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Project Management for Construction Fundamental Concepts for Owners, Engineers, Architects and Builders

by
Chris Hendrickson
and
Tung Au

Department of Civil Engineering
Carnegie Mellon University
Pittsburgh, PA l52l3
June 28, 1999

Copyright C. Hendrickson and T. Au, 1988

Prepared under contract for publication with

Prentice-Hall, Inc.

Englewood Cliffs, New Jersey

1988

Preface

This book develops a specific viewpoint in discussing the participants, the processes and the techniques of project management for construction. This viewpoint is that of owners who desire completion of projects in a timely, cost effective fashion. Some profound implications for the objectives and methods of project management result from this perspective:

• The "life cycle" of costs and benefits from initial planning through operation of a facility are relevant to decision making. An owner is concerned with a project from the cradle to the grave. Construction costs represent only one portion of the overall life cycle costs.
• Optimizing performance at one stage of the process may not be beneficial overall if additional costs or delays occur elsewhere. For example, saving money on the design process will be a false economy if the result is excess construction costs.
• Fragmentation of project management among different specialists may be necessary, but good communication and coordination among the participants is essential to accomplish the overall goals of the project.
• Productivity improvements are always of importance and value. As a result, introducing new materials and automated construction processes is always desirable as long as they are less expensive and are consistent with desired performance.
• Quality of work and performance are critically important to the success of a project since it is the owner who will have to live with the results.

While this book is devoted to a particular viewpoint with respect to project management for construction, it is not solely intended for owners and their direct representatives. By understanding the entire process, all participants can respond more effectively to the owner's needs in their own work, in marketing their services, and in communicating with other participants. In addition, the specific techniques and tools discussed in this book (such as economic evaluation, scheduling, management information systems, etc.) can be readily applied to any portion of the process.

As a result of the focus on the effective management of entire projects, a number of novel organizational approaches and techniques become of interest. First and foremost is the incentive to replace confrontation and adversarial relationships with a spirit of joint endeavor and accomplishment. For example, we discuss the appropriate means to evaluate risks and the appropriate participants to assume the unavoidable risks associated with constructed facilities. Scheduling, communication of data, and quality assurance have particular significance from the viewpoint of an owner, but not necessarily for individual participants. The use of computer-based technology and automation also provides opportunities for increased productivity in the process. Presenting such modern management options in a unified fashion is a major objective of this book.

The unified viewpoint of the entire process of project management in this book differs from virtually all other literature on the subject. Most textbooks in the area treat special problems, such as cost estimating, from the viewpoint of particular participants such as construction managers or contractors. This literature reflects the fragmentation of the construction process among different organizations and professionals. Even within a single profession such as civil engineering, there are quite distinct groups of specialists in planning, design, management, construction and other sub-specialties. Fragmentation of interest and attention also exists in nearly all educational programs. While specialty knowledge may be essential to accomplish particular tasks, participants in the process should also understand the context and role of their special tasks.

This book is intended primarily as a text for advanced undergraduates or beginning graduate students in engineering, construction, architecture or facilities management. Examples and discussion are chosen to remind readers that project management is a challenging, dynamic and exciting enterprise and not just a record of past practices. It should also be useful to professionals who wish an up-to-date reference on project management.

Chapters 1 to 3 present an overview of the construction management and design process which should be of interest to anyone engaged in project management for construction. One need not have detailed knowledge about individual tasks or techniques for this part. Individuals can read these chapters and understand the basic philosophy and principles without further elaboration.

Chapters 4 through 14 describe specific functions and techniques useful in the process of project management. This part presents techniques and requirements during project planning, including risk assessment, cost estimation, forecasting and economic evaluation. It is during this planning and design phase in which major cost savings may be obtained during the eventual construction and operation phases. It also addresses programming and financing issues, such as contracting and bidding for services, financing, organizing communication and insuring effective use of information. It further discusses techniques for control of time, cost and quality during the construction phase. Beginning courses in engineering economics (including cash flow analysis and discounting), use of computers, probability and statistics would be useful. Furthermore, access to a personal computer with spreadsheet or equation solving software would be helpful for readers attempting some of the problems in Chapters 4 to 14. Numerous software programs could be used for this purpose, including both spreadsheet and equation solving programs. Problems in some chapters could also be done on any number of existing software packages for information management and project scheduling. However, the use of personal computers in this fashion is not required in following the text material. Each instructor may exercise discretion in omitting some of the material in these chapters if they are redundant with other classes or too advanced for students in his or her own class.

The last two chapters of this book discuss some future prospects for new technology in the construction field. We expect that these new technologies will have a substantial impact on productivity improvement in the next two decades even though they are not part of standard practice today. By including these chapters, we are challenging readers with the remarkable opportunities for innovation and improvement that exist in the field. These latter chapters may also be reserved for an advanced course.

It is our hope that students beginning their career in project management for construction will be prepared to adopt the integrated approach emphasized in this book. Furthermore, experienced professionals in various fields may discover in this book some surprises that even they have not anticipated. High level decision makers in owner organizations who are not directly involved in the project management process may find the basic philosophy and principles of interest, especially in Chapters 1 through 3, as owners must invariably pay for constructed facilities, for better or worse. If the book can fulfill even a small part of its promises to influence the future of project management for construction, our efforts will have been amply rewarded.

We wish to acknowledge our appreciation to Dr. William J. Hall for his encouragement and assistance in expediting the publication of this book. We are indebted to several colleagues at Carnegie Mellon University, Drs. Paul Christiano, Steven Fenves and Daniel Rehak who reviewed parts of the manuscript and offered valuable suggestions. We also wish to thank Debbie Scappatura and Shirley Knapp for their efforts in typing the manuscript. This book also reflects the contributions of numerous students and colleagues in industry who have challenged us with problems and shared their own ideas and experience over many years. We are grateful to all of these individuals.

Some material in this book has been taken from several papers authored by us and published by the American Society of Civil Engineers. Materials taken from other sources are acknowledged in footnotes, tables or figures. We gratefully acknowledge the permissions given to us by these individuals, publishers and organizations.

Finally, a series of photographs depicting various stages of construction of the PPG building in Pittsburgh, PA is inserted in sequence between chapters. We wish to thank PPG Industries for its cooperation in providing these photographs.

1. The Owners' Perspective

1.1 Introduction

Like the five blind men encountering different parts of an elephant, each of the numerous participants in the process of planning, designing, financing, constructing and operating physical facilities has a different perspective on project management for construction. Specialized knowledge can be very beneficial, particularly in large and complicated projects, since experts in various specialties can provide valuable services. However, it is advantageous to understand how the different parts of the process fit together. Waste, excessive cost and delays can result from poor coordination and communication among specialists. It is particularly in the interest of owners to insure that such problems do not occur. And it behooves all participants in the process to heed the interests of owners because, in the end, it is the owners who provide the resources and call the shots.

By adopting the viewpoint of the owners, we can focus our attention on the complete process of project management for constructed facilities rather than the historical roles of various specialists such as planners, architects, engineering designers, constructors, fabricators, material suppliers, financial analysts and others. To be sure, each specialty has made important advances in developing new techniques and tools for efficient implementation of construction projects. However, it is through the understanding of the entire process of project management that these specialists can respond more effectively to the owner's desires for their services, in marketing their specialties, and in improving the productivity and quality of their work.

The introduction of innovative and more effective project management for construction is not an academic exercise. As reported by the "Construction Industry Cost Effectiveness Project" of the Business Roundtable:[The Business Roundtable, More Construction for the Money, Summary Report of the Construction Industry Cost Effectiveness Project, January 1983, p. 11.]

By common consensus and every available measure, the United States no longer gets it's money's worth in construction, the nation's largest industry ... The creeping erosion of construction efficiency and productivity is bad news for the entire U.S. economy. Construction is a particularly seminal industry. The price of every factory, office building, hotel or power plant that is built affects the price that must be charged for the goods or services produced in it or by it. And that effect generally persists for decades ... Too much of the industry remains tethered to the past, partly by inertia and partly by historic divisions...

1.2 The Project Life Cycle

The acquisition of a constructed facility usually represents a major capital investment, whether its owner happens to be an individual, a private corporation or a public agency. Since the commitment of resources for such an investment is motivated by market demands or perceived needs, the facility is expected to satisfy certain objectives within the constraints specified by the owner and relevant regulations. With the exception of the speculative housing market, where the residential units may be sold as built by the real estate developer, most constructed facilities are custom made in consultation with the owners. A real estate developer may be regarded as the sponsor of building projects, as much as a government agency may be the sponsor of a public project and turns it over to another government unit upon its completion. From the viewpoint of project management, the terms "owner" and "sponsor" are synonymous because both have the ultimate authority to make all important decisions. Since an owner is essentially acquiring a facility on a promise in some form of agreement, it will be wise for any owner to have a clear understanding of the acquisition process in order to maintain firm control of the quality, timeliness and cost of the completed facility.

From the perspective of an owner, the project life cycle for a constructed facility may be illustrated schematically in Figure 1-1. Essentially, a project is conceived to meet market demands or needs in a timely fashion. Various possibilities may be considered in the conceptual planning stage, and the technological and economic feasibility of each alternative will be assessed and compared in order to select the best possible project. The financing schemes for the proposed alternatives must also be examined, and the project will be programmed with respect to the timing for its completion and for available cash flows. After the scope of the project is clearly defined, detailed engineering design will provide the blueprint for construction, and the definitive cost estimate will serve as the baseline for cost control. In the procurement and construction stage, the delivery of materials and the erection of the project on site must be carefully planned and controlled. After the construction is completed, there is usually a brief period of start-up or shake-down of the constructed facility when it is first occupied. Finally, the management of the facility is turned over to the owner for full occupancy until the facility lives out its useful life and is designated for demolition or conversion.

The Project Life Cycle of a Constructed Facility
  

Of course, the stages of development in Figure 1-1 may not be strictly sequential. Some of the stages require iteration, and others may be carried out in parallel or with overlapping time frames, depending on the nature, size and urgency of the project. Furthermore, an owner may have in-house capacities to handle the work in every stage of the entire process, or it may seek professional advice and services for the work in all stages. Understandably, most owners choose to handle some of the work in-house and to contract outside professional services for other components of the work as needed. By examining the project life cycle from an owner's perspective we can focus on the proper roles of various activities and participants in all stages regardless of the contractual arrangements for different types of work.

In the United States, for example, the U.S. Army Corps of Engineers has in-house capabilities to deal with planning, budgeting, design, construction and operation of waterway and flood control structures. Other public agencies, such as state transportation departments, are also deeply involved in all phases of a construction project. In the private sector, many large firms such as DuPont, Exxon, and IBM are adequately staffed to carry out most activities for plant expansion. All these owners, both public and private, use outside agents to a greater or lesser degree when it becomes more advantageous to do so.

The project life cycle may be viewed as a process through which a project is implemented from cradle to grave. This process is often very complex; however, it can be decomposed into several stages as indicated by the general outline in Figure 1-1. The solutions at various stages are then integrated to obtain the final outcome. Although each stage requires different expertise, it usually includes both technical and managerial activities in the knowledge domain of the specialist. The owner may choose to decompose the entire process into more or less stages based on the size and nature of the project, and thus obtain the most efficient result in implementation. Very often, the owner retains direct control of work in the planning and programming stages, but increasingly outside planners and financial experts are used as consultants because of the complexities of projects. Since operation and maintenance of a facility will go on long after the completion and acceptance of a project, it is usually treated as a separate problem except in the consideration of the life cycle cost of a facility. All stages from conceptual planning and feasibility studies to the acceptance of a facility for occupancy may be broadly lumped together and referred to as the Design/Construct process, while the procurement and construction alone are traditionally regarded as the province of the construction industry.

Owners must recognize that there is no single best approach in organizing project management throughout a project's life cycle. All organizational approaches have advantages and disadvantages, depending on the knowledge of the owner in construction management as well as the type, size and location of the project. It is important for the owner to be aware of the approach which is most appropriate and beneficial for a particular project. In making choices, owners should be concerned with the life cycle costs of constructed facilities rather than simply the initial construction costs. Saving small amounts of money during construction may not be worthwhile if the result is much larger operating costs or not meeting the functional requirements for the new facility satisfactorily. Thus, owners must be very concerned with the quality of the finished product as well as the cost of construction itself. Since facility operation and maintenance is a part of the project life cycle, the owners' expectation to satisfy investment objectives during the project life cycle will require consideration of the cost of operation and maintenance. Therefore, the facility's operating management should also be considered as early as possible, just as the construction process should be kept in mind at the early stages of planning and programming.

1.3 Major Types of Construction

Since most owners are generally interested in acquiring only a specific type of constructed facility, they should be aware of the common industrial practices for the type of construction pertinent to them. Likewise, the construction industry is a conglomeration of quite diverse segments and products. Some owners may procure a constructed facility only once in a long while and tend to look for short term advantages. However, many owners require periodic acquisition of new facilities and/or rehabilitation of existing facilities. It is to their advantage to keep the construction industry healthy and productive. Collectively, the owners have more power to influence the construction industry than they realize because, by their individual actions, they can provide incentives or disincentives for innovation, efficiency and quality in construction. It is to the interest of all parties that the owners take an active interest in the construction and exercise beneficial influence on the performance of the industry.

In planning for various types of construction, the methods of procuring professional services, awarding construction contracts, and financing the constructed facility can be quite different. For the purpose of discussion, the broad spectrum of constructed facilities may be classified into four major categories, each with its own characteristics.

Residential Housing Construction

Residential housing construction includes single-family houses, multi-family dwellings, and highrise apartments. During the development and construction of such projects, the developers or sponsors who are familiar with the construction industry usually serve as surrogate owners and take charge, making necessary contractual agreements for design and construction, and arranging the financing and sale of the completed structures. Residential housing designs are usually performed by architects and engineers, and the construction executed by builders who hire subcontractors for the structural, mechanical, electrical and other specialty work. An exception to this pattern is for single-family houses which may be designed by the builders as well.

The residential housing market is heavily affected by general economic conditions, tax laws, and the monetary and fiscal policies of the government. Often, a slight increase in total demand will cause a substantial investment in construction, since many housing projects can be started at different locations by different individuals and developers at the same time. Because of the relative ease of entry, at least at the lower end of the market, many new builders are attracted to the residential housing construction. Hence, this market is highly competitive, with potentially high risks as well as high rewards.

Illustration of Residential Housing Construction
  

Institutional and Commercial Building Construction

Because of the higher costs and greater sophistication of institutional and commercial buildings in comparison with residential housing, this market segment is shared by fewer competitors. Since the construction of some of these buildings is a long process which once started will take some time to proceed until completion, the demand is less sensitive to general economic conditions than that for speculative housing. Consequently, the owners may confront an oligopoly of general contractors who compete in the same market. In an oligopoly situation, only a limited number of competitors exist, and a firm's price for services may be based in part on its competitive strategies in the local market.

Illustration of Construction of the PPG Building in Pittsburgh, PA
  

Specialized Industrial Construction

Specialized industrial construction usually involves very large scale projects with a high degree of technological complexity, such as oil refineries, steel mills, chemical processing plants and coal-fired or nuclear power plants. The owners usually are deeply involved in the development of a project, and prefer to work with designers-builders such that the total time for the completion of the project can be shortened. They also want to pick a team of designers and builders with whom the owner has developed good working relations over the years.

Although the initiation of such projects is also affected by the state of the economy, long range demand forecasting is the most important factor since such projects are capital intensive and require considerable amount of planning and construction time. Governmental regulation such as the rulings of the Environmental Protection Agency and the Nuclear Regulatory Commission in the United States can also profoundly influence decisions on these projects.

Illustration of Construction of a Benzene Plant in Lima, Ohio
  

Infrastructure and Heavy Construction

The engineers and builders engaged in infrastructure construction are usually highly specialized since each segment of the market requires different types of skills. However, demands for different segments of infrastructure and heavy construction may shift with saturation in some segments. For example, as the available highway construction projects are declining, some heavy construction contractors quickly move their work force and equipment into the field of mining where jobs are available.

Illustration of Construction of the Dame Point Bridge in Jacksonville, Florida
  

1.4 Selection of Professional Services

When an owner decides to seek professional services for the design and construction of a facility, he is confronted with a broad variety of choices. The type of services selected depends to a large degree on the type of construction and the experience of the owner in dealing with various professionals in the previous projects undertaken by the firm. Generally, several common types of professional services may be engaged either separately or in some combination by the owners.

Financial Planning Consultants

Architectural and Engineering Firms

In the past two decades, this traditional approach has become less popular for a number of reasons, particularly for large scale projects. The A/E firms, which are engaged by the owner as the prime professionals for design and inspection, have become more isolated from the construction process. This has occurred because of pressures to reduce fees to A/E firms, the threat of litigation regarding construction defects, and lack of knowledge of new construction techniques on the part of architect and engineering professionals. Instead of preparing a construction plan along with the design, many A/E firms are no longer responsible for the details of construction nor do they provide periodic field inspection in many cases. As a matter of fact, such firms will place a prominent disclaimer of responsibilities on any shop drawings they may check, and they will often regard their representatives in the field as observers instead of inspectors. Thus, the A/E firm and the general contractor on a project often become antagonists who are looking after their own competing interests. As a result, even the constructibility of some engineering designs may become an issue of contention. To carry this protective attitude to the extreme, the specifications prepared by an A/E firm for the general contractor often protects the interest of the A/E firm at the expense of the interests of the owner and the contractor.

In order to reduce the cost of construction, some owners introduce value engineering, which seeks to reduce the cost of construction by soliciting a second design that might cost less than the original design produced by the A/E firm. In practice, the second design is submitted by the contractor after receiving a construction contract at a stipulated sum, and the saving in cost resulting from the redesign is shared by the contractor and the owner. The contractor is able to absorb the cost of redesign from the profit in construction or to reduce the construction cost as a result of the re-design. If the owner had been willing to pay a higher fee to the A/E firm or to better direct the design process, the A/E firm might have produced an improved design which would cost less in the first place. Regardless of the merit of value engineering, this practice has undermined the role of the A/E firm as the prime professional acting on behalf of the owner to supervise the contractor.

Design/Construct Firms

One of the most obvious advantages of the integrated design/construct process is the use of phased construction for a large project. In this process, the project is divided up into several phases, each of which can be designed and constructed in a staggered manner. After the completion of the design of the first phase, construction can begin without waiting for the completion of the design of the second phase, etc. If proper coordination is exercised. the total project duration can be greatly reduced. Another advantage is to exploit the possibility of using the turnkey approach whereby an owner can delegate all responsibility to the design/construct firm which will deliver to the owner a completed facility that meets the performance specifications at the specified price.

Professional Construction Managers

It should be obvious to all involved in the construction process that the party which is required to take higher risk demands larger rewards. If an owner wants to engage an A/E firm on the basis of low fees instead of established qualifications, it often gets what it deserves; or if the owner wants the general contractor to bear the cost of uncertainties in construction such as foundation conditions, the contract price will be higher even if competitive bidding is used in reaching a contractual agreement. Without mutual respect and trust, an owner cannot expect that construction managers can produce better results than other professionals. Hence, an owner must understand its own responsibility and the risk it wishes to assign to itself and to other participants in the process.

Operation and Maintenance Managers

Facilities Management

Facilities management is the discipline of planning, designing, constructing and managing space -- in every type of structure from office buildings to process plants. It involves developing corporate facilities policy, long-range forecasts, real estate, space inventories, projects (through design, construction and renovation), building operation and maintenance plans and furniture and equipment inventories.

A common denominator of all firms entering into these new services is that they all have strong computer capabilities and heavy computer investments. In addition to the use of computers for aiding design and monitoring construction, the service includes the compilation of a computer record of building plans that can be turned over at the end of construction to the facilities management group of the owner. A computer data base of facilities information makes it possible for planners in the owner's organization to obtain overview information for long range space forecasts, while the line managers can use as-built information such as lease/tenant records, utility costs, etc. for day-to-day operations.

1.5 Construction Contractors

Builders who supervise the execution of construction projects are traditionally referred to as contractors, or more appropriately called constructors. The general contractor coordinates various tasks for a project while the specialty contractors such as mechanical or electrical contractors perform the work in their specialties. Material and equipment suppliers often act as installation contractors; they play a significant role in a construction project since the conditions of delivery of materials and equipment affect the quality, cost, and timely completion of the project. It is essential to understand the operation of these contractors in order to deal with them effectively.

General Contractors

Specialty Contractors

Material and Equipment Suppliers

1.6 Financing of Constructed Facilities

A major construction project requires an enormous amount of capital that is often supplied by lenders who want to be assured that the project will offer a fair return on the investment. The direct costs associated with a major construction project may be broadly classified into two categories: (1) the construction expenses paid to the general contractor for erecting the facility on site and (2) the expenses for land acquisition, legal fees, architect/engineer fees, construction management fees, interest on construction loans and the opportunity cost of carrying empty space in the facility until it is fully occupied. The direct construction costs in the first category represent approximately 60 to 80 percent of the total costs in most construction projects. Since the costs of construction are ultimately borne by the owner, careful financial planning for the facility must be made prior to construction.

Construction Financing

Construction loans provided for different types of construction vary. In the case of residential housing, construction loans and long-term mortgages can be obtained from savings and loans associations or commercial banks. For institutional and commercial buildings, construction loans are usually obtained from commercial banks. Since the value of specialized industrial buildings as collateral for loans is limited, construction loans in this domain are rare, and construction financing can be done from the pool of general corporate funds. For infrastructure construction owned by government, the property cannot be used as security for a private loan, but there are many possible ways to finance the construction, such as general appropriation from taxation or special bonds issued for the project.

Traditionally, banks serve as construction lenders in a three-party agreement among the contractor, the owner and the bank. The stipulated loan will be paid to the contractor on an agreed schedule upon the verification of completion of various portions of the project. Generally, a payment request together with a standard progress report will be submitted each month by the contractor to the owner which in turn submits a draw request to the bank. Provided that the work to date has been performed satisfactorily, the disbursement is made on that basis during the construction period. Under such circumstances, the bank has been primarily concerned with the completion of the facility on time and within the budget. The economic life of the facility after its completion is not a concern because of the transfer of risk to the owner or an institutional lender.

Facility Financing

Because of the sudden surge of interest rates in the late 1970's, many financial institutions offer, in addition to the traditional fixed rate long-term mortgage commitments, other arrangements such as a combination of debt and a percentage of ownership in exchange for a long-term mortgage or the use of adjustable rate mortgages. In some cases, the construction loan may be granted on an open-ended basis without a long-term financing commitment. For example, the plan might be issued for the construction period with an option to extend it for a period of up to three years in order to give the owner more time to seek alternative long-term financing on the completed facility. The bank will be drawn into situations involving financial risk if it chooses to be a lender without long-term guarantees.

1.7 Legal and Regulatory Requirements

The owners of facilities naturally want legal protection for all the activities involved in the construction. It is equally obvious that they should seek competent legal advice. However, there are certain principles that should be recognized by owners in order to avoid unnecessary pitfalls.

Legal Responsibilities

Mitigation of Conflicts

Government Regulation

U.S. Laws on Environmental Protection, 1895 - 1985
  

Owners must be aware of the impacts of these regulations on the costs and durations of various types of construction projects as well as possibilities of litigation due to various contentions. For example, owners acquiring sites for new construction may be strictly liable for any hazardous wastes already on the site or removed from the site under the U.S. Comprehensive Environmental Response Compensation and Liability (CERCL) Act of 1980. For large scale projects involving new technologies, the construction costs often escalate with the uncertainty associated with such restrictions.

1.8 The Changing Environment of the Construction Industry

The construction industry is a conglomeration of diverse fields and participants that have been loosely lumped together as a sector of the economy. The construction industry plays a central role in national welfare, including the development of residential housing, office buildings and industrial plants, and the restoration of the nation's infrastructure and other public facilities. The importance of the construction industry lies in the function of its products which provide the foundation for industrial production, and its impacts on the national economy cannot be measured by the value of its output or the number of persons employed in its activities alone.

To be more specific, construction refers to all types of activities usually associated with the erection and repair of immobile facilities. Contract construction consists of a large number of firms that perform construction work for others, and is estimated to be approximately 85% of all construction activities. The remaining 15% of construction is performed by owners of the facilities, and is referred to as force-account construction. Although the number of contractors in the United States exceeds a million, over 60% of all contractor construction is performed by the top 400 contractors. The value of new construction in the United States (expressed in constant dollars) and the value of construction as a percentage of the gross national products from 1950 to 1985 are shown in Figure 1-0. It can be seen that construction is a significant factor in the Gross National Product although its importance has been declining in recent years.[The graph is derived from data in "Value of New Construction Put in Place, 1960-1983", Statistical Abstract of the United States, 105th Edition, U.S. Department of Commerce, Bureau of Census, 1985, pp. 722-723, as well as the information in earlier editions.] Not to be ignored is the fact that as the nation's constructed facilities become older, the total expenditure on rehabilitation and maintenance may increase relative to the value of new construction.

Value of New Construction in U.S., 1950-1985
  

Owners who pay close attention to the peculiar characteristics of the construction industry and its changing operating environment will be able to take advantage of the favorable conditions and to avoid the pitfalls. Several factors are particularly noteworthy because of their significant impacts on the quality, cost and time of construction.

New Technologies

The effects of new technologies on construction costs have been mixed because of the high development costs for new technologies. However, it is unmistakable that design professionals and construction contractors who have not adapted to changing technologies have been forced out of the mainstream of design and construction activities. Ultimately, construction quality and cost can be improved with the adoption of new technologies which are proved to be efficient from both the viewpoints of performance and economy.

Labor Productivity

While aggregate construction industry productivity is important as a measure of national economy, owners are more concerned about the labor productivity of basic units of work produced by various crafts on site. Thus, an owner can compare the labor performance at different geographic locations, under different working conditions, and for different types and sizes of projects.

Construction costs usually run parallel to material prices and labor wages. Actually, over the years, labor productivity has increased in some traditional types of construction and thus provides a leveling or compensating effect when hourly rates for labor increase faster than other costs in construction. However, labor productivity has been stagnant or even declined in unconventional or large scale projects.

Public Scrutiny

Figure 1-0 can serve to indicate public attitudes towards the siting of new facilities. It represents the cumulative percentage of individuals who would be willing to accept a new industrial facility at various distances from their homes. For example, over fifty percent of the people surveyed would accept a ten-story office building within five miles of their home, but only twenty-five percent would accept a large factory or coal fired power plant at a similar distance. An even lower percentage would accept a hazardous waste disposal site or a nuclear power plant. Even at a distance of one hundred miles, a significant fraction of the public would be unwilling to accept hazardous waste facilities or nuclear power plants.

Public Acceptance toward New Facilities
  

This objection to new facilities is a widespread public attitude, representing considerable skepticism about the external benefits and costs which new facilities will impose. It is this public attitude which is likely to make public scrutiny and regulation a continuing concern for the construction industry.

International Competition

A bidding competition for a major new offshore drilling platform illustrates the competitive environment in construction. As described in the Wall Street Journal:[See Petzinger, Thomas Jr., "Upstart's Winning Bid for Offshore Platform Stuns its Older Rivals," Wall Street Journal, p. 1, c. 6, Nov. 20, 1985.]

Through most of the postwar years, the nation's biggest builders of offshore oil platforms enjoyed an unusually cozy relationship with the Big Oil Companies they served. Their top officials developed personal friendships with oil executives, entertained them at opulent hunting camps- and won contracts to build nearly every major offshore oil platform in the world....But this summer, the good-old boy network fell apart. Shell [Oil Co.] awarded the main contract for [a new] platform - taller than Chicago's Sears Tower, four times heavier than the Brooklyn Bridge - to a tiny upstart.

Of course, U.S. firms including A/E firms, contractors and construction managers are also competing in foreign countries. Their success or failure in the international arena may also affect their capacities and vitality to provide services in the domestic U.S. market.

Contractor Financed Projects

This type of joint venture has become more important in the international construction market where aggressive contractors often win contracts by offering a more attractive financing package rather than superior technology. With a deepening shadow of international debts in recent years, many developing countries are not in a position to undertake any new project without contractor-backed financing. Thus, the contractors or joint ventures in overseas projects are forced into very risky positions if they intend to stay in the competition.

1.9 The Role of Project Managers

In the project life cycle, the most influential factors affecting the outcome of the project often reside at the early stages. At this point, decisions should be based on competent economic evaluation with due consideration for adequate financing, the prevalent social and regulatory environment, and technological considerations. Architects and engineers might specialize in planning, in construction field management, or in operation, but as project managers, they must have some familiarity with all such aspects in order to understand properly their role and be able to make competent decisions.

Since the 1970's, many large-scale projects have run into serious problems of management, such as cost overruns and long schedule delays. Actually, the management of megaprojects or superprojects is not a practice peculiar to our time. Witness the construction of transcontinental railroads in the Civil War era and the construction of the Panama Canal at the turn of this century. Although the megaprojects of this generation may appear in greater frequency and present a new set of challenge, the problems are organizational rather than technical. As noted by Hardy Cross:[See H. Cross, Engineers and Ivory Towers, McGraw-Hill Book Co., Inc., New York, 1952.]

It is customary to think of engineering as a part of a trilogy, pure science, applied science and engineering. It needs emphasis that this trilogy is only one of a triad of trilogies into which engineering fits. This first is pure science, applied science and engineering; the second is economic theory, finance and engineering; and the third is social relations, industrial relations and engineering. Many engineering problems are as closely allied to social problems as they are to pure science.

The greatest stumbling block to effective management in construction is the inertia and historic divisions among planners, designers and constructors. While technical competence in design and innovation remains the foundation of engineering practice, the social, economic and organizational factors that are pervasive in influencing the success and failure of construction projects must also be dealt with effectively by design and construction organizations. Of course, engineers are not expected to know every detail of management techniques, but they must be knowledgeable enough to anticipate the problems of management so that they can work harmoniously with professionals in related fields to overcome the inertia and historic divisions.

Paradoxically, engineers who are creative in engineering design are often innovative in planning and management since both types of activities involve problem solving. In fact, they can reinforce each other if both are included in the education process, provided that creativity and innovation instead of routine practice are emphasized. A project manager who is well educated in the fundamental principles of engineering design and management can usefully apply such principles once he or she has acquired basic understanding of a new application area. A project manager who has been trained by rote learning for a specific type of project may merely gain one year of experience repeated twenty times even if he or she has been in the field for twenty years. A broadly educated project manager can reasonably hope to become a leader in the profession; a narrowly trained project manager is often relegated to the role of his or her first job level permanently.

The owners have much at stake in selecting a competent project manager and in providing her or him with the authority to assume responsibility at various stages of the project regardless of the types of contractual agreements for implementing the project. Of course, the project manager must also possess the leadership quality and the ability to handle effectively intricate interpersonal relationships within an organization. The ultimate test of the education and experience of a project manager for construction lies in her or his ability to apply fundamental principles to solving problems in the new and unfamiliar situations which have become the hallmarks of the changing environment in the construction industry.

1.10 References

1. Au, T. and C. Hendrickson, "Education in Engineering Planning and Management," Proceedings of the ASCE Conference on Civil Engineering Education, Columbus, Ohio, 1985.
2. Barrie, D.S. (editor), Directions in Managing Construction, John Wiley and Sons, New York, 1981.
3. Bonny, J.B. and J.P. Frein, Handbook of Construction Management and Organization, 2nd Edition, Van Nostrand Reinhold Co., New York, 1980.
4. Lang, J.E. and D.Q. Mills, The Construction Industry, Lexington Books, Lexington, MA, 1979.
5. Walker, N., E.N. Walker and T.K. Rohdenburg, Legal Pitfalls in Architecture, Engineering and Building Construction, 2nd Edition, McGraw-Hill Book Co., New York, 1979.

2. Organizing for Project Management

2.1 What is Project Management?

The management of construction projects requires knowledge of modern management as well as an understanding of the design and construction process. Construction projects have a specific set of objectives and constraints such as a required time frame for completion. While the relevant technology, institutional arrangements or processes will differ, the management of such projects has much in common with the management of similar types of projects in other specialty or technology domains such as aerospace, pharmaceutical and energy developments.

Generally, project management is distinguished from the general management of corporations by the mission-oriented nature of a project. A project organization will generally be terminated when the mission is accomplished. According to the Project Management Institute, the discipline of project management can be defined as follows:[See R. M. Wideman, "The PMBOK Report -- PMI Body of Knowledge Standard," Project Management Journal, Vol. 17, No. 3, August l986, pp. l5-24.]

Project management is the art of directing and coordinating human and material resources throughout the life of a project by using modern management techniques to achieve predetermined objectives of scope, cost, time, quality and participation satisfaction.

The basic ingredients for a project management framework [See L. C. Stuckenbruck, "Project Management Framework," Project Management Journal, Vol. 17, No. 3, August 1986, pp. 25-30.] may be represented schematically in Figure 2-0. A working knowledge of general management and familiarity with the special knowledge domain related to the project are indispensable. Supporting disciplines such as computer science and decision science may also play an important role. In fact, modern management practices and various special knowledge domains have absorbed various techniques or tools which were once identified only with the supporting disciplines. For example, computer-based information systems and decision support systems are now common-place tools for general management. Similarly, many operations research techniques such as linear programming and network analysis are now widely used in many knowledge or application domains. Hence, the representation in Figure 2-0 reflects only the sources from which the project management framework evolves.

Basic Ingredients in Project Management
  

Specifically, project management in construction encompasses a set of objectives which may be accomplished by implementing a series of operations subject to resource constraints. There are potential conflicts between the stated objectives with regard to scope, cost, time and quality, and the constraints imposed on human material and financial resources. These conflicts should be resolved at the onset of a project by making the necessary tradeoffs or creating new alternatives. Subsequently, the functions of project management for construction generally include the following:

1. Specification of project objectives and plans including delineation of scope, budgeting, scheduling, setting performance requirements, and selecting project participants.
2. Maximization of efficient resource utilization through procurement of labor, materials and equipment according to the prescribed schedule and plan.
3. Implementation of various operations through proper coordination and control of planning, design, estimating, contracting and construction in the entire process.
4. Development of effective communications and mechanisms for resolving conflicts among the various participants.

2.2 Trends in Modern Management

In recent years, major developments in management reflect the acceptance to various degrees of the following elements: (1) the management process approach, (2) the management science and decision support approach, and (3) the behavioral science approach for human resource development. These three approaches complement each other in current practice, and provide a useful groundwork for project management.

The management process approach emphasizes the systematic study of management by identifying management functions in an organization and then examining each in detail. There is general agreement regarding the functions of planning, organizing and controlling. A major tenet is that by analyzing management along functional lines, a framework can be constructed into which all new management activities can be placed. Thus, the manager's job is regarded as coordinating a process of interrelated functions, which are neither totally random nor rigidly predetermined, but are dynamic as the process evolves. Another tenet is that management principles can be derived from an intellectual analysis of management functions. By dividing the manager's job into functional components, principles based upon each function can be extracted. Hence, management functions can be organized into a hierarchical structure designed to improve operational efficiency, such as the example of the organization for a manufacturing company shown in Figure 2-0. The basic management functions are performed by all managers, regardless of enterprise, activity or hierarchical levels. Finally, the development of a management philosophy results in helping the manager to establish relationships between human and material resources. The outcome of following an established philosophy of operation helps the manager win the support of the subordinates in achieving organizational objectives.

Illustrative Hierarchical Structure of Management Functions
  

The management science and decision support approach contributes to the development of a body of quantitative methods designed to aid managers in making complex decisions related to operations and production. In decision support systems, emphasis is placed on providing managers with relevant information. In management science, a great deal of attention is given to defining objectives and constraints, and to constructing mathematical analysis models in solving complex problems of inventory, materials and production control, among others. A topic of major interest in management science is the maximization of profit, or in the absence of a workable model for the operation of the entire system, the suboptimization of the operations of its components. The optimization or suboptimization is often achieved by the use of operations research techniques, such as linear programming, quadratic programming, graph theory, queueing theory and Monte Carlo simulation. In addition to the increasing use of computers accompanied by the development of sophisticated mathematical models and information systems, management science and decision support systems have played an important role by looking more carefully at problem inputs and relationships and by promoting goal formulation and measurement of performance. Artificial intelligence has also begun to be applied to provide decision support systems for solving ill-structured problems in management.

The behavioral science approach for human resource development is important because management entails getting things done through the actions of people. An effective manager must understand the importance of human factors such as needs, drives, motivation, leadership, personality, behavior, and work groups. Within this context, some place more emphasis on interpersonal behavior which focuses on the individual and his/her motivations as a socio-psychological being; others emphasize more group behavior in recognition of the organized enterprise as a social organism, subject to all the attitudes, habits, pressures and conflicts of the cultural environment of people. The major contributions made by the behavioral scientists to the field of management include: (1) the formulation of concepts and explanations about individual and group behavior in the organization, (2) the empirical testing of these concepts methodically in many different experimental and field settings, and (3) the establishment of actual managerial policies and decisions for operation based on the conceptual and methodical frameworks.

2.3 Strategic Planning and Project Programming

The programming of capital projects is shaped by the strategic plan of an organization, which is influenced by market demands and resources constraints. The programming process associated with planning and feasibility studies sets the priorities and timing for initiating various projects to meet the overall objectives of the organizations. However, once this decision is made to initiate a project, market pressure may dictate early and timely completion of the facility.

Among various types of construction, the influence of market pressure on the timing of initiating a facility is most obvious in industrial construction.(See, for example, O'Connor, J.T., and Vickory, C.G., Control of Construction Project Scope, A Report to the Construction Industry Institute, The University of Texas at Austin, December 1985.) Demand for an industrial product may be short-lived, and if a company does not hit the market first, there may not be demand for its product later. With intensive competition for national and international markets, the trend of industrial construction moves toward shorter project life cycles, particularly in technology intensive industries.

In order to gain time, some owners are willing to forego thorough planning and feasibility study so as to proceed on a project with inadequate definition of the project scope. Invariably, subsequent changes in project scope will increase construction costs; however, profits derived from earlier facility operation often justify the increase in construction costs. Generally, if the owner can derive reasonable profits from the operation of a completed facility, the project is considered a success even if construction costs far exceed the estimate based on an inadequate scope definition. This attitude may be attributed in large part to the uncertainties inherent in construction projects. It is difficult to argue that profits might be even higher if construction costs could be reduced without increasing the project duration. However, some projects, notably some nuclear power plants, are clearly unsuccessful and abandoned before completion, and their demise must be attributed at least in part to inadequate planning and poor feasibility studies.

The owner or facility sponsor holds the key to influence the construction costs of a project because any decision made at the beginning stage of a project life cycle has far greater influence than those made at later stages, as shown schematically in Figure 2-0. Therefore, an owner should obtain the expertise of professionals to provide adequate planning and feasibility studies. Many owners do not maintain an in-house engineering and construction management capability, and they should consider the establishment of an ongoing relationship with outside consultants in order to respond quickly to requests. Even among those owners who maintain engineering and construction divisions, many treat these divisions as reimbursable, independent organizations. Such an arrangement should not discourage their legitimate use as false economies in reimbursable costs from such divisions can indeed be very costly to the overall organization.

Ability to Influence Construction Cost Over Time
  

Finally, the initiation and execution of capital projects places demands on the resources of the owner and the professionals and contractors to be engaged by the owner. For very large projects, it may bid up the price of engineering services as well as the costs of materials and equipment and the contract prices of all types. Consequently, such factors should be taken into consideration in determining the timing of a project.

Example 2-1: Setting priorities for projects

A department store planned to expand its operation by acquiring 20 acres of land in the southeast of a metropolitan area which consists of well established suburbs for middle income families. An architectural/engineering (A/E) firm was engaged to design a shopping center on the 20-acre plot with the department store as its flagship plus a large number of storefronts for tenants. One year later, the department store owner purchased 2,000 acres of farm land in the northwest outskirts of the same metropolitan area and designated 20 acres of this land for a shopping center. The A/E firm was again engaged to design a shopping center at this new location.

The A/E firm was kept completely in the dark while the assemblage of the 2,000 acres of land in the northwest quietly took place. When the plans and specifications for the southeast shopping center were completed, the owner informed the A/E firm that it would not proceed with the construction of the southeast shopping center for the time being. Instead, the owner urged the A/E firm to produce a new set of similar plans and specifications for the northwest shopping center as soon as possible, even at the sacrifice of cost saving measures. When the plans and specifications for the northwest shopping center were ready, the owner immediately authorized its construction. However, it took another three years before the southeast shopping center was finally built.

The reason behind the change of plan was that the owner discovered the availability of the farm land in the northwest which could be developed into residential real estate properties for upper middle income families. The immediate construction of the northwest shopping center would make the land development parcels more attractive to home buyers. Thus, the owner was able to recoup enough cash flow in three years to construct the southeast shopping center in addition to financing the construction of the northeast shopping center, as well as the land development in its vicinity.

While the owner did not want the construction cost of the northwest shopping center to run wild, it apparently was satisfied with the cost estimate based on the detailed plans of the southeast shopping center. Thus, the owner had a general idea of what the construction cost of the northwest shopping center would be, and did not wish to wait for a more refined cost estimate until the detailed plans for that center were ready. To the owner, the timeliness of completing the construction of the northwest shopping center was far more important than reducing the construction cost in fulfilling its investment objectives.

Example 2-2: Resource Constraints for Mega Projects

A major problem with mega projects is the severe strain placed on the environment, particularly on the resources in the immediate area of a construction project. "Mega" or "macro" projects involve construction of very large facilities such as the Alaska pipeline constructed in the 1970's or the Panama Canal constructed in the 1900's. The limitations in some or all of the basic elements required for the successful completion of a mega project include:

• engineering design professionals to provide sufficient manpower to complete the design within a reasonable time limit.
• construction supervisors with capacity and experience to direct large projects.
• the number of construction workers with proper skills to do the work.
• the market to supply materials in sufficient quantities and of required quality on time.
• the ability of the local infrastructure to support the large number of workers over an extended period of time, including housing, transportation and other services.

2.4 Effects of Project Risks on Organization

The uncertainty in undertaking a construction project comes from many sources and often involves many participants in the project. Since each participant tries to minimize its own risk, the conflicts among various participants can be detrimental to the project. Only the owner has the power to moderate such conflicts as it alone holds the key to risk assignment through proper contractual relations with other participants. Failure to recognize this responsibility by the owner often leads to undesirable results. In recent years, the concept of "risk sharing/risk assignment" contracts has gained acceptance by the federal government.(See, for example, Federal Form 23-A and EPA's Appendix C-2 clauses.) Since this type of contract acknowledges the responsibilities of the owners, the contract prices are expected to be lower than those in which all risks are assigned to contractors.

In approaching the problem of uncertainty, it is important to recognize that incentives must be provided if any of the participants is expected to take a greater risk. The willingness of a participant to accept risks often reflects the professional competence of that participant as well as its propensity to risk. However, society's perception of the potential liabilities of the participant can affect the attitude of risk-taking for all participants. When a claim is made against one of the participants, it is difficult for the public to know whether a fraud has been committed, or simply that an accident has occurred.

Risks in construction projects may be classified in a number of ways. (See E. D'Appolonia, "Coping with Uncertainty in Geotechnical Engineering and Construction," Special Proceedings of the 9th International Conference on Soil Mechanics and Foundation Engineering, Tokyo, Japan, Vol. 4, 1979, pp. 1-18.) One form of classification is as follows:

1. Socioeconomic factors
   • Environmental protection
   • Public safety regulation
   • Economic instability
2. Organizational relationships
   • Contractual relations
   • Attitudes of participants
   • Communication
3. Technological problems
   • Design assumptions
   • Site conditions
   • Construction procedures
   • Construction occupational safety

The environmental protection movement has contributed to the uncertainty for construction because of the inability to know what will be required and how long it will take to obtain approval from the regulatory agencies. The requirements of continued re-evaluation of problems and the lack of definitive criteria which are practical have also resulted in added costs. Public safety regulations have similar effects, which have been most noticeable in the energy field involving nuclear power plants and coal mining. The situation has created constantly shifting guidelines for engineers, constructors and owners as projects move through the stages of planning to construction. These moving targets add a significant new dimension of uncertainty which can make it virtually impossible to schedule and complete work at budgeted cost. Economic conditions of the past decade have further reinforced the climate of uncertainty with high inflation and interest rates. The deregulation of financial institutions has also generated unanticipated problems related to the financing of construction.

Uncertainty stemming from regulatory agencies, environmental issues and financial aspects of construction should be at least mitigated or ideally eliminated. Owners are keenly interested in achieving some form of breakthrough that will lower the costs of projects and mitigate or eliminate lengthy delays. Such breakthroughs are seldom planned. Generally, they happen when the right conditions exist, such as when innovation is permitted or when a basis for incentive or reward exists. However, there is a long way to go before a true partnership of all parties involved can be forged.

During periods of economic expansion, major capital expenditures are made by industries and bid up the cost of construction. In order to control costs, some owners attempt to use fixed price contracts so that the risks of unforeseen contingencies related to an overheated economy are passed on to contractors. However, contractors will raise their prices to compensate for the additional risks.

The risks related to organizational relationships may appear to be unnecessary but are quite real. Strained relationships may develop between various organizations involved in the design/construct process. When problems occur, discussions often center on responsibilities rather than project needs at a time when the focus should be on solving the problems. Cooperation and communication between the parties are discouraged for fear of the effects of impending litigation. This barrier to communication results from the ill-conceived notion that uncertainties resulting from technological problems can be eliminated by appropriate contract terms. The net result has been an increase in the costs of constructed facilities.

The risks related to technological problems are familiar to the design/construct professions which have some degree of control over this category. However, because of rapid advances in new technologies which present new problems to designers and constructors, technological risk has become greater in many instances. Certain design assumptions which have served the professions well in the past may become obsolete in dealing with new types of facilities which may have greater complexity or scale or both. Site conditions, particularly subsurface conditions which always present some degree of uncertainty, can create an even greater degree of uncertainty for facilities with heretofore unknown characteristics during operation. Because construction procedures may not have been fully anticipated, the design may have to be modified after construction has begun. An example of facilities which have encountered such uncertainty is the nuclear power plant, and many owners, designers and contractors have suffered for undertaking such projects.

If each of the problems cited above can cause uncertainty, the combination of such problems is often regarded by all parties as being out of control and inherently risky. Thus, the issue of liability has taken on major proportions and has influenced the practices of engineers and constructors, who in turn have influenced the actions of the owners.

Many owners have begun to understand the problems of risks and are seeking to address some of these problems. For example, some owners are turning to those organizations that offer complete capabilities in planning, design, and construction, and tend to avoid breaking the project into major components to be undertaken individually by specialty participants. Proper coordination throughout the project duration and good organizational communication can avoid delays and costs resulting from fragmentation of services, even though the components from various services are eventually integrated.

Attitudes of cooperation can be readily applied to the private sector, but only in special circumstances can they be applied to the public sector. The ability to deal with complex issues is often precluded in the competitive bidding which is usually required in the public sector. The situation becomes more difficult with the proliferation of regulatory requirements and resulting delays in design and construction while awaiting approvals from government officials who do not participate in the risks of the project.

2.5 Organization of Project Participants

The top management of the owner sets the overall policy and selects the appropriate organization to take charge of a proposed project. Its policy will dictate how the project life cycle is divided among organizations and which professionals should be engaged. Decisions by the top management of the owner will also influence the organization to be adopted for project management. In general, there are many ways to decompose a project into stages. The most typical ways are:

• Sequential processing whereby the project is divided into separate stages and each stage is carried out successively in sequence.
• Parallel processing whereby the project is divided into independent parts such that all stages are carried out simultaneously.
• Staggered processing whereby the stages may be overlapping, such as the use of phased design-construct procedures for fast track operation.

• How many organizations are involved?
• What are the relationships among the organizations?
• When are the various organizations brought into the project?

There are two basic approaches to organize for project implementation, even though many variations may exist as a result of different contractual relationships adopted by the owner and builder. These basic approaches are divided along the following lines:

1. Separation of organizations. Numerous organizations serve as consultants or contractors to the owner, with different organizations handling design and construction functions. Typical examples which involve different degrees of separation are:
   • Traditional sequence of design and construction
   • Professional construction management
2. Integration of organizations. A single or joint venture consisting of a number of organizations with a single command undertakes both design and construction functions. Two extremes may be cited as examples:
   • Owner-builder operation in which all work will be handled in house by force account.
   • Turnkey operation in which all work is contracted to a vendor which is responsible for delivering the completed project

Since construction projects may be managed by a spectrum of participants in a variety of combinations, the organization for the management of such projects may vary from case to case. On one extreme, each project may be staffed by existing personnel in the functional divisions of the organization on an ad-hoc basis as shown in Figure 2-0 until the project is completed. This arrangement is referred to as the matrix organization as each project manager must negotiate all resources for the project from the existing organizational framework. On the other hand, the organization may consist of a small central functional staff for the exclusive purpose of supporting various projects, each of which has its functional divisions as shown in Figure 2-0. This decentralized set-up is referred to as the project oriented organization as each project manager has autonomy in managing the project. There are many variations of management style between these two extremes, depending on the objectives of the organization and the nature of the construction project. For example, a large chemical company with in-house staff for planning, design and construction of facilities for new product lines will naturally adopt the matrix organization. On the other hand, a construction company whose existence depends entirely on the management of certain types of construction projects may find the project-oriented organization particularly attractive. While organizations may differ, the same basic principles of management structure are applicable to most situations.

Example of a Matrix Organization
  

Example of a Project-Oriented Organization
  

To illustrate various types of organizations for project management, we shall consider two examples, the first one representing an owner organization while the second one representing the organization of a construction management consultant under the direct supervision of the owner.

Example 2-3: . Matrix Organization of an Engineering Division

The Engineering Division of an Electric Power and Light Company has functional departments as shown in Figure 2-0. When small scale projects such as the addition of a transmission tower or a sub-station are authorized, a matrix organization is used to carry out such projects. For example, in the design of a transmission tower, the professional skill of a structural engineer is most important. Consequently, the leader of the project team will be selected from the Structural Engineering Department while the remaining team members are selected from all departments as dictated by the manpower requirements. On the other hand, in the design of a new sub-station, the professional skill of an electrical engineer is most important. Hence, the leader of the project team will be selected from the Electrical Engineering Department.

The Matrix Organization in an Engineering Division
  

Example 2-4: . Example of Construction Management Consultant Organization

When the same Electric Power and Light Company in the previous example decided to build a new nuclear power plant, it engaged a construction management consultant to take charge of the design and construction completely. However, the company also assigned a project team to coordinate with the construction management consultant as shown in Figure 2-0.

Coordination between Owner and Consultant
  

Since the company eventually will operate the power plant upon its completion, it is highly important for its staff to monitor the design and construction of the plant. Such coordination allows the owner not only to assure the quality of construction but also to be familiar with the design to facilitate future operation and maintenance. Note the close direct relationships of various departments of the owner and the consultant. Since the project will last for many years before its completion, the staff members assigned to the project team are not expected to rejoin the Engineering Department but will probably be involved in the future operation of the new plant. Thus, the project team can act independently toward its designated mission.

2.6 Traditional Designer-Constructor Sequence

For ordinary projects of moderate size and complexity, the owner often employs a designer (an architectural/engineering firm) which prepares the detailed plans and specifications for the constructor (a general contractor). The designer also acts on behalf of the owner to oversee the project implementation during construction. The general contractor is responsible for the construction itself even though the work may actually be undertaken by a number of specialty subcontractors.

The owner usually negotiates the fee for service with the architectural/engineering (A/E) firm. In addition to the responsibilities of designing the facility, the A/E firm also exercises to some degree supervision of the construction as stipulated by the owner. Traditionally, the A/E firm regards itself as design professionals representing the owner who should not communicate with potential contractors to avoid collusion or conflict of interest. Field inspectors working for an A/E firm usually follow through the implementation of a project after the design is completed and seldom have extensive input in the design itself. Because of the litigation climate in the last two decades, most A/E firms only provide observers rather than inspectors in the field. Even the shop drawings of fabrication or construction schemes submitted by the contractors for approval are reviewed with a disclaimer of responsibility by the A/E firms.

The owner may select a general constructor either through competitive bidding or through negotiation. Public agencies are required to use the competitive bidding mode, while private organizations may choose either mode of operation. In using competitive bidding, the owner is forced to use the designer-constructor sequence since detailed plans and specifications must be ready before inviting bidders to submit their bids. If the owner chooses to use a negotiated contract, it is free to use phased construction if it so desires.

The general contractor may choose to perform all or part of the construction work, or act only as a manager by subcontracting all the construction to subcontractors. The general contractor may also select the subcontractors through competitive bidding or negotiated contracts. The general contractor may ask a number of subcontractors to quote prices for the subcontracts before submitting its bid to the owner. However, the subcontractors often cannot force the winning general contractor to use them on the project. This situation may lead to practices known as bid shopping and bid peddling. Bid shopping refers to the situation when the general contractor approaches subcontractors other than those whose quoted prices were used in the winning contract in order to seek lower priced subcontracts. Bid peddling refers to the actions of subcontractors who offer lower priced subcontracts to the winning general subcontractors in order to dislodge the subcontractors who originally quoted prices to the general contractor prior to its bid submittal. In both cases, the quality of construction may be sacrificed, and some state statutes forbid these practices for public projects.

Although the designer-constructor sequence is still widely used because of the public perception of fairness in competitive bidding, many private owners recognize the disadvantages of using this approach when the project is large and complex and when market pressures require a shorter project duration than that which can be accomplished by using this traditional method.

2.7 Professional Construction Management

Professional construction management refers to a project management team consisting of a professional construction manager and other participants who will carry out the tasks of project planning, design and construction in an integrated manner. Contractual relationships among members of the team are intended to minimize adversarial relationships and contribute to greater response within the management group. A professional construction manager is a firm specialized in the practice of professional construction management which includes:

• Work with owner and the A/E firms from the beginning and make recommendations on design improvements, construction technology, schedules and construction economy.
• Propose design and construction alternatives if appropriate, and analyze the effects of the alternatives on the project cost and schedule.
• Monitor subsequent development of the project in order that these targets are not exceeded without the knowledge of the owner.
• Coordinate procurement of material and equipment and the work of all construction contractors, and monthly payments to contractors, changes, claims and inspection for conforming design requirements.
• Perform other project related services as required by owners.

Professional construction management is usually used when a project is very large or complex. The organizational features that are characteristics of mega-projects can be summarized as follows:(These features and the following example are described in F.P. Moolin, Jr. and F.A. McCoy, "Managing the Alaska Pipeline Project," Civil Engineering, November 1981, pp. 51-54.)

• The overall organizational approach for the project will change as the project advances. The "functional" organization may change to a "matrix" which may change to a "project" organization (not necessarily in this order).
• Within the overall organization, there will probably be functional, project, and matrix suborganizations all at the same time. This feature greatly complicates the theory and the practice of management, yet is essential for overall cost effectiveness.
• Successful giant, complex organizations usually have a strong matrix-type suborganization at the level where basic cost and schedule control responsibility is assigned. This suborganization is referred to as a "cost center" or as a "project" and is headed by a project manager. The cost center matrix may have participants assigned from many different functional groups. In turn, these functional groups may have technical reporting responsibilities to several different and higher tiers in the organization. The key to a cost effective effort is the development of this project suborganization into a single team under the leadership of a strong project manager.
• The extent to which decision-making will be centralized or decentralized is crucial to the organization of the mega-project.

Example 2-5: Managing of the Alaska Pipeline Project

The Alaska Pipeline Project was the largest, most expensive private construction project in the 1970's, which encompassed 800 miles, thousands of employees, and 10 billion dollars.

At the planning stage, the owner (a consortium) employed a Construction Management Contractor (CMC) to direct the pipeline portion, but retained centralized decision making to assure single direction and to integrate the effort of the CMC with the pump stations and the terminals performed by another contractor. The CMC also centralized its decision making in directing over 400 subcontractors and thousands of vendors. Because there were 19 different construction camps and hundreds of different construction sites, this centralization caused delays in decision making.

At about the 15% point of physical completion, the owner decided to reorganize the decision making process and change the role of the CMC. The new organization was a combination of owner and CMC personnel assigned within an integrated organization. The objective was to develop a single project team responsible for controlling all subcontractors. Instead of having nine tiers of organization from the General Manager of the CMC to the subcontractors, the new organization had only four tiers from the Senior Project Manager of the owner to subcontractors. Besides unified direction and coordination, this reduction in tiers of organization greatly improved communications and the ability to make and implement decisions. The new organization also allowed decentralization of decision making by treating five sections of the pipeline at different geographic locations as separate projects, with a section manager responsible for all functions of the section as a profit center.

At about 98% point of physical completion, all remaining activities were to be consolidated to identify single bottom-line responsibility, to reduce duplication in management staff, and to unify coordination of remaining work. Thus, the project was first handled by separate organizations but later was run by an integrated organization with decentralized profit centers. Finally, the organization in effect became small and was ready to be phased out of operation.

2.8 Owner-Builder Operation

In this approach an owner must have a steady flow of on-going projects in order to maintain a large work force for in-house operation. However, the owner may choose to subcontract a substantial portion of the project to outside consultants and contractors for both design and construction, even though it retains centralized decision making to integrate all efforts in project implementation.

Example 2-6: : U.S. Army Corps of Engineers Organization

The District Engineer's Office of the U.S. Army Corps of Engineers may be viewed as a typical example of an owner-builder approach as shown in Figure 2-0.

Organization of a District of Corps of Engineers
  

In the District Engineer's Office of the U.S. Corps of Engineers, there usually exist an Engineering Division and an Operations Division, and, in a large district, a Construction Division. Under each division, there are several branches. Since the authorization of a project is usually initiated by the U.S. Congress, the planning and design functions are separated in order to facilitate operations. Since the authorization of the feasibility study of a project may precede the authorization of the design by many years, each stage can best be handled by a different branch in the Engineering Division. If construction is ultimately authorized, the work may be handled by the Construction Division or by outside contractors. The Operations Division handles the operation of locks and other facilities which require routine attention and maintenance.

When a project is authorized, a project manager is selected from the most appropriate branch to head the project, together with a group of staff drawn from various branches to form the project team. When the project is completed, all members of the team including the project manager will return to their regular posts in various branches and divisions until the next project assignment. Thus, a matrix organization is used in managing each project.

2.9 Turnkey Operation

Some owners wish to delegate all responsibilities of design and construction to outside consultants in a turnkey project arrangement. A contractor agrees to provide the completed facility on the basis of performance specifications set forth by the owner. The contractor may even assume the responsibility of operating the project if the owner so desires. In order for a turnkey operation to succeed, the owner must be able to provide a set of unambiguous performance specifications to the contractor and must have complete confidence in the capability of the contractor to carry out the mission.

This approach is the direct opposite of the owner-builder approach in which the owner wishes to retain the maximum amount of control for the design-construction process.

Example 2-7: : An Example of a Turnkey Organization

A 150-Mw power plant was proposed in 1985 by the Texas-New Mexico Power Company of Fort Worth, Texas, which would make use of the turnkey operation.("Private Money Finances Texas Utility's Power Plant" Engineering News Record: July 25, 1985, p. 13.) Upon approval by the Texas Utility Commission, a consortium consisting of H.B. Zachry Co., Westinghouse Electric Co., and Combustion Engineering, Inc. would design, build and finance the power plant for completion in 1990 for an estimated construction cost of $200 million in 1990 dollars. The consortium would assume total liability during construction, including debt service costs, and thereby eliminate the risks of cost escalation to rate payers, stockholders and the utility company management.

2.10 Leadership and Motivation for the Project Team

The project manager, in the broadest sense of the term, is the most important person for the success or failure of a project. The project manager is responsible for planning, organizing and controlling the project. In turn, the project manager receives authority from the management of the organization to mobilize the necessary resources to complete a project.

The project manager must be able to exert interpersonal influence in order to lead the project team. The project manager often gains the support of his/her team through a combination of the following:

• Formal authority resulting from an official capacity which is empowered to issue orders.
• Reward and/or penalty power resulting from his/her capacity to dispense directly or indirectly valued organization rewards or penalties.
• Expert power when the project manager is perceived as possessing special knowledge or expertise for the job.
• Attractive power because the project manager has a personality or other characteristics to convince others.

In a matrix organization, the members of the functional departments may be accustomed to a single reporting line in a hierarchical structure, but the project manager coordinates the activities of the team members drawn from functional departments. The functional structure within the matrix organization is responsible for priorities, coordination, administration and final decisions pertaining to project implementation. Thus, there are potential conflicts between functional divisions and project teams. The project manager must be given the responsibility and authority to resolve various conflicts such that the established project policy and quality standards will not be jeopardized. When contending issues of a more fundamental nature are developed, they must be brought to the attention of a high level in the management and be resolved expeditiously.

In general, the project manager's authority must be clearly documented as well as defined, particularly in a matrix organization where the functional division managers often retain certain authority over the personnel temporarily assigned to a project. The following principles should be observed:

• The interface between the project manager and the functional division managers should be kept as simple as possible.
• The project manager must gain control over those elements of the project which may overlap with functional division managers.
• The project manager should encourage problem solving rather than role playing of team members drawn from various functional divisions.

2.11 Interpersonal Behavior in Project Organizations

While a successful project manager must be a good leader, other members of the project team must also learn to work together, whether they are assembled from different divisions of the same organization or even from different organizations. Some problems of interaction may arise initially when the team members are unfamiliar with their own roles in the project team, particularly for a large and complex project. These problems must be resolved quickly in order to develop an effective, functioning team.

Many of the major issues in construction projects require effective interventions by individuals, groups and organizations. The fundamental challenge is to enhance communication among individuals, groups and organizations so that obstacles in the way of improving interpersonal relations may be removed. Some behavior science concepts are helpful in overcoming communication difficulties that block cooperation and coordination. In very large projects, professional behavior scientists may be necessary in diagnosing the problems and advising the personnel working on the project. The power of the organization should be used judiciously in resolving conflicts.

The major symptoms of interpersonal behavior problems can be detected by experienced observers, and they are often the sources of serious communication difficulties among participants in a project. For example, members of a project team may avoid each other and withdraw from active interactions about differences that need to be dealt with. They may attempt to criticize and blame other individuals or groups when things go wrong. They may resent suggestions for improvement, and become defensive to minimize culpability rather than take the initiative to maximize achievements. All these actions are detrimental to the project organization.

While these symptoms can occur to individuals at any organization, they are compounded if the project team consists of individuals who are put together from different organizations. Invariably, different organizations have different cultures or modes of operation. Individuals from different groups may not have a common loyalty and may prefer to expand their energy in the directions most advantageous to themselves instead of the project team. Therefore, no one should take it for granted that a project team will work together harmoniously just because its members are placed physically together in one location. On the contrary, it must be assumed that good communication can be achieved only through the deliberate effort of the top management of each organization contributing to the joint venture.

2.12 Perceptions of Owners and Contractors

Although owners and contractors may have different perceptions on project management for construction, they have a common interest in creating an environment leading to successful projects in which performance quality, completion time and final costs are within prescribed limits and tolerances. It is interesting therefore to note the opinions of some leading contractors and owners who were interviewed in 1984.(See J.E. Diekmann and K.B. Thrush, Project Control in Design Engineering, A Report to the Construction Industry Institute, The University of Texas at Austin, Texas, May 1986.)

From the responses of six contractors, the key factors cited for successful projects are:

• well defined scope
• extensive early planning
• good leadership, management and first line supervision
• positive client relationship with client involvement
• proper project team chemistry
• quick response to changes
• engineering managers concerned with the total project, not just the engineering elements.

• ill-defined scope
• poor management
• poor planning
• breakdown in communication between engineering and construction
• unrealistic scope, schedules and budgets
• many changes at various stages of progress
• lack of good project control

The responses of eight owners indicated that they did not always understand the concerns of the contractors although they generally agreed with some of the key factors for successful and unsuccessful projects cited by the contractors. The significant findings of the interviews with owners are summarized as follows:

• All owners have the same perception of their own role, but they differ significantly in assuming that role in practice.
• The owners also differ dramatically in the amount of early planning and in providing information in bid packages.
• There is a trend toward breaking a project into several smaller projects as the projects become larger and more complex.
• Most owners recognize the importance of schedule, but they adopt different requirements in controlling the schedule.
• All agree that people are the key to project success.

From the results of these interviews, it is obvious that owners must be more aware and involved in the process in order to generate favorable conditions for successful projects. Design professionals and construction contractors must provide better communication with each other and with the owner in project implementation.

2.13 References

1. Barrie, Donald S. and Boyd C. Paulson, Jr., Professional Construction Management, McGraw-Hill Book Company, 2nd Ed., 1984.
2. Halpin, Daniel W. and Ronald W. Woodhead, Construction Management, John Wiley and Sons, 1980.
3. Hodgetts, R.M., Management: Theory, Process and Practice, W.B. Saunders Co., Philadelphia, PA, 1979.
4. Kerzner, H. Project Management: A Systems Approach to Planning, Scheduling and Controlling. 2nd. Ed., Van Nostrand Reinhold, New York, 1984.
5. Levitt, R.E., R.D. Logcher and N.H. Quaddumi, "Impact of Owner-Engineer Risk Sharing on Design Conservatism," ASCE Journal of Professional Issues in Engineering, Vol. 110, 1984, pp. 157-167.
6. Moolin, F.P., Jr., and F.A. McCoy: "Managing the Alaska Pipeline Project," Civil Engineering, November 1981, pp. 51-54.
7. Murray, L., E. Gallardo, S. Aggarwal and R. Waywitka, "Marketing Construction Management Services," ASCE Journal of Construction Division, Vol. 107, 1981, pp. 665-677.

3. The Design and Construction Process

3.1 Design and Construction as an Integrated System

In the planning of facilities, it is important to recognize the close relationship between design and construction. These processes can best be viewed as an integrated system. Broadly speaking, design is a process of creating the description of a new facility, usually represented by detailed plans and specifications; construction planning is a process of identifying activities and resources required to make the design a physical reality. Hence, construction is the implementation of a design envisioned by architects and engineers. In both design and construction, numerous operational tasks must be performed with a variety of precedence and other relationships among the different tasks.

Several characteristics are unique to the planning of constructed facilities and should be kept in mind even at the very early stage of the project life cycle. These include the following:

• Nearly every facility is custom designed and constructed, and often requires a long time to complete.
• Both the design and construction of a facility must satisfy the conditions peculiar to a specific site.
• Because each project is site specific, its execution is influenced by natural, social and other locational conditions such as weather, labor supply, local building codes, etc.
• Since the service life of a facility is long, the anticipation of future requirements is inherently difficult.
• Because of technological complexity and market demands, changes of design plans during construction are not uncommon.

In an integrated system, the planning for both design and construction can proceed almost simultaneously, examining various alternatives which are desirable from both viewpoints and thus eliminating the necessity of extensive revisions under the guise of value engineering. Furthermore, the review of designs with regard to their constructibility can be carried out as the project progresses from planning to design. For example, if the sequence of assembly of a structure and the critical loadings on the partially assembled structure during construction are carefully considered as a part of the overall structural design, the impacts of the design on construction falsework and on assembly details can be anticipated. However, if the design professionals are expected to assume such responsibilities, they must be rewarded for sharing the risks as well as for undertaking these additional tasks. Similarly, when construction contractors are expected to take over the responsibilities of engineers, such as devising a very elaborate scheme to erect an unconventional structure, they too must be rewarded accordingly. As long as the owner does not assume the responsibility for resolving this risk-reward dilemma, the concept of a truly integrated system for design and construction cannot be realized.

It is interesting to note that European owners are generally more open to new technologies and to share risks with designers and contractors. In particular, they are more willing to accept responsibilities for the unforeseen subsurface conditions in geotechnical engineering. Consequently, the designers and contractors are also more willing to introduce new techniques in order to reduce the time and cost of construction. In European practice, owners typically present contractors with a conceptual design, and contractors prepare detailed designs, which are checked by the owner's engineers. Those detailed designs may be alternate designs, and specialty contractors may also prepare detailed alternate designs.

Example 3-1: Proposed Responsibility for Shop Drawings

The willingness to assume responsibilities does not come easily from any party in the current litigious climate of the construction industry in the United States. On the other hand, if owner, architect, engineer, contractor and other groups that represent parts of the industry do not jointly fix the responsibilities of various tasks to appropriate parties, the standards of practice will eventually be set by court decisions. In an attempt to provide a guide to the entire spectrum of participants in a construction project, the American Society of Civil Engineers issued a preliminary edition of a Manual of Professional Practice for Quality in the Constructed Project in early 1988. After an 18-month period for trial use and comment, a final version is expected to be published as recommended standards for industry-wide adoption. Hopefully, this manual will help bring a turn around of the fragmentation of activities in the design and construction process.

Shop drawings represent the assembly details for erecting a structure which should reflect the intent and rationale of the original structural design. They are prepared by the construction contractor and reviewed by the design professional. However, since the responsibility for preparing shop drawings was traditionally assigned to construction contractors, design professionals took the view that the review process was advisory and assumed no responsibility for their accuracy. This justification was ruled unacceptable by a court in connection with the walkway failure at the Hyatt Hotel in Kansas City in 1985. In preparing the ASCE Manual of Professional Practice for Quality in the Constructed Project, the responsibilities for preparation of shop drawings proved to be the most difficult to develop.(See "ASCE Unveils Quality Manual", ENR, November 5, 1987, p. 14) The reason for this situation is not difficult to fathom since the responsibilities for the task are diffused, and all parties must agree to the new responsibilities assigned to each in the recommended risk-reward relations shown in Table 3-1.

Traditionally, the owner is not involved in the preparation and review of shop drawings, and perhaps is even unaware of any potential problems. In the recommended practice, the owner is required to take responsibility for providing adequate time and funding, including approval of scheduling, in order to allow the design professionals and construction contractors to perform satisfactorily.

Recommended Responsibility for Shop Drawings
  

~!^!~Responsible Party

~!^!~~!^!~Design~!^!~Construction

Task~!^!~Owner~!^!~Professional~!^!~Contractor

Provide adequate time and funding for shop~!^!~Prime

drawing preparation and review

Specify that drawings be prepared~!^!~Review~!^!~Prime

by professional engineer

Do structural design~!^!~~!^!~Prime

Provide loading requirements~!^!~~!^!~Prime

Specify shop drawing requirements~!^!~Review~!^!~Prime

Provide for structural design of~!^!~~!^!~~!^!~Prime

connections by engineer

Approve scheduling~!^!~Prime~!^!~Advise~!^!~Advise

Provide shop drawings~!^!~~!^!~~!^!~Prime

and submit on schedule

Make timely reviews~!^!~~!^!~Prime

Accept responsibility for~!^!~~!^!~~!^!~Prime

construction bracing, shoring, constructibility

tolerances, fit and detail dimensions.

Example 3-2: Model Metro Project in Milan, Italy(See V. Fairweather, "Milan's Model Metro", Civil Engineering, December 1987, pp. 40-43.)

Under Italian law, unforeseen subsurface conditions are the owner's responsibility, not the contractor's. This is a striking difference from U.S. construction practice where changed conditions clauses and claims and the adequacy of prebid site investigations are points of contention. In effect, the Italian law means that the owner assumes those risks. But under the same law, a contractor may elect to assume the risks in order to lower the bid price and thereby beat the competition.

According to the Technical Director of Rodio, the Milan-based contractor which is heavily involved in the grouting job for tunneling in the Model Metro project in Milan, Italy, there are two typical contractual arrangements for specialized subcontractor firms such as theirs. One is to work on a unit price basis with no responsibility for the design. The other is what he calls the "nominated subcontractor" or turnkey method: prequalified subcontractors offer their own designs and guarantee the price, quality, quantities, and, if they wish, the risks of unforeseen conditions.

At the beginning of the Milan metro project, the Rodio contract ratio was 50/50 unit price and turnkey. The firm convinced the metro owners that they would save money with the turnkey approach, and the ratio became 80% turnkey. What's more, in the work packages where Rodio worked with other grouting specialists, those subcontractors paid Rodio a fee to assume all risks for unforeseen conditions.

Under these circumstances, it was critical that the firm should know the subsurface conditions as precisely as possible, which was a major reason why the firm developed a computerized electronic sensing program to predict stratigraphy and thus control grout mixes, pressures and, most important, quantities.

3.2 Innovation and Technological Feasibility

The planning for a construction project begins with the generation of concepts for a facility which will meet market demands and owner needs. Innovative concepts in design are highly valued not for their own sake but for their contributions to reducing costs and to the improvement of aesthetics, comfort or convenience as embodied in a well-designed facility. However, the constructor as well as the design professionals must have an appreciation and full understanding of the technological complexities often associated with innovative designs in order to provide a safe and sound facility. Since these concepts are often preliminary or tentative, screening studies are carried out to determine the overall technological viability and economic attractiveness without pursuing these concepts in great detail. Because of the ambiguity of the objectives and the uncertainty of external events, screening studies call for uninhibited innovation in creating new concepts and judicious judgment in selecting the appropriate ones for further consideration.

One of the most important aspects of design innovation is the necessity of communication in the design/construction partnership. In the case of bridge design, it can be illustrated by the following quotation from Lin and Gerwick concerning bridge construction: (See T.Y. Lin and B.G. Gerwick, Jr. "Design of Long Span Concrete Bridges with Special References to Prestressing, Precasting, Structural Behavior and Economics," ACI Publication SP-23, First International Symposium, 1969, pp. 693-704)

The great pioneering steel bridges of the United States were built by an open or covert alliance between designers and constructors. The turnkey approach of designer-constructor has developed and built our chemical plants, refineries, steel plants, and nuclear power plants. It is time to ask, seriously, whether we may not have adopted a restrictive approach by divorcing engineering and construction in the field of bridge construction. If a contractor-engineer, by some stroke of genius, were to present to design engineers today a wonderful new scheme for long span prestressed concrete bridges that made them far cheaper, he would have to make these ideas available to all other constructors, even limiting or watering them down so as to "get a group of truly competitive bidders." The engineer would have to make sure that he found other contractors to bid against the ingenious innovator. If an engineer should, by a similar stroke of genius, hit on such a unique and brilliant scheme, he would have to worry, wondering if the low bidder would be one who had any concept of what he was trying to accomplish or was in any way qualified for high class technical work.

Innovative design concepts must be tested for technological feasibility. Three levels of technology are of special concern: technological requirements for operation or production, design resources and construction technology. The first refers to the new technologies that may be introduced in a facility which is used for a certain type of production such as chemical processing or nuclear power generation. The second refers to the design capabilities that are available to the designers, such as new computational methods or new materials. The third refers to new technologies which can be adopted to construct the facility, such as new equipment or new construction methods.

A new facility may involve complex new technology for operation in hostile environments such as severe climate or restricted accessibility. Large projects with unprecedented demands for resources such as labor supply, material and infrastructure may also call for careful technological feasibility studies. Major elements in a feasibility study on production technology should include, but are not limited to, the following:

• Project type as characterized by the technology required, such as synthetic fuels, petrochemicals, nuclear power plants, etc.
• Project size in dollars, design engineer's hours, construction labor hours, etc.
• Design, including sources of any special technology which require licensing agreements.
• Project location which may pose problems in environmental protection, labor productivity and special risks.

An example of innovative design for operation and production is the use of entropy concepts for the design of integrated chemical processes. Simple calculations can be used to indicate the minimum energy requirements and the least number of heat exchange units to achieve desired objectives. The result is a new incentive and criterion for designers to achieve more effective designs. Numerous applications of the new methodology has shown its efficacy in reducing both energy costs and construction expenditures.[See Linnhoff, B., D.W. Townsend, D. Boland, G.F. Hewitt, B.E.A. Thomas, A.R. Guy, and R.H. Marsland, User Guide on Process Integration for the Efficient Use of Energy, Institution of Chemical Engineers, Rugby, Warks., England, 1982.] This is a case in which innovative design is not a matter of trading-off operating and capital costs, but better designs can simultaneously achieve improvements in both objectives.

The choice of construction technology and method involves both strategic and tactical decisions about appropriate technologies and the best sequencing of operations. For example, the extent to which prefabricated facility components will be used represents a strategic construction decision. In turn, prefabrication of components might be accomplished off-site in existing manufacturing facilities or a temporary, on-site fabrication plant might be used. Another example of a strategic decision is whether to install mechanical equipment in place early in the construction process or at an intermediate stage. Strategic decisions of this sort should be integrated with the process of facility design in many cases. At the tactical level, detailed decisions about how to accomplish particular tasks are required, and such decisions can often be made in the field.

Construction planning should be a major concern in the development of facility designs, in the preparation of cost estimates, and in forming bids by contractors. Unfortunately, planning for the construction of a facility is often treated as an after thought by design professionals. This contrasts with manufacturing practices in which the assembly of devices is a major concern in design. Design to insure ease of assembly or construction should be a major concern of engineers and architects. As the Business Roundtable noted, "All too often chances to cut schedule time and costs are lost because construction operates as a production process separated by a chasm from financial planning, scheduling, and engineering or architectural design. Too many engineers, separated from field experience, are not up to date about how to build what they design, or how to design so structures and equipment can be erected most efficiently."["More Construction for the Money," Summary Report of the Construction Industry Cost Effectiveness Project, The Business Roundtable, New York, 1983, pg. 30.]

Example 3-3: Innovative use of structural frames for buildings[See "The Quiet Revolution in Skyscraper Design, " Civil Engineering, May 1983, pp. 54-59.]

The structural design of skyscrapers offers an example of innovation in overcoming the barrier of high costs for tall buildings by making use of new design capabilities. A revolutionary concept in skyscraper design was introduced in the 1960's by Fazlur Khan who argued that, for a building of a given height, there is an appropriate structural system which would produce the most efficient use of the material.

Before 1965, most skyscrapers were steel rigid frames. However, Fazlur Khan believed that it was uneconomical to construct all office buildings of rigid frames, and proposed an array of appropriate structural systems for steel buildings of specified heights as shown in Figure 3-0. By choosing an appropriate structural system, an engineer can use structural materials more efficiently. For example, the 60-story Chase Manhatten Building in New York used about 60 pounds per square foot of steel in its rigid frame structure, while the 100-story John Hancock Center in Chicago used only 30 pounds per square foot for a trusted tube system. At the time the Chase Manhatten Building was constructed, no bracing was used to stiffen the core of a rigid frame building because design engineers did not have the computing tools to do the complex mathematical analysis associated with core bracing.

Proposed Structural Systems for Steel Buildings
  

3.3 Innovation and Economic Feasibility

Innovation is often regarded as the engine which can introduce construction economies and advance labor productivity. This is obviously true for certain types of innovations in industrial production technologies, design capabilities, and construction equipment and methods. However, there are also limitations due to the economic infeasibility of such innovations, particularly in the segments of construction industry which are more fragmented and permit ease of entry, as in the construction of residential housing.

Market demand and firm size play an important role in this regard. If a builder is to construct a larger number of similar units of buildings, the cost per unit may be reduced. This relationship between the market demand and the total cost of production may be illustrated schematically as in Figure 3-0. An initial threshold or fixed cost F is incurred to allow any production. Beyond this threshold cost, total cost increases faster than the units of output but at a decreasing rate. At each point on this total cost curve, the average cost is represented by the slope of a line from the origin to the point on the curve. At a point H, the average cost per unit is at a minimum. Beyond H to the right, the total cost again increases faster than the units of output and at an increasing rate. When the rate of change of the average cost slope is decreasing or constant as between 0 and H on the curve, the range between 0 and H is said to be increasing return to scale; when the rate of change of the average cost slope is increasing as beyond H to the right, the region is said to be decreasing return to scale. Thus, if fewer than h units are constructed, the unit price will be higher than that of exactly h units. On the other hand, the unit price will increase again if more than h units are constructed.

Market Demand and Total Cost Relationship
  

Nowhere is the effect of market demand and total cost more evident than in residential housing.[See J. Landis, "Why Homebuilders Don't Innovate," Built Environment, Vol. 8, No. 1, 1982, pp. 46-53.] The housing segment in the last few decades accepted many innovative technical improvements in building materials which were promoted by material suppliers. Since material suppliers provide products to a large number of homebuilders and others, they are in a better position to exploit production economies of scale and to support new product development. However, homebuilders themselves have not been as successful in making the most fundamental form of innovation which encompasses changes in the technological process of homebuilding by shifting the mixture of labor and material inputs, such as substituting large scale off-site prefabrication for on-site assembly.

There are several major barriers to innovation in the technological process of homebuilding, including demand instability, industrial fragmentation, and building codes. Since market demand for new homes follows demographic trends and other socio-economic conditions, the variation in home building has been anything but regular. The profitability of the homebuilding industry has closely matched aggregate output levels. Since entry and exist from the industry are relatively easy, it is not uncommon during periods of slack demand to find builders leaving the market or suspending their operations until better times. The inconsistent levels of retained earnings over a period of years, even among the more established builders, are likely to discourage support for research and development efforts which are required to nurture innovation. Furthermore, because the homebuilding industry is fragmented with a vast majority of homebuilders active only in local regions, the typical homebuilder finds it excessively expensive to experiment with new designs. The potential costs of a failure or even a moderately successful innovation would outweigh the expected benefits of all but the most successful innovations. Variation in local building codes has also caused inefficiencies although repeated attempts have been made to standardize building codes.

In addition to the scale economies visible within a sector of the construction market, there are also possibilities for scale economies in individual facility. For example, the relationship between the size of a building (expressed in square feet) and the input labor (expressed in laborhours per square foot) varies for different types and sizes of buildings. As shown in Figure 3-0, these relationships for several types of buildings exhibit different characteristics.<See P.J. Cassimates, Economics of the Construction Industry, National Industry Conference Board (SBE No. 111), 1969.> The labor hours per square foot decline as the size of facility increases for houses, public housing and public buildings. However, the labor hours per square foot almost remains constant for all sizes of school buildings and increases as the size of a hospital facility increases.

Illustrative Relationships between Building Size and Input Labor
by Types of Building
  

Example 3-4: Use of new materials(See F. Moavenzadeh, "Construction's High Technology Revolution," Technology Review, October, 1985, pp. 32-39.)

In recent years, an almost entirely new set of materials is emerging for construction, largely from the aerospace and electronics industries. These materials were developed from new knowledge about the structure and properties of materials as well as new techniques for altering existing materials. Additives to traditional materials such as concrete and steel are particularly prominent. For example, it has been known for some time that polymers would increase concrete strength, water resistance and ability to insulate when they are added to the cement. However, their use has been limited by their costs since they have had to replace as much as 10 percent of the cement to be effective. However, Swedish researchers have helped reduce costs by using polymer microspheres 8 millionths of an inch across, which occupy less than 1 percent of the cement. Concretes made with these microspheres meet even the strict standards for offshore structures in the North Sea. Research on micro-additives will probably produce useful concretes for repairing road and bridges as well.

Example 3-5: Habitat(This example is based on a review of the project 20 years after its completion. See The New York Times, July 26, 1987, Sec. 8, pg. 1.)

Habitat was an experimental residential complex designed by Moshe Safdie and constructed in modules with an on-site factory for the 1967 Exposition in Montreal, Canada. The original proposal called for a self-contained community with 1000 to 2000 apartments, but was scaled down to a single 10-story complex with 158 units built on Cite' du Havre, a landfill peninsula in Montreal's inner harbor. The project was budgeted for $11.5 million, and almost half of that was spent building the factories and acquiring special cranes. This start-up cost was absurdly high for a single 10-story apartment complex, but might have been justified in the original proposal for a whole community. As a result of the small scale, development costs amounted to $85,500 for an apartment at a time when average Montreal apartments were selling for $10,000 to $16,000. However, even if mass production was possible, steep increases in urban land costs and interest rates in recent years would have overshadowed the projected savings from production. Thus, an innovation which was hailed at one time as the solution for urban housing has not materialized due to a combination of economic factors.

3.4 Design Methodology

While the conceptual design process may be formal or informal, it can be characterized by a series of actions: formulation, analysis, search, decision, specification, and modification. However, at the early stage in the development of a new project, these actions are highly interactive as illustrated in Figure 3-0.[See R.W. Jensen and C.C. Tonies (Editors), Software Engineering, Prentice-Hall, Inc., Englewood Cliffs, NJ, 1979, p. 22.] Many iterations of redesign are expected to refine the functional requirements, design concepts and financial constraints, even though the analytic tools applied to the solution of the problem at this stage may be very crude.

Conceptual Design Process
  

The series of actions taken in the conceptual design process may be described as follows:

• Formulation refers to the definition or description of a design problem in broad terms through the synthesis of ideas describing alternative facilities.
• Analysis refines the problem definition or description by separating important from peripheral information and by pulling together the essential detail. Interpretation and prediction are ususally required as part of the analysis.
• Search involves gathering a set of potential solutions for performing the specified functions and satisfying the user requirements.
• Decision means that each of the potential solutions is evaluated and compared to the alternatives until the best solution is obtained.
• Specification is to describe the chosen solution in a form which contains enough detail for implementation.
• Modification refers to the change in the solution or re-design if the solution is found to be wanting or if new information is discovered in the process of design.

As the project moves from conceptual planning to detailed design, the design process becomes more formal. In general, the actions of formulation, analysis, search, decision, specification and modification still hold, but they represent specific steps with less random interactions in detailed design. The design methodology thus formalized can be applied to a variety of design problems. For example, the analogy of the schematic diagrams of the structural design process and of the computer program development process is shown in Figure 3-0.<See S.J. Fenves, "Computer Applications," in Structural Engineering Handbook, (Gaylord, E. and C. Gaylord, Editors), McGraw-Hill Book Co., New York, NY, 1979.>

An Analogy between the Structural Design and Computer Program Development
  

Processes
  

The basic approach to design relies on decomposition and integration. Since design problems are large and complex, they have to be decomposed to yield subproblems that are small enough to solve. There are numerous alternative ways to decompose design problems, such as decomposition by functions of the facility, by spatial locations of its parts, or by links of various functions or parts. Solutions to subproblems must be integrated into an overall solution. The integration often creates conceptual conflicts which must be identified and corrected. A hierarchical structure with an appropriate number of levels may be used for the decomposition of a design problem to subproblems. For example, in the structural design of a multistory building, the building may be decomposed into floors, and each floor may in turn be decomposed into separate areas. Thus, a hierarchy representing the levels of building, floor and area is formed.

Different design styles may be used. The adoption of a particular style often depends on factors such as time pressure or available design tools, as well as the nature of the design problem. Examples of different styles are:

• Top-down design. Begin with a behavior description of the facility and work towards descriptions of its components and their interconnections.
• Bottom-up design. Begin with a set of components, and see if they can be arranged to meet the behavior description of the facility.

3.5 Functional Design

The objective of functional design for a proposed facility is to treat the facility as a complex system of interrelated spaces which are organized systematically according to the functions to be performed in these spaces in order to serve a collection of needs. The arrangement of physical spaces can be viewed as an iterative design process to find a suitable floor plan to facilitate the movement of people and goods associated with the operations intended.

A designer often relies on a heuristic approach, i.e., applying selected rules or strategies serving to stimulate the investigation in search for a solution. The heuristic approach used in arranging spatial layouts for facilities is based generally on the following considerations:

1. identification of the goals and constraints for specified tasks,
2. determination of the current state of each task in the iterative design process,
3. evaluation of the differences between the current state and the goals,
4. means of directing the efforts of search towards the goals on the basis of past experience.

Consider, for example, an integrated functional design for a proposed hospital.[See T. Au, E.W. Parti and A.K.C. Wong, "Computer Applications for Health Care Facility Design," Computers in Biology and Medicine, Vol. 1, No. 4, 1971, pp. 299-316.] Since the responsibilities for satisfying various needs in a hospital are divided among different groups of personnel within the hospital administrative structure, a hierarchy of functions corresponding to different levels of responsibilities is proposed in the systematic organization of hospital functions. In this model, the functions of a hospital system are decomposed into a hierarchy of several levels:

1. Hospital--conglomerate of all hospital services resulting from top policy decisions,
2. Division--broadly related activities assigned to the same general area by administrative decisions,
3. Department--combination of services delivered by a service or treatment group,
4. Suite--specific style of common services or treatments performed in the same suite of rooms,
5. Room--all activities that can be carried out in the same internal environment surrounded by physical barriers,
6. Zone--several closely related activities that are undertaken by individuals,
7. Object--a single activity associated with an individual.

In the integrated functional design of hospitals, the connection between physical spaces and functions is most easily made at the lowest level of the hierarchy, and then extended upward to the next higher level. For example, a bed is a physical object immediately related to the activity of a patient. A set of furniture consisting of a bed, a night table and an armchair arranged comfortably in a zone indicates the sphere of private activities for a patient in a room with multiple occupancy. Thus, the spatial representation of a hospital can be organized in stages starting from the lowest level and moving to the top. In each step of the organization process, an element (space or function) under consideration can be related directly to the elements at the levels above it, to those at the levels below it, and to those within the same level.

Since the primary factor relating spaces is the movement of people and supplies, the objective of arranging spaces is the minimization of movement within the hospital. On the other hand, the internal environmental factors such as atmospheric conditions (pressure, temperature, relative humidity, odor and particle pollution), sound, light and fire protection produce constraining effects on the arrangement of spaces since certain spaces cannot be placed adjacent to other spaces because of different requirements in environmental conditions. The consideration of logistics is important at all levels of the hospital system. For example, the travel patterns between objects in a zone or those between zones in a room are frequently equally important for devising an effective design. On the other hand, the adjacency desirability matrix based upon environmental conditions will not be important for organization of functional elements below the room level since a room is the lowest level that can provide a physical barrier to contain desirable environmental conditions. Hence, the organization of functions for a new hospital can be carried out through an interactive process, starting from the functional elements at the lowest level that is regarded as stable by the designer, and moving step by step up to the top level of the hierarchy. Due to the strong correlation between functions and the physical spaces in which they are performed, the arrangement of physical spaces for accommodating the functions will also follow the same iterative process. Once a satisfactory spatial arrangement is achieved, the hospital design is completed by the selection of suitable building components which complement the spatial arrangement.

Example 3-6: Top-down design style

In the functional design of a hospital, the designer may begin with a "reference model", i.e. the spatial layouts of existing hospitals of similar size and service requirements. On the basis of past experience, spaces are allocated to various divisions as shown schematically in Figure 3-0. The space in each division is then divided further for various departments in the division, and all the way down the line of the hierarchy. In every step along the way, the pertinent information of the elements immediately below the level under consideration will be assessed in order to provide input for making necessary adjustments at the current level if necessary. The major drawback of the top-down design style is that the connection between physical spaces and functions at lower levels cannot be easily anticipated. Consequently, the new design is essentially based on the intuition and experience of the designer rather than an objective analysis of the functions and space needs of the facility. Its greatest attraction is its simplicity which keeps the time and cost of design relatively low.

A Model for Top-Down Design of a Hospital
  

Example 3-7: Bottom-up design style

A multi-purpose examination suite in a hospital is used as an illustration of bottom-up design style. In Figure 3-0, the most basic elements (furniture) are first organized into zones which make up the room. Thus the size of the room is determined by spatial layout required to perform the desired services. Finally, the suite is defined by the rooms which are parts of the multi-purpose examination suite.

A Model for Bottom-up Design of an Examination Suite
  

3.6 Physical Structures

The structural design of complex engineering systems generally involves both synthesis and analysis. Synthesis is an inductive process while analysis is a deductive process. The activities in synthesis are often described as an art rather than a science, and are regarded more akin to creativity than to knowledge. The conception of a new structural system is by and large a matter of subjective decision since there is no established procedure for generating innovative and highly successful alternatives. The initial selection of a workable system from numerous possible alternatives relies heavily on the judicious judgment of the designer. Once a structural system is selected, it must be subjected to vigorous analysis to insure that it can sustain the demands in its environment. In addition, compatibility of the structural system with mechanical equipment and piping must be assured.

For traditional types of structures such as office buildings, there are standard systems derived from the past experience of many designers. However, in many situations, special systems must be developed to meet the specified requirements. The choice of materials for a structure depends not only on the suitability of materials and their influence on the form of the structure. For example, in the design of an airplane hangar, a steel skeleton frame may be selected because a similar frame in reinforced concrete will limit the span of the structure owing to its unfavorable ratio or resistance to weight. However, if a thin-shelled roof is adopted, reinforced concrete may prove to be more suitable than steel. Thus, the interplay of the structural forms and materials affects the selection of a structural system, which in turn may influence the method of construction including the use of falsework.

Example 3-8: Steel frame supporting a turbo-blower(The authors are indebted to E. D'Appolonia for suggesting this example.)

The design of a structural frame supporting a turbo-blower supplying pressurized air to a blast furnace in a steel mill can be used to illustrate the structural design process. As shown in Figure 3-0, the turbo-blower consists of a turbine and a blower linked to an air inlet stack. Since the vibration of the turbo-blower is a major concern to its operation, a preliminary investigation calls for a supporting frame which is separated from the structural frame of the building. An analysis of the vibration characteristics of the turbo-blower indicates that the lowest mode of vibration consists of independent vibration of the turbine shaft and the blower shaft, with higher modes for the coupled turbo-blower system when both shafts vibrate either in-phase or out-of-phase. Consequently, a steel frame with separate units for the blower side and the turbine side is selected. The columns of the steel frame are mounted on pile foundation and all joints of the steel frame are welded to reduce the vibration levels.

Since the structural steel frame also supports a condenser, an air inlet and exhaust, and a steam inlet and exhaust in addition to the turbo-blower, a static analysis is made to size its members to support all applied loads. Then, a dynamic analysis is conducted to determine the vibration characteristics of the system incorporating the structural steel frame and the turbo-blower. When the limiting conditions for static loads and natural frequencies of vibration are met, the design is accepted as satisfactory.

Steel Frame Supporting a Turbo-Blower
  

Example 3-9: Multiple hierarchy descriptions of projects

In the previous section, a hierarchy of functional spaces was suggested for describing a facility. This description is appropriate for functional design of spaces and processes within a building, but may be inadequate as a view of the facility's structural systems. A hierarchy suitable for this purpose might divide elements into structural functions such as slabs, walls, frames, footings, piles or mats. Lower levels of the hierarchy would describe individual design elements. For example, frames would be made up of column, beam and diagonal groups which, in turn, are composed of individual structural elements. These individual structural elements comprise the limits on functional spaces such as rooms in a different hierarchical perspective. Designers typically will initiate a view appropriate for their own concerns, and these different hierarchical views must be synthesized to insure consistency and adequacy of the overall design.

3.7 Geotechnical Engineering Investigation

Since construction is site specific, it is very important to investigate the subsurface conditions which often influence the design of a facility as well as its foundation. The uncertainty in the design is particularly acute in geotechnical engineering so that the assignment of risks in this area should be a major concern. Since the degree of uncertainty in a project is perceived differently by different parties involved in a project, the assignment of unquantifiable risks arising from numerous unknowns to the owner, engineer and contractor is inherently difficult. It is no wonder that courts or arbitrators are often asked to distribute equitably a risk to parties who do not perceive the same risks and do not want to assume a disproportionate share of such risks.

Example 3-10: Design of a tie-back retaining wall(See E. D'Appolonia, R. Alperstein and D.J. D'Appolonia, "Behavior of Colluvial Slope", ASCE Journal of Soil Mechanics and Foundations Division, Vol. 93, No. SM4, 1967, pp. 447-473.)

This example describes the use of a tie-back retaining wall built in the 1960's when such construction was uncommon and posed a considerable risk. The engineer designing it and the owner were aware of the risk because of potentially extreme financial losses from both remedial and litigation costs in the event that the retaining wall failed and permitted a failure of the slope. But the benefits were perceived as being worth the risk--benefits to the owner in terms of both lower cost and shorter schedule, and benefits to the engineer in terms of professional satisfaction in meeting the owner's needs and solving what appeared to be an insurmountable technical problem.

The tie-back retaining wall was designed to permit a cut in a hillside to provide additional space for the expansion of a steel-making facility. Figure 3-0 shows a cross section of the original hillside located in an urban area. Numerous residential dwellings were located on top of the hill which would have been prohibitively costly or perhaps impossible to remove to permit regrading of the hillside to push back the toe of the slope. The only realistic way of accomplishing the desired goal was to attempt to remove the toe of the existing slope and use a tie-back retaining wall to stabilize the slope as shown in Figure 3-0.

Typical Cross Section of Hillside Adjoining Site
  

Schematic Section of Anchored Steel Sheet Pile Retaining Wall
  

A commitment was made by both the owner and the engineer to accomplish what was a common goal. The engineer made a commitment to design and construct the wall in a manner which permitted a real-time evaluation of problems and the ability to take mitigating measures throughout the construction of the wall. The owner made a commitment to give the engineer both the professional latitude and resources required to perform his work. A design-construct contract was negotiated whereby the design could be modified as actual conditions were encountered during construction. But even with all of the planning, investigation and design efforts, there still remained a sizable risk of failure.

The wall was successfully built--not according to a pre-devised plan which went smoothly, and not without numerous problems to be resolved as unexpected groundwater and geological conditions were encountered. Estimated costs were exceeded as each unexpected condition was addressed. But there were no construction delays and their attendant costs as disputes over changed conditions and contract terms were reconciled. There were no costs for legal fees arising from litigation nor increased interest costs as construction stopped while disputes were litigated. The owner paid more than was estimated, but not more than was necessary and not as much as if he had to acquire the property at the top of the hill to regrade the slope. In addition, the owner was able to attain the desired facility expansion in far less time than by any other method.

As a result of the success of this experience and others, the use of tie-back retaining walls has become a routine practice.

3.8 Construction Site Environment

While the general information about the construction site is usually available at the planning stage of a project, it is important for the design professionals and construction manager as well as the contractor to visit the site. Each group will be benefited by first-hand knowledge acquired in the field.

For design professionals, an examination of the topography may focus their attention to the layout of a facility on the site for maximum use of space in compliance with various regulatory restrictions. In the case of industrial plants, the production or processing design and operation often dictate the site layout. A poor layout can cause construction problems such as inadequate space for staging, limited access for materials and personnel, and restrictions on the use of certain construction methods. Thus, design and construction inputs are important in the layout of a facility.

The construction manager and the contractor must visit the site to gain some insight in preparing or evaluating the bid package for the project. They can verify access roads and water, electrical and other service utilities in the immediate vicinity, with the view of finding suitable locations for erecting temporary facilities and the field office. They can also observe any interferences of existing facilities with construction and develop a plan for site security during construction.

In examining site conditions, particular attention must be paid to environmental factors such as drainage, groundwater and the possibility of floods. Of particular concern is the possible presence of hazardous waste materials from previous uses. Cleaning up or controlling hazardous wastes can be extremely expensive.

Example 3-11: Groundwater Pollution from a Landfill(The material in this example is adapted from A.L. Tolman, A. P. Ballestero, W.W. Beck, G.H. Emrich, "Guidance Manual for Minimizing Pollution from Waste Disposal Sites," Report to the Municipal Environmental Research Laboratory, U.S. Environmental Protection Agency, EPA-600/2-78-142, August 1978.)

The presence of waste deposits on a potential construction site can have substantial impacts on the surrounding area. Under existing environmental regulations in the United States, the responsibility for cleaning up or otherwise controlling wastes generally resides with the owner of a facility in conjunction with any outstanding insurance coverage.

A typical example of a waste problem is illustrated in Figure 3-0. In this figure, a small pushover burning dump was located in a depression on a slope. The landfill consisted of general refuse and was covered by a very sandy material. The inevitable infiltration of water from the surface or from the groundwater into the landfill will result in vertical or horizontal percolation of leachable ions and organic contamination. This leachate would be odorous and potentially hazardous in water. The pollutant would show up as seepage downhill, as pollution in surface streams, or as pollution entering the regional groundwater.

Cross Section Illustration of a Landfill
  

Before new construction could proceed, this landfill site would have to be controlled or removed. Typical control methods might involve:

• Surface water control measures, such as contour grading or surface sealing.
• Passive groundwater control techniques such as underground barriers between the groundwater and the landfill.
• Plume management procedures such as pumping water from surrounding wells.
• Chemical immobilization techniques such as applying surface seals or chemical injections.
• Excavation and reburial of the landfill requiring the availability of an engineered and environmentally sound landfill.

3.9 Value Engineering

Value engineering may be broadly defined as an organized approach in identifying unnecessary costs in design and construction and in soliciting or proposing alternative design or construction technology to reduce costs without sacrificing quality or performance requirements. It usually involves the steps of gathering pertinent information, searching for creative ideas, evaluating the promising alternatives, and proposing a more cost effective alternative. This approach is usually applied at the beginning of the construction phase of the project life cycle.

The use of value engineering in the public sector of construction has been fostered by legislation and government regulation, but the approach has not been widely adopted in the private sector of construction. One explanation may lie in the difference in practice of engineering design services in the public and private sectors. In the public sector, the fee for design services is tightly monitored against the "market price," or may even be based on the lowest bid for service. Such a practice in setting professional fees encourages the design professionals to adopt known and tried designs and construction technologies without giving much thought to alternatives that are innovative but risky. Contractors are willing to examine such alternatives when offered incentives for sharing the savings by owners. In the private sector, the owner has the freedom to offer such incentives to design professionals as well as the contractors without being concerned about the appearance of favoritism in engaging professional services.

Another source of cost savings from value engineering is the ability of contractors to take advantage of proprietary or unusual techniques and knowledge specific to the contractor's firm. For example, a contractor may have much more experience with a particular method of tunneling that is not specified in the original design and, because of this experience, the alternative method may be less expensive. In advance of a bidding competition, a design professional does not know which contractor will undertake the construction of a facility. Once a particular contractor is chosen, then modifications to the construction technology or design may take advantage of peculiar advantages of the contractor's organization.

As a final source of savings in value engineering, the contractor may offer genuine new design or construction insights which have escaped the attention of the design professional even if the latter is not restrained by the fee structure to explore more alternatives. If the expertise of the contractor can be utilized, of course, the best time to employ it is during the planning and design phase of the project life cycle. That is why professional construction management or integrated design/construction are often preferred by private owners.

3.10 Construction Planning

The development of a construction plan is very much analogous to the development of a good facility design. The planner must weigh the costs and reliability of different options while at the same time insuring technical feasibility. Construction planning is more difficult in some ways since the building process is dynamic as the site and the physical facility change over time as construction proceeds. On the other hand, construction operations tend to be fairly standard from one project to another, whereas structural or foundation details might differ considerably from one facility to another.

Forming a good construction plan is an exceptionally challenging problem. There are numerous possible plans available for any given project. While past experience is a good guide to construction planning, each project is likely to have special problems or opportunities that may require considerable ingenuity and creativity to overcome or exploit. Unfortunately, it is quite difficult to provide direct guidance concerning general procedures or strategies to form good plans in all circumstances. There are some recommendations or issues that can be addressed to describe the characteristics of good plans, but this does not necessarily tell a planner how to discover a good plan. However, as in the design process, strategies of decomposition in which planning is divided into subproblems and hierarchical planning in which general activities are repeatably subdivided into more specific tasks can be readily adopted in many cases.

From the standpoint of construction contractors or the construction divisions of large firms, the planning process for construction projects consists of three stages that take place between the moment in which a planner starts the plan for the construction of a facility to the moment in which the evaluation of the final output of the construction process is finished.

The estimate stage involves the development of a cost and duration estimate for the construction of a facility as part of the proposal of a contractor to an owner. It is the stage in which assumptions of resource commitment to the necessary activities to build the facility are made by a planner. A careful and thorough analysis of different conditions imposed by the construction project design and by site characteristics are taken into consideration to determine the best estimate. The success of a contractor depends upon this estimate, not only to obtain a job but also to construct the facility with the highest profit. The planner has to look for the time-cost combination that will allow the contractor to be successful in his commitment. The result of a high estimate would be to lose the job, and the result of a low estimate could be to win the job, but to lose money in the construction process. When changes are done, they should improve the estimate, taking into account not only present effects, but also future outcomes of succeeding activities. It is very seldom the case in which the output of the construction process exactly echoes the estimate offered to the owner.

In the monitoring and control stage of the construction process, the construction manager has to keep constant track of both activities' durations and ongoing costs. It is misleading to think that if the construction of the facility is on schedule or ahead of schedule, the cost will also be on the estimate or below the estimate, especially if several changes are made. Constant evaluation is necessary until the construction of the facility is complete. When work is finished in the construction process, and information about it is provided to the planner, the third stage of the planning process can begin.

The evaluation stage is the one in which results of the construction process are matched against the estimate. A planner deals with this uncertainty during the estimate stage. Only when the outcome of the construction process is known is he/she able to evaluate the validity of the estimate. It is in this last stage of the planning process that he or she determines if the assumptions were correct. If they were not or if new constraints emerge, he/she should introduce corresponding adjustments in future planning.

3.11 Industrialized Construction and Pre-fabrication

Another approach to construction innovation is to apply the principles and organizational solutions adopted for manufacturing. Industrialized construction and pre-fabrication would involve transferring a significant portion of construction operations from the construction site to more or less remote sites where individual components of buildings and structures are produced. Elements of facilities could be prefabricated off the erection site and assembled by cranes and other lifting machinery.

There are a wide variety and degrees of introducing greater industrialization to the construction process. Many components of constructed facilities have always been manufactured, such as air conditioning units. Lumber, piping and other individual components are manufactured to standard sizes. Even temporary items such as forms for concrete can be assembled off-site and transported for use. Reinforcing bars for concrete can also be pre-cut and shaped to the desired configuration in a manufacturing plant or in an automated plant located proximate to a construction site.

A major problem in extending the use of pre-fabricated units is the lack of standardization for systems and building regulations.[For discussions of industrialized building, see Bender, Richard, A Crack in the Rear View Mirror - A View of Industrialized Building, Von Nostrand Reinhold Co., 1983; Nutt-Powell, Thomas, E., Manufactured Homes: Making Sense of a Housing Opportunity, Auburn House, 1982; or Warzawski, A., M. Avraham, and D. Carmel, "Utilization of Precast Concrete Elements in Building," ASCE Journal of Construction Engineering and Management, Vol. 110, No. CO4, 1984, pp. 476-485.] While designers have long adopted standard sizes for individual components in designs, the adoption of standardized sub-assemblies is rarer. Without standardization, the achievement of a large market and scale economies of production in manufacturing may be impossible. An innovative and more thorough industrialization of the entire building process may be a primary source of construction cost savings in the future.

Example 3-12: Planning of pre-fabrication.

When might pre-fabricated components be used in preference to components assembled on a construction site? A straightforward answer is to use pre-fabricated components whenever their cost, including transportation, is less than the cost of assembly on site. As an example, forms for concrete panels might be transported to a construction site with reinforcing bars already built in, necessary coatings applied to the forms, and even special features such as electrical conduit already installed in the form. In some cases, it might be less expensive to pre-fabricate and transport the entire concrete panel to a manufacturing site. In contrast, traditional construction practice would be to assemble all the different features of the panel on-site. The relevant costs of these alternatives could be assessed during construction planning to determine the lowest cost alternative.

In addition to the consideration of direct costs, a construction planner should also consider some other aspects of this technology choice. First, the planner must insure that pre-fabricated components will satisfy the relevant building codes and regulations. Second, the relative quality of traditional versus pre-fabricated components as experienced in the final facility should be considered. Finally, the availability of components at the required time during the construction process should also be considered.

Example 3-13: Impacts of building codes(See C.G. Field and S.R. Rivkin, The Building Code Burden, Lexington Books, D.C. Heath and Co., Lexington, MA, 1975.)

Building codes originated as a part of the building regulatory process for the safety and general welfare of the public. The source of all authority to enact building codes is based on the police power of the state which may be delegated by the state legislature to local government units. Consequently, about 8,000 localities having their own building codes, either by following a national model code or developing a local code. The lack of uniformity of building codes may be attributed to a variety of reasons:

• Neighboring municipalities may adopt different national models as the basis for local regulation.
• Periodic revisions of national codes may not be adopted by local authorities before the lapse of several years.
• Municipalities may explicitly decline to adopt specific provisions of national model codes or may use their own variants of key provisions.
• Local authorities may differ in interpretation of the same language in national model codes.

The lack of uniformity in building codes has serious impact on design and construction as well as the regulatory process for buildings. Among the significant factors are:

• Delay in the diffusion of new building innovations which may take a long time to find their ways to be incorporated in building codes.
• Discouragement to new production organizations, such as industrialized construction and prefabrication.
• Duplication of administrative cost of public agencies and compliance cost incurred by private firms.

3.12 Computer-Aided Engineering

In the past twenty years, the computer has become an essential tool in engineering, design, and accounting. The innovative designs of complicated facilities cited in the previous sections would be impossible without the aid of computer based analysis tools. By using general purpose analysis programs to test alternative designs of complex structures such as petrochemical plants, engineers are able to greatly improve initial designs. General purpose accounting systems are also available and adopted in organizations to perform routine bookkeeping and financial accounting chores. These applications exploit the capability for computers to perform numerical calculations in a pre-programmed fashion rapidly, inexpensively and accurately.

Despite these advances, the computer is often used as only an incidental tool in the design, construction and project management processes. However, new capabilities, systems and application programs are rapidly being adopted. These are motivated in part by the remarkable improvement in computer hardware capability coupled with a extraordinary decline in cost. New concepts in computer design and in software are also contributing. For example, the introduction of personal computers using microcircuitry has encouraged the adoption of interactive programs because of the low cost and considerable capability of the computer hardware. Personal computers available for several thousand dollars in 1984 have essentially the same capability as expensive mainframe computer systems of fifteen years earlier.

Computer graphics provide another pertinent example of a potentially revolutionary mechanism for design and communication. Graphical representations of both the physical and work activities on projects have been essential tools in the construction industry for decades. However, manual drafting of blueprints, plans and other diagrams is laborious and expensive. Stand alone, computer aided drafting equipment has proved to be less expensive and fully capable of producing the requiring drawings. More significantly, the geometric information required for producing desired drawings might also be used as a database for computer aided design and computer integrated construction. Components of facilities can be represented as three dimensional computer based solid models for this purpose. Geometric information forms only one component of integrated design databases in which the computer can assure consistency, completeness and compliance with relevant specifications and constraints. Several approaches to integrated computer aided engineering environments of this type have already been attempted.[See Rehak, Daniel R. and L.A. Lopez, Computer Aided Engineering Problems and Prospects, Dept. of Civil Engineering, University of Illinois, 1981.]

Computers are also being applied more and more extensively to non-analytical and non-numerical tasks. For example, computer based specification writing assistants are used to rapidly assemble sets of standard specifications or to insert special clauses in the documentation of facility designs. As another example, computerized transfer of information provides a means to avoid laborious and error-prone transcription of project information. While most of the traditional applications and research in computer aids have emphasized numerical calculations, the use of computers will rapidly shift towards the more prevalent and difficult problems of planning, communication, design and management.

Knowledge based systems represent a prominent example of new software approaches applicable to project management. These systems originally emerged from research in artificial intelligence in which human cognitive processes were modeled. In limited problem domains such as equipment configuration or process control, knowledge based systems have been demonstrated to approach or surpass the performance of human experts. The programs are marked by a separation between the reasoning or "inference" engine program and the representation of domain specific knowledge. As a result, system developers need not specify complete problem solving strategies (or algorithms) for particular problems. This characteristic of knowledge based systems make them particularly useful in the ill-structured domains of design and project management. Chapter 15 will discuss knowledge based systems in greater detail.

Computer program assistants will soon become ubiquitous in virtually all project management organizations. The challenge for managers is to use the new tools in an effective fashion. Computer intensive work environments should be structured to aid and to amplify the capabilities of managers rather than to divert attention from real problems such as worker motivation.

3.13 References

1. Au, T. and P. Christiano, Structural Analysis, Prentice-Hall, Inc., Englewood Cliffs, NJ, 1987.
2. Building Research Advisory Board, Exploratory Study on Responsibility, Liability and Accountability for Risks in Construction, National Academy of Sciences, Washington, D.C., 1978.
3. Drucker, P.F., Innovation and Entrepreneurship: Practice and Principles, Harper and Row, New York, 1985.
4. Gaylord, E., and C. Gaylord (Editors), Structural Engineering Handbook, McGraw-Hill Book Co., New York, 1979.
5. Levitt, R.E., R.D. Logcher and N.H. Quaddumi, "Impact of Owner-Engineer Risk Sharing on Design Conservatism," ASCE Journal of Professional Issues in Engineering, Vol. 110, 1984, pp. 157-167.
6. Simon, H.A., The Science of the Artificial, Second Edition, MIT Press, Cambridge, MA, 1981.
7. Tatum, C.B., "Innovation on the Construction Project: A Process View," Project Management Journal, Vol. 18, No. 5, 1987, pp. 57-67.

4. Labor, Material and Equipment Utilization

4.1 Historical Perspective

Good project management in construction must vigorously pursue the efficient utilization of labor, material and equipment. Improvement of labor productivity should be a major and continual concern of those who are responsible for cost control of constructed facilities. Material handling, which includes procurement, inventory, shop fabrication and field servicing, requires special attention for cost reduction. The use of new equipment and innovative methods has made possible wholesale changes in construction technologies in recent decades. Organizations which do not recognize the impact of various innovations and have not adapted to changing environments have justifiably been forced out of the mainstream of construction activities.

Observing the trends in construction technology presents a very mixed and ambiguous picture. On the one hand, many of the techniques and materials used for construction are essentially unchanged since the introduction of mechanization in the early part of the twentieth century. For example, a history of the Panama Canal construction from 1904 to 1914 argues that:

[T]he work could not have done any faster or more efficiently in our day, despite all technological and mechanical advances in the time since, the reason being that no present system could possibly carry the spoil away any faster or more efficiently than the system employed. No motor trucks were used in the digging of the canal; everything ran on rails. And because of the mud and rain, no other method would have worked half so well.[McCullough, David, The Path Between the Seas, Simon and Schuster, 1977, pg. 531.]

Bricklaying...is said not to have changed in thousands of years; perhaps in the literal placing of brick on brick it has not. But masonry technology has changed a great deal. Motorized wheelbarrows and mortar mixers, sophisticated scaffolding systems, and forklift trucks now assist the bricklayer. New epoxy mortars give stronger adhesion between bricks. Mortar additives and cold-weather protection eliminate winter shutdowns.[Rosefielde, Steven and Daniel Quinn Mills, "Is Construction Technologically Stagnant?", in Lange, Julian E. and Daniel Quinn Mills, The Construction Industry, Lexington Books, 1979, pg. 83.]

The United States construction industry often points to factors which cannot be controlled by the industry as a major explanatory factor in cost increases and lack of technical innovation. These include the imposition of restrictions for protection of the environment and historical districts, requirements for community participation in major construction projects, labor laws which allow union strikes to become a source of disruption, regulatory policies including building codes and zoning ordinances, and tax laws which inhibit construction abroad. However, the construction industry should bear a large share of blame for not realizing earlier that the technological edge held by the large U.S. construction firms has eroded in face of stiff foreign competition. Many past practices, which were tolerated when U.S. contractors had a technological lead, must now be changed in the face of stiff competition. Otherwise, the U.S. construction industry will continue to find itself in trouble.

With a strong technological base, there is no reason why the construction industry cannot catch up and reassert itself to meet competition wherever it may be. Individual design and/or construction firms must explore new ways to improve productivity for the future. Of course, operational planning for construction projects is still important, but such tactical planning has limitations and may soon reach the point of diminishing return because much that can be wrung out of the existing practices have already been tried. What is needed the most is strategic planning to usher in a revolution which can improve productivity by an order of magnitude or more. Strategic planning should look at opportunities and ask whether there are potential options along which new goals may be sought on the basis of existing resources. No one can be certain about the success of various development options for the design professions and the construction industry. However, with the availability of today's high technology, some options have good potential of success because of the social and economic necessity which will eventually push barriers aside. Ultimately, decisions for action, not plans, will dictate future outcomes.

4.2 Labor Productivity

Productivity in construction is often broadly defined as output per labor hour. Since labor constitutes a large part of the construction cost and the quantity of labor hours in performing a task in construction is more susceptible to the influence of management than are materials or capital, this productivity measure is often referred to as labor productivity. However, it is important to note that labor productivity is a measure of the overall effectiveness of an operating system in utilizing labor, equipment and capital to convert labor efforts into useful output, and is not a measure of the capabilities of labor alone. For example, by investing in a piece of new equipment to perform certain tasks in construction, output may be increased for the same number of labor hours, thus resulting in higher labor productivity.

Construction output may be expressed in terms of functional units or constant dollars. In the former case, labor productivity is associated with units of product per labor hour, such as cubic yards of concrete placed per hour or miles of highway paved per hour. In the latter case, labor productivity is identified with value of construction in constant dollars per labor hour.

Productivity at the Job Site

Contractors and owners are often concerned with the labor activity at job sites. For this purpose, it is convenient to express labor productivity as functional units per labor hour for each type of construction task. However, even for such specific purposes, different levels of measure may be used. For example, cubic yards of concrete placed per hour is a lower level of measure than miles of highway paved per hour. Lower-level measures are more useful for monitoring individual activities, while higher-level measures may be more convenient for developing industry-wide standards of performance.

While each contractor or owner is free to use its own system to measure labor productivity at a site, it is a good practice to set up a system which can be used to track productivity trends over time and in varied locations. Considerable efforts are required to collect information regionally or nationally over a number of years to produce such results. The productivity indices compiled from statistical data should include parameters such as the performance of major crafts, effects of project size, type and location, and other major project influences.

In order to develop industry-wide standards of performance, there must be a general agreement on the measures to be useful for compiling data. Then, the job site productivity data collected by various contractors and owners can be correlated and analyzed to develop certain measures for each of the major segment of the construction industry. Thus, a contractor or owner can compare its performance with that of the industry average.

Productivity in the Construction Industry

Because of the diversity of the construction industry, a single index for the entire industry is neither meaningful nor reliable. Productivity indices may be developed for major segments of the construction industry nationwide if reliable statistical data can be obtained for separate industrial segments. For this general type of productivity measure, it is more convenient to express labor productivity as constant dollars per labor hours since dollar values are more easily aggregated from a large amount of data collected from different sources. The use of constant dollars allows meaningful approximations of the changes in construction output from one year to another when price deflators are applied to current dollars to obtain the corresponding values in constant dollars. However, since most construction price deflators are obtained from a combination of price indices for material and labor inputs, they reflect only the change of price levels and do not capture any savings arising from improved labor productivity. Such deflators tend to overstate increases in construction costs over a long period of time, and consequently understate the physical volume or value of construction work in years subsequent to the base year for the indices.

4.3 Factors Affecting Job-Site Productivity

Job-site productivity is influenced by many factors which can be characterized either as project work conditions or as non-productive activities. The project work conditions include among other factors:

• Job size and complexity.
• Job site accessibility.
• Labor availability.
• Equipment utilization.
• Contractual agreements.
• Local climate.
• Local cultural characteristics, particularly in foreign operations.

The non-productive activities associated with a project may or may not be paid by the owner, but they nevertheless take up potential labor resources which can otherwise be directed to the project. The non-productive activities include among other factors:

• Indirect labor required to maintain the progress of the project
• Rework for correcting unsatisfactory work
• Temporary work stoppage due to inclement weather or material shortage
• Time off for union activities
• Absentee time, including late start and early quits
• Non-working holidays
• Strikes

Both categories of factors affect the productive labor available to a project as well as the on-site labor efficiency.

Project Work Conditions

Job-site labor productivity can be estimated either for each craft (carpenter, bricklayer, etc.) or each type of construction (residential housing, processing plant, etc.) under a specific set of work conditions. A base labor productivity may be defined for a set of work conditions specified by the owner or contractor who wishes to observe and measure the labor performance over a period of time under such conditions. A labor productivity index may then be defined as the ratio of the job-site labor productivity under a different set of work conditions to the base labor productivity, and is a measure of the relative labor efficiency of a project under this new set of work conditions.

The effects of various factors related to work conditions on a new project can be estimated in advance, some more accurately than others. For example, for very large construction projects, the labor productivity index tends to decrease as the project size and/or complexity increase because of logistic problems and the "learning" that the work force must undergo before adjusting to the new environment. Job-site accessibility often may reduce the labor productivity index if the workers must perform their jobs in round about ways, such as avoiding traffic in repaving the highway surface or maintaining the operation of a plant during renovation. Labor availability in the local market is another factor. Shortage of local labor will force the contractor to bring in non-local labor or schedule overtime work or both. In either case, the labor efficiency will be reduced in addition to incurring additional expenses. The degree of equipment utilization and mechanization of a construction project clearly will have direct bearing on job-site labor productivity. The contractual agreements play an important role in the utilization of union or non-union labor, the use of subcontractors and the degree of field supervision, all of which will impact job-site labor productivity. Since on-site construction essentially involves outdoor activities, the local climate will influence the efficiency of workers directly. In foreign operations, the cultural characteristics of the host country should be observed in assessing the labor efficiency.

Non-Productive Activities

The non-productive activities associated with a project should also be examined in order to examine the productive labor yield, which is defined as the ratio of direct labor hours devoted to the completion of a project to the potential labor hours. The direct labor hours are estimated on the basis of the best possible conditions at a job site by excluding all factors which may reduce the productive labor yield. For example, in the repaving of highway surface, the flagmen required to divert traffic represent indirect labor which does not contribute to the labor efficiency of the paving crew if the highway is closed to the traffic. Similarly, for large projects in remote areas, indirect labor may be used to provide housing and infrastructure for the workers hired to supply the direct labor for a project. The labor hours spent on rework to correct unsatisfactory original work represent extra time taken away from potential labor hours. The labor hours related to such activities must be deducted from the potential labor hours in order to obtain the actual productive labor yield.

Example 4-1: Effects of job size on productivity

A contractor has established that under a set of "standard" work conditions for building construction, a job requiring 500,000 labor hours is considered standard in determining the base labor productivity. All other factors being the same, the labor productivity index will increase to 1.1 or 110% for a job requiring only 400,000 labor-hours. Assuming that a linear relation exists for the range between jobs requiring 300,000 to 700,000 labor hours as shown in Figure 4-0, determine the labor productivity index for a new job requiring 650,000 labor hours under otherwise the same set of work conditions.

Illustrative Relationship between
  

 Productivity Index and Job Size
  

The labor productivity index I for the new job can be obtained by linear interpolation of the available data as follows:

500,000 - 650,000 I = 1.0 + (1.1-1.0) ## ## = 0.85----------------- 500,000 - 400,000

Example 4-2: Productive labor yield(This example was adapted with permission from an unpublished paper "Managing Mega Projects" presented by G.R. Desnoyers at the Project Management Symposium sponsored by the Exxon Research and Engineering Company, Florham Park, NJ, November 12, 1980.)

In the construction of an off-shore oil drilling platform, the potential labor hours were found to be L = 7.5 million hours. Of this total, the non-productive activities expressed in thousand labor hours were as follows:

• A = 417 for holidays and strikes
• B = 1,415 for absentees (i.e. vacation, sick time, etc.)
• C = 1,141 for temporary stoppage (i.e. weather, waiting, union activities, etc.)
• D = 1,431 for indirect labor (i.e. building temporary facilities, cleaning up the site, rework to correct errors, etc.)

The percentages of time allocated to various non-productive activities, A, B, C and D are:

A 417 ##=## ##=##6#%- ----- L 7,500 B 1,415 ##=## ##=##19#%- ----- L 7,500 C 1,141 ##=## ##=##15#%- ----- L 7,500 D 1,431 ##=## ##=##19#%- ----- L 7,500

A#+#B#+#C#+#D X##=## ##=###6#%##+##19#%##+##15#%##+##19#%##=##59#%------------- L

L##-##A##-##B##-##C##-##D Y = = 100#%#-#6#%#-#19#%#-#15#%#-#19#%#=#41#%------------------------- L

Example 4-3: Utilization of on-site worker's time

An example illustrating the effects of indirect labor requirements which limit productive labor by a typical craftsman on the job site was given by R. Tucker with the following percentages of time allocation:(See R.L. Tucker, "Perfection of the Buggy Whip," The Construction Advancement Address, ASCE, Boston, MA, Oct. 29, 1986.)

!!!Productive time!!!40%
!!!Unproductive time
!!!!!!Administrative delays !!!20%
!!!!!!Inefficient work methods!!!20%
!!!!!!Labor jurisdictions and other work restrictions!!!15%
!!!Personal time!!!5%

4.4 Labor Relations in Construction

The market demand in construction fluctuates greatly, often within short periods and with uneven distributions among geographical regions. Even when the volume of construction is relatively steady, some types of work may decline in importance while other types gain. Under an unstable economic environment, employers in the construction industry place great value on flexibility in hiring and laying off workers as their volumes of work wax and wane. On the other hand, construction workers sense their insecurity under such circumstances and attempt to limit the impacts of changing economic conditions through labor organizations.

There are many crafts in the construction labor forces, but most contractors hire from only a few of these crafts to satisfy their specialized needs. Because of the peculiar characteristics of employment conditions, employers and workers are placed in a more intimate relationship than in many other industries. Labor and management arrangements in the construction industry include both unionized and non-unionized operations which compete for future dominance. Most industrial and utility construction is union. In the commercial building sector, non-union contractors have made inroads, while in the housing sector, most contractors are non-union. The heavy construction sector is primarily non-union.

Unionized Construction

The craft unions work with construction contractors using unionized labor through various market institutions such as jurisdiction rules, apprenticeship programs, and the referral system. Craft unions with specific jurisdiction rules for different trades set uniform hourly wage rates for journeymen and offer formal apprenticeship training to provide common and equivalent skill for each trade. Contractors, through the contractors' associations, enter into legally binding collective bargaining agreements with one or more of the craft unions in the construction trades. The system which bind both parties to a collective bargaining agreement is referred to as the "union shop". These agreements obligate a contractor to observe the work jurisdictions of various unions and to hire employees through a union operated referral system commonly known as the hiring hall.

The referral systems operated by union organizations are required to observe several conditions:

1. All qualified workers reported to the referral system must be made available to the contractor without discrimination on the basis of union membership or other relationship to the union. The "closed shop" which limits referral to union members only is now illegal.
2. The contractor reserves the right to hire or refuse to hire any worker referred by the union on the basis of his or her qualifications.
3. The referral plan must be posted in public, including any priorities of referrals or required qualifications.

While these principles must prevail, referral systems operated by labor organizations differ widely in the construction industry.

Contractors and craft unions must negotiate not only wage rates and working conditions, but also hiring and apprentice training practices. The purpose of trade jurisdiction is to encourage considerable investment in apprentice training on the part of the union so that the contractor will be protected by having only qualified workers perform the job even though such workers are not permanently attached to the contractor and thus may have no sense of security or loyalty. The referral system is often a rapid and dependable source of workers, particularly for a contractor who moves into a new geographical location or starts a new project which has high fluctuations in demand for labor. By and large, the referral system has functioned smoothly in providing qualified workers to contractors, even though some other aspects of union operations are not as well accepted by contractors.

Non-Unionized Construction

In recent years, non-union contractors have entered and prospered in an industry which has a long tradition of unionization. Non-union operations in construction are referred to as "open shops." However, in the absence of collective bargaining agreements, many contractors operate under policies adopted by non-union contractors' associations. This practice is referred to as "merit shop", which follows substantially the same policies and procedures as collective bargaining although under the control of a non-union contractors' association without union participation. Other contractors may choose to be totally "unorganized" by not following either union shop or merit shop practices.

The operations of the merit shop are national in scope, except for the local or state apprenticeship and training plans. The comprehensive plans of the contractors' association apply to all employees and crafts of a contractor regardless of their trades. Under such operations, workers have full rights to move through the nation among member contractors of the association. Thus, the non-union segment of the industry is organized by contractors' associations into an integral part of the construction industry. However, since merit shop workers are employed directly by the construction firms, they have a greater loyalty to the firm, and recognize that their own interest will be affected by the financial health of the firm.

Playing a significant role in the early growth and continued expansion of merit shop construction is the Associated Builders and Contractors association. By 1987, it had a membership of nearly 20,000 contractors and a network of 75 chapters through the nation. Among the merit shop contractors are large construction firms such as Fluor Daniel, Blount International, and Brown & Root Construction. The advantages of merit shops as claimed by its advocates are:

• the ability to manage their own work force
• flexibility in making timely management decisions
• the emphasis on making maximum usage of local labor force
• the emphasis on encouraging individual work advancement through continued development of skills
• the shared interest that management and workers have in seeing an individual firm prosper.

By shouldering the training responsibility for producing skill workers, the merit shop contractors have deflected the most serious complaints of users and labor that used to be raised against the open shop. On the other hand, the use of mixed crews of skilled workers at a job site by merit shop contractors enables them to remove a major source of inefficiencies caused by the exclusive jurisdiction practiced in the union shop, namely the idea that only members of a particular union should be permitted to perform any given task in construction. As a result, merit shop contractors are able to exert a beneficial influence on productivity and cost-effectiveness of construction projects.

The unorganized form of open shop is found primarily in housing construction where a large percentage of workers are characterized as unskilled helpers. The skilled workers in various crafts are developed gradually through informal apprenticeships while serving as helpers. This form of open shop is not expected to expand beyond the type of construction projects in which highly specialized skills are not required.

4.5 Problems in Collective Bargaining

In the organized building trades in North American construction, the primary unit is the international union, which is an association of local unions in the United States and Canada. Although only the international unions have the power to issue or remove charters and to organize or combine local unions, each local union has considerable degrees of autonomy in the conduct of its affairs, including the negotiation of collective bargaining agreements. The business agent of a local union is an elected official who is the most important person in handling the day to day operations on behalf of the union. The contractors' associations representing the employers vary widely in composition and structure, particularly in different geographical regions. In general, local contractors' associations are considerably less well organized than the union with which they deal, but they try to strengthen themselves through affiliation with state and national organizations. Typically, collective bargaining agreements in construction are negotiated between a local union in a single craft and the employers of that craft as represented by a contractors' association, but there are many exceptions to this pattern. For example, a contractor may remain outside the association and negotiate independently of the union, but it usually cannot obtain a better agreement than the association.

Because of the great variety of bargaining structures in which the union and contractors' organization may choose to stage negotiations, there are many problems arising from jurisdictional disputes and other causes. Given the traditional rivalries among various crafts and the ineffective organization of some of contractors' associations, coupled with the lack of adequate mechanisms for settling disputes, some possible solutions to these problems deserve serious attention:<For more detailed discussion, see D.G. Mills: "Labor Relations and Collective Bargaining" (Chapter 4) in The Construction Industry (by J.E. Lang and D.Q. Mills), Lexington Books, D.C. Heath and Co., Lexington, MA, 1979.>

Regional Bargaining

Currently, the geographical area in a collective bargaining agreement does not necessarily coincide with the territory of the union and contractors' associations in the negotiations. There are overlapping of jurisdictions as well as territories, which may create successions of contract termination dates for different crafts. Most collective bargaining agreements are negotiated locally, but regional agreements with more comprehensive coverage embracing a number of states have been established. The role of national union negotiators and contractors' representatives in local collective bargaining is limited. The national agreement between international unions and a national contractor normally binds the contractors' association and its bargaining unit. Consequently, the most promising reform lies in the broadening of the geographic region of an agreement in a single trade without overlapping territories or jurisdictions.

Multicraft Bargaining

The treatment of interrelationships among various craft trades in construction presents one of the most complex issues in the collective bargaining process. Past experience on project agreements has dealt with such issues successfully in that collective bargaining agreements are signed by a group of craft trade unions and a contractor for the duration of a project. Project agreements may reference other agreements on particular points, such as wage rates and fringe benefits, but may set their own working conditions and procedures for settling disputes including a commitment of no-strike and no-lockout. This type of agreement may serve as a starting point for multicraft bargaining on a regional, non-project basis.

Improvement of Bargaining Performance

Although both sides of the bargaining table are to some degree responsible for the success or failure of negotiation, contractors have often been responsible for the poor performance of collective bargaining in construction in recent years because local contractors' associations are generally less well organized and less professionally staffed than the unions with which they deal. Legislation providing for contractors' association accreditation as an exclusive bargaining agent has now been provided in several provinces in Canada. It provides a government board that could hold hearings and establish an appropriate bargaining unit by geographic region or sector of the industry, on a single-trade or multi-trade basis.

4.6 Materials Management

Materials management is an important element in project planning and control. Materials represent a major expense in construction, so minimizing procurement or purchase costs presents important opportunities for reducing costs. Poor materials management can also result in large and avoidable costs during construction. First, if materials are purchased early, capital may be tied up and interest charges incurred on the excess inventory of materials. Even worse, materials may deteriorate during storage or be stolen unless special care is taken. For example, electrical equipment often must be stored in waterproof locations. Second, delays and extra expenses may be incurred if materials required for particular activities are not available. Accordingly, insuring a timely flow of material is an important concern of project managers.

Materials management is not just a concern during the monitoring stage in which construction is taking place. Decisions about material procurement may also be required during the initial planning and scheduling stages. For example, activities can be inserted in the project schedule to represent purchasing of major items such as elevators for buildings. The availability of materials may greatly influence the schedule in projects with a fast track or very tight time schedule: sufficient time for obtaining the necessary materials must be allowed. In some case, more expensive suppliers or shippers may be employed to save time.

Materials management is also a problem at the organization level if central purchasing and inventory control is used for standard items. In this case, the various projects undertaken by the organization would present requests to the central purchasing group. In turn, this group would maintain inventories of standard items to reduce the delay in providing material or to obtain lower costs due to bulk purchasing. This organizational materials management problem is analogous to inventory control in any organization facing continuing demand for particular items.

Materials ordering problems lend themselves particularly well to computer based systems to insure the consistency and completeness of the purchasing process. In the manufacturing realm, the use of automated materials requirements planning systems is common. In these systems, the master production schedule, inventory records and product component lists are merged to determine what items must be ordered, when they should be ordered, and how much of each item should be ordered in each time period. The heart of these calculations is simple arithmetic: the projected demand for each material item in each period is subtracted from the available inventory. When the inventory becomes too low, a new order is recommended. For items that are non-standard or not kept in inventory, the calculation is even simpler since no inventory must be considered. With a materials requirement system, much of the detailed record keeping is automated and project managers are alerted to purchasing requirements.

Example 4-4: Examples of benefits for materials management systems.(This example was adapted from Stukhart, G. and Bell, L.C. "Costs and Benefits of Materials Management Systems,", ASCE Journal of Construction Engineering and Management, Vol. 113, No. 2, June 1987, pp. 222-234.)

From a study of twenty heavy construction sites, the following benefits from the introduction of materials management systems were noted:

• In one project, a 6% reduction in craft labor costs occurred due to the improved availability of materials as needed on site. On other projects, an 8% savings due to reduced delay for materials was estimated.
• A comparison of two projects with and without a materials management system revealed a change in productivity from 1.92 man-hours per unit without a system to 1.14 man-hours per unit with a new system. Again, much of this difference can be attributed to the timely availability of materials.
• Warehouse costs were found to decrease 50% on one project with the introduction of improved inventory management, representing a savings of $ 92,000. Interest charges for inventory also declined, with one project reporting a cash flow savings of $ 85,000 from improved materials management.

4.7 Material Procurement and Delivery

The main sources of information for feedback and control of material procurement are requisitions, bids and quotations, purchase orders and subcontracts, shipping and receiving documents, and invoices. For projects involving the large scale use of critical resources, the owner may initiate the procurement procedure even before the selection of a constructor in order to avoid shortages and delays. Under ordinary circumstances, the constructor will handle the procurement to shop for materials with the best price/performance characteristics specified by the designer. Some overlapping and rehandling in the procurement process is unavoidable, but it should be minimized to insure timely delivery of the materials in good condition.

The materials for delivery to and from a construction site may be broadly classified as : (1) bulk materials, (2) standard off-the-shelf materials, and (3) fabricated members or units. The process of delivery, including transportation, field storage and installation will be different for these classes of materials. The equipment needed to handle and haul these classes of materials will also be different.

Bulk materials refer to materials in their natural or semi-processed state, such as earthwork to be excavated, wet concrete mix, etc. which are usually encountered in large quantities in construction. Some bulk materials such as earthwork or gravels may be measured in bank (solid in situ) volume. Obviously, the quantities of materials for delivery may be substantially different when expressed in different measures of volume, depending on the characteristics of such materials.

Standard piping and valves are typical examples of standard off-the-shelf materials which are used extensively in the chemical processing industry. Since standard off-the-shelf materials can easily be stockpiled, the delivery process is relatively simple.

Fabricated members such as steel beams and columns for buildings are pre-processed in a shop to simplify the field erection procedures. Welded or bolted connections are attached partially to the members which are cut to precise dimensions for adequate fit. Similarly, steel tanks and pressure vessels are often partly or fully fabricated before shipping to the field. In general, if the work can be done in the shop where working conditions can better be controlled, it is advisable to do so, provided that the fabricated members or units can be shipped to the construction site in a satisfactory manner at a reasonable cost.

As a further step to simplify field assembly, an entire wall panel including plumbing and wiring or even an entire room may be prefabricated and shipped to the site. While the field labor is greatly reduced in such cases, "materials" for delivery are in fact manufactured products with value added by another type of labor. With modern means of transporting construction materials and fabricated units, the percentages of costs on direct labor and materials for a project may change if more prefabricated units are introduced in the construction process.

In the construction industry, materials used by a specific craft are generally handled by craftsmen, not by general labor. Thus, electricians handle electrical materials, pipefitters handle pipe materials, etc. This multiple handling diverts scarce skilled craftsmen and contractor supervision into activities which do not directly contribute to construction. Since contractors are not normally in the freight business, they do not perform the tasks of freight delivery efficiently. All these factors tend to exacerbate the problems of freight delivery for very large projects.

Example 4-5: Freight delivery for the Alaska Pipeline Project(The information for this example was provided by Exxon Pipeline Company, Houston, Texas, with permission from the Alyeska Pipeline Service Co., Anchorage, Alaska.)

The freight delivery system for the Alaska pipeline project was set up to handle 600,000 tons of materials and supplies. This tonnage did not include the pipes which comprised another 500,000 tons and were shipped through a different routing system.

The complexity of this delivery system is illustrated in Figure 4-0. The rectangular boxes denote geographical locations. The points of origin represent plants and factories throughout the US and elsewhere. Some of the materials went to a primary staging point in Seattle and some went directly to Alaska. There were five ports of entry: Valdez, Anchorage, Whittier, Seward and Prudhoe Bay. There was a secondary staging area in Fairbanks and the pipeline itself was divided into six sections. Beyond the Yukon River, there was nothing available but a dirt road for hauling. The amounts of freight in thousands of tons shipped to and from various locations are indicated by the numbers near the network branches (with arrows showing the directions of material flows) and the modes of transportation are noted above the branches. In each of the locations, the contractor had supervision and construction labor to identify materials, unload from transport, determine where the material was going, repackage if required to split shipments, and then re-load material on outgoing transport.

Freight Delivery for the Alaska Pipeline Project
  

Example 4-6: Process plant equipment procurement[This example was adapted from A.E. Kerridge, "How to Develop a Project Schedule," in A.E. Kerridge and C. H. Vervalin (eds.), Engineering and Construction Project Management, Gulf Publishing Company, Houston, 1986.]

The procurement and delivery of bulk materials items such as piping electrical and structural elements involves a series of activities if such items are not standard and/or in stock. The times required for various activities in the procurement of such items might be estimated to be as follows:

    Activities!!!Duration!!!Cumulative
!!!  (days)!!!Duration
Requisition ready by designer!!!0!!!0
Owner approval!!!5!!!5
Inquiry issued to vendors!!!3!!!8
Vendor quotations received!!!15!!!23
Complete bid evaluation by designer!!!7!!!30
Owner approval!!!5!!!35
Place purchase order!!!5!!!40
Receive preliminary shop drawings!!!10!!!50
Receive final design drawings!!!10!!!60
Fabrication and delivery!!!60-200!!!120-260

4.8 Inventory Control

Once goods are purchased, they represent an inventory used during the construction process. The general objective of inventory control is to minimize the total cost of keeping the inventory while making tradeoffs among the major categories of costs: (1) purchase costs, (2) order cost, (3) holding costs, and (4) unavailable cost. These cost categories are interrelated since reducing cost in one category may increase cost in others. The costs in all categories generally are subject to considerable uncertainty.

Purchase Costs

The purchase cost of an item is the unit purchase price from an external source including transportation and freight costs. For construction materials, it is common to receive discounts for bulk purchases, so the unit purchase cost declines as quantity increases. These reductions may reflect manufacturers' marketing policies, economies of scale in the material production, or scale economies in transportation. There are also advantages in having homogeneous materials. For example, a bulk order to insure the same color or size of items such as bricks may be desirable. Accordingly, it is usually desirable to make a limited number of large purchases for materials. In some cases, organizations may consolidate small orders from a number of different projects to capture such bulk discounts; this is a basic saving to be derived from a central purchasing office.

The cost of materials is based on prices obtained through effective bargaining. Unit prices of materials depend on bargaining leverage, quantities and delivery time. Organizations with potential for long-term purchase volume can command better bargaining leverage. While orders in large quantities may result in lower unit prices, they may also increase holding costs and thus cause problems in cash flow. Requirements of short delivery time can also adversely affect unit prices. Furthermore, design characteristics which include items of odd sizes or shapes should be avoided. Since such items normally are not available in the standard stockpile, purchasing them causes higher prices.

The transportation costs are affected by shipment sizes and other factors. Shipment by the full load of a carrier often reduces prices and assures quicker delivery, as the carrier can travel from the origin to the destination of the full load without having to stop for delivering part of the cargo at other stations. Avoiding transshipment is another consideration in reducing shipping cost. While the reduction in shipping costs is a major objective, the requirements of delicate handling of some items may favor a more expensive mode of transportation to avoid breakage and replacement costs.

Order Cost

The order cost reflects the administrative expense of issuing a purchase order to an outside supplier. Order costs include expenses of making requisitions, analyzing alternative vendors, writing purchase orders, receiving materials, inspecting materials, checking on orders, and maintaining records of the entire process. Order costs are usually only a small portion of total costs for material management in construction projects, although ordering may require substantial time.

Holding Costs

The holding costs or carrying costs are primarily the result of capital costs, handling, storage, obsolescence, shrinkage and deterioration. Capital cost results from the opportunity cost or financial expense of capital tied up in inventory. Once payment for goods is made, borrowing costs are incurred or capital must be diverted from other productive uses. Consequently, a capital carrying cost is incurred equal to the value of the inventory during a period multiplied by the interest rate obtainable or paid during that period. Note that capital costs only accumulate when payment for materials actually occurs; many organizations attempt to delay payments as long as possible to minimize such costs. Handling and storage represent the movement and protection charges incurred for materials. Storage costs also include the disruption caused to other project activities by large inventories of materials that get in the way. Obsolescence is the risk that an item will lose value because of changes in specifications. Shrinkage is the decrease in inventory over time due to theft or loss. Deterioration reflects a change in material quality due to age or environmental degradation. Many of these holding cost components are difficult to predict in advance; a project manager knows only that there is some chance that specific categories of cost will occur. In addition to these major categories of cost, there may be ancillary costs of additional insurance, taxes (many states treat inventories as taxable property), or additional fire hazards. As a general rule, holding costs will typically represent 20 to 40% of the average inventory value over the course of a year; thus if the average material inventory on a project is $ 1 million over a year, the holding cost might be expected to be $200,000 to $400,000.

Unavailability Cost

The unavailability cost is incurred when a desired material is not available at the desired time. In manufacturing industries, this cost is often called the stockout or depletion cost. Shortages may delay work, thereby wasting labor resources or delaying the completion of the entire project. Again, it may be difficult to forecast in advance exactly when an item may be required or when an shipment will be received. While the project schedule gives one estimate, deviations from the schedule may occur during construction. Moreover, the cost associated with a shortage may also be difficult to assess; if the material used for one activity is not available, it may be possible to assign workers to other activities and, depending upon which activities are critical, the project may not be delayed.

4.9 Tradeoffs of Costs in Materials Management.

To illustrate the type of trade-offs encountered in materials management, suppose that a particular item is to be ordered for a project. The amount of time required for processing the order and shipping the item is uncertain. Consequently, the project manager must decide how much lead time to provide in ordering the item. Ordering early and thereby providing a long lead time will increase the chance that the item is available when needed, but it increases the costs of inventory and the chance of spoilage on site.

Let T be the time for the delivery of a particular item, R be the time required for process the order, and S be the shipping time. Then, the minimum amount of time for the delivery of the item is T = R + S. In general, both R and S are random variables; hence T is also a random variable. For the sake of simplicity, we shall consider only the case of instant processing for an order, i.e. R = 0. Then, the delivery time T equals the shipping time S.

Since T is a random variable, the chance that an item will be delivered on day t is represented by the probability p(t). Then, the probability that the item will be delivered on or before t day is given by:

             t 
P (T L t) =      p(u)S 
            u=0

If a and b are the lower and upper bounds of possible delivery dates, the expected delivery time is then given by:

        b 
E[T] =      t[p(t)]S 
       t=a

The lead time L for ordering an item is the time period ahead of the delivery time, and will depend on the tradeoff between holding costs and unavailability costs. A project manager may want to avoid the unavailable cost by requiring delivery on the scheduled date of use, or may be to lower the holding cost by adopting a more flexible lead time based on the expected delivery time. For example, the manager may make the tradeoff by specifying the lead time to be D days more than the expected delivery time, i.e.,

L = E[T] + D

where D may vary from 0 to the number of additional days required to produce certain delivery on the desired date.

In a more realistic situation, the project manager would also contend with the uncertainty of exactly when the item might be required. Even if the item is scheduled for use on a particular date, the work progress might vary so that the desired date would differ. In many cases, greater than expected work progress may result in no savings because materials for future activities are unavailable.

Example 4-7: : Lead time for ordering with no processing time.

Table 4-0 summarizes the probability of different delivery times for an item. In this table, the first column lists the possible shipping times (ranging from 10 to 16 days), the second column lists the probability or chance that this shipping time will occur and the third column summarizes the chance that the item arrives on or before a particular date. This table can be used to indicate the chance that the item will arrive on a desired date for different lead times. For example, if the order is placed 12 days in advance of the desired date (so the lead time is 12 days), then there is a 15% chance that the item will arrive exactly on the desired day and a 35% chance that the item will arrive on or before the desired date. Note that this implies that there is a 1 - 0.35 = 0.65 or 65% chance that the item will not arrive by the desired date with a lead time of 12 days. Given the information in Table 4-0, when should the item order be placed?

______________________________________________________________________________

Delivery Date on Orders and Probability of Delivery for an Example
  

!!!Delivery!!!Probability of!!!Cumulative Probability

!!!Date!!!Delivery on Day t!!!of Delivery by Day t

!!! t!!! p(t)!!! Pr{T L t}

!!!10 .10!!! .10!!!

!!!11 .10!!! .20!!!

!!!12 .15!!! .35!!!

!!!13 .20!!! .55!!!

!!!14 .30!!! .85!!!

!!!15 .10!!! .95!!!

!!!16 .05!!! 1.00!!!

______________________________________________________________________________

Suppose that the scheduled date of use for the item is in 16 days. To be completely certain to have delivery by the desired day, the order should be placed 16 days in advance. However, the expected delivery date with a 16 day lead time would be:

16 E[T]#=## t[p(t)]S t=10 #####=##(10)(0.1)#+#(11)(0.1)#+#(12)(0.15)#+ \* #(13)0(.20)#+#(14)(0.30)#+#(15)(0.10)#=#13.0

Thus, the actual delivery date may be 16-13 = 3 days early, and this early delivery might involve significant holding costs. A project manager might then decide to provide a lead time so that the expected delivery date was equal to the desired assembly date as long as the availability of the item was not critical. Alternatively, the project manager might negotiate a more certain delivery date from the supplier.

4.10 Construction Equipment

The selection of the appropriate type and size of construction equipment often affects the required amount of time and effort and thus the job-site productivity of a project. It is therefore important for site managers and construction planners to be familiar with the characteristics of the major types of equipment most commonly used in construction.(For further details on equipment characteristics, see, for example, S.W. Nunnally, Construction Methods and Management, Second Edition, Prentice-Hall, 1986)

Excavation and Loading

One family of construction machines used for excavation is broadly classified as a crane-shovel as indicated by the variety of machines in Figure 4-0. The crane-shovel consists of three major components:

• a carrier or mounting which provides mobility and stability for the machine.
• a revolving deck or turntable which contains the power and control units.
• a front end attachment which serves the special functions in an operation.

The type of mounting for all machines in Figure 4-0 is referred to as crawler mounting, which is particularly suitable for crawling over relatively rugged surfaces at a job site. Other types of mounting include truck mounting and wheel mounting which provide greater mobility between job sites, but require better surfaces for their operation. The revolving deck includes a cab to house the person operating the mounting and/or the revolving deck. The types of front end attachments in Figure 4-0 might include a crane with hook, claim shell, dragline, backhoe, shovel and piledriver.

Typical Machines in the Crane-Shovel Family
  

A tractor consists of a crawler mounting and a non-revolving cab. When an earth moving blade is attached to the front end of a tractor, the assembly is called a bulldozer. When a bucket is attached to its front end, the assembly is known as a loader or bucket loader. There are different types of loaders designed to handle most efficiently materials of different weights and moisture contents.

Scrapers are multiple-units of tractor-truck and blade-bucket assemblies with various combinations to facilitate the loading and hauling of earthwork. Major types of scrapers include single engine two-axle or three axle scrapers, twin-engine all-wheel-drive scrapers, elevating scrapers, and push-pull scrapers. Each type has different characteristics of rolling resistance, maneuverability stability, and speed in operation.

Compaction and Grading

The function of compaction equipment is to produce higher density in soil mechanically. The basic forces used in compaction are static weight, kneading, impact and vibration. The degree of compaction that may be achieved depends on the properties of soil, its moisture content, the thickness of the soil layer for compaction and the method of compaction. Some major types of compaction equipment are shown in Figure 4-0, which includes rollers with different operating characteristics.

Some Major Types of Compaction Equipment
  

The function of grading equipment is to bring the earthwork to the desired shape and elevation. Major types of grading equipment include motor graders and grade trimmers. The former is an all-purpose machine for grading and surface finishing, while the latter is used for heavy construction because of its higher operating speed.

Drilling and Blasting

Rock excavation is an audacious task requiring special equipment and methods. The degree of difficulty depends on physical characteristics of the rock type to be excavated, such as grain size, planes of weakness, weathering, brittleness and hardness. The task of rock excavation includes loosening, loading, hauling and compacting. The loosening operation is specialized for rock excavation and is performed by drilling, blasting or rippling.

Major types of drilling equipment are percussion drills, rotary drills, and rotary-percussion drills. A percussion drill penetrates and cuts rock by impact while it rotates without cutting on the upstroke. Common types of percussion drills include a jackhammer which is hand-held and others which are mounted on a fixed frame or on a wagon or crawl for mobility. A rotary drill cuts by turning a bit against the rock surface. A rotary-percussion drill combines the two cutting movements to provide a faster penetration in rock.

Blasting requires the use of explosives, the most common of which is dynamite. Generally, electric blasting caps are connected in a circuit with insulated wires. Power sources may be power lines or blasting machines designed for firing electric cap circuits. Also available are non-electrical blasting systems which combine the precise timing and flexibility of electric blasting and the safety of non-electrical detonation.

Tractor-mounted rippers are capable of penetrating and prying loose most rock types. The blade or ripper is connected to an adjustable shank which controls the angle at the tip of the blade as it is raised or lowered. Automated ripper control may be installed to control ripping depth and tip angle.

In rock tunneling, special tunnel machines equipped with multiple cutter heads and capable of excavating full diameter of the tunnel are now available. Their use has increasingly replaced the traditional methods of drilling and blasting.

Lifting and Erecting

Derricks are commonly used to lift equipment of materials in industrial or building construction. A derrick consists of a vertical mast and an inclined boom sprouting from the foot of the mast. The mast is held in position by guys or stifflegs connected to a base while a topping lift links the top of the mast and the top of the inclined boom. A hook in the road line hanging from the top of the inclined boom is used to lift loads. Guy derricks may easily be moved from one floor to the next in a building under construction while stiffleg derricks may be mounted on tracks for movement within a work area.

Tower cranes are used to lift loads to great heights and to facilitate the erection of steel building frames. Horizon boom type tower cranes are most common in highrise building construction. Inclined boom type tower cranes are also used for erecting steel structures.

Mixing and Paving

Basic types of equipment for paving include machines for dispensing concrete and bituminous materials for pavement surfaces. Concrete mixers may also be used to mix portland cement, sand, gravel and water in batches for other types of construction other than paving.

A truck mixer refers to a concrete mixer mounted on a truck which is capable of transporting ready mixed concrete from a central batch plant to construction sites. A paving mixer is a self propelled concrete mixer equipped with a boom and a bucket to place concrete at any desired point within a roadway. It can be used as a stationary mixer or used to supply slipform pavers that are capable of spreading, consolidating and finishing a concrete slab without the use of forms.

A bituminous distributor is a truck-mounted plant for generating liquid bituminous materials and applying them to road surfaces through a spray bar connected to the end of the truck. Bituminous materials include both asphalt and tar which have similar properties except that tar is not soluble in petroleum products. While asphalt is most frequently used for road surfacing, tar is used when the pavement is likely to be heavily exposed to petroleum spills.

Construction Tools and Other Equipment

Air compressors and pumps are widely used as the power sources for construction tools and equipment. Common pneumatic construction tools include drills, hammers, grinders, saws, wrenches, staple guns, sandblasting guns, and concrete vibrators. Pumps are used to supply water or to dewater at construction sites and to provide water jets for some types of construction.

Automation of Equipment

The introduction of new mechanized equipment in construction has had a profound effect on the cost and productivity of construction as well as the methods used for construction itself. An exciting example of innovation in this regard is the introduction of computer microprocessors on tools and equipment. As a result, the performance and activity of equipment can be continually monitored and adjusted for improvement. In many cases, automation of at least part of the construction process is possible and desirable. For example, wrenches that automatically monitor the elongation of bolts and the applied torque can be programmed to achieve the best bolt tightness. On grading projects, laser controlled scrapers can produce desired cuts faster and more precisely than wholly manual methods.[See Paulson, C., "Automation and Robotics for Construction," ASCE Journal of Construction Engineering and Management, Vol. 111, No. CO-3, 1985, pp. 190-207.] Possibilities for automation and robotics in construction are explored more fully in Chapter 16.

Example 4-8: Tunneling Equipment(This example is adapted from Fred Moavenzadeh, "Construction's High-Technology Revolution," Technology Review, October, 1985, pg. 32.)

In the mid-1980's, some Japanese firms were successful in obtaining construction contracts for tunneling in the United States by using new equipment and methods. For example, the Japanese firm of Ohbayashi won the sewer contract in San Francisco because of its advanced tunneling technology. When a tunnel is dug through soft earth, as in San Francisco, it must be maintained at a few atmospheres of pressure to keep it from caving in. Workers must spend several hours in a pressure chamber before entering the tunnel and several more in decompression afterwards. They can stay inside for only three or four hours, always at considerable risk from cave-ins and asphyxiation. Ohbayashi used the new Japanese "earth-pressure-balance" method, which eliminates these problems. Whirling blades advance slowly, cutting the tunnel. The loose earth temporarily remains behind to balance the pressure of the compact earth on all sides. Meanwhile, prefabricated concrete segments are inserted and joined with waterproof seals to line the tunnel. Then the loose earth is conveyed away. This new tunneling method enabled Ohbayashi to bid $5 million below the engineer's estimate for a San Francisco sewer. The firm completed the tunnel three months ahead of schedule. In effect, an innovation involving new technology and method led to considerable cost and time savings.

4.11 Choice of Equipment and Standard Production Rates

Typically, construction equipment is used to perform essentially repetitive operations, and can be broadly classified according to two basic functions: (1) operators such as cranes, graders, etc. which stay within the confines of the construction site, and (2) haulers such as dump trucks, ready mixed concrete truck, etc. which transport materials to and from the site. In both cases, the cycle of a piece of equipment is a sequence of tasks which is repeated to produce a unit of output. For example, the sequence of tasks for a crane might be to fit and install a wall panel (or a package of eight wall panels) on the side of a building; similarly, the sequence of tasks of a ready mixed concrete truck might be to load, haul and unload two cubic yards (or one truck load) of fresh concrete.

In order to increase job-site productivity, it is beneficial to select equipment with proper characteristics and a size most suitable for the work conditions at a construction site. In excavation for building construction, for examples, factors that could affect the selection of excavators include:

1. Size of the job: Larger volumes of excavation will require larger excavators, or smaller excavators in greater number.
2. Activity time constraints: Shortage of time for excavation may force contractors to increase the size or numbers of equipment for activities related to excavation.
3. Availability of equipment: Productivity of excavation activities will diminish if the equipment used to perform them is available but not the most adequate.
4. Cost of transportation of equipment: This cost depends on the size of the job, the distance of transportation, and the means of transportation.
5. Type of excavation: Principal types of excavation in building projects are cut and/or fill, excavation massive, and excavation for the elements of foundation. The most adequate equipment to perform one of these activities is not the most adequate to perform the others.
6. Soil characteristics: The type and condition of the soil is important when choosing the most adequate equipment since each piece of equipment has different outputs for different soils. Moreover, one excavation pit could have different soils at different stratums.
7. Geometric characteristics of elements to be excavated: Functional characteristics of different types of equipment makes such considerations necessary.
8. Space constraints: The performance of equipment is influenced by the spatial limitations for the movement of excavators.
9. Characteristics of haul units: The size of an excavator will depend on the haul units if there is a constraint on the size and/or number of these units.
10. Location of dumping areas: The distance between the construction site and dumping areas could be relevant not only for selecting the type and number of haulers, but also the type of excavators.
11. Weather and temperature: Rain, snow and severe temperature conditions affect the job-site productivity of labor and equipment.

The choice of the type and size of haulers is based on the consideration that the number of haulers selected must be capable of disposing of the excavated materials expeditiously. Factors which affect this selection include:

1. Output of excavators: The size and characteristics of the excavators selected will determine the output volume excavated per day.
2. Distance to dump site: Sometimes part of the excavated materials may be piled up in a corner at the job-site for use as backfill.
3. Probable average speed: The average speed of the haulers to and from the dumping site will determine the cycle time for each hauling trip.
4. Volume of excavated materials: The volume of excavated materials including the part to be piled up should be hauled away as soon as possible.
5. Spatial and weight constraints: The size and weight of the haulers must be feasible at the job site and over the route from the construction site to the dumping area.

The cycle capacity C of a piece of equipment is defined as the number of output units per cycle of operation under standard work conditions. The capacity is a function of the output units used in the measurement as well as the size of the equipment and the material to be processed. The cycle time T refers to units of time per cycle of operation. The standard production rate R of a piece of construction equipment is defined as the number of output units per unit time. Hence:

      C
R##=##-
      T
or

      C
T##=##-
      R

The daily standard production rate P@-(e) of an excavator can be obtained by multiplying its standard production rate R@-(e) by the number of operating hours H@-(e) per day. Thus:

                            C@-(e)H@-(e)
P@-(e)##=##R@-(e)H@-(e)##=##------------
                               T@-(e)   

 

In determining the daily standard production rate of a hauler, it is necessary to determine first the cycle time from the distance D to a dump site and the average speed S of the hauler. Let T@-(t) be the travel time for the round trip to the dump site, T@-(o) by the loading time and T@-(d) be the dumping time. Then the travel time for the round trip is given by:

           2#D
T@-(t)##=##---
            S 

 

                 C@-(h)
T@-(o)##=##T@-(e)------
                 C@-(e)

 

           2#D            C@-(h)
T@-(h)##=##   ##+##T@-(e)#      ##+##T@-(d)---            ------
            S             C@-(e)

 

                             C@-(h)#H@-(h)
P@-(h)##=##R@-(h)#H@-(h)##=##-------------
                                T@-(h)    

 

The number of haulers required is also of interest. Let w denote the swell factor of the soil such that wP@-(e) denotes the daily volume of loose excavated materials resulting from the excavation volume P@-(e). Then the approximate number of haulers required to dispose of the excavated materials is given by:

           w#P@-(e)
N@-(h)##=##--------
            P@-(h) 

While the standard production rate of a piece of equipment is based on "standard" or ideal conditions, equipment productivities at job sites are influenced by actual work conditions and a variety of inefficiencies and work stoppages. As one example, various factor adjustments can be used to account in a approximate fashion for actual site conditions. If the conditions that lower the standard production rate are denoted by n factors F@-(1), F@-(2), ..., F@-(n), each of which is smaller than 1, then the actual equipment productivity R' at the job site can be related to the standard production rate R as follows:

R'##A##R#F@-(1)#F@-(2)# : : : #F@-(n)

 

                    T              
T'##A##----------------------------
       F@-(1)#F@-(2)# : : : #F@-(n)

 

In addition to the problem of estimating the various factors, F@-(1), F@-(2), ..., F@-(n), it may also be important to account for interactions among the factors and the exact influence of particular site characteristics.

Example 4-9: : Daily standard production rate of a power shovel[This and the following examples in this section have been adapted from E. Baracco-Miller and C.T. Hendrickson, Planning for Construction, Technical Report No. R-87-162, Department of Civil Engineering, Carnegie Mellon University, Pittsburgh, PA 1987.]

A power shovel with a dipper of one cubic yard capacity has a standard operating cycle time of 30 seconds. Find the daily standard production rate of the shovel.

For C@-(e) = 1 cu. yd., T@-(e) = 30 sec. and H@-(e) = 8 hours, the daily standard production rate is found from Eq. (4.4.11) as follows:

(1#cu.#yd.)(8#hr.)(3,600#sec./hr.) P@-(e)##=## ##=##960#cu.#yd.---------------------------------- 30#sec.

Example 4-10: Daily standard production rate of a dump truck

A dump truck with a capacity of 6 cubic yards is used to dispose of excavated materials at a dump site 4 miles away. The average speed of the dump truck is 30 mph and the dumping time is 30 seconds. Find the daily standard production rate of the truck. If a fleet of dump trucks of this capacity is used to dispose of the excavated materials in Example 4-8 for 8 hours per day, determine the number of trucks needed daily, assuming a swell factor of 1.1 for the soil.

The daily standard production rate of a dump truck can be obtained by using Equations (4.4.11) through (4.4.11):

(2)(4#mi.)(3,600#sec./hr.) T@-(t)##=## ##=##960sec.-------------------------- (30#mi./hr.) 6#cu.#yd. T@-(o)##=##(30#sec.)## ## ## ##=##180#sec.--------- 1#cu.#yd. T@-(h)##=##960##+##180##+##30##=##1,170#sec.

(6#cu.#yd.)(8#hr.)(3,600#sec./hr.) P@-(h)##=## ##=##147.7#cu.#yd.---------------------------------- (1,170#sec.)

(1.1)(960#cu.#yd.) N@-(h)##=## ##=##7.1------------------ 147.7#cu.#yd.

Example 4-11: Job site productivity of a power shovel

A power shovel with a dipper of one cubic yard capacity (in Example 4-9) has a standard production rate of 960 cubic yards for an 8-hour day. Determine the job site productivity and the actual cycle time of this shovel under the work conditions at the site that affects its productivity as shown below:

     Work Conditions at the Site!!!Factors
   Bulk composition!!!  0.954
   Soil properties and water content!!!  0.983
   Equipment idle time for worker breaks!!!  0.8
   Management efficiency!!!  0.7

P'@-(e)##=##(960#cu.#yd.)(0.954)(0.983)(0.8)(0.7)##=##504#cu.#yd.

(30#sec.) T'@-(e)##=## ##=##57#sec.------------------------ (0.954)(0.983)(0.8)(0.7)

(1#cu.#yd.)(8#hr.)(3,600#sec./hr.) T'@-(e)##=## ##=##57#sec.---------------------------------- 504#cu.#yd.

Example 4-12: Job site productivity of a dump truck

A dump truck with a capacity of 6 cubic yards (in Example 4-10) is used to dispose of excavated materials. The distance from the dump site is 4 miles and the average speed of the dump truck is 30 mph. The job site productivity of the power shovel per day (in Example 4-11) is 504 cubic yards, which will be modified by a swell factor of 1.1. The only factors affecting the job site productivity of the dump truck are 0.80 for equipment idle time and 0.70 for management efficiency. Determine the job site productivity of the dump truck. If a fleet of such trucks is used to haul the excavated material, find the number of trucks needed daily.

The actual cycle time T'@-(h) of the dump truck can be obtained by summing the actual times for traveling, loading and dumping:

T'@-(t)##=##
Num "T@-(t)", Denom "F@-[1]F@-[2]"
  
  ##=##
Num
"(2)(4#mi.)(3,600#sec./hr.)", Denom "(30#mi./hr.)(0.8)(0.7)"
  
  ##=##1,714#sec.
T'@-(o)##=##
Num "T'@-(e)", denom "F@-{1} F@-{2}"
  
  #
Num "C@-(h)",
 Denom "C@-(e)"
  
  ##=##  ##
Num "57#sec.", denom "(0.8) (0.7)"
  
  ##  ##  ##
Num
"6#cu.#yd.",
Denom "1#cu.#yd."
  
  ##  ##=##342#sec.
T'@-(d)##=##
Num "T@-(d)", Denom "F@-[1]F@-[2]"
  
  ##=##
Num
"30#sec.", Denom "(0.8)(0.7)"
  
  ##=##54#sec.

 

T'@-(h)##=##T'@-(t)##+##T'@-(o)##+##T'@-(d)##=##1714##+##611
*\
##+##54##=##2,379#sec.

 

P'@-(h)##=##
Num "C@-(h)H@-(h)", Denom "T'@-(h)"
  
  ##=##
Num
"(6#cu.#yd.)(8#hr.)(3,600#sec./hr.)", Denom "2,379#sec."
  
  ##=##72.6#cu.#yd.

 

N'@-(h)##=##
Num "wP'@-(e)", Denom "P'@-(h)"
  
  ##=##
Num
"(1.1)(504#cu.#yd.)", Denom "72.6#cu.#yd."
  
  ##=##7.6

 

4.12 Construction Processes

The previous sections described the primary inputs of labor, material and equipment to the construction process. At varying levels of detail, a project manager must insure that these inputs are effectively coordinated to achieve an efficient construction process. This coordination involves both strategic decisions and tactical management in the field. For example, strategic decisions about appropriate technologies or site layout are often made during the process of construction planning. During the course of construction, foremen and site managers will make decisions about work to be undertaken at particular times of the day based upon the availability of the necessary resources of labor, materials and equipment. Without coordination among these necessary inputs, the construction process will be inefficient or stop altogether.

Example 4-13: Steel erection

Erection of structural steel for buildings, bridges or other facilities is an example of a construction process requiring considerable coordination. Fabricated steel pieces must arrive on site in the correct order and quantity for the planned effort during a day. Crews of steelworkers must be available to fit pieces together, bolt joints, and perform any necessary welding. Cranes and crane operators may be required to lift fabricated components into place; other activities on a job site may also be competing for use of particular cranes. Welding equipment, wrenches and other hand tools must be readily available. Finally, ancillary materials such as bolts of the correct size must be provided.

In coordinating a process such as steel erection, it is common to assign different tasks to specific crews. For example, one crew may place members in place and insert a few bolts in joints in a specific area. A following crew would be assigned to finish bolting, and a third crew might perform necessary welds or attachment of brackets for items such as curtain walls.

With the required coordination among these resources, it is easy to see how poor management or other problems can result in considerable inefficiency. For example, if a shipment of fabricated steel is improperly prepared, the crews and equipment on site may have to wait for new deliveries.

Example 4-14: Construction process simulation models

Computer based simulation of construction operations can be a useful although laborious tool in analyzing the efficiency of particular processes or technologies. These tools tend to be either oriented toward modeling resource processes or towards representation of spatial constraints and resource movements. Later chapters will describe simulation in more detail, but a small example of a construction operation model can be described here.[This model used the INSIGHT simulation language and was described in B.C. Paulson, W.T. Chan, and C.C. Koo, "Construction Operations Simulation by Microcomputer," ASCE Journal of Construction Engineering and Management, Vol. 113, No. CO-2, June 1987, pp. 302-314.] The process involved placing concrete within existing formwork for the columns of a new structure. A crane-and-bucket combination with one cubic yard capacity and a flexible "elephant trunk" was assumed for placement. Concrete was delivered in trucks with a capacity of eight cubic yards. Because of site constraints, only one truck could be moved into the delivery position at a time. Construction workers and electric immersion-type concrete vibrators were also assumed for the process.

The simulation model of this process is illustrated in Figure 4-0. Node 2 signals the availability of a concrete truck arriving from the batch plant. As with other circular nodes in Figure 4-0, the availability of a truck may result in a resource waiting or queueing for use. If a truck (node 2) and the crane (node 3) are both available, then the crane can load and hoist a bucket of concrete (node 4). As with other rectangular nodes in the model, this operation will require an appreciable period of time. On the completion of the load and hoist operations, the bucket (node 5) is available for concrete placement. Placement is accomplished by having a worker guide the bucket's elephant trunk between the concrete forms and having a second worker operate the bucket release lever. A third laborer operates a vibrator in the concrete while the bucket (node 8) moves back to receive a new load. Once the concrete placement is complete, the crew becomes available to place a new bucket load (node 7). After two buckets are placed, then the column is complete (node 9) and the equipment and crew can move to the next column (node 10). After the movement to the new column is complete, placement in the new column can begin (node 11). Finally, after a truck is emptied (nodes 12 and 13), the truck departs and a new truck can enter the delivery stall (node 14) if one is waiting.

Illustration of a Concrete-Placing Simulation Model
  

Application of the simulation model consists of tracing through the time required for these various operations. Events are also simulated such as the arrival times of concrete trucks. If random elements are introduced, numerous simulations are required to estimate the actual productivity and resource requirements of the process. For example, one simulation of this process using four concrete trucks found that a truck was waiting 83% of the time with an average wait at the site of 14 minutes. This type of simulation can be used to estimate the various productivity adjustment factors described in the previous section.

4.13 Queues and Resource Bottlenecks

A project manager needs to insure that resources required for and/or shared by numerous activities are adequate. Problems in this area can be indicated in part by the existence of queues of resource demands during construction operations. A queue can be a waiting line for service. One can imagine a queue as an orderly line of customers waiting for a stationary server such as a ticket seller. However, the demands for service might not be so neatly arranged. For example, we can speak of the queue of welds on a building site waiting for inspection. In this case, demands do not come to the server, but a roving inspector travels among the waiting service points. Waiting for resources such as a particular piece of equipment or a particular individual is an endemic problem on construction sites. If workers spend appreciable portions of time waiting for particular tools, materials or an inspector, costs increase and productivity declines. Insuring adequate resources to serve expected demands is an important problem during construction planning and field management.

In general, there is a trade-off between waiting times and utilization of resources. Utilization is the proportion of time a particular resource is in productive use. Higher amounts of resource utilization will be beneficial as long as it does not impose undue costs on the entire operation. For example, a welding inspector might have one hundred percent utilization, but workers throughout the jobsite might be wasting inordinate time waiting for inspections. Providing additional inspectors may be cost effective, even if they are not utilized at all times.

A few conceptual models of queueing systems may be helpful to construction planners in considering the level of adequate resources to provide. First, we shall consider the case of time-varying demands and a server with a constant service rate. This might be the situation for an elevator in which large demands for transportation occur during the morning or at a shift change. Second, we shall consider the situation of randomly arriving demands for service and constant service rates. Finally, we shall consider briefly the problems involving multiple serving stations.

Single-Server with Deterministic Arrivals and Services

Suppose that the cumulative number of demands for service or "customers" at any time t is known and equal to the value of the function A(t). These "customers" might be crane loads, weld inspections, or any other defined group of items to be serviced. Suppose further that a single server is available to handle these demands, such as a single crane or a single inspector. For this model of queueing, we assume that the server can handle customers at some constant, maximum rate denoted as x "customers" per unit of time. This is a maximum rate since the server may be idle for periods of time if no customers are waiting. This system is deterministic in the sense that both the arrival function and the service process are assumed to have no random or unknown component.

A cumulative arrival function of customers, A(t), is shown in Figure 4-0 in which the vertical axis represents the cumulative number of customers, while the horizontal axis represents the passage of time. The arrival of individual customers to the queue would actually represent a unit step in the arrival function A(t), but these small steps are approximated by a continuous curve in the figure. The rate of arrivals for a unit time interval @g[D]t from t-1 to t is given by:

@g[D]A@-(t) = A(t) - A(t-1)

While an hour or a minute is a natural choice as a unit time interval, other time periods may also be used as long as the passage of time is expressed as multiples of such time periods. For instance, if half an hour is used as unit time interval for a process involving ten hours, then the arrivals should be represented by 20 steps of half hour each. Hence, the unit time interval between t-1 and t is @g[D] t = t - (t-1) = 1, and the slope of the cumulative arrival function in the interval is given by:

               A(t) - A(t-1)
A@+(')(t)##=##               = A(t) - A(t-1)-------------
                  @g[D]t    

The cumulative number of customers served over time is represented by the cumulative departure function D(t). While the maximum service rate is x per unit time, the actual service rate for a unit time interval @g[D]t from t-1 to t is:

@g{D}D@-[t] = D(t) - D(t-1)

 

      D(t) - D(t-1)
D't =               = D(t) - D(t-1)-------------
         @g{D}t    

Any time that the rate of arrivals to the queue exceeds the maximum service rate, then a queue begins to form and the cumulative departures will occur at the maximum service rate. The cumulative departures from the queue will proceed at the maximum service rate of x "customers" per unit of time, so that the slope of D(t) is x during this period. The cumulative departure function D(t) can be readily constructed graphically by running a ruler with a slope of x along the cumulative arrival function A(t). As soon as the function A(t) climbs above the ruler, a queue begins to form. The maximum service rate will continue until the queue disappears, which is represented by the convergence of the cumulative arrival and departure functions A(t) and D(t).

Cumulative Arrivals and Departures in a Deterministic Queue
  

With the cumulative arrivals and cumulative departure functions represented graphically, a variety of service indicators can be readily obtained as shown in Figure 4-0. Let A'(t) and D'(t) denote the derivatives of A(t) and D(t) with respect to t, respectively. For 0 L t L t@-(i) in which A'(t) L x, there is no queue. At t = t@-(i), when A'(t) > D'(t), a queue is formed. Then D'(t) = x in the interval t@-(i) L t L t@-(k). As A'(t) continues to increase with increasing t, the queue becomes longer since the service rate D'(t) = x cannot catch up with the arrivals. However, when again A'(t) L D'(t) as t increases, the queue becomes shorter until it reaches 0 at t = t@-(k). At any given time t, the queue length is

Q(t) = A(t) - D(t)

 

Generally, the arrival rates @g[D]A@-(t) = 1, 2, . . ., n periods of a process as well as the maximum service rate x are known. Then the cumulative arrival function and the cumulative departure function can be constructed systematically together with other pertinent quantities as follows:

1. Starting with the initial conditions D(t-1)=0 and Q(t-1)=0 at t=1, find the actual service rate at t=1:

     @g[D]D@-(1) = minimum {x;@g[D]A@-[1]}

2. Starting with A(t-1)=0 at t=1, find the cumulative arrival function for t=2,3,. . .,n accordingly:

     A(t) =A(t-1) + @g{D}A@-(t)

3. Compute the queue length for t=1,2, . . .,n.

     Q(t) = Q(t-1) + @g{D}A@-(t) - @g{D}D@-(t)

4. Compute @g{D}D@-(t) for t=2,3,. . .,n after Q(t-1) is found first for each t.

     @g{D}D@-(t) = minimum {x; Q(t-1) + @g{D}A@-(t)}

5. If A'(t) > x, find the cumulative departure function in the time period between t@-(i) where a queue is formed and t@-(k) where the queue dissipates.

     D(t) = D(t-1) + @g{D}D@-(t)

6. Compute the waiting time @g{D}w for the arrivals which are waiting for service in interval @g{D}t.

     @g[D]w = Q(t) (@g{D}t)

7. Compute the total waiting time W over the time period between t@-(i) and t@-(k).

     t@-(k) 
W =           @g{D}wS    
    t=t@-{i}

8. Compute the average waiting time w for arrivals which are waiting for service in the process.

               W          
w =  ---------------------
     A(t@-{k}) - A(t@-{i})

This simple, deterministic model has a number of implications for operations planning. First, an increase in the maximum service rate will result in reductions in waiting time and the maximum queue length. Such increases might be obtained by speeding up the service rate such as introducing shorter inspection procedures or installing faster cranes on a site. Second, altering the pattern of cumulative arrivals can result in changes in total waiting time and in the maximum queue length. In particular, if the maximum arrival rate never exceeds the maximum service rate, no queue will form, or if the arrival rate always exceeds the maximum service rate, the bottleneck cannot be dispersed. Both cases are shown in Figure 4-0.

Cases of No Queue and Permanent Bottleneck
  

A practical means to alter the arrival function and obtain these benefits is to inaugurate a reservation system for customers. Even without drawing a graph such as Figure 4-0, good operations planners should consider the effects of different operation or service rates on the flow of work. Clearly, service rates less than the expected arrival rate of work will result in resource bottlenecks on a job.

Single-Server with Random Arrivals and Constant Service Rate

Suppose that arrivals of "customers" to a queue are not deterministic or known as in Figure 4-0. In particular, suppose that "customers" such as joints are completed or crane loads arrive at random intervals. What are the implications for the smooth flow of work? Unfortunately, bottlenecks and queues may arise in this situation even if the maximum service rate is larger than the average or expected arrival rate of customers. This occurs because random arrivals will often bunch together, thereby temporarily exceeding the capacity of the system. While the average arrival rate may not change over time, temporary resource shortages can occur in this circumstance.

Let w be the average waiting time, a be the average arrival rate of customers, and x be the deterministic constant service rate (in customers per unit of time). Then, the expected average time for a customer in this situation is given by:[In the literature of queueing theory, this formula represents an M/D/1 queue, meaning that the arrival process is Markovian or random, the service time is fixed, only one server exists, and the system is in "steady state," implying that the service time and average arrival rate are constant. Altering these assumptions would require changes in the waiting time formula; for example, if service times were also random, the waiting time formula would not have the 2 shown in the denominator of Eq. (4.4.13). For more details on queueing systems, see Newell, G.F. Applications of Queueing Theory, Chapman and Hall, London, 1982.]

       w##=##
num"a", denom<2#x@+[2]#  ##1 -## 
num"a", denom "x"
  
  ##  >
  

If the average utilization rate of the service is defined as the ratio of the average arrival rate and the constant service rate, i.e.,

    a
u = -
    x

 

       u   
w = -------
    2x(1-u)

 

Illustrative Waitfing Times for Different Average
  

 Arrival Rates and Service Times
  

Multiple Servers

Both of the simple models of service performance described above are limited to single servers. In operations planning, it is commonly the case that numerous operators are available and numerous stages of operations exist. In these circumstances, a planner typically attempts to match the service rates occurring at different stages in the process. For example, construction of a high rise building involves a series of operations on each floor, including erection of structural elements, pouring or assembling a floor, construction of walls, installation of HVAC (Heating, ventilating and air conditioning) equipment, installation of plumbing and electric wiring, etc. A smooth construction process would have each of these various activities occurring at different floors at the same time without large time gaps between activities on any particular floor. Thus, floors would be installed soon after erection of structural elements, walls would follow subsequently, and so on. From the standpoint of a queueing system, the planning problem is to insure that the productivity or service rate per floor of these different activities are approximately equal, so that one crew is not continually waiting on the completion of a preceding activity or interfering with a following activity. In the realm of manufacturing systems, creating this balance among operations is called assembly line balancing.

Example 4-15: Effect of a crane breakdown

Suppose that loads for a crane are arriving at a steady rate of one every ten minutes. The crane has the capacity to handle one load every five minutes. Suppose further that the crane breaks down for ninety minutes. How many loads are delayed, what is the total delay, and how long will be required before the crane can catch up with the backlog of loads?

The cumulative arrival and service functions are graphed in Figure 4-0. Starting with the breakdown at time zero, nine loads arrive during the ninety minute repair time. From Figure 4-0, an additional nine loads arrive before the entire queue is served. Algebraically, the required time for service, t, can be calculated by noted that the number of arrivals must equal the number of loads served. Thus:

A(t) = 
num "t", denom "10"
  
   ##for## t G 0
D@-(1)(t) = 0 ### for ### 0 L t L 90 min
D@-(2)(t) = 
num "t-90", denom "5"
  
   ### for ### t G 90 min

 

     
num "t", denom "10"
  
   = 
num "t-90", denom "5"
  

 

t## =## 180 ##minutes####and ### A(180##=##D@-(2)(180)##=##18##loads.

 

     W## =## 
Num "(18)(180)", Denom "2"
  
   ##-##
Num
"(18)(90)", Denom "2"
  
   ##=##810#minutes

 

Arrivals and Services of Crane Loads with a Crane Breakdown
  

Example 4-16: Waiting time with random arrivals

Suppose that material loads to be inspected arrive randomly but with an average of 5 arrivals per hour. Each load requires ten minutes for an inspection, so an inspector can handle six loads per hour. Inspections must be completed before the material can be unloaded from a truck. The cost per hour of holding a material load in waiting is $ 30, representing the cost of a driver and a truck. In this example, the arrival rate, a, equals 5 arrivals per hour and the service rate, x, equals 6 material loads per hour. Then, the average waiting time of any material load for u = 5/6 is:

     
num "5/6", denom "(2)(6)## -## (1# -# 5/6)"
  
  ## =## 0.4## hours.

 

In contrast, if the possible service rate is x=10 material loads per hour, then the expected waiting time of any material load for u = 5/10 = 0.5 is:

     
num "0.5", denom "(2)(10)(1#-#0.5)"
  
  ##  =## 0.05## hours.

 

Example 4-17: Delay of lift loads on a building site

Suppose that a single crane is available on a building site and that each lift requires three minutes including the time for attaching loads. suppose further that the cumulative arrivals of lift loads at different time periods are as follows:

6:00-7:00 AM.!!! 4 per hour!!!  12:00-4:00 PM.!!!8 per hour
7:00-8:00 AM.!!!15 per hour!!!   4:00-6:00 PM.!!!4 per hour
8:00-11:00 AM.!!!25 per hour!!!  6:00 PM-6:00 AM.!!!0 per hour
11:00-12:00 AM.!!!5 per hour

1. Find the cumulative arrivals and cumulative number of loads served as a function of time, beginning with 6:00 AM.
2. Estimate the maximum queue length of loads waiting for service. What time does the maximum queue occur?
3. Estimate the total waiting time for loads.
4. Graph the cumulative arrival and departure functions.

The maximum service rate x = 60 min/3 min per lift = 20 lifts per minute. The detailed computation can be carried out in the Table 4-2, and the graph of A(t) and D(t) is given in Figure 4-10.

Computation of Queue Length and Waiting Time
  

Period!!!Arrival!!!Cumulative!!!!!!Departure!!!Cumulative!!!Waiting
!!!Rate!!!Arrivals!!!Queue!!!Rate!!!Departures!!!Time
!!!!!!A(t)!!!!!!!!!D(t)
5-7:00!!!4!!!4!!!0!!!4!!!4!!!0
7-8:00!!!15!!!19!!!0!!!15!!!19!!!0
8-9:00!!!25!!!44!!!5!!!20!!!39!!!5
9-10:00!!!25!!!69!!!10!!!20!!!59!!!10
10-11:00!!!25!!!94!!!15!!!20!!!79!!!15
11-12:00!!!5!!!99!!!0!!!20!!!99!!!0
12-1:00!!!8!!!107!!!0!!!8!!!107!!!0
1-2:00!!!8!!!115!!!0!!!8!!!115!!!0
2-3:00!!!8!!!123!!!0!!!8!!!123!!!0
3-4:00!!!8!!!131!!!0!!!8!!!131!!!0
4-5:00!!!4!!!135!!!0!!!4!!!135!!!0
5-6:00!!!4!!!139!!!0!!!4!!!139!!!9
6-7:00!!!0!!!139!!!0!!!0!!!139!!!0
7-8:00!!!0!!!139!!!0!!!0!!!139!!!0
!!!!!!!!!!!!Total Waiting Time =  30
!!!!!!!!!!!!Maximum Queue = 15

Delay of Lift Loads on a Building Site
  

4.14 References

1. Bourdon, C.C., and R.W. Levitt, Union and Open Shop Construction, Lexington Books, D.C. Heath and Co., Lexington, MA, 1980.
2. Caterpillar Performance Handbook, 18@+(th) Edition, Caterpillar, Inc., Peoria, IL, 1987.
3. Cordell, R.H., "Construction Productivity Management," Cost Engineering, Vol. 28, No. 2, February 1986, pp. 14-23.
4. Lange, J.E., and D.Q. Mills, The Construction Industry, Lexington Books, D.C. Heath and Co., Lexington, MA, 1979.
5. Nunnally, S.W., Construction Methods and Management, Prentice-Hall, Englewoood Cliffs, NJ, 2nd Ed., 1987.
6. Peurifoy, R.L., Construction Planning, Equipment and Methods, 2nd Edition, McGraw-Hill, New York, 1970.
7. Tersine, R.J., Principles of Inventory and Materials Management, North Holland, New York, 1982.

4.15 Problems

1. Using the relationship between the productivity index and job size in Example 4-1, determine the labor productivity for a new job requiring 350,000 labor hours under otherwise the same set of work conditions.
2. The potential labor hours available for a large energy complex were found to be 5.4 million hours. The non-productive activities expressed in thousands of labor hours were:

           A. 360 for holidays and strikes
           B. 1,152 for absentees
           C. 785 for temporary stoppage
           D. 1,084 for indirect labor
   
      

   Determine the productive labor yield after the above factors are taken into consideration.
3. Labor productivity at job site is known to decrease with overtime work. Let x be the percentage of overtime over normal work week. If x is expressed in decimals, the productivity index I as a function of the percentage of overtime is found to be: I = -0.8 x@+(2) + 1 0 L x L 0.5 Find the value of the index I for x = 0, 0.1, 0.2, 0.3, 0.4 and 0.5 and plot the relationship in a graph.
4. Labor productivity for a complex project is known to increase gradually in the first 500,000 labor hours because of the learning effects. Let x be the number of 100,000 labor hours. The, the labor productivity index I is found to be a function of x as follows:

                       -0.016#x@+{2}# +# 0.16x# + #0.6## for# 0 < # x #L #5
      I## =##         B
                       1.0 ##### for ## x ## G ## 5
   
       

   Find the value of the index I for x = 0, 1, 2, 3, 4 and 5 and plot the relationship in a graph.
5. The probabilities for different delivery times of an item are given in Table P4-5. Find the expected delivery date of the item. Also find the lead time required to provide an expected delivery date one day less than the desired delivery date.

   ---

      Table P4-5
      

   t!!!p(t)!!!P{T L t} 12!!!0.05!!!0.05 13!!!0.10!!!0.15 14!!!0.25!!!0.40 15!!!0.35!!!0.75 16!!!0.15!!!0.90 17!!!0.10!!!1.00

   ---

6. A power shovel with a dipper of two cubic yard capacity has a standard operating cycle time of 80 seconds. The excavated material which has a swell factor of 1.05 will be disposed by a dump truck with an 8 cubic yard capacity at a dump site 6 miles away. The average speed of the dump truck is 30 mph and the dumping time is 40 seconds. Find the daily standard production rates of the power shovel and the dump truck if both are operated 8 hours per day. Determine also the number of trucks needed daily to dispose of the excavated material.
7. The power shovel in Problem P4-6 has a daily standard production rate of 720 cubic yards. Determine the job site productivity and the actual cycle time of this shovel under the work conditions at the site that affect the productivity as shown below:

      !!!Work conditions at site                                          Factors
      !!!Bulk composition                                                    0.972
      !!!Soil properties and water content                                   0.960
      !!!Equipment idle time for breaks                                      0.750
      !!!Management inefficiency                                             0.750
      

8. Based on the information given for Problems P4-6 and P4-7, find the job site productivity of a dump truck, assuming that the only factors affecting work conditions are 0.85 for equipment idle time and 0.80 for management efficiency. Also find the number of dump trucks required.
9. A Power shovel with a dipper of 1.5 cubic yard capacity has a standard operating cycle time of 60 seconds. The excavated material which has a swell factor of 1.08 will be disposed by a dump truck with a 7.5 cubic yard capacity at a dumpsite 5 miles away. The average speed of a dump truck is 25 mph and the dumping time is 75 seconds. Both the power shovel and the dump truck are operated 8 hours per day.
   1. Find the daily standard production rate of the power shovel.
   2. Find the daily standard production rate of the dump truck and number of trucks required.
   3. If the work conditions at the site that affect the productivity of the shovel can be represented by four factors F@-(1) = 0.940, F@-(3) = 0.850 and F@-(4) = 0.750, determine the job-site productivity and the actual cycle time.
   4. If the work conditions at the site affect the productivity of the dump truck can be represented by three factors F@-(1) = 0.952, F@-(2) = 0.700 and F@-(3) = 0.750, determine the job site productivity of the dump truck, and the number of dump trucks required.
10. Suppose that a single piece of equipment is available on a site for testing joints. Further, suppose that each joint has to be tested and certified before work can proceed. Joints are completed and ready for testing at random intervals during a shift. Each test requires an average of ten minutes. What is the average utilization of the testing equipment and the average wait of a completed joint for testing if the number of joints completed is (a) five per hour or (b) three per hour.
11. Suppose that the steel plates to be inspected are arriving steadily at a rate of one every twelve minutes. Each inspection requires sixteen minutes, but two inspectors are available so the inspection service rate is one every eight minutes. Suppose one inspector takes a break for sixty minutes. What is the resulting delay in the arriving pieces? What is the average delay among the pieces that have to wait?
12. Suppose that three machines are available in a fabrication ship for testing welded joints of structural members so that the testing service rate of the three machines is one in every 20 minutes. However, one of the three machines is shut down for 90 minutes when the welded joints to be tested arrive at a rate of one in every 25 minutes. What is the total delay for the testing service of the arriving joints? What is the average delay? Sketch the cumulative arrivals and services versus time.
13. Solve Example 4-17 if each lift requires 5 minutes instead of 3 minutes.
14. Solve Example 4-17 if each lift requires 6 minutes instead of 3 minutes
15. Suppose that up to 12 customers can be served per hour in an automated inspection process. What is the total waiting time and maximum queue with arrival rates for both cases (a) and (b) below:

       !!!(a)!!!(b)
       6-7:00 am!!!0!!!0
       7-8:00 am!!!25!!!10
       8-9:00 am!!!25!!!10
       9-10:00 am!!!25!!!15
       10-11:00 am!!!25!!!15
       11-12:00 am!!!10!!!10
       12-1:00 am!!!8!!!15
       1-2:00 pm!!!0!!!15
       2-3:00 pm!!!0!!!15
       3-4:00 pm!!!0!!!10
       4-5:00 pm!!!0!!!10
       After 5 pm!!!0!!!0
       Total number of arrivals!!!110!!!110
       

5. Cost Estimation

5.1 Costs Associated with Constructed Facilities

The costs of a constructed facility to the owner include both the initial capital cost and the subsequent operation and maintenance costs. Each of these major cost categories consists of a number of cost components.

The capital cost for a construction project includes the expenses related to the following activities:

• Land acquisition, including assembly, holding and improvement
• Planning and feasibility studies
• Architectural and engineering design
• Construction, including materials, equipment and labor
• Field supervision of construction
• Construction financing
• Insurance and taxes during construction
• Owner's general office overhead
• Equipment and furnishings not included in construction
• Inspection and testing

• Land rent, if applicable
• Operating staff
• Labor and material for maintenance and repairs
• Periodic renovations
• Insurance and taxes
• Financing costs
• Utilities
• Owner's other expenses

It is important for design professionals and construction managers to realize that while the construction cost may be the single largest component of the capital cost, other cost components are not insignificant. For example, land acquisition costs are a major expenditure for building construction in high-density urban areas, and construction financing costs can reach the same order of magnitude as the construction cost in large projects such as the construction of nuclear power plants.

From the owner's perspective, it is equally important to estimate the corresponding operation and maintenance cost of each alternative for a proposed facility in order to analyze the life cycle costs. The large expenditures needed for facility maintenance, especially for publicly owned infrastructure, are reminders of the neglect in the past to consider fully the implications of operation and maintenance cost in the design stage.

In this chapter, we shall focus on the estimation of construction cost, with only occasional reference to other cost components. In Chapter 6, we shall deal with the economic evaluation of a constructed facility on the basis of both the capital cost and the operation and maintenance cost in the life cycle of the facility. It is at this stage that tradeoffs between operating and capital costs can be analyzed.

Example 5-1: Energy project resource demands(This example was adapted with permission from a paper, "Forecasting Industry Resources," presented by A.R. Crosby at the Institution of Chemical Engineers in London, November 4, 1981.)

The resources demands for three types of major energy projects investigated during the energy crisis in the 1970's are shown in Table 5-0. These projects are: (1) an oil shale project with a capacity of 50,000 barrels of oil product per day; (2) a coal gasification project that makes gas with a heating value of 320 billions of British thermal units per day, or equivalent to about 50,000 barrels of oil product per day; and (3) a tar sand project with a capacity of 150,000 barrels of oil product per day.

For each project, the cost in billions of dollars, the engineering manpower requirement for basic design in thousands of hours, the engineering manpower requirement for detailed engineering in millions of hours, the skilled labor requirement for construction in millions of hours and the material requirement in billions of dollars are shown in Table 5-0. To build several projects of such an order of magnitude concurrently could drive up the costs and strain the availability of all resources required to complete the projects. Consequently, cost estimation often represents an exercise in professional judgment instead of merely compiling a bill of quantities and collecting cost data to reach a total estimate mechanically.

______________________________________________________________________________

Resource Requirements of Some Major Energy Projects
  

!!!Oil Shale!!! Coal Gasification!!! Tar Sands

!!! 50,000!!! 320 billions!!! 150,000

!!!barrels/day!!! BTU/day!!! barrels/day

Cost ($ billion)!!! 2.5!!! 4!!! 8 to 10

Basic Design !!!80!!! 200!!! 100

(Thousands of hours)

Detailed Engineering!!! 3 to 4!!! 4 to 5!!! 6 to 8

(Millions of hours)

Construction !!!20!!! 30!!! 40

(Millions of hours)

Materials ($ billion)!!! 1!!! 2!!! 2.5

Source: Exxon Research and Engineering Company, Florham Park, NJ

______________________________________________________________________________

5.2 Approaches to Cost Estimation

Cost estimating is one of the most important steps in project management. A cost estimate establishes the base line of the project cost at different stages of development of the project. A cost estimate at a given stage of project development represents a prediction provided by the cost engineer or estimator on the basis of available data. According to the American Association of Cost Engineers, cost engineering is defined as that area of engineering practice where engineering judgment and experience are utilized in the application of scientific principles and techniques to the problem of cost estimation, cost control and profitability.

Virtually all cost estimation is performed according to one or some combination of the following basic approaches:

Production function. In microeconomics, the relationship between the output of a process and the necessary resources is referred to as the production function. In construction, the production function may be expressed by the relationship between the volume of construction and a factor of production such as labor or capital. A production function relates the amount or volume of output to the various inputs of labor, material and equipment. For example, the amount of output Q may be derived as a function of various input factors x@-(1), x@-(2), ..., x@-(n) by means of mathematical and/or statistical methods. Thus, for a specified level of output, we may attempt to find a set of values for the input factors so as to minimize the production cost. The relationship between the size of a building project (expressed in square feet) to the input labor (expressed in labor hours per square foot) is an example of a production function for construction. Several such production functions are shown in Figure 3-3 of Chapter 3.

Empirical cost inference. Empirical estimation of cost functions requires statistical techniques which relate the cost of constructing or operating a facility to a few important characteristics or attributes of the system. The role of statistical inference is to estimate the best parameter values or constants in an assumed cost function. Usually, this is accomplished by means of regression analysis techniques.

Unit costs for bill of quantities. A unit cost is assigned to each of the facility components or tasks as represented by the bill of quantities. The total cost is the summation of the products of the quantities multiplied by the corresponding unit costs. The unit cost method is straightforward in principle but quite laborious in application. The initial step is to break down or disaggregate a process into a number of tasks. Collectively, these tasks must be completed for the construction of a facility. Once these tasks are defined and quantities representing these tasks are assessed, a unit cost is assigned to each and then the total cost is determined by summing the costs incurred in each task. The level of detail in decomposing into tasks will vary considerably from one estimate to another.

Allocation of joint costs. Allocations of cost from existing accounts may be used to develop a cost function of a operation. The basic idea in this method is that each expenditure item can be assigned to particular characteristics of the operation. Ideally, the allocation of joint costs should be causally related to the category of basic costs in an allocation process. In many instances, however, a causal relationship between the allocation factor and the cost item cannot be identified or may not exist. For example, in construction projects, the accounts for basic costs may be classified according to (1) labor, (2) material, (3) construction equipment, (4) construction supervision, and (5) general office overhead. These basic costs may then be allocated proportionally to various tasks which are subdivisions of a project.

5.3 Types of Construction Cost Estimates

Construction cost constitutes only a fraction, though a substantial fraction, of the total project cost. However, it is the part of the cost under the control of the construction project manager. The required levels of accuracy of construction cost estimates vary at different stages of project development, ranging from ball park figures in the early stage to fairly reliable figures for budget control prior to construction. Since design decisions made at the beginning stage of a project life cycle are more tentative than those made at a later stage, the cost estimates made at the earlier stage are expected to be less accurate. Generally, the accuracy of a cost estimate will reflect the information available at the time of estimation.

Construction cost estimates may be viewed from different perspectives because of different institutional requirements. In spite of the many types of cost estimates used at different stages of a project, cost estimates can best be classified into three major categories according to their functions. A construction cost estimate serves one of the three basic functions: design, bid and control. For establishing the financing of a project, either a design estimate or a bid estimate is used.

1. Design Estimates. For the owner or its designated design professionals, the types of cost estimates encountered run parallel with the planning and design as follows:

• Screening estimates (or order of magnitude estimates)
• Preliminary estimates (or conceptual estimates)
• Detailed estimates (or definitive estimates)
• Engineer's estimates based on plans and specifications

2. Bid Estimates. For the contractor, a bid estimate submitted to the owner either for competitive bidding or negotiation consists of direct construction cost including field supervision, plus a markup to cover general overhead and profits. The direct cost of construction for bid estimates is usually derived from a combination of the following approaches.

• Subcontractor quotations
• Quantity takeoffs
• Construction procedures.

3. Control Estimates. For monitoring the project during construction, a control estimate is derived from available information to establish:

• Budget estimate for financing
• Budgeted cost after contracting but prior to construction
• Estimated cost to completion during the progress of construction.

Design Estimates

In the planning and design stages of a project, various design estimates reflect the progress of the design. At the very early stage, the screening estimate or order of magnitude estimate is usually made before the facility is designed, and must therefore rely on the cost data of similar facilities built in the past. A preliminary estimate or conceptual estimate is based on the conceptual design of the facility at the state when the basic technologies for the design are known. The detailed estimate or definitive estimate is made when the scope of work is clearly defined and the detailed design is in progress so that the essential features of the facility are identifiable. The engineer's estimate is based on the completed plans and specifications when they are ready for the owner to solicit bids from construction contractors. In preparing these estimates, the design professional will include expected amounts for contractors' overhead and profits.

The costs associated with a facility may be decomposed into a hierarchy of levels that are appropriate for the purpose of cost estimation. The level of detail in decomposing the facility into tasks depends on the type of cost estimate to be prepared. For conceptual estimates, for example, the level of detail in defining tasks is quite coarse; for detailed estimates, the level of detail can be quite fine.

As an example, consider the cost estimates for a proposed bridge across a river. A screening estimate is made for each of the potential alternatives, such as a tied arch bridge or a cantilever truss bridge. As the bridge type is selected, e.g. the technology is chosen to be a tied arch bridge instead of some new bridge form, a preliminary estimate is made on the basis of the layout of the selected bridge form on the basis of the preliminary or conceptual design. When the detailed design has progressed to a point when the essential details are known, a detailed estimate is made on the basis of the well defined scope of the project. When the detailed plans and specifications are completed, an engineer's estimate can be made on the basis of items and quantities of work.

Bid Estimates

The contractor's bid estimates often reflect the desire of the contractor to secure the job as well as the estimating tools at its disposal. Some contractors have well established cost estimating procedures while others do not. Since only the lowest bidder will be the winner of the contract in most bidding contests, any effort devoted to cost estimating is a loss to the contractor who is not a successful bidder. Consequently, the contractor may put in the least amount of possible effort for making a cost estimate if it believes that its chance of success is not high.

If a general contractor intends to use subcontractors in the construction of a facility, it may solicit price quotations for various tasks to be subcontracted to specialty subcontractors. Thus, the general subcontractor will shift the burden of cost estimating to subcontractors. If all or part of the construction is to be undertaken by the general contractor, a bid estimate may be prepared on the basis of the quantity takeoffs from the plans provided by the owner or on the basis of the construction procedures devised by the contractor for implementing the project. For example, the cost of a footing of a certain type and size may be found in commercial publications on cost data which can be used to facilitate cost estimates from quantity takeoffs. However, the contractor may want to assess the actual cost of construction by considering the actual construction procedures to be used and the associated costs if the project is deemed to be different from typical designs. Hence, items such as labor, material and equipment needed to perform various tasks may be used as parameters for the cost estimates.

Control Estimates

Both the owner and the contractor must adopt some base line for cost control during the construction. For the owner, a budget estimate must be adopted early enough for planning long term financing of the facility. Consequently, the detailed estimate is often used as the budget estimate since it is sufficient definitive to reflect the project scope and is available long before the engineer's estimate. As the work progresses, the budgeted cost must be revised periodically to reflect the estimated cost to completion. A revised estimated cost is necessary either because of change orders initiated by the owner or due to unexpected cost overruns or savings.

For the contractor, the bid estimate is usually regarded as the budget estimate, which will be used for control purposes as well as for planning construction financing. The budgeted cost should also be updated periodically to reflect the estimated cost to completion as well as to insure adequate cash flows for the completion of the project.

Example 5-2: Screening estimate of a grouting seal beneath a landfill(This example is adapted from a cost estimate in A.L. Tolman, A.P. Ballestero, W.W. Beck and G.H. Emrich, Guidance Manual for Minimizing Pollution from Waste Disposal Sites, Municipal Environmental Research Laboratory, U.S. Environmental Protection Agency, Cincinatti, Ohio, 1978.)

One of the methods of isolating a landfill from groundwater is to create a bowl-shaped bottom seal beneath the site as shown in Figure 5-0. The seal is constructed by pumping or pressure-injecting grout under the existing landfill. Holes are bored at regular intervals throughout the landfill for this purpose and the grout tubes are extended from the surface to the bottom of the landfill. A layer of soil at a minimum of 5 ft. thick is left between the grouted material and the landfill contents to allow for irregularities in the bottom of the landfill. The grout liner can be between 4 and 6 feet thick. A typical material would be Portland cement grout pumped under pressure through tubes to fill voids in the soil. This grout would then harden into a permanent, impermeable liner.

Illustration of Grout Bottom Seal Liner at a Landfill
  

The work items in this project include (1) drilling exploratory bore holes at 50 ft. intervals for grout tubes, and (2) pumping grout into the voids of a soil layer between 4 and 6 feet thick. The quantities for these two items are estimated on the basis of the landfill area:

       8 acres = (8)
(43,560 sq.ft./acre) = 348,480 sq. ft.
          (As an approximation, use 360,000 sq.
ft. to account for the bowl shape)

Num "360,000#sq.#ft.",
Denom "(50#ft.)(50#ft.)"
  
  ##=##144

 

The volume of the soil layer for grouting is estimated to be:

     for a 4 ft. layer, volume = (4 ft.)
(360,000 sq. ft.) = 1,440,000 cu. ft.
     for a 6 ft. layer, volume = (6 ft.)
(360,000 sq. ft.) = 2,160,000 cu. ft.

  grouting in 20 % voids =
(20 %)(1,440,000) = 288,000 cu. ft.
  grouting in 30 % voids =
(30 %)(1,440,000) = 432,000 cu. ft.

  grouting in 20 % voids =
 (20 %)(2,160,000) = 432,000 cu. ft.
  grouting in 30 % voids =
 (30 %)(2,160,000) = 648,000 cu. ft.

The unit cost for drilling exploratory bore holes is estimated to be between $3 and $10 per foot (in 1978 dollars) including all expenses. Thus, the total cost of boring will be between (2,880)(3) = $ 8,640 and (2,880)(10) = $ 28,800. The unit cost of Portland cement grout pumped into place is between $ 4 and $ 10 per cubic foot including overhead and profit. In addition to the variation in the unit cost, the total cost of the bottom seal will depend upon the thickness of the soil layer grouted and the proportion of voids in the soil. That is:

  for a 4 ft. layer with 20% voids, grouting cost = $ 1,152,000 to $ 2,880,000
  for a 4 ft. layer with 30% voids, grouting cost = $ 1,728,000 to $ 4,320,000
  for a 6 ft. layer with 20% voids, grouting cost = $ 1,728,000 to $ 4,320,000
  for a 6 ft. layer with 30% voids, grouting cost = $ 2,592,000 to $ 6,480,000

The total cost of drilling bore holes is so small in comparison with the cost of grouting that the former can be omitted in the screening estimate. Furthermore, the range of unit cost varies greatly with soil characteristics, and the engineer must exercise judgment in narrowing the range of the total cost. Alternatively, additional soil tests can be used to better estimate the unit cost of pumping grout and the proportion of voids in the soil. Suppose that, in addition to ignoring the cost of bore holes, an average value of a 5 ft. soil layer with 25% voids is used together with a unit cost of $ 7 per cu. ft. of Portland cement grouting. In this case, the total project cost is estimated to be:

   (5 ft)(360,000 sq. ft.)(25 %)($ 7/cu.ft.) = $ 3,150,000

Example 5-3: Example of engineer's estimate and contractors' bids(See "Utah Interstate Forges On," ENR, July 2, 1987, p. 39.)

The engineer's estimate for a project involving 14 miles of Interstate 70 roadway in Utah was $ 20,950,859. Bids were submitted on March 10, 1987 for completing the project within 320 working days. The three low bidders were:

!!!1. Ball, Ball & Brosame, Inc., Danville CA                   $ 14,129,798!!!
!!!2. National Projects, Inc., Phoenix, AR                      $ 15,381,789!!!
!!!3. Kiewit Western Co., Murray, Utah                          $ 18,146,714!!!

The unit prices for different items of work submitted for this project by (1) Ball, Ball & Brosame, Inc. and (2) National Projects, Inc. are shown in Table 5-0. The similarity of their unit prices for some items and the disparity in others submitted by the two contractors can be noted.

5.4 Effects of Scale on Construction Cost

Screening cost estimates are often based on a single variable representing the capacity or some physical measure of the design such as floor area in buildings, length of highways, volume of storage bins and production volumes of processing plants. Costs do not always vary linearly with respect to different facility sizes. Typically, scale economies or diseconomies exist. If the average cost per unit of capacity is declining, then scale economies exist. Conversely, scale diseconomies exist if average costs increase with greater size. Empirical data are sought to establish the economies of scale for various types of facility, if they exist, in order to take advantage of lower costs per unit of capacity.

Let x be a variable representing the facility capacity, and y be the resulting construction cost. Then, a linear cost relationship can be expressed in the form:

       y = a + bx

 

A nonlinear cost relationship between the facility capacity x and construction cost y can often be represented in the form:

        y = a x@+(b)

 

         ln y = ln a + b ln x

 

A nonlinear cost relationship often used in estimating the cost of a new industrial processing plant from the known cost of an existing facility of a different size is known as the exponential rule. Let y@-(n) be the known cost of an existing facility with capacity Q@-(n), and y be the estimated cost of the new facility which has a capacity Q. Then, from the empirical data, it can be assumed that:

   y   =   y@-(n)     ## 
num "Q", denom "Q@-(n)"
  
       @+[m]

 

   ln#y### =### ln# y@-(n)# +# m# ln#    
num "Q", denom "Q@-{n}"
  
  #
or
  
    ln##  ## 
Num "y", Denom "y@-{n}"
  
  #   ##=### m ###ln#  # 
Num "Q", Denom "Q@-{n}"
  
  #

 

Example 5-4: Determination of m for the exponential rule

The empirical cost data from a number of sewage treatment plants are plotted on a log-log scale for ln(Q/Q@-(n)) and ln(y/y@-(n)) and a linear relationship between these logarithmic ratios is shown in Figure 5-0. For (Q/Q@-(n)) = 1 or ln(Q/Q@-(n)) = 0, ln(y/y@-(n)) = 0; and for Q/Q@-(n) = 2 or ln(Q/Q@-(n)) = 0.301, ln(y/y@-(n)) = 0.1765. Since m is the slope of the line in the figure, it can be determined from the geometric relation as follows:

m = 
num"0.1765", denom"0.301"
  
   = 0.585

 

Example 5-5: Cost exponents for water and wastewater treatment plants[This and the next example have been adapted from P.M. Berthouex, "Evaluating Economy of Scale," Journal of the Water Pollution Control Federation, Vol. 44, No. 11, November 1972, pp. 2111-2118.]

The magnitude of the cost exponent m in the exponential rule provides a simple measure of the economy of scale associated with building extra capacity for future growth and system reliability for the present in the design of treatment plants. When m is small, there is considerable incentive to provide extra capacity since scale economies exist as illustrated in Figure 5-0. When m is close to 1, the cost is directly proportional to the design capacity. The value of m tends to increase as the number of duplicate units in a system increases. The values of m for several types of treatment plants with different plant components derived from statistical correlation of actual construction costs are shown in Table 5--1.

Example 5-6: Cost data for the exponential rule

The exponential rule as represented by Equation (5.4) can be expressed in a different form as:

y###=###K#Q@+(m)

 

K##=##
Num "y@-(n)", Denom "(Q@-(n))@+(m)"
  

 

The estimated values of K and m for various water and sewage treatment plant components are shown in Table 5--1. The K values are based on 1968 dollars. The range of data from which the K and m values are derived in the primary sources should be observed in order to use them in making cost estimates.

As an example, take K = $ 399 and m = 0.60 for a primary sedimentation component in Table 5--1. For a proposed new plant with the primary sedimentation process having a capacity of 15,000 sq. ft., the estimated cost (in 1968 dollars) is:

y##=##($#399)(15,000)@+(0.60)##A##$#128,000.

5.5 Unit Cost Method of Estimation

If the design technology for a facility has been specified, the project can be decomposed into elements at various levels of detail for the purpose of cost estimation. The unit cost for each element in the bill of quantities must be assessed in order to compute the total construction cost. This concept is applicable to both design estimates and bid estimates, although different elements may be selected in the decomposition.

For design estimates, the unit cost method is commonly used when the project is decomposed into elements at various levels of a hierarchy as follows:

1. Preliminary Estimates. The project is decomposed into major structural systems or production equipment items, e.g. the entire floor of a building or a cooling system for a processing plant.

2. Detailed Estimates. The project is decomposed into components of various major systems, i.e., a single floor panel for a building or a heat exchanger for a cooling system.

3. Engineer's Estimates. The project is decomposed into detailed items of various components as warranted by the available cost data. Examples of detailed items are slabs and beams in a floor panel, or the piping and connections for a heat exchanger.

For bid estimates, the unit cost method can also be applied even though the contractor may choose to decompose the project into different levels in a hierarchy as follows:

1. Subcontractor Quotations. The decomposition of a project into subcontractor items for quotation involves a minimum amount of work for the general contractor. However, the accuracy of the resulting estimate depends on the reliability of the subcontractors since the general contractor selects one among several contractor quotations submitted for each item of subcontracted work.

2. Quantity Takeoffs. The decomposition of a project into items of quantities that are measured (or taken off) from the engineer's plan will result in a procedure similar to that adopted for a detailed estimate or an engineer's estimate by the design professional. The levels of detail may vary according to the desire of the general contractor and the availability of cost data.

3. Construction Procedures. If the construction procedure of a proposed project is used as the basis of a cost estimate, the project may be decomposed into items such as labor, material and equipment needed to perform various tasks in the projects.

Simple Unit Cost Formula

Suppose that a project is decomposed into n elements for cost estimation. Let Q@-(i) be the quantity of the i@+(th) element and u@-(i) be the corresponding unit cost. Then, the total cost of the project is given by:

    y   =   
from "i=1", to "n"
  
     u@-(i)Q@-(i)

 

Factored Estimate Formula

A special application of the unit cost method is the "factored estimate" commonly used in process industries. Usually, an industrial process requires several major equipment components such as furnaces, towers drums and pump in a chemical processing plant, plus ancillary items such as piping, valves and electrical elements. The total cost of a project is dominated by the costs of purchasing and installing the major equipment components and their ancillary items. Let C@-(i) be the purchase cost of a major equipment component i and f@-(i) be a factor accounting for the cost of ancillary items needed for the installation of this equipment component i. Then, the total cost of a project is estimated by:

   y   =   ##
from"i=1", To "n"
  
     C@-(i)   +   
from
 "i=1", to "n"
  
    f@-(i)C@-(i)####=##
from "i=1",
to "n"
  
  ##C@-(i)#(1#+#f@-(i))

 

Formula Based on Labor, Material and Equipment

Consider the simple case for which costs of labor, material and equipment are assigned to all tasks. Suppose that a project is decomposed into n tasks. Let Q@-[i] be the quantity of work for task i, M@-[i] be the unit material cost of task i, E@-(i) be the unit equipment rate for task i, L@-[i] be the units of labor required per unit of Q@-[i], and W@-[i] be the wage rate associated with L@-[i]. In this case, the total cost y is:

y# =# 
from "i=1", to "n"
  
  #y@-(i)##=##
from "i=1",to "n"
  
  # Q@-[i] (M@-[i]#+# E@-(i)#+# W@-[i] L@-[i])

Note that W@-(i)L@-(i) yields the labor cost per unit of Q@-(i), or the labor unit cost of task i. Consequently, the units for all terms in Equation (5.5.5) are consistent.

Example 5-7: Decomposition of a building foundation into design and construction elements.

The concept of decomposition is illustrated by the example of estimating the costs of a building foundation excluding excavation as shown in Table 5--1 in which the decomposed design elements are shown on horizontal lines and the decomposed contract elements are shown in vertical columns. For a design estimate, the decomposition of the project into footings, foundation walls and elevator pit is preferred since the designer can easily keep track of these design elements; however, for a bid estimate, the decomposition of the project into formwork, reinforcing bars and concrete may be preferred since the contractor can get quotations of such contract items more conveniently from specialty subcontractors.

Example 5-8: Cost estimate using labor, material and equipment rates.

For the given quantities of work Q@-(i) for the concrete foundation of a building and the labor, material and equipment rates in Table 5--1, the cost estimate is computed on the basis of Equation (5.5.5). The result is tabulated in the last column of the same table.

5.6 Methods for Allocation of Joint Costs

The principle of allocating joint costs to various elements in a project is often used in cost estimating. Because of the difficulty in establishing casual relationship between each element and its associated cost, the joint costs are often prorated in proportion to the basic costs for various elements.

One common application is found in the allocation of field supervision cost among the basic costs of various elements based on labor, material and equipment costs, and the allocation of the general overhead cost to various elements according to the basic and field supervision cost. Suppose that a project is decomposed into n tasks. Let y be the total basic cost for the project and y@-(i) be the total basic cost for task i. If F is the total field supervision cost and F@-(i) is the proration of that cost to task i, then a typical proportional allocation is:

F@-(i)##=##F##
num"y@-[i]",
 denom"y"
  

 

G@-(i)##=##G##
num"z@-(i)", denom"z"
  

 

z## =## F## +## y## =## F## +##
from"i=1",to"n"
  
     y@-(i)
and
  
w## =## G## +## z## =## G## +##
 
from"i=1", to"n"
  
     z@-(i)

Example 5-9: Prorated costs for field supervision and office overhead

If the field supervision cost is $ 13,245 for the project in Table 5-6 (Example 5-8) with a total direct cost of $ 88,300, find the prorated field supervision costs for various elements of the project. Furthermore, if the general office overhead charged to the project is 4% of the direct field cost which is the sum of basic costs and field supervision cost, find the prorated general office overhead costs for various elements of the project.

For the project, y = $ 88,300 and F = $13,245. Hence:

     z =  13,245 +  88,300 = $ 101,545
     G = (0.04)(101,545) = $ 4,062
     w =  101,545 +  4,062 = $ 105,607

Example 5-10: A standard cost report for allocating overhead

The reliance on labor expenses as a means of allocating overhead burdens in typical management accounting systems can be illustrated by the example of a particular product's standard cost sheet.(See H.T. Johnson and R.S. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, Boston, MA 1987, p. 185.) Table 5--1 is an actual product's standard cost sheet of a company following the procedure of using overhead burden rates assessed per direct labor hour. The material and labor costs for manufacturing a type of valve were estimated from engineering studies and from current material and labor prices. These amounts are summarized in Columns 2 and 3 of Table 5--1. The overhead costs shown in Column 4 of Table 5--1 were obtained by allocating the expenses of several departments to the various products manufactured in these departments in proportion to the labor cost. As shown in the last line of the table, the material cost represents 29% of the total cost, while labor costs are 11% of the total cost. The allocated overhead cost constitutes 60% of the total cost. Even though material costs exceed labor costs, only the labor costs are used in allocating overhead. Although this type of allocation method is common in industry, the arbitrary allocation of joint costs introduces unintended cross subsidies among products and may produce adverse consequences on sales and profits. For example, a particular type of part may incur few overhead expenses in practice, but this phenomenon would not be reflected in the standard cost report.

5.7 Historical Cost Data

Preparing cost estimates normally requires the use of historical data on construction costs. Historical cost data will be useful for cost estimation only if they are collected and organized in a way that is compatible with future applications. Organizations which are engaged in cost estimation continually should keep a file for their own use. The information must be updated with respect to changes that will inevitably occur. The format of cost data, such as unit costs for various items, should be organized according to the current standard of usage in the organization.

Construction cost data are published in various forms by a number of organizations. These publications are useful as references for comparison. Basically, the following types of information are available:

• Catalogs of vendors' data on important features and specifications relating to their products for which cost quotations are either published or can be obtained. A major source of vendors' information for building products is Sweets' Catalog published by McGraw-Hill Information Systems Company.
• Periodicals containing construction cost data and indices. One source of such information is ENR, the McGraw-Hill Construction Weekly, which contains extensive cost data including quarterly cost reports. Cost Engineering, a journal of the American Society of Cost Engineers, also publishes useful cost data periodically.
• Commercial cost reference manuals for estimating guides. An example is the Building Construction Cost Data published annually by R.S. Means Company, Inc., which contains unit prices on building construction items. Dodge Manual for Building Construction, published by McGraw-Hill, provides similar information.
• Digests of actual project costs. The Dodge Digest of Building Costs and Specifications provides descriptions of design features and costs of actual projects by building type. Once a week, ENR publishes the bid prices of a project chosen from all types of construction projects.

Historical cost data must be used cautiously. Changes in relative prices may have substantial impacts on construction costs which have increased in relative price. Unfortunately, systematic changes over a long period of time for such factors are difficult to predict. Errors in analysis also serve to introduce uncertainty into cost estimates. It is difficult, of course, to foresee all the problems which may occur in construction and operation of facilities. There is some evidence that estimates of construction and operating costs have tended to persistently understate the actual costs. This is due to the effects of greater than anticipated increases in costs, changes in design during the construction process, or overoptimism.

Since the future prices of constructed facilities are influenced by many uncertain factors, it is important to recognize that this risk must be borne to some degree by all parties involved, i.e., the owner, the design professionals, the construction contractors, and the financing institution. It is to the best interest of all parties that the risk sharing scheme implicit in the design-construct process adopted by the owner is fully understood by all. When inflation adjustment provisions have very different risk implications to various parties, the price level changes will also be treated differently for various situations.

Example 5-11: Cost data from commercial publications

Cost data from commercial publications often provide useful information for cost estimating. An example of cost data for earthwork (bulk excavation with a backhoe) is shown in Figure 5-0, which is reproduced from Building Construction Cost Data, 1987, by R.S. Means Company, Inc. These excavation costs assume standard crews with the associated costs summarized in Figure 5-0. For example, operation of a 2 cubic yard capacity hydraulic backhoe for bulk excavation would require standard crew B-12C, would have a standard daily output of (75 c.y./hr)(8 hr) = 600 cubic yards, and would require 0.027 labor hours per cubic yard of excavation for a total of (600 c.y.)(0.027 hr/c.y.) = 16.2 labor hours. Costs exclusive of overhead and profit (i.e. "bare costs") as well as total costs including standard overhead and profit rates are shown in Figure 5-0. Thus, the total bare cost for a standard daily output of 600 cubic yards is (600 c.y.)($ 1.87/c.y.) = $ 1,122. The standard crew B-12C for this task consists of two equipment operators as shown in Figure 5-0. Using a daily total of 16 labor hours, the daily bare cost is seen to be $ 1,118, which is essentially the same as the $ 1,122 obtained from Figure 5-0 except for the difference due to truncation of decimals in the process of computation. Note that costs would increase 15% if the excavated material must be loaded onto trucks (Figure 5-0).

5.8 Cost Indices

Since historical cost data are often used in making cost estimates, it is important to note the price level changes over time. Trends in price changes can also serve as a basis for forecasting future costs. The input price indices of labor and/or material reflect the price level changes of such input components of construction; the output price indices, where available, reflect the price level changes of the completed facilities, thus to some degree also measuring the productivity of construction.

A price index is a weighted aggregate measure of constant quantities of goods and services selected for the package. The price index at a subsequent year represents a proportionate change in the same weighted aggregate measure because of changes in prices. Let l@-[t] be the price index in year t, and l@-[t+1] be the price index in the following year t+1. Then, the percent change in price index for year t+1 is:

     j@-[t+1]   =   
Num "I@-[t+1]-I@-[t]", Denom "I@-[t]"
  
  ## (##100%)

 

or

     I@-[t+1] = I@-[t] (1 +  j@-[t+1])

 

The best-known indicators of general price changes are the GNP deflators compiled periodically by the U.S. Department of Commerce, and the consumer price index (CPI) compiled periodically by the U.S. Department of Labor. They are widely used as broad gauges of the changes in production costs and in consumer prices for essential goods and services. Special price indices related to construction are also collected by industry sources since some input factors for construction and the outputs from construction may disproportionately outpace or fall behind the general price indices. Examples of special price indices for construction input factors are the wholesale Building Material Price and Building Trades Union Wages, both compiled by the U.S. Department of Labor. In addition, the construction cost index and the building cost index are reported periodically in the Engineering News-Record (ENR). Both ENR cost indices measure the effects of wage rate and material price trends, but they are not adjusted for productivity, efficiency, competitive conditions, or technology changes. Consequently, all these indices measure only the price changes of respective construction input factors as represented by constant quantities of material and/or labor. On the other hand, the price indices of various types of completed facilities reflect the price changes of construction output including all pertinent factors in the construction process. The building construction output indices compiled by Turner Construction Company and Handy-Whitman Utilities are compiled in the U.S. Statistical Abstracts published each year.

Figure 5-0 shows the Gross National Product (GNP) price deflator and the ENR building index from 1955 to 1985, using 1982 as the base year with an index of 100. Before 1976, the ENR building index rose more sharply than the GNP deflator except in 1973, whereas from 1976 to 1985, both indices practically coincide. The ENR building index is an input price index reflecting the cost of inputs to the building construction process such as wage rates and standard material costs. Figure 5-0 shows the Turner Construction Company building cost index, also using 1982 as the base year for an index of 100. The Handy-Whitman Utilities building cost index and the GNP price deflator are almost identical to the Turner index, and therefore cannot be detected as separate curves if plotted in Figure 5-0. Both the Turner and the Handy-Whitman indices are referred to as output price indices because they represent the cost of completed buildings. Before 1982, the Turner index runs very close to the ENR building index, indicating no significant changes in productivity. However, from 1982 to 1985, the Turner index increases slightly faster than the ENR building index, suggesting a possible decline in productivity. In view of the fact that the productivity of manufacturing industries has improved significantly from 1955 to 1985, the performance of the construction industry has been viewed as being stagnant by comparison. A summary of these indices from 1970 to 1985 is also shown in Table 5--1 for illustration.

Since construction costs vary in different regions of the United States and in all parts of the world, locational indices showing the construction cost at a specific location relative to the national trend are useful for cost estimation. ENR publishes periodically the indices of local construction costs at the major cities in different regions of the United States as percentages of local to national costs.

When the inflation rate is relatively small, i.e., less than 10%, it is convenient to select a single price index to measure the inflationary conditions in construction and thus to deal only with a single set of price change rates in forecasting. Let j@-[t] be the price change rate in year t+1 over the price in year t. If the base year is denoted as year 0 (t=0), then the price change rates at years 1,2,...t are j@-[1],j@-[2],...j@-[t], respectively. Let A@-[t] be the cost in year t expressed in base-year dollars and A@+[']@-[t] be the cost in year t expressed in then-current dollars. Then:

A@+[']@-[t]## =## A@-[t](1+j@-[1])(1+j@-[2])...
(1+j@-[t-1])(1+j@-[t])##=##A@-(t)##  ##
Num "I@-(t)", Denom "I@-(o)"
  
  ##


 

A@-[t]## = ##A@+[']@-[t](1+j@-[t])
@+[-1](1+j@-[t-1])@+[-1]...(1+j@-[2])
@+[-1](1+j@-[1])@+[-1]##=##A'
@-(t)##  ##
Num "I
@-(o)",
 Denom "I@-(t)"
  
  ##

If the prices of certain key items affecting the estimates of future benefits and costs are expected to escalate faster than the general price levels, it may become necessary to consider the differential price changes over and above the general inflation rate. For example, during the period between 1973 through 1979, it was customary to assume that fuel costs would escalate faster than the general price levels. With hindsight in 1983, the assumption for estimating costs over many years would have been different. Because of the uncertainty in the future, the use of differential inflation rates for special items should be judicious.

Future forecasts of costs will be uncertain: the actual expenses may be much lower or much higher than those forecasted. This uncertainty arises from technological changes, changes in relative prices, inaccurate forecasts of underlying socioeconomic conditions, analytical errors, and other factors. For the purpose of forecasting, it is often sufficient to project the trend of future prices by using a constant rate j for price changes in each year over a period of t years, then

     A@-[t]@+['] = A@-[t](1+j)@+[t]

 

     A@-[t] = A@-[t](1+j)@+[-1]

 

          j = j@-(t-1)

 

j##=##
from "i=1", to "n"
  
  ##
Num "j@-(t-i)", Denom
"n"
  

 

Example 5-12: Changes in highway and building costs

Table 5--1 shows the change of standard highway costs from 1940 to 1980, and Table 5--1 shows the change of residential building costs from 1970 to 1980. For these series, the quality of the finished product was held roughly equivalent. In each case, the rate of cost increase was substantially above the rate of inflation after 1970. Indeed, the real cost increase between 1970 and 1980 was in excess of three percent per year in both cases. However, these data also show some cause for optimism. For the case of the standard highway, real cost decreases took place in the period from l940 to l980. Unfortunately, comparable indices of outputs are not being compiled on a nationwide basis for other types of construction.

5.9 Applications of Cost Indices to Estimating

In the screening estimate of a new facility, a single parameter is often used to describe a cost function. For example, the cost of a power plant is a function of electricity generating capacity expressed in megawatts, or the cost of a sewage treatment plant as a function of waste flow expressed in million gallons per day.

The general conditions for the application of the single parameter cost function for screening estimates are:

1. Exclude special local conditions in historical data
2. Determine new facility cost on basis of specified size or capacity (using the methods described in Sections 5.3 to 5.6)
3. Adjust for inflation index
4. Adjust for local index of construction costs
5. Adjust for different regulatory constraints
6. Adjust for local factors for the new facility

Example 5-13: Screening estimate for a refinery

The total construction cost of a refinery with a production capacity of 200,000 bbl/day in Gary, Indiana, completed in 1981 was $100 million. It is proposed that a similar refinery with a production capacity of 300,000 bbl/day be built in Los Angeles, California, for completion in 1983. For the additional information given below, make an order of magnitude estimate of the cost of the proposed plant.

1. In the total construction cost for the Gary, Indiana, plant, there was an item of $5 million for site preparation which is not typical for other plants.
2. The variation of sizes of the refineries can be approximated by the exponential rule, Equation (5.4), with m = 0.6.

   Unit Prices in Two Contractors' Bids for Roadway Construction
     
   

   !!!!!!!!! Unit Price

   Items!!!Unit!!!Qty.!!! 1!!! 2

   Mobilization.!!!ls!!!1!!!115,000!!!569,554.!

   Removal, berm.!!!lf!!!8,020!!!1.00!!!1.50.!!

   Finish subgrade.!!!sy!!!1,207,500!!!0.50!!!0.30.!!!s

   Surface ditches.!!!lf!!!525!!!2.00!!!1.00.!!

   Excavation structures.!!!cy!!!7,000!!!3.00!!!5.00.!!

   Base course, untreated, 3/4".!!!ton!!!362,200!!!4.50!!!5.00.!!!ton!!!362,200!!

   Lean concrete, 4" thick.!!!sy!!!820,310!!!3.10!!!3.00.!!!sy!!!820,310!!!3.10

   PCC, pavement, 10" thick.!!!sy!!!706,010!!!10.90!!!12.00.!!!sy!!!706,010!!!10.

   Concrete, ci AA(AE).!!!ls!!!1!!!200,000!!!190,000.!!

   Small structure.!!!cy!!!50!!!500!!!475.!!!

   Barrier, precast.!!!lf!!!7,920!!!15.00!!!16.00.!!!

   Flatwork, 4" thick.!!!sy!!!7,410!!!10.00!!!8.00.!!

   10" thick.!!!sy!!!4,241!!!20.00!!!27.00.!!

   Slope protection.!!!sy!!!2,104!!!25.00!!!30.00.!!!

   Metal, end section, 15".!!!ea!!!39!!!100!!!125.!!!ea

   18".!!!ea!!!3!!!150!!!200

   Post, right-of-way, modification.!!!lf!!!4,700!!!3.00!!!2.50.!!!lf!!!4,700!!

   Salvage & relay pipe.!!!lf!!!1,680!!!5.00!!!12.00.!!

   Loose riprap.!!!cy!!!32!!!40.00!!!30.00.!!!c

   Braced posts.!!!ea!!!54!!!100!!!110

   Delineators, type I.!!!lb!!!1,330!!!12.00!!!12.00.!!

   type II.!!!ea!!!140!!!15.00!!!12.00.!!!ea!

   Constructive signs fixed.!!!sf!!!52,600!!!0.10!!!0.40.!!!sf!!!52,600!!!0.10!!!

   Barricades, type III.!!!lf!!!29,500!!!0.20!!!0.20.

   Warning lights.!!!day!!!6,300!!!0.10!!!0.50.

   Pavement marking, epoxy material, black.!!!gal!!!475!!!90.00!!!100.!!!gal!!!47

   Yellow.!!!gal!!!740!!!90.00!!!80.00.!!!gal

   White.!!!gal!!!985!!!90.00!!!70.00.!!!gal!

   Plowable, one way white.!!!ea!!!342!!!50.00!!!20.00.!!!ea!!!342!!!50.00!!!20

   Topsoil, contractor furnished.!!!cy!!!260!!!10.00!!!6.00.!!!cy!!!260!!!10.00!!

   Seedling, method A.!!!acr!!!103!!!150!!!200.

   Excelsior blanket.!!!sy!!!500!!!2.00!!!2.00.

   Unit Prices in Bids Submitted by Two Contractors, (Continued)
     
   

   !!!!!!!!! Unit Price

   Items!!!Unit!!!Qty.!!! 1!!! 2

   Corrugated, metal pipe, 18".!!!lf!!!580!!!20.00!!!18.00.!!!lf!!!580!!!20.00!!!

   Polyethylene pipe, 12".!!!lf!!!2,250!!!15.00!!!13.00.!!!lf!!!2,250!!!15.00!!

   Catch basin grate & frame.!!!ea!!!35!!!350!!!280.!!!

   Equal opportunity training.!!!hr!!!18,000!!!0.80!!!0.80.!!!hr!!!18,000!!!0.80!

   Granular backfill borrow.!!!cy!!!274!!!10.00!!!16.00

   Drill caisson, 2' x 6".!!!lf!!!722!!!100!!!80.00.!!!

   Flagging.!!!hr!!!20,000!!!8.25!!!12.50.!!!hr

   Prestressed concrete member

   type IV, 141' x 4".!!!ea!!!7!!!12,000!!!16,000.!!!

   132' x 4".!!!ea!!!6!!!11,000!!!14,000.!!!e

   Reinforced steel.!!!lb!!!6,300!!!0.60!!!0.50

   Epoxy coated.!!!lb!!!122,241!!!0.55!!!0.50

   Structural steel.!!!ls!!!1!!!5,000!!!1,600.!

   Sign, covering.!!!sf!!!16!!!10.00!!!4.00.!!!

   type C-2, wood post.!!!sf!!!98!!!15.00!!!17.00.!!!

   24".!!!ea!!!3!!!100!!!400

   30".!!!ea!!!2!!!100!!!160

   48".!!!ea!!!11!!!200!!!300.!!!ea!

   Auxiliary.!!!sf!!!61!!!15.00!!!12.00.!!!sf

   Steel post, 48" x 60".!!!ea!!!11!!!500!!!700.!!!ea

   type 3, wood post.!!!sf!!!669!!!15.00!!!19.00.!!!s

   24".!!!ea!!!23!!!100!!!125.!!!ea!

   30".!!!ea!!!1!!!100!!!150

   36".!!!ea!!!12!!!150!!!180.!!!ea!

   42" x 60".!!!ea!!!8!!!150!!!220.!

   48".!!!ea!!!7!!!200!!!270

   Auxiliary.!!!sf!!!135!!!15.00!!!13.00.!!!s

   Steel post.!!!sf!!!1,610!!!40.00!!!35.00.!

   12" x 36".!!!ea!!!28!!!100!!!150.

   Foundation, concrete.!!!ea!!!60!!!300!!!650.!!!ea!

   Barricade, 48" x 42".!!!ea!!!40!!!100!!!100.

   Wood post, road closed.!!!lf!!!100!!!30.00!!!36.00

   Linear Cost Relationship with Economies of Scale
     
   

   Nonlinear Cost Relationship with Increasing or
   Decreasing Economies of Scale
     
   

   Log-Log Scale Graph of Exponential Rule Example
     
   

   ---

   Estimated Values of Cost Exponents for Water Treatment Plants
     
   

   Treatment Plant!!!Exponent!!!Capacity Range

   Type!!! m!!!(millions of gallons per day)

   1. Water treatment!!! 0.67!!! 1-100

   2. Waste treatment!!!

   Primary with digestion (small)!!! 0.55!!! 0.1-10

   Primary with digestion (large)!!! 0.75!!! 0.7-100

   Trickling filter!!! 0.60!!! 0.1-20

   Activated sludge!!! 0.77!!! 0.1-100

   Stabilization ponds!!! 0.57!!! 0.1-100

   Note: Data are collected from various sources by P.M. Berthouex. See the references in his article for the primary sources.

   ---

   ---

   Cost Factors of Processing Units for Treatment Plants
     
   

   Processing!!!Unit of!!!K value!!! m

   Unit!!!Capacity!!!(1968 $)!!!value

   1. Liquid processing

   Oil separation!!!mgd!!!58,000!!!0.84

   Hydroclone degritter!!!mgd!!!3,820!!!0.35

   Primary sedimentation!!!sq. ft.!!!399!!!0.60

   Furial clarifier!!!sq. ft.!!!700!!!0.57

   Sludge aeration basin!!!mil. gal.!!!170,000!!!0.50

   Tickling filter!!!sq. ft.!!!21,000!!!0.71

   Aerated lagoon basin!!!mil. gal.!!!46,000!!!0.67

   Equalization!!!mil. gal.!!!72,000!!!0.52

   Neutralization!!!mgd!!!60,000!!!0.70

   2. Sludge handling

   Digestion!!!cu. ft.!!!67,500!!!0.59

   Vacuum filter!!!sq. ft.!!!9,360!!!0.84

   Centrifuge!!!lbs dry !!!318!!!0.81

   !!! solids/hr.

   Note: Data are collected from various sources by P.M. Berthouex. See the references in his article for the primary sources.

   ---

   ---

   Illustrative Decomposition of Building Foundation Costs
     
   

   
   !!!!!!Contract Elements
   Design!!!!!!!!!!!!Total
   Elements!!!Formwork!!!Re-bars!!!Concrete!!!Cost
   
   Footings!!!$5,000!!!$10,000!!!$13,000!!!$28,000
   Foundation Walls!!!$15,000!!!$18,000!!!$28,000!!!$61,000
   Elevator Pit!!!$9,000!!!$15,000!!!$16,000!!!$40,000
   
   Total Cost!!!$29,000!!!$43,000!!!$57,000!!!$129,000
   
   

   ---

   Illustrative Cost Estimate Using Labor, Material and Equipment Rates
     
   

   !!! !!! Material!!! Equipment!!!

   Wage!!! Labor!!! Labor!!! Direct

   !!! Quantity!!! Unit Cost!!! Unit Cost!!!

   Rate!!! Input!!! Unit Cost!!! Cost

   Description!!! Q@-(i)!!! M@-(i)!!! E@-(i)!!!

   W@-(i)!!! L@-(i)!!! W@-(i)L@-(i)!!! y@-(i)

   Formwork!!! 12,000 ft@+(2)!!! $ 0.4/ft@+(2)!!!

   $ 0.8/ft@+(2)!!! $15/hr!!! 0.2 hr/ft

   @+(2)!!!$ 3.0/ft@+(2)!!! $ 50,400

   Re-bars!!! 4,000 lb!!! $ 0.2/lb!!!

   $ 0.3/lb!!! $ 15/hr!!! 0.04 hr/lb!!!

   $ 0.6/lb!!! $ 4,400

   Concrete!!! 500 yd@+(3)!!! $ 5.0/yd@+(3)!!!

   $ 50/yd@+(3)!!! $ 15/hr!!! 0.8 hr/yd@+(3)!!!

   $12.0/yd@+(3)!!! $ 33,500

   Total!!! !!!!!! !!!

   !!! !!! !!! $ 88,300

   ---

   ---

   Proration of Field Supervision and Office Overhead Costs
     
   

   
   !!!!!!Allocated!!!!!!Allocated
   !!!Direct!!!Field Sup.!!!
   Total Field!!!Overhead!!!Total
   !!!Cost!!!Cost!!!Cost!!!Cost!!!Cost
   Description!!!y@-(i)!!!F
   @-(i)!!!z@-(i)!!!G@-(i)!!!w@-(i)
   Formwork!!!$50,400!!!$7,560!!!
   $57,960!!!$ 2,319!!!$ 60,279
   Re-bars!!!$4,400!!!$660!!!
   $5,060!!!$202!!!$5,262
   Concrete!!!$33,500!!!$5,025!!!
   $38,525!!!$1,541!!!$40,066
   
   Total!!!$88,300!!!$13,245!!!
   $101,545!!!$4,062!!!$105,607
   
   

   ---

   Standard Cost Report for a Type of Valve
     
   

   !!!Material!!!Labor!!!Overhead!!!Total

   !!! Cost!!! Cost!!! Cost!!!Cost

   PURCHASED PART!!!$1.1980!!!!!!!!!$1.1980

   OPERATION

   Drill, face, tap (2)!!!!!!

   $0.0438!!!$0.2404!!! 0.2842

   Degrease!!!!!! 0.0031!!!

   0.0337!!! 0.0368

   Remove burs!!!!!! 0.0577!!!

   0.3241!!! 0.3818

   Total Cost, This Item!!! 1.1980!!!

   0.1046!!! 0.5982!!! 1.9008

   Other subassemblies!!! 0.3253!!!

   0.2994!!! 1.8519!!!

   2.4766

   Total Cost,

   Subassemblies!!! 1.5233!!! 0.4040!!!

   2.4501!!! 4.3773

   Assemble and test!!!!!! 0.1469!!!

   0.4987!!! 0.6456

   Pack without paper!!!!!! 0.0234!!!

   0.1349!!! 0.1583

   Total Cost, This Item!!!$1.5233!!!

   $0.5743!!!$3.0837!!!$5.1813

   COST COMPONENT %!!! 29%!!!

   11%!!! 60%!!! 100%

   From H. Thomas Johnson and Robert S. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, Boston, MA. Reprinted with permission.

   ---

   Illustrative Cost Data for Earthwork - Bulk Excavating with Backhoe
     
   

   Illustrative Cost Data for Crews Operating Construction Equipment
     
   

   Changes in the GNP Price Deflator and the ENR Building Cost
   Indices, 1955-1985
     
   

   Changes in the Turner Construction Company Building Index, 1955-1985
     
   

   ______________________________________________________________________________

   Summary of Input and Output Price Indices
     
   

   !!!!!!!!!Turner

   !!!!!!ENR!!!Construction!!!Handy-Whitman

   Year!!!GNP!!!Building!!!Co. Building!!!Utilities Building

   !!!Deflator!!!Cost Index!!!Cost Index!!!Cost Index

   1970!!!43!!!37!!!39!!!38

   1971!!!45!!!43!!!44!!!41

   1972!!!47!!!47!!!47!!!45

   1973!!!50!!!51!!!49!!!49

   1974!!!55!!!54!!!57!!!59

   1975!!!60!!!58!!!61!!!66

   1976!!!63!!!63!!!62!!!67

   1977!!!67!!!67!!!64!!!70

   1978!!!72!!!72!!!68!!!77

   1979!!!79!!!79!!!76!!!86

   1980!!!86!!!86!!!84!!!95

   1981!!!94!!!94!!!93!!!100

   1982!!!100!!!100!!!100!!!100

   1983!!!104!!!104!!!105!!!103

   1984!!!108!!!108!!!111!!!107

   1985!!!112!!!112!!!115!!!110

   Note: Index = 100 in base year of 1982.

   ______________________________________________________________________________

   ______________________________________________________________________________

   Comparison of Standard Highway Costs, 1940-1980
     
   

   !!! Standard Hgwy!!! Price Deflator!!!

   Standard Hgwy!!! Percentage

   Year!!! Cost !!! !!!

   Real Cost !!! Change

   !!!(1972=100) (1972=100)

   (1972=100)!!! Per Year

   1940!!! 26!!! --!!! 90

   1950!!! 48!!! 54!!! 89!!! -0.1

   1960!!! 58!!! 69!!! 84!!! -0.6

   1970!!! 91!!! 92!!! 99!!! +1.8

   1980!!! 255!!! 179!!! 143!!! +4.4

   Source: Statistical Abstract of the United States. GNP Deflator is used for the price deflator index.

   ______________________________________________________________________________

   ______________________________________________________________________________

   Comparison of Residential Building Costs, 1970-1980
     
   

   !!! Standard Residence!!! Price Deflator!!!

   Standard Residence!!! Percentage

   Year!!! Cost !!! !!! Real Cost !!!

   Change

   !!!(1972=100) (1972=100) (1972=100)!!! Per Year

   1970!!! 77!!! 92!!! 74

   1980!!! 203!!! 179!!! 99!!! +3.4

   Source: Statistical Abstract of the United States. The GNP deflator is used for the price deflator index.

   ______________________________________________________________________________

3. The inflation rate is expected to be 8% per year from 1979 to 1983.
4. The location index was 0.92 for Gary, Indiana and 1.14 for Los Angeles in 1979. These indices are deemed to be appropriate for adjusting the costs between these two cities.
5. New air pollution equipment for the LA plant costs $7 million in 1983 dollars (not required in the Gary plant).
6. The contingency cost due to inclement weather delay will be reduced by the amount of 1% of total construction cost because of the favorable climate in LA (compared to Gary).

On the basis of the above conditions, the estimate for the new project may be obtained as follows:

1. Typical cost excluding special item at Gary, IN is

                100 - 5 = 95
      

2. Adjustment for capacity based on the exponential law yields

               (95)#      
      num "300,000",
       denom "200,000"
   
        @+[0.6]   =
         (95)(1.5)@+[0.6]   =   121.2
   
      

3. Adjustment for inflation leads to the cost in 1983 dollars as

                (121.2) (1.08)@+(4) = 164.6
      

4. Adjustment for location index gives

                (164.6)    ## 
      num "1.14",
       denom "0.92"
   
       ## =   204.6
      

5. Adjustment for new pollution equipment at the LA plant gives

                204.6 + 7 = 211.6
      

6. Reduction in contingency cost yields

                (211.6) (1 - 0.01) = 209.5
      

Since there is no adjustment for the cost of construction financing, the order of magnitude estimate for the new project is $209.5 million.

Example 5-14: Conceptual estimate for a chemical processing plant

In making a preliminary estimate of a chemical processing plant, several major types of equipment are the most significant parameters in affecting the installation cost. The cost of piping and other ancillary items for each type of equipment can often be expressed as a percentage of that type of equipment for a given capacity. The standard costs for the major equipment types for two plants with different daily production capacities in 1972 are as shown in Table 5--1. It has been established that the installation cost of all equipment for a plant with daily production capacity between 100,000 bbl and 400,000 bbl can best be estimated by using linear interpolation of the standard data.

______________________________________________________________________________

Cost Data for Equipment and Ancillary Items
  

Equipment!!!Equipment Cost ($1000)

!!!Cost of ancillary items as % of

Type!!!!!!!!! equipment cost ($1000)

!!!100,000 bbl!!!400,000 bbl!!!100,000 bbl!!!400,000 bbl

Furnace!!!3,000!!!10,000!!!40%!!!30%

Tower!!!2,000!!! 6,000!!!45%!!!35%

Drum!!!1,500!!! 5,000!!!50%!!!40%

Pump, etc.!!!1,000!!! 4,000!!!60%!!!50%

______________________________________________________________________________

A new chemical processing plant with a daily production capacity of 200,000 bbl was constructed in Memphis, TN in 1976. Determine the total preliminary cost estimate of the plant including the building and the equipment on the following basis:

1. The installation cost for equipment was based on linear interpolation from Table 5--1, and adjusted for inflation for the intervening four years using the ENR building cost index.
2. The location index for equipment installation is 0.95 for Memphis, TN, in comparison with the standard cost.
3. An additional cost of $ 500,000 was required for the local conditions in Memphis, TN.

(1) The costs of the equipment and ancillary items for a plant with a capacity of 200,000 bbl can be estimated in 1972 dollars by linear interpolation of the data in Table 5--1, and the results are shown in Table 5--1.

______________________________________________________________________________

Results of Linear Interpolation for an Estimation Example
  

.

Equipment!!! Equipment Cost!!! Percentage for

Type !!! (in $1,000)!!! ancillary items

Furnace!!!3,000 + (1/3)(10,000-3,000) = 5,333!!!40 - (1/3)(40-30) = 37

Tower!!!2,000 + (1/3)(6,000-2,000) = 3,333!!!45 - (1/3)(45-35) = 42

Drum!!!1,500 + (1/3)(5,000-1,500) = 2,667!!!50 - (1/3)(50-40) = 47

Pumps, etc.!!!1,000 + (1/3)(4,000-1,000) = 2,000!!!60 - (1/3)(60-50) = 57

______________________________________________________________________________

Hence, the total project cost in thousands of 1972 dollars is given by Equation (5.8) as:

    (5,333)(1.37) + (3,333)(1.42) + (2,667)(1.47) + (2,000)(1.57)
           = 2,307 + 4,733 + 3,920 + 3,140 = 19,100.

(2) The corresponding cost in thousands of 1976 dollars according to the ENR building cost index in Table 5--1 and using Equation (5.16) is:

        (19,100)(63/47) = 25,600

(3) The total cost of the project after adjustment for location is

    (0.95) (25,600,000) + 500,000 A $ 24,800,000

5.10 Estimate Based on Engineer's List of Quantities

The engineer's estimate is based on a list of items and the associated quantities from which the total construction cost is derived. This same list is also made available to the bidders if unit prices of the items on the list are also solicited from the bidders. Thus, the itemized costs submitted by the winning contractor may be used as the starting point for budget control.

In general, the progress payments to the contractor are based on the units of work completed and the corresponding unit prices of the work items on the list. Hence, the estimate based on the engineers' list of quanitities for various work items essentially defines the level of detail to which subsequent measures of progress for the project will be made.

Example 5-15: Bid estimate based on engineer's list of quantities

Using the unit prices in the bid of contractor 1 for the quantitites specified by the engineer in Table 5-2 (Example 5-3), we can compute the total bid price of contractor 1 for the roadway project. The itemized costs for various work items as well as the total bid price are shown in Table 5--1.

5.11 Allocation of Construction Costs Over Time

Since construction costs are incurred over the entire construction phase of a project, it is often necessary to determine the amounts to be spent in various periods to derive the cash flow profile, especially for large projects with long durations. Consequently, it is important to examine the percentage of work expected to be completed at various time periods to which the costs would be charged. More accurate estimates may be accomplished once the project is scheduled as described in Chapter 10, but some rough estimate of the cash flow may be required prior to this time.

Consider the basic problem in determining the percentage of work completed during construction. One common method of estimating percentage of completion is based on the amount of money spent relative to the total amount budgeted for the entire project. This method has the obvious drawback in assuming that the amount of money spent has been used efficiently for production. A more reliable method is based on the concept of value of work completed which is defined as the product of the budgeted labor hours per unit of production and the actual number of production units completed, and is expressed in budgeted labor hours for the work completed. Then, the percentage of completion at any stage is the ratio of the value of work completed to date and the value of work to be completed for the entire project. Regardless of the method of measurement, it is informative to understand the trend of work progress during construction for evaluation and control.

In general, the work on a construction project progresses gradually from the time of mobilization until it reaches a plateau; then the work slows down gradually and finally stops at the time of completion. The rate of work done during various time periods (expressed in the percentage of project cost per unit time) is shown schematically in Figure 5-0 in which ten time periods have been assumed. The solid line A represents the case in which the rate of work is zero at time t = 0 and increases linearly to 12.5% of project cost at t = 2, while the rate begins to decrease from 12.5% at t = 8 to 0% at t = 10. The dotted line B represents the case of rapid mobilization by reaching 12.5% of project cost at t = 1 while beginning to decrease from 12.5% at t = 7 to 0% at t = 10. The dash line C represents the case of slow mobilization by reaching 12.5% of project cost at t = 3 while beginning to decrease from 12.5% at t = 9 to 0% at t = 10.

The value of work completed at a given time (expressed as a cumulative percentage of project cost) is shown schematically in Figure 5-0. In each case (A, B or C), the value of work completed can be represented by an "S-shaped" curve. The effects of rapid mobilization and slow mobilization are indicated by the positions of curves B and C relative to curve A, respectively.

While the curves shown in Figures 5-0 and 5-0 represent highly idealized cases, they do suggest the latitude for adjusting the schedules for various activities in a project. While the rate of work progress may be changed quite drastically within a single period, such as the change from rapid mobilization to a slow mobilization in periods 1, 2 and 3 in Figure 5-0, the effect on the value of work completed over time will diminish in significance as indicated by the cumulative percentages for later periods in Figure 5-0. Thus, adjustment of the scheduling of some activities may improve the utilization of labor, material and equipment, and any delay caused by such adjustments for individual activities is not likely to cause problems for the eventual progress toward the completion of a project.

In addition to the speed of resource mobilization, another important consideration is the overall duration of a project and the amount of resources applied. Various strategies may be applied to shorten the overall duration of a project such as overlapping design and construction activities (as described in Chapter 2) or increasing the peak amounts of labor and equipment working on a site. However, spatial, managerial and technical factors will typically place a minimum limit on the project duration or cause costs to escalate with shorter durations.

Example 5-16: Calculation of Value of Work Completed

From the area of work progress in Figure 5-0, the value of work completed at any point in Figure 5-0 can be derived by noting the area under the curve up to that point in Figure 5-0. The result for t = 0 through t = 10 is shown in Table 5--2 and plotted in Figure 5-0.

5.12 Estimation of Operating Costs

In order to analyze the life cycle costs of a proposed facility, it is necessary to estimate the operation and maintenance costs over time after the start up of the facility. The stream of operating costs over the life of the facility depends upon subsequent maintenance policies and facility use. In particular, the magnitude of routine maintenance costs will be reduced if the facility undergoes periodic repairs and rehabilitation at periodic intervals.

Since the tradeoff between the capital cost and the operating cost is an essential part of the economic evaluation of a facility, the operating cost is viewed not as a separate entity, but as a part of the larger parcel of life cycle cost at the planning and design stage. The techniques of estimating life cycle costs are similar to those used for estimating capital costs, including empirical cost functions and the unit cost method of estimating the labor, material and equipment costs. However, it is the interaction of the operating and capital costs which deserve special attention.

As suggested earlier in the discussion of the exponential rule for estimating, the value of the cost exponent may influence the decision whether extra capacity should be built to accommodate future growth. Similarly, the economy of scale may also influence the decision on rehabilitation at a given time. As the rehabilitation work becomes extensive, it becomes a capital project with all the implications of its own life cycle. Hence, the cost estimation of a rehabilitation project may also involve capital and operating costs.

While deferring the discussion of the economic evaluation of constructed facilities to Chapter 6, it is sufficient to point out that the stream of operating costs over time represents a series of costs at different time periods which have different values with respect to the present. Consequently, the cost data at different time periods must be converted to a common base line if meaningful comparison is desired.

Example 5-17: Maintenance cost on a roadway[This example is adapted from McNeil, S. and C. Hendrickson, "A Statistical Model of Pavement Maintenance Expenditure," Transportation Research Record No. 846, 1982, pp. 71-76.]

Maintenance costs for constructed roadways tend to increase with both age and use of the facility. As an example, the following empirical model was estimated for maintenance expenditures on sections of the Ohio Turnpike:

     C = 596 + 0.0019 V + 21.7 A

For example, for V = 500,300 ESAL and A = 5 years, the annual cost of routine maintenance per lane-mile is estimated to be:

     C = 596 + (0.0019)(500,300) + (21.7)(5)
       = 596 + 950.5 + 108.5 = 1,655 (in 1967 dollars)

Example 5-18: Time stream of costs over the life of a roadway[This example is adapted from S. McNeil, Three Statistical Models of Road Management Based on Turnpike Data, M.S. Thesis, Carnegie-Mellon University, Pittsburgh, PA, 1981.]

The time stream of costs over the life of a roadway depends upon the intervals at which rehabilitation is carried out. If the rehabilitation strategy and the traffic are known, the time stream of costs can be estimated.

Using a life cycle model which predicts the economic life of highway pavement on the basis of the effects of traffic and other factors, an optimal schedule for rehabilitation can be developed. For example, a time stream of costs and resurfacing projects for one pavement section is shown in Figure 5-0. As described in the previous example, the routine maintenance costs increase as the pavement ages, but decline after each new resurfacing. As the pavement continues to age, resurfacing becomes more frequent until the roadway is completely reconstructed at the end of 35 years.

5.13 References

1. Ahuja, H.N. and W.J. Campbell, Estimating: From Concept to Completion, Prentice-Hall, Inc., Englewood Cliffs, NJ, 1987.
2. Clark, F.D., and A.B. Lorenzoni, Applied Cost Engineering, Marcel Dekker, Inc., New York, 1978.
3. Clark, J.E., Structural Concrete Cost Estimating, McGraw-Hill, Inc., New York, 1983.
4. Diekmann, J.R., "Probabilistic Estimating: Mathematics and Applications," ASCE Journal of Construction Engineering and Management, Vol. 109, 1983, pp. 297-308.
5. Humphreys, K.K. (ed.) Project and Cost Engineers' Handbook (sponsored by American Association of Cost Engineers), 2nd Ed., Marcel Dekker, Inc., New York, 1984.
6. Maevis, A.C., "Construction Cost Control by the Owners," ASCE Journal of the Construction Division, Vol. 106, 1980, pp. 435-446.
7. Wohl, M. and C. Hendrickson, Transportation Investment and Pricing Principles, John Wiley & Sons, New York, 1984.

5.14 Problems

1. Suppose that the grouting method described in Example 5-2 is used to provide a grouting seal beneath another landfill of 12 acres. The grout line is expected to be between 4.5 and 5.5 feet thickness. The voids in the soil layer are between 25% to 35%. Using the same unit cost data (in 1978 dollars), find the range of costs in a screening estimate for the grouting project.
2. To avoid submerging part of U.S. Route 40 south and east of Salt Lake City due to the construction of the Jardinal Dam and Reservoir, 22 miles of highway were relocated to the west around the site of the future reservoir. Three separate contracts were let, including one covering 10 miles of the work which had an engineer's estimate of $ 34,095,545. The bids were submitted on July 21, 1987 and the completion date of the project under the contract was August 15, 1989. (See ENR, October 8, 1987, p. 34). The three lowest bids were:

      !!!1. W.W. Clyde & Co., Springville, Utah                       $ 21,384,919
      !!!2. Sletten Construction company, Great Falls, Montana        $ 26,701,018
      !!!3. Gilbert Western Corporation, Salt Lake city, Utah         $ 30,896,203
      

   Find the percentage of each of these bidders below the engineer's cost estimate.
3. In making a screening estimate of an industrial plant for the production of batteries, an empirical formula based on data of a similar buildings completed before 1987 was proposed:

            C = (16,000)(Q + 50,000)@+(1/2)
   
      

   where Q is the daily production capacity of batteries and C is the cost of the building in 1987 dollars. If a similar plant is planned for a daily production capacity of 200,000 batteries, find the screening estimate of the building in 1987 dollars.
4. For the cost factor K = $ 46,000 (in 1968 dollars) and m = 0.67 for an aerated lagoon basin of a water treatment plant in Table 5--1 (Example 5-6), find the estimated cost of a proposed new plant with a similar treatment process having a capacity of 480 million gallons (in 1968 dollars). If another new plant was estimated to cost $ 160,000 by using the same exponential rule, what would be the proposed capacity of that plant?
5. Using the cost data in Figure 5-0 (Example 5-11), find the total cost including overhead and profit of excavating 90,000 cu.yd. of bulk material using a backhoe of 1.5 cu.yd. capacity for a detailed estimate. Assume that the excavated material will be loaded onto trucks for disposal.
6. The basic costs (labor, material and equipment) for various elements of a construction project are given as follows:

      !!!Excavation!!!$ 240,000
      !!!Subgrade!!!$ 100,000
      !!!Base course!!!$ 420,000
      !!!Concrete pavement!!!$ 640,000
      !!!Total!!!$ 1,400,000
      

   Assuming that field supervision cost is 10% of the basic cost, and the general office overhead is 5% of the direct costs (sum of the basic costs and field supervision cost), find the prorated field supervision costs, general office overhead costs and total costs for the various elements of the project.
7. In making a preliminary estimate of a chemical processing plant, several major types of equipment are the most significant components in affecting the installation cost. The cost of piping and other ancillary items for each type of equipment can often be expressed as a percentage of that type of equipment for a given capacity. The standard costs for the major equipment types for two plants with different daily production capacities are as shown in Table P5-7. It has been established that the installation cost of all equipment for a plant with daily production capacity between 150,000 bbl and 600,000 bbl can best be estimated by using liner interpolation of the standard data. A new chemical processing plant with a daily production capacity of 400,000 bbl is being planned. Assuming that all other factors remain the same, estimate the cost of the new plant.
8. The total construction cost of a refinery with a production capacity of 100,000 bbl/day in Caracas, Venezuela, completed in 1977 was $40 million. It was proposed that a similar refinery with a production capacity of $160,000 bbl/day be built in New Orleans, LA for completion in 1980. For the additional information given below, make a screening estimate of the cost of the proposed plant.
   1. In the total construction cost for the Caracus, Venezuela plant, there was an item of $2 million for site preparation and travel which is not typical for similar plants.
   2. The variation of sizes of the refineries can be approximated by the exponential law with m = 0.6.
   3. The inflation rate in U.S. dollars was approximately 9% per year from 1977 to 1980.
   4. An adjustment factor of 1.40 was suggested for the project to account for the increase of labor cost from Caracas, Venezuela to New Orleans, LA.
   5. New air pollution equipment for the New Orleans, LA plant cost $4 million in 1980 dollars (not required for the Caracas plant).
   6. The site condition at New Orleans required special piling foundation which cost $2 million in 1980 dollars.
9. The total cost of a sewage treatment plant with a capacity of 50 million gallons per day completed 1981 for a new town in Colorado was $4.5 million. It was proposed that a similar treatment plant with a capacity of 80 million gallons per day be built in another town in New Jersey for completion in 1985. For additional information given below, make a screening estimate of the cost of the proposed plant.
   1. In the total construction cost in Colorado, an item of $300,000 for site preparation is not typical for similar plants.
   2. The variation of sizes for this type of treatment plants can be approximated by the exponential law with m = 0.5.
   3. The inflation rate was approximately 5% per year from 1981 to 1985.
   4. The locational indices of Colorado and New Jersey areas are 0.95 and 1.10, respectively, against the national average of 1.00.
   5. The installation of a special equipment to satisfy the new environmental standard cost an extra $200,000 in 1985 dollar for the New Jersey plant.
   6. The site condition in New Jersey required special foundation which cost $500,00 in 1985 dollars.
10. Using the ENR building cost index, estimate the 1985 cost of the grouting seal on a landfill described in Example 5-2, including the most likely estimate and the range of possible cost.
11. Using the unit prices in the bid of contractor 2 for the quantitites specified by the engineer in Table 5-2 (Example 5-3), compute the total bid price of contractor 2 for the roadway project including the expenditure on each item of work.
12. The rate of work progress in percent of completion per period of a construction project is shown in Figure P5-12 in which 13 time periods have been assumed. The cases A, B and C represent the normal mobilization time, rapid mobilization and slow mobilization for the project, respectively. Calculate the value of work completed in cumulative percentage for periods 1 through 13 for each of the cases A, B and C. Also plot the volume of work completed versus time for these cases.
13. The rate of work progress in percent of completion per period of a construction project is shown in Figure P5-13 in which 10 time periods have been assumed. The cases A, B and C represent the normal mobilization time, rapid mobilization and slow mobilization for the project, respectively. Calculate the value of work completed in cumulative percentage for periods 1 through 10 for each of the cases A, B and C. Also plot the volume of work completed versus time for these cases.
14. Suppose that the empirical model for estimating annual cost of routine maintenance in Example 5-17 is applicable to sections of the Pennsylvania Turnpike in 1985 if the ENR building cost index is applied to inflate the 1967 dollars. Estimate the annual cost of maintenance per lane-mile of the tunrpike for which the traffic volume on the roadway is 750,000 ESAL and the age of the pavement is 4 years in 1985.
15. The initial construction cost for a electric rower line is known to be a function of the cross-sectional area A (in cm@+[2]) and the length L (in kilometers). Let C@-[1] be the unit cost of construction (in dollars per cm@+[3]). Then, the initial construction cost P (in dollars) is given by

    P = C@-[1] AL (10@+[5])

    The annual operating cost of the power line is assumed to be measured by the power loss. The power loss S (in kwh) is known to be

    J@+[2]R L (10@+[5]) J@+[2]RL S = [ ] [ ] = (10@+[2])--------- ----------- -------- (10@+[3]) A A

    where J is the electric current in amperes, R is the resistivity in ohm-centimeters. Let C@-[2] be the unit operating cost (in dollars per kwh). Then, the annual operating cost U (in dollars) is given by

    J@+[2]RL U = C@-[2] (10@+[2])-------- A

    Suppose that the power line is expected to last n years and the life cycle cost T of the power line is equal to:

              T = P + UK
    
       

    where K is a discount factor depending on the useful life cycle n and the discount rate i (to be explained in Chapter 6). In designing the power line, all quantitites are assumed to be known except A which is to be determined. If the owner wants to minimize the life cycle cost, find the best cross-sectional area A in terms of the known quantities.

6. Economic Evaluation of Facility Investments

6.1 Project Life Cycle and Economic Feasibility

Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. In the public sector, such decisions also affect the viability of facility investment programs and the credibility of the agency in charge of the programs. It is important to evaluate facilities rationally with regard to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects.

This chapter will present an overview of the decision process for economic evaluation of facilities with regard to the project life cycle. The cycle begins with the initial conception of the project and continues though planning, design, procurement, construction, start-up, operation and maintenance. It ends with the disposal of a facility when it is no longer productive or useful. Four major aspects of economic evaluation will be examined:

1. The basic concepts of facility investment evaluation, including time preference for consumption, opportunity cost, minimum attractive rate of return, cash flows over the planning horizon and profit measures.
2. Methods of economic evaluation, including the net present value method, the equivalent uniform annual value method, the benefit-cost ratio method, and the internal rate of return method.
3. Factors affecting cash flows, including depreciation and tax effects, price level changes, and treatment of risk and uncertainty.
4. Effects of different methods of financing on the selection of projects, including types of financing and risk, public policies on regulation and subsidies, the effects of project financial planning, and the interaction between operational and financial planning.

It is important to distinguish between the economic evaluation of alternative physical facilities and the evaluation of alternative financing plans for a project. The former refers to the evaluation of the cash flow representing the benefits and costs associated with the acquisition and operation of the facility, and this cash flow over the planning horizon is referred to as the economic cash flow or the operating cash flow. The latter refers to the evaluation of the cash flow representing the incomes and expenditures as a result of adopting a specific financing plan for funding the project, and this cash flow over the planning horizon is referred to as the financial cash flow. In general, economic evaluation and financial evaluation are carried out by different groups in an organization since economic evaluation is related to design, construction, operations and maintenance of the facility while financial evaluations require knowledge of financial assets such as equities, bonds, notes and mortgages. The separation of economic evaluation and financial evaluation does not necessarily mean one should ignore the interaction of different designs and financing requirements over time which may influence the relative desirability of specific design/financing combinations. All such combinations can be duly considered. In practice, however, the division of labor among two groups of specialists generally leads to sequential decisions without adequate communication for analyzing the interaction of various design/financing combinations because of the timing of separate analyses.

As long as the significance of the interaction of design/financing combinations is understood, it is convenient first to consider the economic evaluation and financial evaluation separately, and then combine the results of both evaluations to reach a final conclusion. Consequently, this chapter is devoted primarily to the economic evaluation of alternative physical facilities while the effects of a variety of financing mechanisms will be treated in the next chapter. Since the methods of analyzing economic cash flows are equally applicable to the analysis of financial cash flows, the techniques for evaluating financing plans and the combined effects of economic and financial cash flows for project selection are also included in this chapter.

6.2 Basic Concepts of Economic Evaluation

A systematic approach for economic evaluation of facilities consists of the following major steps:

1. Generate a set of projects or purchases for investment consideration.
2. Establish the planning horizon for economic analysis.
3. Estimate the cash flow profile for each project.
4. Specify the minimum attractive rate of return (MARR).
5. Establish the criterion for accepting or rejecting a proposal, or for selecting the best among a group of mutually exclusive proposals, on the basis of the objective of the investment.
6. Perform sensitivity or uncertainty analysis.
7. Accept or reject a proposal on the basis of the established criterion.

The period of time to which the management of a firm or agency wishes to look ahead is referred to as the planning horizon. Since the future is uncertain, the period of time selected is limited by the ability to forecast with some degree of accuracy. For capital investment, the selection of the planning horizon is often influenced by the useful life of facilities, since the disposal of usable assets, once acquired, generally involves suffering financial losses.

In economic evaluations, project alternatives are represented by their cash flow profiles over the n years or periods in the planning horizon. Thus, the interest periods are normally assumed to be in years t = 0,1,2, ..., n with t = 0 representing the present time. Let B@-(t,x) be the annual benefit at the end of year t for a investment project x where x = 1, 2, ... refer to projects No. 1, No. 2, etc., respectively. Let C@-(t,x) be the annual cost at the end of year t for the same investment project x. The net annual cash flow is defined as the annual benefit in excess of the annual cost, and is denoted by A@-(t,x) at the end of year t for an investment project x. Then, for t = 0,1, . . . ,n:

        A@-(t,x) = B@-(t,x)- C@-(t,x)
 

Once the management has committed funds to a specific project, it must forego other investment opportunities which might have been undertaken by using the same funds. The opportunity cost reflects the return that can be earned from the best alternative investment opportunity foregone. The foregone opportunities may include not only capital projects but also financial investments or other socially desirable programs. Management should invest in a proposed project only if it will yield a return at least equal to the minimum attractive rate of return (MARR) from foregone opportunities as envisioned by the organization.

In general, the MARR specified by the top management in a private firm reflects the opportunity cost of capital of the firm, the market interest rates for lending and borrowing, and the risks associated with investment opportunities. For public projects, the MARR is specified by a government agency, such as the Office of Management and Budget or the Congress of the United States. The public MARR thus specified reflects social and economic welfare considerations, and is referred to as the social rate of discount.

Regardless of how the MARR is determined by an organization, the MARR specified for the economic evaluation of investment proposals is critically important in determining whether any investment proposal is worthwhile from the standpoint of the organization. Since the MARR of an organization often cannot be determined accurately, it is advisable to use several values of the MARR to assess the sensitivity of the potential of the project to variations of the MARR value.

6.3 Costs and Benefits of a Constructed Facility

The basic principle in assessing the economic costs and benefits of new facility investments is to find the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The changes in welfare are generally measured in monetary terms, but there are exceptions, since some effects cannot be measured directly by cash receipts and disbursements. Examples include the value of human lives saved through safety improvements or the cost of environmental degradation. The difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds and expenditures related to financial transactions, such as interest and subsidies, must also be considered by private firms and by public agencies.

To obtain an accurate estimate of costs in the cash flow profile for the acquisition and operation of a project, it is necessary to specify the resources required to construct and operate the proposed physical facility, given the available technology and operating policy. Typically, each of the labor and material resources required by the facility is multiplied by its price, and the products are then summed to obtain the total costs. Private corporations generally ignore external social costs unless required by law to do so. In the public sector, externalities often must be properly accounted for. An example is the cost of property damage caused by air pollution from a new plant. In any case, the measurement of external costs is extremely difficult and somewhat subjective for lack of a market mechanism to provide even approximate answers to the appropriate value.

In the private sector, the benefits derived from a facility investment are often measured by the revenues generated from the operation of the facility. Revenues are estimated by the total of price times quantity purchased. The depreciation allowances and taxes on revenues must be deducted according to the prevailing tax laws. In the public sector, income may also be accrued to a public agency from the operation of the facility. However, several other categories of benefits may also be included in the evaluation of public projects. First, private benefits can be received by users of a facility or service in excess of costs such as user charges or price charged. After all, individuals only use a service or facility if their private benefit exceeds their cost. These private benefits or consumer surplus represent a direct benefit to members of the public. In many public projects, it is difficult, impossible or impractical to charge for services received, so direct revenues equal zero and all user benefits appear as consumers surplus. Examples are a park or roadways for which entrance is free. As a second special category of public benefit, there may be external or secondary beneficiaries of public projects, such as new jobs created and profits to private suppliers. Estimating these secondary benefits is extremely difficult since resources devoted to public projects might simply be displaced from private employment and thus represent no net benefit.

6.4 Interest Rates and the Costs of Capital

Constructed facilities are inherently long-term investments with a deferred pay-off. The cost of capital or MARR depends on the real interest rate (i.e., market interest rate less the inflation rate) over the period of investment. As the cost of capital rises, it becomes less and less attractive to invest in a large facility because of the opportunities foregone over a long period of time.

In Figure 6-0, the changes in the cost of capital from 1955 to 1985 are illustrated. This figure presents the market interest rate on a 20-year treasury bond, and the corresponding real interest rate over this period. The real interest rate is calculated as the market interest rate less the general rate of inflation. During the last decade in this figure, the real interest rate has varied substantially, ranging from 10% to -4%. The exceptional nature of the 1980 to 1985 years is dramatically evident: the real rate of interest reached remarkably high historic levels.

With these volatile interest rates, interest charges and the ultimate cost of projects are uncertain. Organizations and institutional arrangements capable of dealing with this uncertainty and able to respond to interest rate changes effectively would be quite valuable. For example, banks offer both fixed rate and variable rate mortgages. An owner who wants to limit its own risk may choose to take a fixed rate mortgage even though the ultimate interest charges may be higher. On the other hand, an owner who chooses a variable rate mortgage will have to adjust its annual interest charges according to the market interest rates.

In economic evaluation, a constant value of MARR over the planning horizon is often used to simplify the calculations. The use of a constant value for MARR is justified on the ground of long-term average of the cost of capital over the period of investment. If the benefits and costs over time are expressed in constant dollars, the constant value for MARR represents the average real interest rate anticipated over the planning horizon; if the benefits and costs over time are expressed in then-current dollars, the constant value for MARR reflects the average market interest rate anticipated over the planning horizon.

6.5 Investment Profit Measures

A profit measure is defined as an indicator of the desirability of a project from the standpoint of a decision maker. A profit measure may or may not be used as the basis for project selection. Since various profit measures are used by decision makers for different purposes, the advantages and restrictions for using these profit measures should be fully understood.

There are several profit measures that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for the restrictive purposes for which they are appropriate. With the availability of computer based analysis and commercial software, it takes only a few seconds to compute these profit measures. However, it is important to define these measures precisely:

1. Net Future Value and Net Present Value. When an organization makes an investment, the decision maker looks forward to the gain over a planning horizon, against what might be gained if the money were invested elsewhere. A minimum attractive rate of return (MARR) is adopted to reflect this opportunity cost of capital. The MARR is used for compounding the estimated cash flows to the end of the planning horizon, or for discounting the cash flow to the present. The profitability is measured by the net future value (NFV) which is the net return at the end of the planning horizon above what might have been gained by investing elsewhere at the MARR. The net present value (NPV) of the estimated cash flows over the planning horizon is the discounted value of the NFV to the present. A positive NPV for a project indicates the present value of the net gain corresponding to the project cash flows.

2. Equivalent Uniform Annual Net Value. The equivalent uniform annual net value (NUV) is a constant stream of benefits less costs at equally spaced time periods over the intended planning horizon of a project. This value can be calculated as the net present value multiplied by an appropriate "capital recovery factor." It is a measure of the net return of a project on an annualized or amortized basis. The equivalent uniform annual cost (EUAC) can be obtained by multiplying the present value of costs by an appropriate capital recovery factor. The use of EUAC alone presupposes that the discounted benefits of all potential projects over the planning horizon are identical and therefore only the discounted costs of various projects need be considered. Therefore, the EUAC is an indicator of the negative attribute of a project which should be minimized.

3. Benefit Cost Ratio. The benefit-cost ratio (BCR), defined as the ratio of discounted benefits to the discounted costs at the same point in time, is a profitability index based on discounted benefits per unit of discounted costs of a project. It is sometimes referred to as the savings-to-investment ratio (SIR) when the benefits are derived from the reduction of undesirable effects. Its use also requires the choice of a planning horizon and a MARR. Since some savings may be interpreted as a negative cost to be deducted from the denominator or as a positive benefit to be added to the numerator of the ratio, the BCR or SIR is not an absolute numerical measure. However, if the ratio of the present value of benefit to the present value of cost exceeds one, the project is profitable irrespective of different interpretations of such benefits or costs.

4. Internal Rate of Return. The internal rate of return (IRR) is defined as the discount rate which sets the net present value of a series of cash flows over the planning horizon equal to zero. It is used as a profit measure since it has been identified as the "marginal efficiency of capital" or the "rate of return over cost". The IRR gives the return of an investment when the capital is in use as if the investment consists of a single outlay at the beginning and generates a stream of net benefits afterwards. However, the IRR does not take into consideration the reinvestment opportunities related to the timing and intensity of the outlays and returns at the intermediate points over the planning horizon. For cash flows with two or more sign reversals of the cash flows in any period, there may exist multiple values of IRR; in such cases, the multiple values are subject to various interpretations.

5. Adjusted Internal Rate of Return. If the financing and reinvestment policies are incorporated into the evaluation of a project, an adjusted internal rate of return (AIRR) which reflects such policies may be a useful indicator of profitability under restricted circumstances. Because of the complexity of financing and reinvestment policies used by an organization over the life of a project, the AIRR seldom can reflect the reality of actual cash flows. However, it offers an approximate value of the yield on an investment for which two or more sign reversals in the cash flows would result in multiple values of IRR. The adjusted internal rate of return is usually calculated as the internal rate of return on the project cash flow modified so that all costs are discounted to the present and all benefits are compounded to the end of the planning horizon.

6. Return on Investment. When an accountant reports income in each year of a multi-year project, the stream of cash flows must be broken up into annual rates of return for those years. The return on investment (ROI) as used by accountants usually means the accountant's rate of return for each year of the project duration based on the ratio of the income (revenue less depreciation) for each year and the undepreciated asset value (investment) for that same year. Hence, the ROI is different from year to year, with a very low value at the early years and a high value in the later years of the project.

7. Payback Period. The payback period (PBP) refers to the length of time within which the benefits received from an investment can repay the costs incurred during the time in question while ignoring the remaining time periods in the planning horizon. Even the discounted payback period indicating the "capital recovery period" does not reflect the magnitude or direction of the cash flows in the remaining periods. However, if a project is found to be profitable by other measures, the payback period can be used as a secondary measure of the financing requirements for a project.

6.6 Methods of Economic Evaluation

The objective of facility investment in the private sector is generally understood to be profit maximization within a specific time frame. Similarly, the objective in the public sector is the maximization of net social benefit which is analogous to profit maximization in private organizations. Given this objective, a method of economic analysis will be judged by the reliability and ease with which a correct conclusion may be reached in project selection.

The basic principle underlying the decision for accepting and selecting investment projects is that if an organization can lend or borrow as much money as it wishes at the MARR, the goal of profit maximization is best served by accepting all independent projects whose net present values based on the specified MARR are nonnegative, or by selecting the project with the maximum nonnegative net present value among a set of mutually exclusive proposals. The net present value criterion reflects this principle and is most straightforward and unambiguous when there is no budget constraint. Various methods of economic evaluation, when properly applied, will produce the same result if the net present value criterion is used as the basis for decision. For convenience of computation, a set of tables for the various compound interest factors is given in Appendix A.

Net Present Value Method

Let BPV@-(x) be the present value of benefits of a project x and CPV@-(x) be the present value of costs of the project x. Then, for MARR = i over a planning horizon of n years,

   BPV@-(x)   =   
from "t=0",to "n"
  
     B@-(t,x)(1+i)@+{-t}   =   
from"t=0",to"n"
  
    B@-(t,x)(P |  F,i,t)
   CPV@-(x)   =   
from "t=0",to "n"
  
    C@-(t,x)(1+i)@+[-t]   =   
from "t=0",to "n"
  
     C@-(t,x)(P| F,i,t)

 

   NPV@-(x)   =   BPV@-(x)   -   CPV@-(x)


 

   NPV@-(x)   =   
from "t=0",to "n"
  
     (B@-(t,x)-C@-(t,x))(P| F,i,t)   =   
from "t=0",to "n"
  
     A@-(t,x)(P| F,i,t)

If there is no budget constraint, then all independent projects having net present values greater than or equal to zero are acceptable. That is, project x is acceptable as long as

        NPV@-(x) > 0

 

        NPV@-(j) = Max@-[x I m]{ NPV@-(x) }

 

Net Future Value Method

Since the cash flow profile of an investment can be represented by its equivalent value at any specified reference point in time, the net future value (NFV@-[x]) of a series of cash flows A@-(t,x) (for t=0,1,2,...,n) for project x is as good a measure of economic potential as the net present value. Equivalent future values are obtained by multiplying a present value by the compound interest factor (F|P,i,n) which is (1+i)@+[n]. Specifically,

     NFV@-(x) = NPV@-(x) (1 + i)@+(n) = NPV@-(x)(F|P,i,n)
Bid Price of Contractor 1 in a Highway Project
  

   
!!!!!!!!!Unit!!!Item
Items!!!Unit!!!Qty.!!!Price!!!Cost

Mobilization.!!!ls!!!1!!!115,000!!!115,000..
Removal, berm.!!!lf!!!8,020!!!1.00!!!8,020..
Finish subgrade.!!!sy!!!1,207,500!!!0.50!!!603,750..
Surface ditches.!!!lf!!!525!!!2.00!!!1,050..
Excavation structures.!!!cy!!!7,000!!!3.00!!!21,000.
Base course, untreated, 3/4".!!!ton!!!362,200!!!4.50!!!1,629,900..!!!ton!!!362
Lean concrete, 4" thick.!!!sy!!!820,310!!!3.10!!!2,542,961..!!!sy!!!820,310!
PCC, pavement, 10" thick.!!!sy!!!706,010!!!10.90!!!7,695,509..!!!sy!!!706,010!
Concrete, ci AA(AE).!!!ls!!!1!!!200,000!!!200,000..!
Small structure.!!!cy!!!50!!!500!!!25,000.
Barrier, precast.!!!lf!!!7,920!!!15.00!!!118,800..
Flatwork, 4" thick.!!!sy!!!7,410!!!10.00!!!74,100.
10" thick.!!!sy!!!4,241!!!20.00!!!84,820..
Slope protection.!!!sy!!!2,104!!!25.00!!!52,600..!
Metal, end section, 15".!!!ea!!!39!!!100!!!3,900..!!
18".!!!ea!!!3!!!150!!!450..!!!ea!
Post, right-of-way, modification.!!!lf!!!4,700!!!3.00!!!14,100..!!!lf!!!4,70
Salvage & relay pipe.!!!lf!!!1,680!!!5.00!!!8,400..!
Loose riprap.!!!cy!!!32!!!40.00!!!1,280..!!!
Braced posts.!!!ea!!!54!!!100!!!5,400..!!!ea
Delineators, type I.!!!lb!!!1,330!!!12.00!!!15,960..
type II.!!!ea!!!140!!!15.00!!!2,100..!!!ea
Constructive signs fixed.!!!sf!!!52,600!!!0.10!!!5,260..!!!sf!!!52,600!!!0.10!
Barricades, type III.!!!lf!!!29,500!!!0.20!!!5,900..!!!lf!!!29,500!!!0.20!!!
Warning lights.!!!day!!!6,300!!!0.10!!!630..
Pavement marking, epoxy material, black.!!!gal!!!475!!!90.00!!!42,750..!!!gal!
Yellow.!!!gal!!!740!!!90.00!!!66,600..!!!g
White.!!!gal!!!985!!!90.00!!!88,650..!!!ga
Plowable, one way white.!!!ea!!!342!!!50.00!!!17,100..!!!ea!!!342!!!50.00!!!
Topsoil, contractor furnished.!!!cy!!!260!!!10.00!!!2,600..!!!cy!!!260!!!10.00
Seedling, method A.!!!acr!!!103!!!150!!!15,450..!!!a
Excelsior blanket.!!!sy!!!500!!!2.00!!!1,000..!!!sy!
Bid Price of Contractor 1 in a Highway Project (Continued)
  

  
!!!!!!!!!Unit!!!Item
Items!!!Unit!!!Qty.!!!Price!!!Cost

Corrugated, metal pipe, 18".!!!lf!!!580!!!20.00!!!11,600..!!!lf!!!580!!!20.00!
Polyethylene pipe, 12".!!!lf!!!2,250!!!15.00!!!33,750..!!!lf!!!2,250!!!15.00
Catch basin grate & frame.!!!ea!!!35!!!350!!!12,250.
Equal opportunity training.!!!hr!!!18,000!!!0.80!!!14,400..!!!hr!!!18,000!!!0.
Granular backfill borrow.!!!cy!!!274!!!10.00!!!2,740..!!!cy!!!274!!!10.00!!!2,
Drill caisson, 2' x 6".!!!lf!!!722!!!100!!!72,200..!
Flagging.!!!hr!!!20,000!!!8.25!!!165,000..!!
Prestressed concrete member
type IV, 141' x 4".!!!ea!!!7!!!12,000!!!84,000..!!
132' x 4".!!!ea!!!6!!!11,000!!!66,000..!!!
Reinforced steel.!!!lb!!!6,300!!!0.60!!!3,780..!!!lb
Epoxy coated.!!!lb!!!122,241!!!0.55!!!67,232.55.!!
Structural steel.!!!ls!!!1!!!5,000!!!5,000..
Sign, covering.!!!sf!!!16!!!10.00!!!160..!!!
type C-2, wood post.!!!sf!!!98!!!15.00!!!1,470.00.
24".!!!ea!!!3!!!100!!!300..!!!ea!
30".!!!ea!!!2!!!100!!!200..!!!ea!
48".!!!ea!!!11!!!200!!!2,200..!!!
Auxiliary.!!!sf!!!61!!!15.00!!!915..!!!sf!
Steel post, 48" x 60".!!!ea!!!11!!!500!!!5,500..!!
type 3, wood post.!!!sf!!!669!!!15.00!!!10,035..!!
24".!!!ea!!!23!!!100!!!2,300..!!!
30".!!!ea!!!1!!!100!!!100..!!!ea!
36".!!!ea!!!12!!!150!!!1,800..!!!
42" x 60".!!!ea!!!8!!!150!!!1,200..!!!ea!!
48".!!!ea!!!7!!!200!!!1,400..!!!e
Auxiliary.!!!sf!!!135!!!15.00!!!2,025..!!!
Steel post.!!!sf!!!1,610!!!40.00!!!64,400.
12" x 36".!!!ea!!!28!!!100!!!2,800..!!!ea!
Foundation, concrete.!!!ea!!!60!!!300!!!18,000..!!
Barricade, 48" x 42".!!!ea!!!40!!!100!!!4,000..!!!ea
Wood post, road closed.!!!lf!!!100!!!30.00!!!3,000..!!!lf!!!100!!!30.00!!!3,


Total.!!!$ 14,129,797.55.!!!$ 14,129,797.55.!!!$

Rate of Work Progress over Project Time
  


Value of Work Completed over Project Time
  



Calculation of Value of Work Completed
  

  

  
!!!Time!!!Case A!!!Case B!!!Case C

!!!0!!!0!!!0!!!0
!!!1!!!3.1%!!!6.2%!!!2.1%
!!!2!!!12.5%!!!18.7%!!!8.3%
!!!3!!!25.0%!!!31.2%!!!18.8%
!!!4!!!37.5%!!!43.7%!!!31.3%
!!!5!!!50.0%!!!56.2%!!!43.8%
!!!6!!!62.5%!!!68.7%!!!56.3%
!!!7!!!75.0%!!!81.2%!!!68.8%
!!!8!!!87.5%!!!91.7%!!!81.9%
!!!9!!!96.9%!!!97.9%!!!93.8%
!!!10!!!100.0%!!!100.0%!!!100.0%



Time Stream of Costs over the Life of a Highway Pavement
  

   

   
   Table P5-7
   

   Equipment!!!Equipment Cost ($1000)!!!Factor for Ancillary Items
   Type!!!150,000 bbl!!!600,000 bbl!!!150,000 bbl!!!600,000 bbl
   Furnace!!!3,000!!!10,000!!!0.32!!!0.24
   Tower!!!2,000!!!  6,000!!!0.42!!!0.36
   Drum!!!1,500!!!  5,000!!!0.42!!!0.32
   Pumps, etc.!!!1,000!!!  4,000!!!0.54!!!0.42
   


   
   Figure P5-12
   

   
   Figure P5-13
   

Nominal and Real Interest Rates on U.S. Bonds, 1955-1985
  


 

Net Equivalent Uniform Annual Value Method

The net equivalent uniform annual value (NUV@-[x]) refers to a uniform series over a planning horizon of n years whose net present value is that of a series of cash flow A@-(t,x) (for t= 1,2,...,n) representing project x. That is,

    NUV@-(x)##=##NPV@-(x)##  
Num "i(1+i)@+<n>", Denom "(1+i)@+<n>-1"
  
  ## =##NPV@-(x) (U |  P,i,n)

 

Benefit-Cost Ratio Method

The benefit-cost ratio method is not as straightforward and unambiguous as the net present value method but, if applied correctly, will produce the same results as the net present value method. While this method is often used in the evaluation of public projects, the results may be misleading if proper care is not exercised in its application to mutually exclusive proposals.

The benefit-cost ratio is defined as the ratio of the discounted benefits to the discounted cost at the same point in time. In view of Eqs. (6.6.6) and (6.6.6), it follows that the criterion for accepting an independent project on the basis of the benefit-cost ratio is whether or not the benefit-cost ratio is greater than or equal to one:

num "BPV@-(x)",denom "CPV@-(x)"
  
         >   1

 

Internal Rate of Return Method

The term internal rate of return method has been used by different analysts to mean somewhat different procedures for economic evaluation. The method is often misunderstood and misused, and its popularity among analysts in the private sector is undeserved even when the method is defined and interpreted in the most favorable light. The method is usually applied by comparing the MARR to the internal rate of return value(s) for a project or a set of projects.

A major difficulty in applying the internal rate of return method to economic evaluation is the possible existence of multiple values of IRR when there are two or more changes of sign in the cash flow profile A@-(t,x) (for t=0,1,2,...,n). When that happens, the method is generally not applicable either in determining the acceptance of independent projects or for selection of the best among a group of mutually exclusive proposals unless a set of well defined decision rules are introduced for incremental analysis. In any case, no advantage is gained by using this method since the procedure is cumbersome even if the method is correctly applied. This method is not recommended for use either in accepting independent projects or in selecting the best among mutually exclusive proposals.

Example 6-1: Evaluation of Four Independent Projects

The cash flow profiles of four independent projects are shown in Table 6-0. Using a MARR of 20%, determine the acceptability of each of the projects on the basis of the net present value criterion for accepting independent projects.

Cash Flow Profiles of Four Independent Projects (in $ million)
  

t!!!A@-(t,1)!!!A@-(t,2)!!!A@-(t,3)!!!A@-(t,4)

0!!!-77.0!!!-75.3!!!-39.9!!!18.0

1!!!0!!!28.0!!!28.0!!!10.0

2!!!0!!!28.0!!!28.0!!!-40.0

3!!!0!!!28.0!!!28.0!!!-60.0

4!!!0!!!28.0!!!28.0!!!30.0

5!!!235.0!!!28.0!!!-80.0!!!50.0

Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. (6.5). Then, the acceptability of each project can be determined from Eq. (6.6). Thus,

      [NPV@-(1)]@-(20%) = -77 + (235)(P
 | F, 20%, 5) = -77 + 94.4 = 17.4
      [NPV@-(2)]@-(20%) = -75.3 + (28)(P
 | U, 20%, 5) = -75.3 + 83.7 = 8.4
      [NPV@-(3)]@-(20%) = -39.9 + (28)(P
 | U, 20%, 4) - (80)(P | F, 20%, 5)
                        = -39.9 + 72.5 - 32.2 = 0.4
      [NPV@-(4)]@-(20%) = 18 + (10)(P
 | F, 20%, 1) - (40)(P
 | F, 20%, 2) - (60)(P | F, 20%, 3) +
                             (30)(P
 | F, 20%, 4) + (50)(P | F, 20%, 5)
                        = 18 + 8.3 - 27.8
 - 34.7 + 14.5 + 20.1 = -1.6

It is interesting to note that if the four projects are mutually exclusive, the net present value method can still be used to evaluate the projects and, according to Eq. (6.7), the project (x = 1) which has the highest positive NPV should be selected. The use of the net equivalent uniform annual value or the net future value method will lead to the same conclusion. However, the project with the highest benefit-cost ratio is not necessarily the best choice among a group of mutually exclusive alternatives. Furthermore, the conventional internal rate of return method cannot be used to make a meaningful evaluation of these projects as the IRR for both x=1 and x=2 are found to be 25% while multiple values of IRR exist for both the x=3 and x=4 alternatives.

6.7 Depreciation and Tax Effects

For private corporations, the cash flow profile of a project is affected by the amount of taxation. In the context of tax liability, depreciation is the amount allowed as a deduction due to capital expenses in computing taxable income and, hence, income tax in any year. Thus, depreciation results in a reduction in tax liabilities.

It is important to differentiate between the estimated useful life used in depreciation computations and the actual useful life of a facility. The former is often an arbitrary length of time, specified in the regulations of the U.S. Internal Revenue Service or a comparable organization. The depreciation allowance is a bookkeeping entry that does not involve an outlay of cash, but represents a systematic allocation of the cost of a physical facility over time.

There are various methods of computing depreciation which are acceptable to the U.S. Internal Revenue Service. The different methods of computing depreciation have different effects on the streams of annual depreciation charges, and hence on the stream of taxable income and taxes paid. Let P be the cost of an asset, S its estimated salvage value, and N the estimated useful life (depreciable life) in years. Furthermore, let D@-(t) denote the depreciation amount in year t, T@-(t) denote the accumulated depreciation up to year t, and B@-(t) denote the book value of the asset at the end of year t, where t=1,2,..., or n refers to the particular year under consideration. Then,

           T@-(t) = D@-(1) + D@-(2) + ... + D@-(t)
and
  
           B@-(t) = P - T@-(t) = B@-(t-1) - D@-(t)

The depreciation methods most commonly used to compute D@-(t) and B@-(t) are the straight line method, sum-of-the-years'-digits methods, and the double declining balanced method. The U.S. Internal Revenue Service provides tables of acceptable depreciable schedules using these methods. Under straight line depreciation, the net depreciable value resulting from the cost of the facility less salvage value is allocated uniformly to each year of the estimated useful life. Under the sum-of-the-year's-digits (SOYD) method, the annual depreciation allowance is obtained by multiplying the net depreciable value multiplied by a fraction, which has as its numerator the number of years of remaining useful life and its denominator the sum of all the digits from 1 to n. The annual depreciation allowance under the double declining balance method is obtained by multiplying the book value of the previous year by a constant depreciation rate 2/n.

To consider tax effects in project evaluation, the most direct approach is to estimate the after-tax cash flow and then apply an evaluation method such as the net present value method. Since projects are often financed by internal funds representing the overall equity-debt mix of the entire corporation, the deductibility of interest on debt may be considered on a corporate-wide basis. For specific project financing from internal funds, let after-tax cash flow in year t be Y@-(t). Then, for t=0,1,2,...,n,

          Y@-(t) = A@-(t) - X@-(t)(A@-(t)-D@-(t))

 

Besides corporate income taxes, there are other provisions in the federal income tax laws that affect facility investments, such as tax credits for low-income housing. Since the tax laws are revised periodically, the estimation of tax liability in the future can only be approximate.

Example 6-2: Effects of Taxes on Investment

A company plans to invest $55,000 in a piece of equipment which is expected to produce a uniform annual net revenue before tax of $15,000 over the next five years. The equipment has a salvage value of $5,000 at the end of 5 years and the depreciation allowance is computed on the basis of the straight line depreciation method. The marginal income tax rate for this company is 34%, and there is no expectation of inflation. If the after-tax MARR specified by the company is 8%, determine whether the proposed investment is worthwhile, assuming that the investment will be financed by internal funds.

Using Equations (6.6.7) and (6.6.7), the after-tax cash flow can be computed as shown in Table 6-0. Then, the net present value discounted at 8% is obtained from Equation (6.6.6) as follows:

     [NPV]@-(8%)  # =  # -55,000## +##
 
from"t=1",to"5"
  
   ####(13,300 )(P
 |  F, 8%, t)  ### + (5,000)
 (P |  F, 8%, 5)  # =  # $1,510

 

The positive result indicates that the project is worthwhile.

After-Tax Cash Flow Computation
  

Year !!!Before-tax!!!Straight-line!!!

Taxable!!!Income!!!After-Tax

t !!!Cash Flow!!!Depreciation!!!

Income!!!Tax!!!Cash-Flow

!!! A@-(t)!!! D@-(t)!!!A@-(t) - D@-(t)!!!X@-(t)

(A@-[t] - D@-[t])!!! Y@-[t]

0!!!-55,000!!!!!!!!!!!!-55,000

1-5 each!!!+15,000!!!10,000!!!5,000!!!1,700!!!+13,300

5 only!!!+5,000!!!!!!!!!!!!+5,000

6.8 Price Level Changes: Inflation and Deflation

In the economic evaluation of investment proposals, two approaches may be used to reflect the effects of future price level changes due to inflation or deflation. The differences between the two approaches are primarily philosophical and can be succinctly stated as follows:

1. The constant dollar approach. The investor wants a specified MARR excluding inflation. Consequently, the cash flows should be expressed in terms of base-year or constant dollars, and a discount rate excluding inflation should be used in computing the net present value.
2. The inflated dollar approach. The investor includes an inflation component in the specified MARR. Hence, the cash flows should be expressed in terms of then-current or inflated dollars, and a discount rate including inflation should be used in computing the net present value.

Let i be the discount rate excluding inflation, i' be the discount rate including inflation, and j be the annual inflation rate. Then,

     i' = i + j + ij

 

     i   =   
num "i ' - j", denom "1 + j"
  

 

     i' = i + j    or    i = i' - j

 

If A@-(t) denotes the cash flow in year t expressed in terms of constant (base year) dollars, and A'@-(t) denotes the cash flow in year t expressed in terms of inflated (then-current) dollars, then

     NPV   =   A@-(0)   +    
from "t=1",to "n"
  
     A@-(t) (1+i)@+(-t)
or
  
     NPV   =   A@-(0)   +    
from "t=1",to "n"
  
     A'@-(t) (1+i')@+(-t)

It can be shown that the results from these two equations are identical. Furthermore, the relationship applies to after-tax cash flow as well as to before-tax cash flow by replacing A@-(t) and A@-(t)@+(') with Y@-(t) and Y@-(t)@+(') respectively in Equations (6.6.8) and (6.6.8).

Example 6-3: Effects of Inflation

Suppose that, in the previous example, the inflation expectation is 5% per year, and the after-tax MARR specified by the company is 8% excluding inflation. Determine whether the investment is worthwhile.

In this case, the before-tax cash flow A@-(t) in terms of constant dollars at base year 0 is inflated at j = 5% to then-current dollars A@-(t)@+(') for the computation of the taxable income (A@-[t]@+['] - D@-[t]) and income taxes. The resulting after-tax flow Y@-(t)@+(') in terms of then-current dollars is converted back to constant dollars. That is, for X@-(t) = 34% and D@-(t) = $10,000. The annual depreciation charges D@-(t) are not inflated to current dollars in conformity with the practice recommended by the U.S. Internal Revenue Service. Thus:

     A@-(t)@+(') = A@-(t)(1 + j)@+(t) =
 A@-(t)(1 + 0.05)@+(t)
     Y@-(t)@+(') = A@-(t)@+(') -
 X@-(t)(A@-(t)@+(') - D@-(t)) =
A@-(t)@+(') - (34%)(A@-(t)@+(') - 10,000)

      Y@-(t) = Y@-(t)@+(')(1+ j)@+(-t) =
Y@-(t)@+(')(1 + 0.05)@+(-t)

     [NPV]@-(8%) = -55,000 + (13,138)(P|F,
 8%,1) + (12,985)(P|F,8%, 2) +
                 (12,837)(P|F, 8%, 3)
 + (12,697)(P|F, 8%, 4)    +
 (12,564 + 5,000)(P|F, 8%, 5)
                    = -$227

After-Tax Cash Flow Including Inflation
  

!!! Constant $!!! Current $!!! Current $!!!

Current $!!! Current $!!! Current $!!! Constant $

Time!!!B-Tax CF!!! B-Tax CF!!! Depr.!!!

After Depr.!!! Income Tax!!! A-Tax CF!!! A-Tax CF

t!!! A@-(t)!!! A@-(t)@+(')!!! D@-(t)!!! A@-(t)

@+(')-D@-(t)!!! X@-[t](A@-(t)@+(')-D

@-[t])!!!Y@-(t)@+(')!!! Y@-(t)

0!!!-55,000!!!+55,000!!!!!!!!!!!!-55,000!!!-55,000

1!!!+15,000!!!+15,750!!!10,000!!!5,750!!!1,955!!!+13,795!!!+13,138

2!!!+15,000!!!+16,540!!!10,000!!!6,540!!!2,224!!!+14,316!!!+12,985

3!!!+15,000!!!+17,365!!!10,000!!!7,365!!!2,504!!!+14,861!!!+12,837

4!!!+15,000!!!+18,233!!!10,000!!!8,233!!!2,799!!!+15,434!!!+12,697

5!!!+15,000!!!+19,145!!!10,000!!!9,145!!!3,109!!!+16,036!!!12,564

5!!!+5,000!!!!!!!!!!!!!!!!!!+5,000

Note: B-Tax CF refers to Before-Tax Cash

Flow; A-Tax CF refers to After-Tax Cash Flow

6.9 Uncertainty and Risk

Since future events are always uncertain, all estimates of costs and benefits used in economic evaluation involve a degree of uncertainty. Probabilistic methods are often used in decision analysis to determine expected costs and benefits as well as to assess the degree of risk in particular projects.

In estimating benefits and costs, it is common to attempt to obtain the expected or average values of these quantities depending upon the different events which might occur. Statistical techniques such as regression models can be used directly in this regard to provide forecasts of average values. Alternatively, the benefits and costs associated with different events can be estimated and the expected benefits and costs calculated as the sum over all possible events of the resulting benefits and costs multiplied by the probability of occurrence of a particular event:

E[B@-(t)]## = 
from"q=1",To"m"
  
   (B@-<t | q >) .##Pr{q}
and
  
 E[C@-(t)]## = 
from"q=1",To"m"
  
   (C@-(t| q )).##Pr{q}

 

     E[A@-(t)] = E[B@-(t)] - E[C@-(t)]

For example, the average cost of a facility in an earthquake prone site might be calculated as the sum of the cost of operation under normal conditions (multiplied by the probability of no earthquake) plus the cost of operation after an earthquake (multiplied by the probability of an earthquake). Expected benefits and costs can be used directly in the cash flow calculations described earlier.

In formulating objectives, some organizations wish to avoid risk so as to avoid the possibility of losses. In effect, a risk avoiding organization might select a project with lower expected profit or net social benefit as long as it had a lower risk of losses. This preference results in a risk premium or higher desired profit for risky projects. A rough method of representing a risk premium is to make the desired MARR higher for risky projects. Let r@-[f] be the risk free market rate of interest as represented by the average rate of return of a safe investment such as U.S. government bonds. However, U.S. government bonds do not protect from inflationary changes or exchange rate fluctuations, but only insure that the principal and interest will be repaid. Let r@-[p] be the risk premium reflecting an adjustment of the rate of return for the perceived risk. Then, the risk-adjusted rate of return r is given by:

      r = r@-[f] + r@-[p]

 

[NPV]@-[r]  = 
from "t=0", to "n"
  
   A@-[t](1 + r)@+[-t]

More directly, a decision maker may be confronted with the subject choice among alternatives with different expected benefits of levels of risk such that at a given period t, the decision maker is willing to exchange an uncertain A@-[t] with a smaller but certain return a@-[t]A@-[t] where a@-[t] is less than one. Consider the decision tree in Figure 6-0 in which the decision maker is confronted with a choice between the certain return of a@-(t)A@-(t) and a gamble with possible outcomes (A@-<t>)@-(q) and respective probabilities Pr{q} for q = 1,2,...,m. Then, the net present value for the series of "certainty equivalents" over n years may be computed on the basis of the risk free rate. Hence:

[NPV]@-[r@-{f}]  = 
from"t=0",to"n"
  
   (a@-[t]A@-[t]) (1 +##r@-[f])@+[-t]

 

(1 + r@-[f])(1 + r@-[p]) = 1 +r@-[f] + r@-[p] + r@-[f] r@-[p] = 1 + r

Hence, for Eq. (6.6.9)

A@-[t] (1 + r)@+[-t] = (a @-[t]A@-[t]/a@-[t]) (1 + r@-[f])@+[-t] (1 + r@-[p])@+[-t] =[(a@-[t]A@-[t]) (1 + r@-[f])@+[-t]] [(1 + r@-[p])@+[-t]/a@-[t]]

Determination of a Certainty Equivalent Value
  

6.10 Effects of Financing on Project Selection

Selection of the best design and financing plans for capital projects is typically done separately and sequentially. Three approaches to facility investment planning most often adopted by an organization are:

1. Need or demand driven: Public capital investments are defined and debated in terms of an absolute "need" for particular facilities or services. With a pre-defined "need," design and financing analysis then proceed separately. Even when investments are made on the basis of a demand or revenue analysis of the market, the separation of design and financing analysis is still prevalent.
2. Design driven: Designs are generated, analyzed and approved prior to the investigation of financing alternatives, because projects are approved first and only then programmed for eventual funding.
3. Finance driven: The process of developing a facility within a particular budget target is finance-driven since the budget is formulated prior to the final design. It is a common procedure in private developments and increasingly used for public projects.

Typically, different individuals or divisions of an organization conduct the analysis for the operating and financing processes. Financing alternatives are sometimes not examined at all since a single mechanism is universally adopted. An example of a single financing plan in the public sector is the use of pay-as-you-go highway trust funds. However, the importance of financial analysis is increasing with the increase of private ownership and private participation in the financing of public projects. The availability of a broad spectrum of new financing instruments has accentuated the needs for better financial analysis in connection with capital investments in both the public and private sectors. While simultaneous assessment of all design and financing alternatives is not always essential, more communication of information between the two evaluation processes would be advantageous in order to avoid the selection of inferior alternatives.

There is an ever increasing variety of borrowing mechanisms available. First, the extent to which borrowing is tied to a particular project or asset may be varied. Loans backed by specific, tangible and fungible assets and with restrictions on that asset's use are regarded as less risky. In contrast, specific project finance may be more costly to arrange due to transactions costs than is general corporate or government borrowing. Also, backing by the full good faith and credit of an organization is considered less risky than investments backed by generally immovable assets. Second, the options of fixed versus variable rate borrowing are available. Third, the repayment schedule and time horizon of borrowing may be varied. A detailed discussion of financing of constructed facilities will be deferred until the next chapter.

As a general rule, it is advisable to borrow as little as possible when borrowing rates exceed the minimum attractive rate of return. Equity or pay-as-you-go financing may be desirable in this case. It is generally preferable to obtain lower borrowing rates, unless borrowing associated with lower rates requires substantial transaction costs or reduces the flexibility for repayment and refinancing. In the public sector, it may be that increasing taxes or user charges to reduce borrowing involves economic costs in excess of the benefits of reduced borrowing costs of borrowed funds. Furthermore, since cash flow analysis is typically conducted on the basis of constant dollars and loan agreements are made with respect to current dollars, removing the effects of inflation will reduce the cost of borrowing. Finally, deferring investments until pay-as-you-go or equity financing are available may unduly defer the benefits of new investments.

It is difficult to conclude unambiguously that one financing mechanism is always superior to others. Consequently, evaluating alternative financing mechanisms is an important component of the investment analysis procedure. One possible approach to simultaneously considering design and financing alternatives is to consider each combination of design and financing options as a specific, mutually exclusive alternative. The cash flow of this combined alternative would be the sum of the economic or operating cash flow (assuming equity financing) and the financial cash flow over the planning horizon.

6.11 Combined Effects of Operating and Financing Cash Flows

A general approach for obtaining the combined effects of operating and financing cash flows of a project is to make use of the additive property of net present values by calculating an adjusted net present value. The adjusted net present value (APV) is the sum of the net present value (NPV) of the operating cash flow plus the net present value of the financial cash flow due to borrowing or raising capital (FPV). Thus,

          APV = [NPV]@-(i) + [FPV]@-(i)

 

To be specific, let A@-[t] be the net operating cash flow, @-[t] be the netA financial cash flow resulting from debt financing, and AA@-<t> be the combined net cash flow, all for year t before tax. Then:

                                                    -
AA@-[t] = A@-[t] +                                   @-[t]A
                -
 

                                                    -
YY@-[t] = Y@-[t] +                                   @-[t]Y

The tax shields for interest on borrowing (for t = 1, 2, ..., n) are usually given by

                                 -                                         -
                                  @-[t] =Y                                         A
@-[t] + X@-[t]I@-[t]

 

                                                    -
YY@-[t] = A@-[t] +                                   @-[t]A
 - X@-[t] (A@-[t] - D@-[t] - I@-[t])

When MARR = i is applied to both the operating and the financial cash flows in Eqs. (6.13) and (6.28), respectively, in computing the net present values, the combined effect will be the same as the net present value obtained by applying MARR = i to the combined cash flow in Eq. (6.29).

In many instances, a risk premium related to the specified type of operation is added to the MARR for discounting the operating cash flow. On the other hand, the MARR for discounting the financial cash flow for borrowing is often regarded as relatively risk-free because debtors or holders of corporate bonds must be paid first before stockholders in case financial difficulties are encountered by a corporation. Then, the adjusted net present value is given by

APV = [NPV]@-[r] + [FPV]@-[r@-[f]]
 

The evaluation of combined alternatives based on the adjusted net present value method should also be performed in dollar amounts which either consistently include or remove the effects of inflation. The MARR value used would reflect the inclusion or exclusion of inflation accordingly. Furthermore, it is preferable to use after-tax cash flows in the evaluation of projects for private firms since different designs and financing alternatives are likely to have quite different implications for tax liabilities and tax shields.

In theory, the corporate finance process does not necessarily require a different approach than that of the APV method discussed above. Rather than considering single projects in isolation, groups or sets of projects along with financing alternatives can be evaluated. The evaluation process would be to select that group of operating and financing plans which has the highest total APV. Unfortunately, the number of possible combinations to evaluate can become very large even though many combinations can be rapidly eliminated in practice because they are clearly inferior. More commonly, heuristic approaches are developed such as choosing projects with the highest benefit/cost ratio within a particular budget or financial constraint. These heuristic schemes will often involve the separation of the financing and design alternative evaluation. The typical result is design-driven or finance-driven planning in which one or the other process is conducted first.

Example 6-4: Combined Effects of Operating and Financing Plans

A public agency plans to construct a facility and is considering two design alternatives with different capacities. The operating net cash flows for both alternatives over a planning horizon of 5 years are shown in Table 6-0. For each design alternative, the project can be financed either through overdraft on bank credit or by issuing bonds spanning over the 5-year period, and the cash flow for each financing alternative is also shown in Table 6-0. The public agency has specified a MARR of 10% for discounting the operating and financing cash flows for this project. Determine the best combination of design and financing plan if

      (a) a design is selected before financing plans are considered, or
      (b) the decision is made simultaneously rather than sequentially.

The net present values (NPV) of all cash flows can be computed by Eq.(6.6.6), and the results are given at the bottom of Table 6-0. The adjusted net present value (APV) combining the operating cash flow of each design and an appropriate financing is obtained according to Eq. (6.25), and the results are also tabulated at the bottom of Table 6-0.

Under condition (a), design alternative 2 will be selected since NPV = $767,000 is the higher value when only operating cash flows are considered. Subsequently, bonds financing will be chosen because APV = $466,000 indicates that it is the best financing plan for design alternative 2.

Under condition (b), however, the choice will be based on the highest value of APV, i.e., APV = $484,000 for design alternative one in combination will overdraft financing. Thus, the simultaneous decision approach will yield the best results.

Illustration of Different Design and Financing Alternatives
  

!!!Design Alternative One Design Alternative Two

Year!!!Operating!!!Overdraft!!!Bond!!!Operating!!!Overdraft!!!Bond

!!!Cash Flow!!!Financing!!!Financing!!!Cash Flow!!!Financing!!!Financing

0!!!-1,000!!!1,000!!!3,653!!!-2,500!!!2,500!!!3,805

1!!!-2,500!!!2,500!!!-418!!!-1,000!!!1,000!!!-435

2!!!1,000!!!-1,000!!!-418!!!1,000!!!-1,000!!!-435

3!!!1,500!!!-1,500!!!-418!!!1,500!!!-1,500!!!-435

4!!!1,500!!!-1,500!!!-418!!!1,500!!!-1,500!!!-435

5!!!1,700!!!-921!!!-4,217!!!1,930!!!-1,254!!!-4,392

NPV or FPV!!!761!!!-277!!!-290!!!767!!!-347!!!-301

at 10%

APV =!!!!!!484!!!471!!!!!!420!!!466

NPV + FPV

Note: All monetary values are in thousands of dollars

6.12 Public versus Private Ownership of Facilities

In recent years, various organizational ownership schemes have been proposed to raise the level of investment in constructed facilities. For example, independent authorities are assuming responsibility for some water and sewer systems, while private entrepreneurs are taking over the ownership of public buildings such as stadiums and convention centers in joint ventures with local governments. Such ownership arrangements not only can generate the capital for new facilities, but also will influence the management of the construction and operation of these facilities. In this section, we shall review some of these implications.

A particular organizational arrangement or financial scheme is not necessarily superior to all others in each case. Even for similar facilities, these arrangements and schemes may differ from place to place or over time. For example, U.S. water supply systems are owned and operated both by relatively large and small organizations in either the private or public sector. Modern portfolio theory suggest that there may be advantages in using a variety of financial schemes to spread risks. Similarly, small or large organizations may have different relative advantages with respect to personnel training, innovation or other activities.

Differences in Required Rates of Return

A basic difference between public and private ownership of facilities is that private organizations are motivated by the expectation of profits in making capital investments. Consequently, private firms have a higher minimum attractive rate of return (MARR) on investments than do public agencies. The MARR represents the desired return or profit for making capital investments. Furthermore, private firms often must pay a higher interest rate for borrowing than public agencies because of the tax exempt or otherwise subsidized bonds available to public agencies. International loans also offer subsidized interest rates to qualified agencies or projects in many cases. With higher required rates of return, we expect that private firms will require greater receipts than would a public agency to make a particular investment desirable.

In addition to different minimum attractive rates of return, there is also an important distinction between public and private organizations with respect to their evaluation of investment benefits. For private firms, the returns and benefits to cover costs and provide profit are monetary revenues. In contrast, public agencies often consider total social benefits in evaluating projects. Total social benefits include monetary user payments plus users' surplus (e.g., the value received less costs incurred by users), external benefits (e.g., benefits to local businesses or property owners) and nonquantifiable factors (e.g., psychological support, unemployment relief, etc.). Generally, total social benefits will exceed monetary revenues.

While these different valuations of benefits may lead to radically different results with respect to the extent of benefits associated with an investment, they do not necessarily require public agencies to undertake such investments directly. First, many public enterprises must fund their investments and operating expenses from user fees. Most public utilities fall into this category, and the importance of user fee financing is increasing for many civil works such as waterways. With user fee financing, the required returns for the public and private firms to undertake the aforementioned investment are, in fact, limited to monetary revenues. As a second point, it is always possible for a public agency to contract with a private firm to undertake a particular project.

All other things being equal, we expect that private firms will require larger returns from a particular investment than would a public agency. From the users or taxpayers point of view, this implies that total payments would be higher to private firms for identical services. However, there are a number of mitigating factors to counterbalance this disadvantage for private firms.

Tax Implications of Public Versus Private Organizations

Another difference between public and private facility owners is in their relative liability for taxes. Public entities are often exempt from taxes of various kinds, whereas private facility owners incur a variety of income, property and excise taxes. However, these private tax liabilities can be offset, at least in part, by tax deductions of various kinds.

For private firms, income taxes represent a significant cost of operation. However, taxable income is based on the gross revenues less all expenses and allowable deductions as permitted by the prevalent tax laws and regulations. The most significant allowable deductions are depreciation and interest. By selecting the method of depreciation and the financing plan which are most favorable, a firm can exert a certain degree of control on its taxable income and, thus, its income tax.

Another form of relief in tax liability is the tax credit which allows a direct deduction for income tax purposes of a small percentage of the value of certain newly acquired assets. Although the provisions for investment tax credit for physical facilities and equipment had been introduced at different times in the US federal tax code, they were eliminated in the 1986 Tax Reformation Act except a tax credit for low-income housing.

Of course, a firm must have profits to take direct advantage of such tax shields, i.e., tax deductions only reduce tax liabilities if before-tax profits exist. In many cases, investments in constructed facilities have net outlays or losses in the early years of construction. Generally, these losses in early years can be offset against profits occurred elsewhere or later in time. Without such offsetting profits, losses can be carried forward by the firm or merged with other firms' profits, but these mechanisms will not be reviewed here.

Effects of Financing Plans

Major investments in constructed facilities typically rely upon borrowed funds for a large portion of the required capital investments. For private organizations, these borrowed funds can be useful for leverage to achieve a higher return on the organizations' own capital investment.

For public organizations, borrowing costs which are larger than the MARR results in increased "cost" and higher required receipts. Incurring these costs may be essential if the investment funds are not otherwise available: capital funds must come from somewhere. But it is not unusual for the borrowing rate to exceed the MARR for public organizations. In this case, reducing the amount of borrowing lowers costs, whereas increasing borrowing lowers costs whenever the MARR is greater than the borrowing rate.

Although private organizations generally require a higher rate of return than do public bodies (so that the required receipts to make the investment desirable are higher for the private organization than for the public body), consideration of tax shields and introduction of a suitable financing plan may reduce this difference. The relative levels of the MARR for each group and their borrowing rates are critical in this calculation.

Effects of Capital Grant Subsidies

An important element in public investments is the availability of capital grant subsidies from higher levels of government. For example, interstate highway construction is eligible for federal capital grants for up to 90% of the cost. Other programs have different matching amounts, with 50/50 matching grants currently available for wastewater treatment plants and various categories of traffic systems improvement in the U.S. These capital grants are usually made available solely for public bodies and for designated purposes.

While the availability of capital grant subsidies reduces the local cost of projects, the timing of investment can also be affected. In particular, public subsidies may be delayed or spread over a longer time period because of limited funds. To the extent that (discounted) benefits exceed costs for particular benefits, these funding delays can be costly. Consequently, private financing and investment may be a desirable alternative, even if some subsidy funds are available.

Implications for Design and Construction

Different perspectives and financial considerations also may have implications for design and construction choices. For example, an important class of design decisions arises relative to the trade-off between capital and operating costs. It is often the case that initial investment or construction costs can be reduced, but at the expense of a higher operating costs or more frequent and extensive rehabilitation or repair expenditures. It is this trade-off which has led to the consideration of "life cycle costs" of alternative designs. The financial schemes reviewed earlier can profoundly effect such evaluations.

For financial reasons, it would often be advantageous for a public body to select a more capital intensive alternative which would receive a larger capital subsidy and, thereby, reduce the project's local costs. In effect, the capital grant subsidy would distort the trade-off between capital and operating costs in favor of more capital intensive projects.

The various tax and financing considerations will also affect the relative merits of relatively capital intensive projects. For example, as the borrowing rate increases, more capital intensive alternatives become less attractive. Tax provisions such as the investment tax credit or accelerated depreciation are intended to stimulate investment and thereby make more capital intensive projects relatively more desirable. In contrast, a higher minimum attractive rate of return tends to make more capital intensive projects less attractive.

6.13 Economic Evaluation of Different Forms of Ownership

While it is difficult to conclude definitely that one or another organizational or financial arrangement is always superior, different organizations have systematic implications for the ways in which constructed facilities are financed, designed and constructed. Moreover, the selection of alternative investments for constructed facilities is likely to be affected by the type and scope of the decision-making organization.

As an example of the perspectives of public and private organizations, consider the potential investment on a constructed facility with a projected useful life of n years. Let t = 0 be the beginning of the planning horizon and t = 1, 2, ... n denote the end of each of the subsequent years. Furthermore, let C@-(o) be the cost of acquiring the facility at t = 0, and C@-(t) be the cost of operation in year t. Then, the net receipts A@-(t) in year t is given by A@-(t) = B@-(t) - C@-(t) in which A@-(t) may be positive or negative for t = 0, 1, 2, ..., n.

Let the minimum attractive rate of return (MARR) for the owner of the facility be denoted by i. Then, the net present value (NPV) of a project as represented by the net cash flow discounted to the present time is given by

                n
         NPV = S
                t=0    n
 A@-(t)(1 + i)@+(-t) =S     B@-(t)(1 + i)
          n            t=0
@+(-t) - S
 C@-(t)(1 + i)@+(-t)t=0

 

            n                    n
         B S     (1 + i)@+(-t) =S     C@-(t)(1 + i)@+(-t)
            t=1                  t=0
 

Example 6-5: Different MARRs for Public and Private Organizations For the facility cost stream of a potential investment with n = 7 in Table 6-5, the required uniform annual gross receipts B are different for public and private ownerships since these two types of organizations usually choose different values of MARR. With a given value of MARR = i in each case, the value of B can be obtained from Eq. (6.32). With a MARR of 10%, a public agency requires at least B = $184,000. By contrast, a private firm using a 20% MARR before tax while neglecting other effects such as depreciation and tax deduction would require at least B = $219,000. Then, according to Eq. (6.31), the gross receipt streams for both public and private ownerships in Table 6-0 will satisfy the condition NPV = 0 when each of them is netted from the cost stream and discounted at the appropriate value of MARR, i.e., 10% for a public agency and 20% (before tax) for a private firm. Thus, this case suggests that public provision of the facility has lower user costs.

Required Uniform Annual Gross Receipts for Public and Private
Ownership of a Facility
  

!!!!!!Public Ownership!!!!!!Private Ownership

Year!!!Facility!!!Gross!!!Net Receipt!!!Gross!!!Net Receipt

t!!!Cost, C@-(t)!!!Receipt, B@-(t)!!!A@-(t)=B

@-(t)=C@-(t)!!!receipt, B@-(t)!!!A

@-(t)=B@-(t)=C@-(t)

0!!!500!!!0!!!-500!!!0!!!-500

1!!!76!!!184!!!108!!!219!!!143

2!!!78!!!184!!!106!!!219!!!141

3!!!80!!!184!!!104!!!219!!!139

4!!!82!!!184!!!102!!!219!!!137

5!!!84!!!184!!!100!!!219!!!135

6!!!86!!!184!!!98!!!219!!!133

7!!!88!!!184!!!96!!!219!!!131

*All Monetary amounts are in thousands of dollars

Effects of Depreciation and Tax Deductions for Private Ownership
in a Facility
  

Year!!!Net Receipt!!!Depreciation!!!Taxable!!!Income!!!After-tax

t!!!Before-tax !!!(SOYD)!!!Income!!!Tax!!!Cash Flow

!!! A@-(t)!!! D@-(t)!!!(A@-[t]-D@-[t])!!!X -

@-[t](A@-[t]-D@-[t])!!! @-(t)Y

0!!!-500!!!0!!!0!!!0!!!-500

1!!!143!!!125!!!18!!!6!!!137

2!!!141!!!107!!!34!!!12!!!129

3!!!139!!!89!!!50!!!17!!!122

4!!!137!!!71!!!66!!!22!!!115

5!!!135!!!54!!!81!!!28!!!107

6!!!133!!!36!!!97!!!33!!!100

7!!!131!!!18!!!113!!!38!!!93

*All monetary amounts are in thousands of dollars.

Example 6-6: Effects of Depreciation and Tax Shields for Private Firms Using the same data as in Example 6-5, we now consider the effects of depreciation and tax deduction for private firms. Suppose that the marginal tax rate of the firm is 34% in each year of operation, and losses can always be offset by company-wide profits. Suppose further that the salvage value of the facility is zero at the end of seven years so that the entire amount of cost can be depreciated by means of the sum-of-the-years'-digits (SOYD) method. Thus, for the sum of digits 1 through 7 equal to 28, the depreciation allowances for years 1 to 7 are respectively 7/28, 6/28, ..., 1/28 of the total depreciable value of $ 500,000, and the results are recorded in column 3 of Table 6-0. For a uniform annual gross receipt B = $219,000, the net receipt before tax in Column 6 of Table 6-0 in Example 6-5 can be used as the starting point for computing the after-tax cash flow according to Equation (6.13) which is carried out step-by-step in Table 6-6. (Dollar amounts are given to the nearest $1,000). By trial and error, it is found that an after-tax MARR = 14.5% will produce a zero value for the net present value of the discounted after-tax flow at t = 0. In other words, the required uniform annual gross receipt for this project at 14.5% MARR after tax is also B = $219,000. It means that the MARR of this private firm must specify a 20% MARR before tax in order to receive the equivalent of 14.5% MARR after tax.

Example 6-7: Effects of Borrowing on Public Agencies

Suppose that the gross uniform annual receipt for public ownership is B = $190,000 instead of $184,000 for the facility with cost stream given in Column 2 of Table 6-5. Suppose further that the public agency must borrow $400,000 (80% of the facility cost) at 12% annual interest, resulting in an annual uniform payment of $88,000 for the subsequent seven years. This information has been summarized in Table 6-0. The use of borrowed funds to finance a facility is referred to as debt financing or leveraged financing, and the combined cash flow resulting from operating and financial cash flows is referred to as the levered cash flow.

To the net receipt A@-(t) in Column 4 of Table 6-0, which has been obtained from a uniform annual gross receipt of $190,000, we add the financial cash flow - @-(t) which included a loan of $400,000 with an annual repayment of $88,000A corresponding to an interest rate of 12%. Then the resulting combined cash flow AA@-(t) as computed according to Equation (6.26) is shown in column 6 of Table 6-7. Note that for a loan at 12% interest, the net present value of the combined cash flow AA@-(t) is zero when discounted at a 10% MARR for the public agency. This is not a coincidence, but several values of B have been tried until B = $190,000 is found to satisfy NPV = 0 at 10% MARR. Hence, the minimum required uniform annual gross receipt is B = $190,000.

Effects of Borrowing on a Publicly Owned Facility
  

!!!!!!!!!!!!Loan and!!!Combined

!!!Gross!!!Facility!!!Net Receipt!!!Payment!!!Cash Flow

Year!!!receipt!!!cost!!!(no loan)!!!(12% interest)!!!(12% interest)

t!!!B@-(t)!!!C@-(t)!!!A@-(t)!!! -

@-[t]!!!AA@-[t]A

0!!!0!!!500!!!-500!!!+400!!!-100

1!!!190!!!76!!!114!!!-88!!!-26

2!!!190!!!78!!!112!!!-88!!!24

3!!!190!!!80!!!110!!!-88!!!22

4!!!190!!!82!!!108!!!-88!!!20

5!!!190!!!84!!!106!!!-88!!!18

6!!!190!!!86!!!104!!!-88!!!16

7!!!190!!!88!!!102!!!-88!!!14

*All monetary amounts are in thousands of dollars.

Example 6-8: Effects of Leverage and Tax Shields for Private Organizations

Suppose that the uniform annual gross receipt for a private firm is also B = $190,000 (the same as that for the public agency in Example 6-7). The salvage value of the facility is zero at the end of seven years so that the entire amount of cost can be depreciated by means of the sum-of-the-years'-digit (SOYD) method. The marginal tax rate of the firm is 34% in each year of operation, and losses can always be offset by company-wide profits. Suppose further that the firm must borrow $400,000 (80% of the facility cost) at a 12% annual interest, resulting in an annual uniform payment of $88,000 for the subsequent seven years. The interest charge each year can be computed as 12% of the remaining balance of the loan in the previous year, and the interest charge is deductible from the tax liability.

For B = $190,000 and a facility cost stream identical to that in Example 6-7, the net receipts before tax A@-(t) (operating cash flow with no loan) in Table 6-7 can be used as the starting point for analyzing the effects of financial leverage through borrowing. Thus, column 4 of Table 6-7 is reproduced in column 2 of Table 6-8.

Effects of Financial Leverage and Tax Shields on Private Ownership
of a Facility
  

!!!Net Receipt!!!!!!Loan and!!!!!!After Tax

!!!Before Tax!!!Depreciation!!!Scheduled!!!Interest!!!Income Tax!!!Cash Flow

Year!!!(no loan)!!!(SOYD)!!!Payment!!!On Loan!!!(34% rate)!!!(levered) -

t!!!A@-(t)!!!D@-(t)!!! A

@-(t)!!!I@-(t)!!!X@-(t)(A@-(t)-D@-(t)-I@-(t))!!!YY@-(t)

0!!!-500!!!0!!!400!!!0!!!0!!!-100

1!!!114!!!125!!!-88!!!48!!!-19!!!45

2!!!112!!!107!!!-88!!!43!!!-13!!!37

3!!!110!!!89!!!-88!!!38!!!-6!!!28

4!!!108!!!71!!!-88!!!32!!!2!!!

5!!!106!!!54!!!-88!!!25!!!9!!!45

6!!!104!!!36!!!-88!!!18!!!17!!!45

7!!!102!!!18!!!-88!!!9!!!26!!!45

*All monetary amounts are in thousands of dollars.

The computation of the after-tax cash flow of the private firm including the effects of tax shields for interest is carried out in Table 6-8. The financial - cash stream @-(t) in Column 4 of Table 6-8 indicates a loan of $400,000 whichA is secured at t = 0 for an annual interest of 12%, and results in a series of uniform annual payments of $88,000 in order to repay the principal and interest. The levered after-tax cash flow YY@-(t) can be obtained by Eq. (6.29), using the same investment credit, depreciation method and tax rate, and is recorded in Column 7 of Table 6-8. Since the net present value of YY@-[t] in Column 7 of Table 6-8 discounted at 14.5% happens to be zero, the minimum required uniform annual gross receipt for the potential investment is $190,000. By borrowing $400,000 (80% of the facility cost) at 12% annual interest, the investment becomes more attractive to the private firm. This is expected because of the tax shield for the interest and the 12% borrowing rate which is lower than the 14.5% MARR after-tax for the firm.

Example 6-9: Comparison of Public and Private Ownership.

In each of the analyses in Examples 6-5 through 6-8, a minimum required uniform annual gross receipt B is computed for each given condition whether the owner is a public agency or a private firm. By finding the value of B which will lead to NPV = 0 for the specified MARR for the organization in each case, various organizational effects with or without borrowing can be analyzed. The results are summarized in Table 6-9 for comparison. In this example, public ownership with a 80% loan and a 10% MARR has the same required benefit as private ownership with an identical 80% loan and a 14.5% after-tax MARR.

Summary Effects of Financial Leverage and Tax Shields on Private
Ownership
  

Organizational!!!Financial!!!Minimum Benefit

Condition!!!Arrangement!!!Required

Public-No Tax!!!No loan!!!$184,000

(MARR = 10%)!!!80% loan at 12% interest!!!$190,000

Private-before Tax!!!No loan!!!$219,000

(MARR = 20%)!!!!!!$219,000

Private-after tax!!!No loan!!!$219,000

(MARR = 14.5%)!!!80% loan at 12% interest!!!$190,000

6.14 References

1. Au, T., "Profit Measures and Methods of Economic Analysis for Capital Project Selection," ASCE Journal of Management in Engineering, Vol. 4, No. 3, 1988.
2. Au, T. and T. P. Au, Engineering Economics for Capital Investment Analysis, Allyn and Bacon, Newton, MA, 1983.
3. Bierman, H., Jr., and S. Smidt, The Capital Budgeting Decision, 5th Ed., Macmillan, New York, 1984.
4. Brealey, R. and S. Myers, Principles of Corporate Finance, Second Edition, McGraw-Hill, New York, 1984.
5. Edwards, W.C. and J.F. Wong, "A Computer Model to Estimate Capital and Operating Costs," Cost Engineering, Vol. 29, No. 10, 1987, pp. 15-21.
6. Hendrickson, C. and T. Au, "Private versus Public Ownership of Constructed Facilities," ASCE Journal of Management in Engineering, Vol. 1, No. 3, 1985, pp. 119-131.
7. Wohl, M. and C. Hendrickson, Transportation Investment and Pricing Principles, John Wiley, New York, 1984.

6.15 Problems

1. The Salisbury Corporation is considering four mutually exclusive alternatives for a major capital investment project. All alternatives have a useful life of 10 years with no salvage value at the end. Straight line depreciation will be used. The corporation pays federal and state tax at a rate of 34%, and expects an after-tax MARR of 10%. Determine which alternative should be selected, using the NPV method.

      !!!!!!Before-tax uniform
      !!!initial cost!!!annual net benefits
      Alternatives!!!($million)!!!($ million)
         1!!!  4.0!!!    1.5
         2!!!  3.5!!!    1.1
         3!!!  3.0!!!    1.0
         4!!!  3.7!!!    1.3
      

2. The operating cash flow for the acquisition and maintenance of a clamshell for excavation is given by A@-(t) in the table below. Three financing plans, each charging a borrowing rate of 8% but having a different method of - repayment, are represented by three different cash flows of @-(t). FindA the net present value for each of the three combined cash flows AA@-(t) for operating and financing if the MARR is specified to be 8%.

                                                                            -
      Year    Operating!!!!!!    Financing                                   @-(t)A
        t               A@-(t)   !!!  (a)  !!!  (b)  !!!                  (c)  !!!
      0    -80,000!!!      40,000!!! 40,000!!!                           40,000!!!
      1     30,000!!!     -10,200!!! -3,200!!!                          -13,200!!!
      2     30,000!!!     -10,020!!! -3,200!!!                          -12,400!!!
      3     30,000!!!     -10,020!!! -3,200!!!                          -11,600!!!
      4     30,000!!!     -10,020!!! -3,200!!!                          -10,800!!!
      5     30,000!!!     -10,020!!!          -43,200!!!                      0!!!
      

3. Find the net present value for each of the three cases in Problem P6-2 if the MARR is specified to be (a) 5% or (b) 10%.
4. Suppose the clamshell in Problem P6-2 is purchased by a private firm which pays corporate taxes at a rate of 34%. Depreciation is based on the straight line method with no salvage value at the end of five years. If the after-tax MARR of the firm is 8%, find the net present value for each of the combined cash flows for operating and financing, including the interest deduction. The interest payments included in the annual repayments of each of the loans are 8% times the unpaid principal in each year, with the following values:

      Year (t)!!!(a)!!!(b)!!!(c)
      1!!!800!!!3,200!!!3,200
      2!!!664!!!3,200!!!2,400
      3!!!516!!!3,200!!!1,600
      4!!!357!!!3,200!!!  800
      5!!!185!!!3,200!!!   0
      

5. An investment in a hauler will cost $ 40,000 and have no salvage value at the end of 5 years. The hauler will generate a gross income of $ 12,000 per year, but its operating cost will be $ 2,000 during the first year, increasing by $ 500 per year until it reaches $ 5,000 in the fifth year. The straight line depreciation method is used. The tax rate is 34% and the after-tax MARR is 10%. Determine the net present value of the hauler purchase for a five year planning horizon.
6. The Bailey Construction Company is considering the purchase of a diesel power shovel to improve its productivity. The shovel, which costs $ 80,000, is expected to produce a before-tax benefit of $ 36,000 in the first year, and $ 4,000 less in each succeeding year for a total of five years (i.e., before tax benefit of $ 32,000 in the second year, $ 28,000 in the third year, continuing to $ 20,000 in the fifth year). The salvage value of the equipment will be $ 5,000 at the end of 5 years. The firm uses the sum-of-years'-digits depreciation for the equipment and has an annual tax rate of 34%. If the MARR after tax is 10%, is the purchase worthwhile?
7. The ABC Corporation is considering the purchase of a number of pipe-laying machines in order to facilitate the operation in a new pipeline project expected to last six years. Each machine will cost $ 26,000 and will have no salvage value after the project is complete. The firm uses the straight line depreciation method and pays annual income taxes on profits at the rate of 34%. If the firm's MARR is 8%, which is the minimum uniform annual benefit before tax that must be generated by this machine in order to justify its purchase?
8. The Springdale Corporation plans to purchase a demolition and wrecking machine to save labor costs. The machine costs $60,000 and has a salvage value of $10,000 at the end of 5 years. The machine is expected to be in operation for 5 years, and it will be depreciated by the straight line method up to the salvage value. The corporation specifies an after-tax MARR including inflation of 10% and has an income tax rate of 34%. The annual inflation rate is expected to be 5% during the next 5 years. If the uniform annual net benefit before tax in terms of base-year dollars for the next 5 years is $20,000, is the new investment worthwhile?
9. XYZ Company plans to invest $2 million in a new plant which is expected to produce a uniform annual net benefit before tax of $600,000 in terms of the base-year dollars over the next 6 years. The plant has a salvage value of $250,000 at the end of 6 years and the depreciation allowance is based on the straight line depreciation method. The corporate tax rate is 34%, and the after-tax MARR specified by the firm is 10% excluding inflation. If the annual inflation rate during the next 6 years is expected to be 5%, determine whether the investment is worthwhile.
10. A sewage treatment plant is being planned by a public authority. Two proposed designs require initial and annual maintenance costs as shown below.

    
       Year!!!Design No. 1!!!Design No. 2
        t!!! ($1000s)!!! ($1000s)
        0!!! 1,000!!!  900
       1-16(each)!!!  150!!!   180
       

    Both designs will last 16 years with no salvage value. The federal government will subsidize 50% of the initial capital cost, and the state government has a policy to subsidize 10% of the annual maintenance cost. The local community intends to obtain a loan to finance 30% of the initial capital cost at a borrowing rate of 10% with sixteen equal annual payments including principal and interest. The MARR for this type of project is 12% reflecting its operating risk. What is the uniform annual revenue that must be collected in the next 16 years to make each of the two designs worthwhile from the view of the local authority? Which design has lower cost from this perspective?

7. Financing of Constructed Facilities

7.1 The Financing Problem

Investment in a constructed facility represents a cost in the short term that returns benefits only over the long term use of the facility. Thus, costs occur earlier than the benefits, and owners of facilities must obtain the capital resources to finance the costs of construction. A project cannot proceed without adequate financing, and the cost of providing adequate financing can be quite large. For these reasons, attention to project finance is an important aspect of project management. Finance is also a concern to the other organizations involved in a project such as the general contractor and material suppliers. Unless an owner immediately and completely covers the costs incurred by each participant, these organizations face financing problems of their own.

At a more general level, project finance is only one aspect of the general problem of corporate finance. If numerous projects are considered and financed together, then the net cash flow requirements constitutes the corporate financing problem for capital investment. Whether project finance is performed at the project or at the corporate level does not alter the basic financing problem.

In essence, the project finance problem is to obtain funds to bridge the time between making expenditures and obtaining revenues. Based on the conceptual plan, the cost estimate and the construction plan, the cash flow of costs and receipts for a project can be estimated. Normally, this cash flow will involve expenditures in early periods. Covering this negative cash balance in the most beneficial or cost effective fashion is the project finance problem. During planning and design, expenditures of the owner are modest, whereas substantial costs are incurred during construction. Only after the facility is complete do revenues begin. In contrast, a contractor would receive periodic payments from the owner as construction proceeds. However, a contractor also may have a negative cash balance due to delays in payment and retainage of profits or cost reimbursements on the part of the owner.

Plans considered by owners for facility financing typically have both long and short term aspects. In the long term, sources of revenue include sales, grants, and tax revenues. Borrowed funds must be eventually paid back from these other sources. In the short term, a wider variety of financing options exist, including borrowing, grants, corporate investment funds, payment delays and others. Many of these financing options involve the participation of third parties such as banks or bond underwriters. For private facilities such as office buildings, it is customary to have completely different financing arrangements during the construction period and during the period of facility use. During the latter period, mortgage or loan funds can be secured by the value of the facility itself. Thus, different arrangements of financing options and participants are possible at different stages of a project, so the practice of financial planning is often complicated.

On the other hand, the options for borrowing by contractors to bridge their expenditures and receipts during construction are relatively limited. For small or medium size projects, overdrafts from bank accounts are the most common form of construction financing. Usually, a maximum limit is imposed on an overdraft account by the bank on the basis of expected expenditures and receipts for the duration of construction. Contractors who are engaged in large projects often own substantial assets and can make use of other forms of financing which have lower interest charges than overdrafting.

In this chapter, we will first consider facility financing from the owner's perspective, with due consideration for its interaction with other organizations involved in a project. Later, we discuss the problems of construction financing which are crucial to the profitability and solvency of construction contractors.

7.2 Institutional Arrangements for Facility Financing

Financing arrangements differ sharply by type of owner and by the type of facility construction. As one example, many municipal projects are financed in the United States with tax exempt bonds for which interest payments to a lender are exempt from income taxes. As a result, tax exempt municipal bonds are available at lower interest charges. Different institutional arrangements have evolved for specific types of facilities and organizations.

A private corporation which plans to undertake large capital projects may use its retained earnings, seek equity partners in the project, issue bonds, offer new stocks in the financial markets, or seek borrowed funds in another fashion. Potential sources of funds would include pension funds, insurance companies, investment trusts, commercial banks and others. Developers who invest in real estate properties for rental purposes have similar sources, plus quasi-governmental corporations such as urban development authorities. Syndicators for investment such as real estate investment trusts (REITs) as well as domestic and foreign pension funds represent relatively new entries to the financial market for building mortgage money.

Public projects may be funded by tax receipts, general revenue bonds, or special bonds with income dedicated to the specified facilities. General revenue bonds would be repaid from general taxes or other revenue sources, while special bonds would be redeemed either by special taxes or user fees collected for the project. Grants from higher levels of government are also an important source of funds for state, county, city or other local agencies.

As an indication of the potential sources of financing, Table 7-0 shows the dollar amounts of borrowing in United States credit markets during 1985. Not all of these funds are used for construction, of course. Compared to the one trillion in borrowed funds shown in Table 7-0, the value of construction put in place is slightly more than a quarter of the total. Also, some construction is funded from other sources. Nevertheless, it is apparent that bonds, mortgages and bank loans are all major sources of financing.

______________________________________________________________________________

Funds Raised in United States Credit Markets - 1985
  

!!! Type !!!Amount

!!!!!!($ billions)

!!!U.S. Government Securities 324!!!

!!!State and Local Obligations 183!!!

!!!Corporate and Foreign Bonds 108!!!

!!!Mortgages

!!!!!!Home Mortgages 156!!!

!!!!!!Multi-Family Residential Mortgages 26!!!

!!!!!!Commercial Mortgages 61!!!

!!!!!!Farm Mortgages -6!!!

!!!Mortgages (Total) 237!!!

!!!Consumer Credit 97!!!

!!!Bank Loans 42!!!

!!!Open Market Paper 53!!!

!!!Other 50!!!

!!!Total $ 1,094!!!

Source: Federal Reserve Bulletin, Table 1.57, pg. A42, August 1986.

______________________________________________________________________________

Despite the different sources of borrowed funds, there is a rough equivalence in the actual cost of borrowing money for particular types of projects. Because lenders can participate in many different financial markets, they tend to switch towards loans that return the highest yield for a particular level of risk. As a result, borrowed funds that can be obtained from different sources tend to have very similar costs, including interest charges and issuing costs.

As a general principle, however, the costs of funds for construction will vary inversely with the risk of a loan. Lenders usually require security for a loan represented by a tangible asset. If for some reason the borrower cannot repay a loan, then the borrower can take possession of the loan security. To the extent that an asset used as security is of uncertain value, then the lender will demand a greater return and higher interest payments. Loans made for projects under construction represent considerable risk to a financial institution. If a lender acquires an unfinished facility, then it faces the difficult task of re-assembling the project team. Moreover, a default on a facility may result if a problem occurs such as foundation problems or anticipated unprofitability of the future facility. As a result of these uncertainties, construction lending for unfinished facilities commands a premium interest charge of several percent compared to mortgage lending for completed facilities.

Financing plans will typically include a reserve amount to cover unforeseen expenses, cost increases or cash flow problems. This reserve can be represented by a special reserve or a contingency amount in the project budget. In the simplest case, this reserve might represent a borrowing agreement with a financial institution to establish a line of credit in case of need. For publicly traded bonds, specific reserve funds administered by a third party may be established. The cost of these reserve funds is the difference between the interest paid to bondholders and the interest received on the reserve funds plus any administrative costs.

Finally, arranging financing may involve a lengthy period of negotiation and review. Particularly for publicly traded bond financing, specific legal requirements in the issue must be met. A typical seven month schedule to issue revenue bonds would include the various steps outlined in Table 7-0.[This table is adapted from A.J. Henkel, "The Mechanics of a Revenue Bond Financing: An Overview," Infrastructure Financing, Kidder, Peabody & Co., New York, 1984.] In many cases, the speed in which funds may be obtained will determine a project's financing mechanism.

______________________________________________________________________________

Illustrative Process and Timing for Issuing Revenue Bonds
  

!!! Activities!!!Time of Activities

!!!Analysis of financial alternatives!!!Weeks 0-4

!!!Preparation of legal documents!!!Weeks 1-17

!!!Preparation of disclosure documents!!!Weeks 2-20

!!!Forecasts of costs and revenues!!!Weeks 4-20

!!!Bond Ratings!!!Weeks 20-23

!!!Bond Marketing!!!Weeks 21-24

!!!Bond Closing and Receipt of Funds!!!Weeks 23-26

______________________________________________________________________________

Example 7-1: Example of financing options

Suppose that you represent a private corporation attempting to arrange financing for a new headquarters building. These are several options that might be considered:

• Use corporate equity and retained earnings: The building could be financed by directly committing corporate resources. In this case, no other institutional parties would be involved in the finance. However, these corporate funds might be too limited to support the full cost of construction.
• Construction loan and long term mortgage: In this plan, a loan is obtained from a bank or other financial institution to finance the cost of construction. Once the building is complete, a variety of institutions may be approached to supply mortgage or long term funding for the building. This financing plan would involve both short and long term borrowing, and the two periods might involve different lenders. The long term funding would have greater security since the building would then be complete. As a result, more organizations might be interested in providing funds (including pension funds) and the interest charge might be lower. Also, this basic financing plan might be supplemented by other sources such as corporate retained earnings or assistance from a local development agency.
• Lease the building from a third party: In this option, the corporation would contract to lease space in a headquarters building from a developer. This developer would be responsible for obtaining funding and arranging construction. This plan has the advantage of minimizing the amount of funds borrowed by the corporation. Under terms of the lease contract, the corporation still might have considerable influence over the design of the headquarters building even though the developer was responsible for design and construction.

7.3 Evaluation of Alternative Financing Plans

Since there are numerous different sources and arrangements for obtaining the funds necessary for facility construction, owners and other project participants require some mechanism for evaluating the different potential sources. The relative costs of different financing plans are certainly important in this regard. In addition, the flexibility of the plan and availability of reserves may be critical. As a project manager, it is important to assure adequate financing to complete a project. Alternative financing plans can be evaluated using the same techniques that are employed for the evaluation of investment alternatives.

As described in Chapter 6, the availability of different financing plans can affect the selection of alternative projects. A general approach for obtaining the combined effects of operating and financing cash flows of a project is to determine the adjusted net present value (APV) which is the sum of the net present value of the operating cash flow (NPV) and the net present value of the financial cash flow (FPV), discounted at their respective minimum attractive rates of return (MARR), i.e.,

APV = [NPV]@-(r) + [FPV]@-(r@-{f})

 

APV##=##
from"t=0", to"n"
  
  ##
num "A@-{t}",
denom "(1#+#r#)@+(t)"
  
  ##+##
from"t=0", to"n"
  
  ##
                                      -
num "                                  @-{t}",A
denom "(1#+#r@-{f}#)@+{t}"
  

                  -
 

For the sake of simplicity, we shall emphasize in this chapter the evaluation of financing plans, with occasional references to the combined effects of operating and financing cash flows. In all discussions, we shall present various financing schemes with examples limiting to cases of before-tax cash flows discounted at a before-tax MARR of r = r@-(f) for both operating and financial cash flows. Once the basic concepts of various financing schemes are clearly understood, their application to more complicated situations involving depreciation, tax liability and risk factors can be considered in combination with the principles for dealing with such topics enunciated in Chapter 6.

In this section, we shall concentrate on the computational techniques associated with the most common types of financing arrangements. More detailed descriptions of various financing schemes and the comparisons of their advantages and disadvantages will be discussed in later sections.

Typically, the interest rate for borrowing is stated in terms of annual percentage rate (A.P.R.), but the interest is accrued according to the rate for the interest period specified in the borrowing agreement. Let i@-(p) be the nominal annual percentage rate, and i be the interest rate for each of the p interest periods per year. By definition

i###=###
num"i@-(p)", denom"p"
  

 

i@-(e)###=###(1##+##i)@+(p)##-##1##=##  ##1##+##
num"i@-(p)",
denom"p"
  
  #  @+(p)##-1

 

For a coupon bond, the face value of the bond denotes the amount borrowed (called principal) which must be repaid in full at a maturity or due date, while each coupon designates the interest to be paid periodically for the total number of coupons covering all periods until maturity. Let Q be the amount borrowed, and I@-(p) be the interest payment per period which is often six months for coupon bonds. If the coupon bond is prescribed to reach maturity in n years from the date of issue, the total number of interest periods will be pn = 2n. The semi-annual interest payment is given by:

I@-(p)###=###iQ###=###i@-(p)##
num "Q", denom "2"
  

 

An alternative loan arrangement is to make a series of uniform payments including both interest and part of the principal for a pre-defined number of repayment periods. In the case of uniform payments at an interest rate i for n repayment periods, the uniform repayment amount U is given by:

#####U##=##Q##
Num "i(1+i)@+(n)",Denom "(1+i)@+(n)#-#1"
  
  ##=Q##(U | P,i,n)

 

Usually, there is an origination fee associated with borrowing for legal and other professional services which is payable upon the receipt of the loan. This fee may appear in the form of issuance charges for revenue bonds or percentage point charges for mortgages. The borrower must allow for such fees in addition to the construction cost in determining the required original amount of borrowing. Suppose that a sum of P@-(o) must be reserved at t=0 for the construction cost, and K is the origination fee. Then the original loan needed to cover both is:

Q@-(o) = P@-(o) + K

 

Q@-(o)##=##
num "P@-(o)", denom "1-k"
  

 

N@-(o)##=##Q##-##K##+##A@-(o)
and at t = 1,2,...,n:
  
N@-(t)##=##(1##+##h)N@-(t-1)##+##A@-(t)##+##
                                 -
                                  @-(t)A

                              -
 

Because the borrowing rate i will generally exceed the investment rate h for the running balance in the project account and since the origination fee increases with the amount borrowed, the financial planner should minimize the amount of money borrowed under this finance strategy. Thus, there is an optimal value for Q such that all estimated shortfalls are covered, interest payments and expenses are minimized, and adequate reserve funds are available to cover unanticipated factors such as construction cost increases. This optimal value of Q can either be identified analytically or by trial and error.

Finally, variations in ownership arrangements may also be used to provide at least partial financing. Leasing a facility removes the need for direct financing of the facility. Sale-leaseback involves sale of a facility to a third party with a separate agreement involving use of the facility for a pre-specified period of time. In one sense, leasing arrangements can be viewed as a particular form of financing. In return for obtaining the use of a facility or piece of equipment, the user (lesser) agrees to pay the owner (lesser) a lease payment every period for a specified number of periods. Usually, the lease payment is at a fixed level due every month, semi-annually, or annually. Thus, the cash flow associated with the equipment or facility use is a series of uniform payments. This cash flow would be identical to a cash flow resulting from financing the facility or purchase with sufficient borrowed funds to cover initial construction (or purchase) and with a repayment schedule of uniform amounts. Of course, at the end of the lease period, the ownership of the facility or equipment would reside with the lesser. However, the lease terms may include a provision for transferring ownership to the lesser after a fixed period.

Example 7-2: A coupon bond cash flow and cost

A private corporation wishes to borrow $10.5 million for the construction of a new building by issuing a twenty-year coupon bond at an annual percentage interest rate of 10% to be paid semi-annually, i.e. 5% per interest period of six months. The principal will be repaid at the end of 20 years. The amount borrowed will cover the construction cost of $10.331 million and an origination fee of $169,000 for issuing the coupon bond.

The interest payment per period is (5%) (10.5) = $0.525 million over a life time of (2) (20) = 40 interest periods. Thus, the cash flow of financing by the coupon bond consists of a $10.5 million receipt at period 0, -$0.525 million each for periods 1 through 40, and an additional -$10.5 million for period 40. Assuming a MARR of 5% per period, the net present value of the financial cash flow is given by:

[FPV]@-(5%) = 10.5 - (0.525) (P| U, 5%, 40) - (10.5) (P| F, 5%, 40) = 0

 

     i@-(e) = (1 + 0.05)@+(2) - 1 = 0.1025 = 10.25%

     0.525 (1 + 0.05) + 0.525 = 1.076

 

     [FPV]@-(10.25%) = 10.5 - (1.076)
 (P|U, 10.25%, 20) - (10.5)
 (P|F, 10.25%, 20) = 0

 

Example 7-3: An example of leasing versus ownership analysis

Suppose that a developer offered a building to a corporation for an annual lease payment of $ 10 million over a thirty year lifetime. For the sake of simplicity, let us assume that the developer also offers to donate the building to the corporation at the end of thirty years or, alternatively, the building would then have no commercial value. Also, suppose that the initial cost of the building was $ 65.66 million. For the corporation, the lease is equivalent to receiving a loan with uniform payments over thirty years at an interest rate of 15% since the present value of the lease payments is equal to the initial cost at this interest rate:

From "t=1", To "30"
  
  ##
Num "10",Denom
"(1.15)@+(t)"
  
  ##=##(10)##(P |
 U,##15%,##30)##=##$#65.66##million

 

[FPV]@-(20%)## =## 65.66## - ##(10)# (P
| U, 20%, 30)## =## $#15.871## million

 

[FPV]@-(10%)## =## 65.66## -## (10) (P
| U, 10%, 30)## =## -$#28.609# million

 

Example 7-4: Example evaluation of alternative financing plans.

Suppose that a small corporation wishes to build a headquarters building. The construction will require two years and cost a total of $ 12 million, assuming that $ 5 million is spent at the end of the first year and $7 million at the end of the second year. To finance this construction, several options are possible, including:

• Investment from retained corporate earnings;
• Borrowing from a local bank at an interest rate of 11.2 % with uniform annual payments over twenty years to pay for the construction costs. The shortfalls for repayments on loans will come from corporate earnings. An origination fee of 0.75% of the original loan is required to cover engineer's reports, legal issues, etc; or
• A twenty year coupon bond at an annual interest rate of 10.25% with interest payments annually, repayment of the principal in year 20, and a $ 169,000 origination fee to pay for the construction cost only.

The first step in evaluation is to calculate the required amounts and cash flows associated with these three alternative financing plans. First, investment using retained earnings will require a commitment of $ 5 million in year 1 and $ 7 million in year 2.

Second, borrowing from the local bank must yield sufficient funds to cover both years of construction plus the issuing fee. With the unused fund accumulating interest at a rate of 10%, the amount of dollars needed at the beginning of the first year for future construction cost payments is:

#####P@-(o)##=##
Num "5", Denom "(1.1)"
  
  ##+##
Num"7", Denom
"(1.1)@+(2)"
  
  ##=##$#10.331#million

 

Year 1,     I@-(1) = (10%) (10.331) = $1.033 million
Year 2,     I@-(2) = (10%) (10.331 + 1.033 - 5.0) = 0.636 million

Q@-(o)##=##
num "10.331", denom "1-0.0075"
  
  ##=##$#10.409 ##million.
 

If this loan is to be repaid by annual uniform payments from corporate earnings, the amount of each payment over the twenty year life time of the loan can be calculated by Eq. (7.6) as follows:

####U##=##(10.409)#
Num "(0.112)#(1.112)@+(20)", Denom
"(1.112)@+(20)#-#1"
  
  ##=##$#1.324#million

Finally, the twenty-year coupon bond would have to be issued in the amount of $10.5 million which will reflect a higher origination fee of $169,000. Thus, the amount for financing is:

Q@-(o)## =## 10.331## +## 0.169## =## $#10.5 #million

 

Table 7-0 summarizes the cash flows associated with the three alternative financing plans. Note that annual incomes generated from the use of this building have not been included in the computation. The adjusted net present value of the combined operating and financial cash flows for each of the three plans discounted at the corporate MARR of 15% is also shown in the table. In this case, the coupon bond is the least expensive financing plan. Since the borrowing rates for both the bank loan and the coupon bond are lower than the corporate MARR, these results are expected.

______________________________________________________________________________

Cash Flow Illustration of Three Alternative Financing Plans
  

!!!!!! Retained!!! Bank!!! Coupon

Year!!! Source!!! Earnings!!! Loan!!! Bond

0!!!Principal!!! -!!! $ 10.409!!! $ 10.500

0!!!Issuing Cost!!! -!!! -0.078!!! -0.169

1!!!Earned Interest!!!-!!! 1.033!!! 1.033

1!!!Contractor Payment!!!$ -5.000!!! $ -5.000!!! $ -5.000

1!!!Loan Repayment!!!-!!! -1.324!!! - 1.076

2!!!Earned Interest!!!-!!! 0.636!!! 0.636

2!!!Contractor Payment!!!$ -7.000!!! $ -7.000!!! $ -7.000

2!!!Loan Repayment!!!-!!! - 1.324!!! - 1.076

3-19!!!Loan Repayment!!!-!!! - 1.324!!! - 1.076

20!!!Loan Repayment!!!-!!! -1.324!!! -11.576

[APV]@-(15%)!!!!!!-9.641!!! - 6.217!!! - 5.308

___________________________________________________________