Estimation of the Escalation Factor in Construction Projects Using Value at Risk

Abstract

Cost overrun in construction projects is a critical challenge for both owners and contractors. Budgeting for cost escalation is a major concern in the planning stage of these projects. This study aims to introduce a systematic approach to model the cost escalation factors in the construction projects. First, it is proposed to use the ENR construction cost index (CCI) as a measure of the construction cost escalation. Then, using GARCH family models, variance or so-called volatility of the escalation factor was calculated. Finally, having the estimation of the volatility of the escalation factor, and using the Value at Risk (VaR) technique, we calculate the VaR of the escalation factor. VaR, in its most general form measures the potential decrease or increase in value of a risky asset or a price index over a defined period for a given confidence interval. This calculation assures cost estimators that the actual value of the escalation factor will not exceed more than the calculated one within a reasonable bound. Planners and cost estimators can use this systematic approach for budgeting and calculating the escalation factor and risk premiums in a more conservative way.