Mar-2008

Value engineering in an escalating business environment

The EPFC (engineering, procurement, fabrication and construction) business environment serving the hydrocarbon processing industry has experienced price escalation of services offered due to concurrent high demand, rising material costs and rising labour costs, most notably since 2002

David Nash, CB&I

Article Summary

This article documents the elements of the price escalation and applies the concept of value engineering as a solution to move forward capital projects exposed to cost strains. Here, a few real-world examples are shared, offering lessons-learned and strategic considerations leading to successful value engineering

Current EPFC businessenvironment
Worldwide demand from the hydrocarbon processing industry for EPFC services has increased dramatically since 2002. This higher demand, coupled with rising costs for material and labour, has led to increased price tags for projects. Part of the escalation appears to be due to rising raw material costs. Figure 11 shows increases in price per pound from below $5 prior to 2005 to a peak of near $25 in mid-2007. This translates to higher costs for nickel-containing alloys and any downstream element of the value chain containing nickel, including entire process units such as hydrotreaters and hydrocrackers.

Refinery construction labour costs have also increased significantly. Figure 2 illustrates labour cost increases since 2002.² Cost has risen more than 20% during a five-year period; however, total construction costs have risen even higher due to lower productivity and labour incentives such as per diem cost increases.

Engineering costs have increased as well. Most notable is the cost of pipe drafting/design labour. This component of engineering has escalated more than 60% since 2002 and now commonly exceeds half of total engineering costs (see Figure 3).³

Related to increases in raw material costs, equipment costs have also increased. However, the increases can only partially be explained by raw material costs. Equipment supplier margins are healthy (due to demand) and certainly a contributor to price escalation. Take as evidence General Electrics’ infrastructure division with a record $120B of backlog.4 CB&I recently received requotes on equipment originally quoted in late 2004. Twenty-eight months had elapsed between quotes. Equipment quoted was identical (and, incidentally, part of a ULSD process unit). Table 1 illustrates the cost increases. Annualised cost increase is more than 25% for this time period.

As to be expected, the escalation in labour, materials and equipment has resulted in project escalation. Project escalation is evident in at least two well-known major refinery capital projects (see Figures 5 and 6).5,6,7,8 Marathon’s new Garyville 180 mbpd refinery expansion experienced an increase of nearly one-third in the space of a year; Kuwait National Petroleum’s new 600+ mbpd grassroots refinery cost estimates have doubled in less than two years.

How are management decisions relating to capital expenditures in this environment of escalation influenced? In most cases, negatively. Cash reserves are increasingly being spent on stock repurchase. For example, Chevron recently announced a $15B stock repurchase.9 Obviously, capital ventures continue, albeit with trepidation. To tie these experiences with the current business environment of escalation, the concepts of value and value engineering will be considered.

Value engineering
Value engineering is defined as a systematic method to improve the value of goods and services by using an examination of function. Value in this context is defined as the ratio of function over cost. A primary tenet of value engineering is that function is at least maintained. So, you can improve the value by improving the function or decreasing the cost. Decreasing the function violates the definition.

Value engineering was discovered at General Electric Co. during World War II. Due to shortages of labour, raw materials and equipment parts, Lawrence Miles and Harry Erlicher were looking into the use of acceptable substitutes. 10 An unexpected and surprising outcome resulted — some of the substitutes reduced costs, improved the product, or both! What started out as an accident of necessity was developed into a systematic process that at the time was named value analysis.

Application of value engineering: five examples
Even though the current situation is not as critical as during WWII, today’s environment of high demand and escalation certainly lends itself to applying the concept of value engineering.

Following are a few examples of actual business experiences and varying approaches to challenges resulting from the current environment. The consideration of value engineering is relevant for each.

Example 1 - DOA
A client requests a proposal for a new grassroots crude unit with an integral gas plant. Given high energy costs, the crude heater is to be high efficiency and the crude preheat train is to recover maximum heat. A dual-parallel heat exchange train allows greater heat recovery made possible by improved approach temperatures. The dual train also allows for mid-cycle cleaning of individual heat exchangers with less interruption to the operation — another advantage. As a result of increased equipment, capital cost is greater with a dual train. To provide for feedstock flexibility, metallurgical upgrades are specified for the high-temperature equipment and piping to allow processing of high-acid crude feed. To allow mid-cycle heater decoking, the crude heater service is designed with two parallel heaters. These features improve the function of the proposed unit by providing reduced operating cost (utilities and maintenance) and feedstock flexibility.

During a three-month period, the process design specification and an LSTK proposal are developed. The cost estimate for the proposal is based on firm quotations for equipment from suppliers. The proposal was received with a reaction of acute sticker-shock. Due to unanticipated escalation, the offering was rejected, as the price was much higher than expected. The proposal was dead-on-arrival — a victim of escalation. Suspicions arise on the accuracy and integrity of the proposal; the supplier’s good faith is questioned.