August 2019 | Insights From the CEO
Years ago, when a reporter asked Mike Tyson if he was worried about the upcoming match with Evander Holyfield and his opponent’s strategy, the heavyweight boxing champion responded, “Everyone has a plan until they get punched in the mouth.”
While Tyson presumably was speaking literally, his statement provides a great metaphor for what happens regularly to those who oversee and manage the construction of large, capital-intensive, non-repeatable (site-specific), real estate development projects. They figuratively get punched in the mouth whenever something arises that wasn’t accounted for in the original project budget (the “plan”) but will affect the actual cost to complete the office tower, stadium, shopping center or whatever structure is being built.
We all know that these “punches” are a frequent reality of construction – stuff happens – so it’s important for our clients to know how to manage when they get hit, so to speak. The leading practice is to determine as soon as possible what a project will really cost to finish, regardless of the budget or pro forma. RealFoundations calls the practice “anticipated cost philosophy,” or ACP, although others may refer to it as “anticipated cost reporting” and “anticipated cost methodology.”
If a company stays in the development game long enough to survive and become profitable, its construction teams have done a good job of anticipating the variances between budgets and actual costs and are using some version of this approach and the methods that go with it. The senior executives running the company also have done a good job of holding their construction teams accountable for anticipating and communicating expected final costs.
ACP has always been and will continue to be important, and at RealFoundations we’ve always made this a priority to discuss with our clients and encourage them to apply it with discipline and rigor to their projects. But there’s particular urgency today in having these conversations due to the emergence in the post-recession era of a new group of developers.
This group includes a growing number of investment management companies (for example, firms serving pension funds) that historically have steered clients to put their money into existing, occupied properties with predictable operating costs and revenue but without the financial risks inherent in building a structure from scratch. In recent years, though, as real estate has ascended in popularity as an asset class, there’s been a shortage of properties for such investment, so these managers have turned their focus toward development to create more inventory. While experienced in real estate operations and management for investor portfolios, they just don’t have comparable background and know-how in building from the ground up.
What is ACP and How Does it Work?
ACP is based on several important realities of real estate development:
A budget has a limited shelf life – once a project starts, it loses its primacy as the real holder of current cost information very quickly.
The people who develop the budget are rarely the same people responsible for cost once a project starts.
The best sources for anticipating costs for project completion are the people actually building the project, e.g., the general contractor, construction manager, project manager and/or trades.
It’s also important to remember that the method of creating a budget before a project starts is structurally different than the method of forecasting the final or anticipated costs while a project is active.
A budget is based on an estimating process that treats a building like an erector set. It takes a building apart and prices the physical components based on prior experience and knowledge – X square feet of drywall, Y square feet of floor tile, Z tons of structural steel, etc.
But once a project starts, then time and unforeseen developments become primary cost factors.
Because of that difference, it is useful to clearly delineate the two processes. The budget is the best possible pre-construction estimate of cost but once construction is underway, it should be put aside and only used as a benchmark. At this point, the anticipated cost process should kick in and forecast actual costs from scratch. Anticipated costing arguably is a variant of zero-based budgeting (ZBB).
Investopedia defines ZBB as follows: “Traditional budgeting calls for incremental increases over previous budgets, such as a 2% increase in spending, as opposed to a justification of both old and new expenses, as called for with zero-based budgeting. Traditional budgeting analyzes only new expenditures, while ZBB starts from zero and calls for a justification of old, recurring expenses in addition to new expenditures. Zero-based budgeting aims to put the onus on managers to justify expenses and .aims to drive value for an organization by optimizing costs and not just revenue.”
The only reason to change the budget after construction begins is if there is a physical change in scope, e.g., the developer/owner decides to put marble in the bathrooms or add a floor to the building. The budget should not get changed whenever something cost more or less than originally estimated.
As soon as construction starts, the general contractor or construction or project manager starts the anticipated cost process.
S/he declares what s/he believes the anticipated final cost of an element will be (trade, cost code, etc.). Often, this will be the same as the budget but sometimes it will be different because s/he now knows something that wasn’t known when the budget was developed.
Then as s/he buys out each trade, s/he records the pending trade contract and estimates the anticipated final cost and decides whether there’s a need to spend anything more to finish the trade or whether all work required is included in the scope of the contract. If it’s all included, then the anticipated cost is now $0.00 for that trade.
However, s/he may not know every last thing to include in the scope of a trade contract, e.g., there may be uncertainty about whether a specific contractor is available for certain work or the possibility of another project scope change that would require extra paper work, etc. If, at that moment and to the best of one's knowledge, s/he knows there will be an additional spend to finish that trade, then her/his estimate of that cost goes into the anticipated cost column of the Cost to Complete Report. Even if this number is a guesstimate, a guesstimate is better than a complete surprise days, weeks or months later when the actual cost may be known. The same applies if a lower cost is anticipated – that’s equally important to know.
The key point here is to make the people closest to the work underway continually think about what it will truly cost to complete the project, record that thinking based on what they know at that moment in time, and share the information as soon as possible with those responsible for managing the capital invested in the project – the developers and investment managers, plus their accountants. These stakeholders then can decide in a timely manner whether it makes sense to proceed with specific work or find alternatives. Conversely, if something is going to cost less than budgeted for, they can reallocate those funds or even conserve them for future use.
That’s a vastly different approach than the typical practice. What people in the field usually do is accumulate costs and assume that they will just spend the amount allocated in the budget less what they've contracted for until they run out of budget. Anticipated cost discipline forces a ZBB exercise every month, week or day – whatever frequency is determined at a project’s outset. The greater the frequency, the greater the likelihood of knowing sooner what the real costs for completion will be and managing accordingly.
ACP in Action
Below is a sample Cost to Complete Report, describing how the person responsible for the construction budget should implement ACP. Starting with the original project budget, detailed by trade/cost code (before the start of construction), changes to scope and unexpected costs are documented (as soon as possible) throughout the construction period.
Pre-Construction Budget Items:
A – Original Budget: The number provided by “Estimators” before start of project (this number does not change).
B – Approved Scope Changes: Additional costs due to true scope changes.
C – Approved Adjusted Budget: The sum of A + B.
D – Pending Scope Changes: True scope changes that have not yet been approved.
Cost Management AFTER Construction Begins:
E – Approved Trade Contracts: Amount of original trade contracts (should be close to C, but with more firm detail).
F – Approved C/O to Trade Contracts: Approved change orders to trade contracts.
G – Pending C/Os to Trade Contracts: Like F, not completed negotiated or executed.
H – Estimated C/Os: Having put thought/research into expected cost.
I – Anticipated Cost Item: Recorded as soon as anything is known that is not already accounted for in E, F, G, H.
J – Total Anticipated Cost: E+F+G+H+I.
Note that columns E, F and G come out of a control – and accounting – oriented process which considers preparing and approving trade contracts and changes to those contracts. Often these are documented within the construction accounting system, which in turn may attempt to automate columns H and I as remaining costs or cost to complete. THIS IS A BAD IDEA as it removes the obligation for constant thinking and forecasting from the responsible party!
The simple but groundbreaking practice is to force the responsible party look at the work that has or is being contracted for (cols E-G) and then consider anything else that needs to be contracted to finish the work and make sure they are accounted for in column H (if some work has been done to actually estimate the $) or column I (if one is simply guesstimating)… Note that a guesstimate is better than a complete surprise!
On London’s Canary Wharf, a $10 billion development with 10 managers overseeing construction of 13 buildings, the rule was that if you found out something on the job that would – or might – cost money but that wasn’t yet covered by a contract or pending contract, you had to record an anticipated cost item that day. Maybe a truck backed into and damaged a wall, a trade reminded you that something was accidentally excluded from his contract that wasn’t otherwise included in a construction order and/or the owner just walked through the site and wanted extra wheelchair rails in all the bathrooms, etc. If you had no idea what it might cost, you would put in $.01 as a reminder to make an update once you figured out the cost.
By 7 a.m. every day, we had a full anticipated cost report for this massive project. There was no reason for someone working on this to know about something that might cost money but not put it into the system to share this “news” with all parties that needed to know. Recording an anticipated cost is easy and takes about 15 seconds – it involves entering a brief description, cost code(s) and a dollar amount to the Cost to Complete Report, or at least putting in $ .01 as a placeholder for updating later (when the real cost has been more accurately estimated).
A more current example of an ACP-driven project is Hudson Yards, the largest private real estate development in the United States by area. Upon completion 16 structures will exist in the Chelsea and Hudson Yards neighborhoods of Manhattan. The first of two phases - comprised of eight structures that include residences, a hotel, office buildings, a mall and a cultural facility, plus public green spaces - opened in early 2019.
If a development organization is practicing ACP effectively, its executives will know about costs long before they are incurred and about payments well before they are made. Payments simply confirm that the work they were expecting has been completed. There’s no “news” each time an invoice arrives. And when construction concludes, there shouldn’t be much “news,” if any, about the final cost of the entire project.
When requests for payment actually do contain “news” about the final cost, something is broken in the committing process. It means that no one in the field during construction recorded the implied commitment and anticipated cost but the work was performed anyway and then the trade requested payment. The payment is then a retroactive commitment of sorts. Although very common, this type of behavior throughout the construction process makes it impossible to know a project’s real costs in time to optimally manage them.
If you would like to continue this discussion on Anticipated Cost Philosophy and how we can help you incorporate this approach to your projects, please reach out to us at email@example.com.
Authored by: Chris Shaida, Founder and Enterprise Managing Consultant, RealFoundations
About the Author
Chris Shaida is an Enterprise Managing Consultant and founder of RealFoundations. Mr. Shaida founded RealFoundations to provide a place where like-minded professionals are able focus their deep industry and solution knowledge and passion to help improve the operations of our real estate industry and corporate real estate clients.
RealFoundations is a professional services firm focused on the real estate industry. With offices on four continents, 400+ client-serving professionals and off-shore delivery capabilities in India, RealFoundations provides Management Consulting, Managed Services and Energy Solutions to developers, owners/operators, service providers, institutional investors and corporate occupiers. From the building itself to the way it is used, operated and financed, no firm understands the inner workings of the entire real estate ecosystem as well as RealFoundations. We Make Real Estate Run Better.