In 1999, voters in San Francisco approved a $299 million bond measure to provide partial funding for a skilled nursing facility. The estimated project cost was $401 million, and the budget included 3.8 percent per year in anticipated cost escalation. In early 2005, initial bids revealed a projected budget shortfall of $96 million.

A May 2005 state controller’s report notes that the overrun was attributed to cost escalation and that, while 3.8 percent per year was budgeted, actual cost escalation for the 23 months prior to May 2005 was 2.4 percent per month. The controller’s report goes on to forecast probable project costs at $600 million to $640 million, a 50 percent increase in forecasted costs.

What is cost escalation?

Simply put, cost escalation is the continual change in construction labor and material costs. And as the example above illustrates, cost escalation must be planned in every major health care project. While the San Francisco case is an extreme example, even “normal” escalation can and will result in millions of dollars in project costs that a facilities professional must account for when planning a project budget.

Recently, the national average construction escalation has been higher than historical escalation values. The reasons for this are varied. Oil prices have tripled in the last five years, and the price of gas has doubled in the same time. Everything on a construction site, including workers, is brought in a gas-burning vehicle. Common building products such as polyvinyl chloride (PVC) and asphalt include petroleum in their manufacturing processes. It is not an overstatement to say that the price of oil is impacting virtually every construction site in America.

Additionally, the global market and rapid growth in places like China have fueled supply and demand impacts on commodities like copper and scrap metal, which continue to increase in value. One major contractor reports that the cost of copper wire increased by 167 percent between 2004 and the end of 2007. The cost of ceiling tiles doubled in the same time frame, and the cost of structural steel increased by 68 percent. In some markets, labor is also a scarce commodity, and the competition for qualified and experienced health care contractors can be very intense, also driving up costs.

State and federal regulations are also contributing to the increasing cost of health care projects. California’s 1994 seismic legislation has resulted in the need for billions to be spent on upgrading health care facilities. With each project competing for limited construction materials and labor, the cost of hospital construction in California has skyrocketed at double-digit annual rates to costs approaching $700 per square foot.

Factors to consider

So what is a prudent health facilities manager to do when building a project budget model? Following are some factors they must keep in mind:

Construction market dynamics. Global, national and local markets are all dynamic, but they do not all move in lockstep. National publications are helpful, but they typically only address national issues. Understanding the issues and trends in a specific geographic area and how they impact health care construction is the first step in making reasonable projections about how escalation will impact a project. Experienced health care contractors keep close track of the material and labor markets in their business areas, and they are the best source of up-to-date cost information and local trends.

In the early budget modeling phase of a project, facilities professionals should seek out multiple contractors and ask them to share what they are seeing in current costs and where they see those costs heading. When that is coupled with information in national publications, facilities professionals will have a reasonable basis for deciding how to account for current market dynamics. Simply carrying 3 percent because it is a historical average is a recipe for trouble.

Equipment, furnishings and finishes costs. Every line item in a construction budget needs to be evaluated with respect to potential annual cost increases. Medical equipment, furniture, signage, kitchen equipment and other similar items are all examples of project budget line items that are each subject to yearly escalation.

Most hospitals routinely work with furniture and equipment vendors, and these are excellent sources of information on cost trends for their products. Professional equipment or furniture planning consultants can also provide valuable information on projected costs. For each project line item there is a specialist with whom a health facilities professional can consult regarding future cost projections. It is worth the time to talk to as many people as possible to get a variety of opinions before settling on escalation projections.

Design and consultant costs. These costs are also subject to increases, primarily due to annual salary raises. If facilities professionals are in the early modeling stage and don’t yet have contracts in place, they can usually account for these costs on a percentage basis. For example, if it is assumed that design/consulting costs will range between 10 percent and 15 percent of a construction cost, then as long as the escalation is factored into the construction costs, it will automatically be accounted for in the consultant costs. A normal annual consultant salary increase will probably be in the 3 percent to 5 percent range, but that information is only helpful if the salaries are known up front. Consultant cost escalation is not typically a major concern when building a health care project budget.

Cost compounding. A common rule of thumb for calculating the construction cost escalation is to estimate the number of years until the midpoint of the construction schedule and then compound the annual escalation rate to that midpoint.

The closer a facilities professional gets to the actual bid time of a project, the less impact that escalation is likely to have on the project. For example, if a facility is three years away from the midpoint of construction and the facilities professional determines that 5 percent is the appropriate rate, he or she should compound 5 percent for three years and include that dollar value in the budget for escalation.

If the facilities professional is three months away from bidding the project, the current costs are probably a reasonable indicator of what the costs will be on bid day, and the facilities professional might be able to reduce the escalation projections.

Mitigating escalation impacts

Beyond simply projecting future costs and hoping for the best, there are specific strategies that a facilities professional can implement in an attempt to mitigate escalation impacts on the project. They include the following:

Build the team early. Building a health care project team early is a good idea for a number of reasons, and escalation mitigation is one of them. Assembling an experienced design team, construction team and program management team early on allows facilities professionals to tap into the experience and resources of many firms.

Health care builders and consultants typically keep good track of their project costs in detail and thus have a significant database from which to draw assistance in developing a budget model. Beyond that, having the entire team assembled early allows facilities professionals the clear opportunity to begin building early. Typically, the earlier ground is broken, the earlier costs are locked in and the impacts of spiraling escalation are controlled.

Retain major subcontractors early. If the primary project team is on board early, they can also provide advice on the merits of bringing on key subcontractors early in the process.

This strategy is particularly important when a local market is busy and work is plentiful. All things being equal, many key contractors such as mechanical, electrical and plumbing contractors would prefer to work on non-health-care projects because they are shorter and less complex. Health care projects are often viewed as risky by the contracting community.

Thus, in busy markets, health facilities professionals may want to bring in key subcontractors early in the project to avoid the prospect of going out to bid and not getting enough bidders to ensure competitive pricing.

Get early packages (fast-track construction). More and more, fast-track construction is becoming the norm for health care projects. The pressure of increasing costs coupled with the organizational pressure to finish early and reap the rewards of a new facility is driving facilities professionals to ask their project teams to issue early design and construction packages.

These packages consist of design documents that are issued in advance of the total design being complete. A design team might issue early site-work and building-foundation packages to allow a contractor to begin site and foundation work while the design team finishes the rest of the plans. The benefit of this approach is fairly obvious in that it allows the facilities professional to turn the design and construction process into parallel activities instead of a series of linear ones.

Purchase materials early. Another benefit to building a broad team early is that it allows facilities professionals the opportunity to purchase materials early and lock in pricing earlier.

A contractor or supplier who is in need of a project might be willing to negotiate and lock in pricing, in exchange for gaining the business. Again, the project’s construction manager is the best adviser on these types of issues.

The risk with this approach is always that the price of the items purchased early will actually decrease or will not increase as much as was assumed. Typically, once a price is locked in, any savings or overruns revert to the contractor supplying the material.

Form effective team structure and decision-making process. The bottom line is that “time is money.” The longer it takes to make decisions, the longer it takes to implement those decisions. Health care projects require a key management committee that regularly devotes time to the project so the facilities professional can present key issues, and decisions can be made quickly.

Undertake contingency planning. Overall budget contingency planning should attempt to account for all of the issues that may financially impact a project. Escalation is only one of those issues, and a facilities professional cannot overload the contingency to account for every market turn.

Having given the issue proper consideration, the facilities professional will be able to come up with a reasonable projection to include in the budget. If the facilities professional budgets for 4 percent escalation in the main portion of the budget, he or she might account for another percent or 2 in the contingency to gain a range of escalation scenarios that might be covered.

Developing a sound model

Early project budget models are often educated guesses. The further along in the process, the more information is known and the better a budget model will become. This applies to all aspects of a budget model, including escalation.

There are times when circumstances result in a situation such as the one that occurred in San Francisco. While such scenarios do occur and are very difficult to deal with, they are not the norm.

By implementing the strategies outlined above, health facilities professionals can develop sound budget models that hold up to escalation and the myriad other issues faced during the course of a health care project.