Here's why "worst case scenario" is a bad approach.

[rockstar.esq]

"Quick, how much will you charge to make my dream come true?"

Sometimes, that question isn't too far from what it's like to be an estimator.  In my experience, people tend to focus on whatever they can measure to reduce uncertainty and the risk it brings.  When there's less detail or "stuff" to measure, the majority of people will switch to imagining the "worst case scenario".  I suppose the idea here is that you'll reduce your uncertainty by filling the gap with every imaginable fear.  Sadly, a lot of people who follow this process to price their work, find themselves surprised by some unforeseen problem that they're now obliged to solve for the original bid.  This inexorably leads these people to slap a hefty premium on the next "worst case scenario" they price.  

So to sum up, "worst case scenario" pricing efforts tends to generate high prices for the client without reducing risk for the contractor.

There's a much better way to handle this, but it requires a shift in your thinking.  There's a concept in design called "negative space".  A good example of this is the FedEx logo.  If you look carefully at the junctions of the E and the x, you'll see that it forms an arrow pointing right.  That arrow is "negative space".  Put another way, you're using the absence of something to better define the borders of something else.

So what does that have to do with pricing unicorns?  Well, consider how much negative space there is an open request for pricing.  Context is huge here.  Start by defining what you are.  If your firm mostly makes things between X and Y, there's no reason to assume that a client approached you wanting something totally outside of your expertise.  If you're not competent or capable of making the thing requested, don't price it.  It's not helpful or reasonable to present your pricing as an honest answer to a legitimate contract opportunity.

OK, so that just knocked the "stratospheric" options off the table.  That still doesn't help to price the discrepancies between lesser and greater unicorns.  Go back to the negative space.  Anything that's not defined, is an opportunity to provide boundaries for understanding what is and isn't included in your price.

Here again, we need to make sure that our perspective is pointed in the right direction.  Listing sentence fragments like a malfunctioning robot-lawyer will not do you any favors.  Time is very easy to measure and quantify.  If you'd typically take 80 hours to make something similar, you can actually write that into your proposal.  For example; "We included 80 hours for XYZ task based on past project experience, additional hours will be billed at $X per hour."  This tells your client how much you're giving them, while also providing some insights into your reasoning.  Strive for clarity, competency, and concise wording to convey the important information.  

Estimators spend a lot of time talking in terms of clarifications, inclusions, and exclusions.  Clients, spend most of their time trying not to get suckered by a buried condition.  As a general rule, I believe that exclusions should be for things that nobody reasonably expects you to have.  If there's a good reason that you're not including something that people might think is your job, it's time to write a clarification explaining why you didn't include it.  Any conversations to follow will be much more productive because the client can see that you are addressing their concerns.

Inclusions should be items that you're 100% comfortable with.  I find that it builds trust to speak plainly.  For example; "Includes all stonework"  versus "Includes approximately 126 square feet of stone work".  A lot of fastidious estimators would choose the second statement figuring that more detail is better.  Most clients won't know exactly how much stone work they'll need, they're hiring it out and just want the job done.  The proposal that promises to do the obvious thing reads as more complete and trustworthy.  

Ok so that's all well and good, but how does this approach protect against unforeseen stuff?  To answer, let's go back to that FedEx logo again.  The arrow has a well-defined perimeter.  Consider that perimeter for a moment.  The letters of the FedEx are simplistic, consistent and orderly.  Well-crafted inclusions would be written the same way.  Adding a border or a banner to the letters wouldn't increase the legibility or convey the same clarity.  There's a point where more detail would actually detract from the message.  

Now for the arrow, well-crafted clarifications illustrates the negative space which conveys your intent and/or understanding.  From there, it's possible to exclude anything not expressly included or clarified in the proposal.  The goal here is to avoid a list of "gotcha" exclusions without leaving your firm open to a long list of extras.  Often, it helps to consider the nature of whatever it is that you're worried about.  If you're concerned that the client will demand a premium material, you might provide an alternate to upgrade.  When there's a huge range of prices, you could offer multiple alternates for  defined ranges of material cost by meaningful (to the client) descriptor.  For example "Residential grade, Commercial grade,  Commercial grade".  

Summing up, the "worst case scenario" approach to pricing is too passive and reactive to be an effective means of controlling risk.  With the focus on imagining all the things that can go wrong, little attention goes towards defining what you're actually trying to do.  When the work isn't well-defined in the proposal, there is less basis to defend your firm from unexpected conditions. In contrast, it's often possible to greatly simplify the scope of work by providing clear boundaries for what is included and why.  When the focus is on the boundaries of what is in the proposal, the "holes" can be explained with clarifications that build on the reasoning set forth in the inclusions.  This conveys the limits of what's in your proposal better than a list of every fanciful fear you can imagine.  

 

 

[Kozzy]

In my business, we tend to have the opposite problem of "worst case".  We tend to get engineers designing and demanding based on " what the book says"...basically best-case...which ignores mechanical components and how they operate a couple of years down the road.  Stuff starts to wear.  Maintenance is neglected. Cleaning is neglected.  Lubrication is neglected.  Then the customer wonders why the mechanical parts are failing before the expected lifespan...and we get the blame for making inferior products (because manure rolls down hill and suppliers tend to be at the bottom of that hill).  Downtime in my industry costs the customer about $ 15,000 an hour on average so a couple of hours of downtime costs more than the whole product we produce.

So...I design for what I call "real world".  I include some extra safety factor based on 35 years of experience with the product and the customer base.  Even that may be adjusted up if I happen to know the end user or specific industry is particularly bad at maintenance and operation.  I rarely go the other way when I know a customer has a top-notch maintenance team but sometimes do.  With new customers we often lose on price compared to competitors who cut it to the minimums.  With established customers who've been burned by that game, we get the order 98% of the time.

Even at that, I always also calculate based on worst-case when designing.  That lets me know how close I am to that subjective figure when doing my more realistic "real world" calculations.  I did one this morning calculating a couple of chain options, one being 71% of max and the other option being 50% of max (both higher than I would have recommended if working from scratch but they already have existing machines from elsewhere).  The 71% is just not enough cushion in my opinion, even though it calculates to be adequate.  Although I did give them the both options, I recommended they take the larger cushion option as a better value even though it did increase the changeover costs quite a bit (I make no extra money here from the better option).  If they don't understand value gained from those extra costs, I can't make them...and often don't even want that kind of customer.  

 

[Charles R. Stevens]

3 to one and 5 to one safety margins always make sense in man lift and automotive applications. As to construction fail safer seems to be the reasonable thing. 

That said we see what happens when we leave engineers unsupervised all to often, lol

[rockstar.esq]

Kozzy,

I suspect you would agree that engineering is very different from estimating.  There's no doubt that engineering decisions impact price.  The purpose of my post is to help with pricing something that's very poorly defined.  

 

 

[Buzzkill]

I'm pretty sure you work on a much larger scale than anything I've ever dealt with, so my experiences may not transfer well. 

When I'm working up rates I try to include the cost of all the known variables - labor (including all the labor cost items like taxes and projected overtime), energy, maintenance and equipment costs, consumables, desired profit margin, etc.  After all those things have been accounted for I look at similar situations in the past and compare projected costs to actual costs.  If you have historical data to work with, in my limited experience you can come up with a percentage over the "everything goes like clockwork" projection compared to "as it happened in the past."  I've found that method more useful in projecting fairly accurate real costs than trying to deal with worst case or best case scenarios.

The problem for me is that when things are slow then your "fixed" costs like management salaries, property taxes, and utilities for buildings, cost more per unit of production than the same people and facilities cost per unit of production when you are busy.  However, I still find that using historical data tends to allow for matching projected costs to actual costs pretty reliably without trying to nail down every detail of what is likely to go wrong and exactly how much that will cost. YMMV

[rockstar.esq]

Buzzkill,  five years ago I copied a blog post onto IFI that might help with your problem.

https://www.iforgeiron.com/topic/39281-why-overhead-should-not-be-figured-as-a-percentage/

The shorter version: Overhead is a time driven expense that gets paid for proportionately by the work that is ongoing when the overhead  accrued. Long term projects generate more overhead than short term projects.  When work is scarce, each individual job has to carry more of the overhead which really makes it hard to get prices low enough to beat a competitor.  For some firms, the  answer is to reduce overhead by downsizing.

 

[George N. M.]

Dear Kozzy,

You bring up a factor that has always puzzled me, the lack of recognition that maintenance is cheap and repairs/replacement is expensive.  I once worked at a series of flourite mines and the managements philosophy regarding machinery was to run it until it breaks then fix it the cheapest way possible and if that wasn't an option buy the cheapest used replacement.  If they had had the sense to here a maintenance tech to walk around all day with a grease gun and a wrench their costs would have gone down and the production would have gone up.  I worked there just after being on active duty in the US Army where every piece of equipment had a maintenance log and preventive maintenance on everything form your individual weapon on up was a command emphasis.  I was too junior to make any changes or even raise the subject but I have seen similar problems since.  It always seems counter-intuitive to me.

On a smaller scale there can be a similar problem in our shops.  Lots of people ignore the need to keep moving parts lubricated.  I remember Francis Whittaker requiring that all blowers, etc. be oiled every day before lighting the forge.

"By hammer and hand all arts do stand."   

[rockstar.esq]

George,

Your comment reminds me of a story a Journeyman Electrician told me about his grandfather.  Apparently his grandfather was quite a renaissance man.  He played a part in designing things as varied as a limited slip differential for a light truck, and a hydro-electric power plant for a rural community.  The grandson inherited a neat prototype 100 series pickup with tandem axles from the 1950's.

Anyhow, the hydro plant originally had two buildings.  The larger of the two housed the power generation, the smaller housed the management.  Over the course of forty years or so, there were a lot of improvements made to that site. Three more buildings went up on the site, all of them were for management.  When the whole plant was going to be decommissioned in the 1990's this guy's family was invited out to tour the facility one last time.  He said that all the generation equipment was original.  

Maybe the expansion of administrative bureaucracy is the key to understanding why maintenance is so often neglected.  There's a lot of cynicism applied to corporate takeovers that lead to mass layoffs.  It seems plausible to assume that "greed" motivates the buyer to discard long-term employees of the purchased firm.  However, it's pretty easy to show how human nature leads managers to propagate bureaucracy.  Despite all evidence to the contrary, most bureaucrats are actually human.  Most of them will figure out that any painless cuts to the bureaucracy threatens their continued employment.  Costs constantly rise, quality constantly declines. 

If the means of operational production is in constant peril, there's a lot of justification for all that management.  For the most part, none of that is true, which is why middle management gets wiped out in mergers and acquisitions.  

The question that's been cooking my noodle for some time, is; "If human nature is the cause, how do you prevent this from happening?"  The best I can come up with so far is to arrange incentives so that it's profitable for the wrong people to do the right thing.  I had a discussion similar to this with a fellow traveler several years ago.  She thought my suggestion sounded "very expensive".  I replied "You know what, you're absolutely right.  How much is the national debt?"

 

[Buzzkill]

18 hours ago, rockstar.esq said:

The shorter version: Overhead is a time driven expense that gets paid for proportionately by the work that is ongoing when the overhead  accrued. Long term projects generate more overhead than short term projects.  When work is scarce, each individual job has to carry more of the overhead which really makes it hard to get prices low enough to beat a competitor. 

That's almost exactly what I said in my second paragraph using different words.

I'm not talking about overhead.  I'm talking about the difference between calculated costs and real costs.  Calculated costs, including overhead, are done at current conditions.  Often that still doesn't capture everything, and very rarely does everything go according to plan so it is necessary to build in some cushion for the "likely scenario" rather than the "worst case scenario."

We have some customers that historically and consistently require more time on site than others.  Although we have "standard" calculations for labor costs for certain jobs it would be inadvisable to ignore the history of that particular customer and pretend that the standard calculations will apply to them.  It makes more sense to me to look at what has actually happened in similar situations, figure the difference between calculated costs and real costs as a percentage, and then add that percentage to the new job even if you can't itemize the details of the extra costs. If they are real they need to be taken into account.  History cannot always predict the present or future, but it is often a very good indicator.

In general we operate in such a way that we always try to give the lowest rate possible and still maintain profitability, but there are some exceptions.  Jobs that we can do but are considered undesirable for our business are often rated a bit higher. When work is scarce downsizing is always a valid option, but working at a loss is not a good option IMO. I'd rather lose business that can only be profitable in the best case scenario (which is what calculated costs often are).  None of us want to go broke, but going broke while working ourselves to death is about the worst thing we can do. It's better to keep resources available for other opportunities and hopefully help drive the market back up by refusing to work for no profit or at a loss.  If someone else gets the job and it's not profitable for them they probably won't stay in business for long.  If they can do it profitably for a lower price but you cannot, then you still have to find a way to cut your own costs before you should accept the work at that lower rate IMO.

Unfortunately I'm seeing more third party logistics companies getting between the people who pay for the work and the people doing the work.  This may have a tendency to drive down prices, but it tends to ignore the importance of long term relationships and decreases the importance of reliable and good service.  The lowest bid gets the work the majority of the time, and that seems to make sense on the surface.  However, the lowest bid does not always represent the best value or the lowest overall cost when the work is done.  It's pretty hard to get that across through a third party entity.  The trend I've seen in the past decade or so is to find a way to submit a low cost up front with a lot of "hidden" costs in accessorial charges and addendums.

For example you'll see this type of thing a lot in maintenance/repair shops.  There will be an hourly rate and also a "miscellaneous" or "shop supplies" rate which is typically a percentage of the hourly labor rate.  At the same time you'll get charged for every nut, bolt, welding rod, or can of paint used. It looks like they have a lower hourly rate than someone who doesn't bill out their work the same way, but the end cost may be higher by a good margin.

[rockstar.esq]

Buzzkill,  sorry I mistook what you were getting at. You're describing a situation where you've got a lot more information to go on, than a poorly-defined conceptual pricing request from a new client.  My original post obviously doesn't apply to situations where you're working with a lot of information.

If you have past experience with any factor of the project, that knowledge becomes a baseline for the project scope.  As you put it, this is the "real case" cost.  We have some clients who get different pricing depending on which of their Project Managers will be running the job.  Incompetence, and corruption, generates a lot of risk.  Risk is expensive.  I've struggled with situations similar to what you're describing because it's relatively easy to knock up a percentage, but it's difficult to prove that the percentage is driven by the correct factors.

For example, let's say a client tends to dither on decisions.  Past projects show they consumed X% more hours of management's time than the typical job.  Management time isn't exclusively spent on client decisions.  A large part of it is just processing paperwork, communicating, sitting in meetings, etc.  Sometimes we're dealing with really poor designs that will generate lots of hard decisions for the waffling client.  That's a perfect storm of intersecting professional incompetence.  Working through that morass might take a different approach than just adding management hours.  It might be better to price the necessary technical and administrative support to meet that challenge.  

In the past we've sought the services of an independent engineering consultant to counter problems generated by the clients incompetent design team.  Contrary to my original expectations, it was actually cheaper to hire an engineering consultant to resolve major issues quickly, than it would have been to pay a manager to ride it out hoping the correct thing would eventually happen.

 

[George N. M.]

To add a bit to my story illustrating the maintenance issue, the mining operation was connected to a mill which processed and upgraded the ore before it was shipped.  There were none of the maintenance problems in the mill operation that were present in the mine.  I think that part of the problem was the competence of the management.  The company was headquartered and had most of it's operations in the mid-west.  I suspect that the Colorado operation was corporate Siberia.  If they had a marginal manager that they didn't want to fire, for whatever reason, they would send him to Colorado where the damage he could do to the entire company was minimal compared to him being at one of the larger operations in the mid-west.

[Irondragon Forge ClayWorks]

Sound a lot like the Peter Principle, which I've seen first hand in several careers.

[George N. M.]

The geologic version of the Peter Principle is, "The clods sink to the top."

"By hammer and hand all arts do stand."