stage of the project, when the scope is still being defined and there’s no historical data. It’s an “educated guess” from a project manager that will eventually need refinement.

Parametric estimate

A parametric estimate is based on historical data. For example, if a hotel with 100 rooms costs $300,000, then a hotel with 200 rooms in a similar location may cost roughly $600,000.

Unit rate or bottom-up estimate

The unit rate, or bottom-up estimate, occurs when the basis for the project’s design has been developed in sufficient detail. This method requires detailed quantity data, such as an engineering document list, Material Take Off (MTO), total construction hours, and unit rate to produce a total cost estimate.

3-point estimate

As the name suggests, a 3-point estimate is based on the average of three projections: optimistic (o), medium (m), and pessimistic (p). Those points are decided by experience or past projects. Then, the final estimate is calculated using one of the following formulas:

1. Triangular distribution = (o + m + p)/3
2. Beta distribution/PERT = (o + 4m + p)/6

What are the key components of a construction estimate?

There are several ways to describe key components of a construction estimate. The common practice is to divide the cost into its core categories: Project Management Team (PMT), engineering, procurement, and construction.

• PMT: The cost required for the project management team, including the project manager, project engineers, and project control. Typically, PMT costs are 5% of the total project cost.
• Engineering: The cost required for developing engineering design, calculation, and MTO. Engineering usually accounts for 10% of the overall cost. 
• Procurement: The cost required for material, equipment, inspection, packing, and delivery to the site. Procurement expenses are usually 35% of the total cost. 
• Construction: The cost required for on-site personnel, site preparation, earthworks, assembly, building erection, mechanical works, electrical work, etc. Commissioning works, such as function tests and running tests, are typically included here. Typically, construction expenses make up at least half of the total cost.

What is the difference between accuracy and precision?

Accuracy is an estimate versus reality, while precision is repeatability. In cost estimates, both accuracy and precision are important. An accurate estimate provides a reliable forecast, while precision indicates the estimate’s predictability and consistency. You’ll need both to prevent a project from going over-budget.

How to perform a construction cost estimate

As construction projects are typically executed in phases, the cost estimate should also follow suit. This method provides a systematic and step-by-step approach to cost estimation. 

As the project progresses and more information is known, the cost estimate becomes more accurate. There is also a term called class, with class 5 being the least accurate and class 1 being the most.

Class	Stage	Description	Estimation Steps	Accuracy
5	Initial screening	Due to limited data, a rough estimate is usually acceptable at the beginning of the project.	• List everything that is already known from the project (e.g., general scope, location, building description, etc.) • Use historical data to create a preliminary forecast	-50% to +100%
4	Feasibility study	This stage determines the economic viability of the project.	• Identify major cost contributors (such as main material, construction method, or specialized vendor) • Conduct a survey or market assessment of the main cost contributors • Assume the quantity and unit rate of other cost contributors	-30% to +50%
3	Budgetary estimate	Preliminary engineering design or pre-Front-End Engineering Design (FEED) is available in this stage.	• Refine the estimate of main cost contributors from the previous stage with more detailed data • Source quotes for main material cost contributors	-20% to +30%
2	Tender estimate	In this stage, FEED is completed, and the information is sufficient for a tender or bid estimate; it’s the last estimate before the Final Investment Decision (FID).	• Create a thorough Work Breakdown Structure (WBS) • Establish project timeline • Determine specific resource requirements	-15% to +20%
1	Detail engineering design	After the completion of a bid or tender, a detailed design is created to provide the actual construction work	• Itemize all materials needed • Create a detailed schedule • Source all unit rates and quotes • Total all expenses to calculate the final cost estimate	-3% to +15%

How to estimate costs for modular and prefabricated construction projects

Modular and prefabricated buildings have gained popularity in recent years, due to their faster, easier, and often cheaper installation. One famous example is Stadium 974 in Qatar for the 2022 World Cup. The stadium was built from 974 containers that were dismantled immediately after the event. 

The main principles of cost estimation for modular buildings are largely the same as for non-modular construction: Start with a clear scope of work, perform the engineering work, and obtain as much information as possible to create the cost estimate. There are, however, some key differences.

Design cost

The design of modular buildings is often simpler and cheaper than that of non-modular buildings because most components come preconfigured.

Packaging cost

The cost of packaging might be higher for modular buildings because the materials are larger and heavier than those used in non-modular buildings.

Delivery and transportation cost

Modular buildings can incur higher delivery and transportation costs due to their size and weight. Some modules may even require special routes, vehicles, shipping vessels, and other accommodations. 

Installation cost

Modular building installation is almost always cheaper than non-modular installation, because modular buildings don’t require construction from scratch and can be assembled on-site. 

How to model escalation in a cost estimate

A construction project always involves risks and uncertainties, which may escalate costs. That’s why a risk mitigation plan is essential.

After you’ve identified all potential risks and determined their probabilities, you can calculate the total risked cost escalation for the project. For each risk, multiply the unrisked cost (what you’d expect in an ideal world) by the risk’s probability.

Here’s an example:

Risk description	Unrisked cost	Probability	Risked cost escalation
Rising material cost	$500,000	30%	$150,000
Tariffs increase	$100,000	25%	$25,000
Rising labor cost	$750,000	40%	$300,000
Total risked cost escalation			$475,000

Like all probability calculations, the actual value may be higher or lower. This calculation, however, makes it easier to prepare for worst-case scenarios.

A risk estimation and management plan must be conducted before the FID, since it’s a crucial consideration in deciding whether to execute the project. As the project progresses, the risk plan should also be updated to align with changes to the risk assessment. 

How to review cost estimates

Here’s a simple checklist to review the cost estimates along with potential red flags.

Item description	Checklist	Potential red flags
Total cost estimate	• Is the total project cost comparable to similar projects? • What is included and excluded in the total cost?	Have a sense-check about the usual cost of that project to avoid an excessively expensive price. Find other projects’ prices for comparison.
Project scope	• Has the overall scope been covered?	Ensure no missing scope to avoid cost escalation later.
Key assumptions	• What assumptions are made in the estimate? • Do the assumptions make sense?	Assumptions are accepted in the cost estimate, but have some sense-check around those assumptions and data
Key components	• Are the key components (PMT, engineering, procurement, and construction) already covered? • What is the percentage cost of each component?	There is a rule of thumb for the percentage cost for each component as described in the previous section. Pay attention to the component with an unusually high percentage.
PMT	• Are key personnel for the project already included? • Has it considered both direct & indirect personnel?	Beware if PMT takes a large proportion of the project cost.
Engineering	• Are key engineering documents already included? • Does it include as-built documents?	Have your lead engineer check the engineering documents list. Also, ensure that as-built documents are included in the project close-out later.
Procurement	• Are all key materials and equipment already included? • Does it include packing, delivery, and preservation on-site? • Any warranty for the materials?	Check the delivery terms of the materials. Also, material preservation is important in a multi-year project.
Construction	• Does it have a detailed construction schedule? • What is the manpower rate and quantity? • What is the assumed productivity rate?	Construction is typically the largest cost component. Check the detailed schedule. Also, check the productivity assumptions (e.g., how many steel structures in kilograms can be built per day)
Cost risk	• Does it have a cost risk management plan? • What is included in the risks? • What is the total risked value?	Keep an eye on project risk, as it can significantly impact costs. Ensure that the major risks have been identified.

How do we manage uncertainties in labor costs?

Labor costs can rise unexpectedly, and this uncertainty can significantly affect the reliability of a cost estimate. One way to mitigate this risk is to implement the plan outlined in the table above, along with respectful negotiation and discussion with the labor. 

Here’s a more detailed step-by-step guide specific to labor costs:

1. Estimate the total cost for labor.
2. Review the history of rate-raising labor costs.
3. Obtain the unrisked value from steps 1 and 2.
4. Estimate the probability of raising labor costs.
5. Obtain the risk value from steps 3 and 4.

Example:

A project has an estimated total labor cost of $1,000,000 with a duration of one year. Historically, labor costs in that area have risen by 5% per year. The project team puts some margin and predicts that the increase may reach 8%. 

The unrisked value is $80,000. The project team estimates that this raise has a quite high likelihood of happening by 70%. Hence, the final risk value is $56,000.  

What are some best practices and common challenges in cost estimation?

Best practices:

• Understand the scope fully, including what is included and excluded.
• The more detailed front engineering work is performed, the more accurate the estimate will be.
• Identify the most expensive product (e.g., a rare material) or service (e.g., must be performed by a specialized vendor).
• Perform a risk assessment to identify sources of cost uncertainty, including logistical challenges, weather, and economic conditions.

Common challenges:

• Obtaining historical data from similar projects.
• Establishing an accurate estimate quickly and with minimal upfront work.
• Risk assessment and management for multi-year projects.

What tools can you use for construction cost estimation?

The most basic tool for a cost estimate is a simple spreadsheet, such as Excel or Google Sheets. But top project management software, such as Smartsheet, is an option for those who want a spreadsheet-like experience but with more advanced or automated features.

However, many construction projects require more sophisticated software, such as Primavera P6 or Microsoft Project, as those tools have features for creating detailed cost estimates.

Frequently asked questions (FAQ)

Bottom line

Cost estimation is a critical part of project management planning. It has many functionalities, which include supporting decisions to sanction the project, preventing cost overrun, calculating the economic benefits of the project, and tracking the actual spending. 

Cost should be estimated in the very beginning of the project, and it should be revisited throughout the project stage. As cost can make or break a project, it’s imperative that everyone involved in the project understands the cost estimate.