Better Forecasting for Capital Projects
Project proposals often overestimate benefits and underestimate costs. Here’s why—and what you can do about it.
November 2010 | by David Delaney
Large capital investments that are completed on schedule and within their budgets are probably the exception rather than the rule—and even when completed many fail to meet expected revenues. Executives often blame project underperformance on foreseeable complexities and uncertainties having to do with the scope of and demand for the project, the technology or project location, or even stakeholder opposition. No doubt, all of these factors at one time or another contribute to cost overruns, benefit shortfalls, and delays.
But knowing that such factors are likely to crop up, why do project planners, on average, fail to forecast their effect on the costs of complex projects? We’ve covered this territory but continue to see companies making strategic decisions based on inaccurate data. Deliberately or not, costs are systematically underestimated and benefits are overestimated during project preparation—because of delusions or honest mistakes on one hand and deceptions or manipulation of information or processes on the other.
Psychological Biases Can Create Cognitive Delusion
Most of the underestimation of costs and overestimation of benefits of capital projects is the result of people taking what’s called an “inside view” of their forecasts. That is, they use typical bottom-up decision-making techniques, bringing to bear all they know about a problem, with special attention to its unique details—focusing tightly on a case at hand, considering a project plan and the obstacles to its completion, constructing scenarios of progress, and extrapolating trends. An inside view can lead to two cognitive delusions.
The planning fallacy. Psychologists have defined the planning fallacy as the tendency of people to underestimate task-completion times and costs even when they know that the vast majority of similar tasks have run late or gone over budget. In its grip, managers make decisions based on delusional optimism rather than on a rational weighting of gains, losses, and probabilities—involuntarily spinning scenarios of success and overlooking the potential for mistakes and miscalculations. Executives and entrepreneurs seem to be highly susceptible to this bias. Indeed, studies that compare the actual outcomes of capital-investment projects, mergers and acquisitions, and market entries with managers’ original expectations for those ventures show a strong tendency toward overoptimism.
Anchoring and adjustment. This heuristic rule of thumb is another consequence of inside-view thinking that leads to overoptimistic forecasts. Anchoring, one of the most robust biases of judgment, occurs because the answer to a question is subconsciously affected by the first cost or budget numbers considered. In the context of planning for a large capital project, for example, there is always an initial plan that unavoidably becomes an anchor for later-stage estimates, which never sufficiently adjust to the reality of the project’s performance. In fact, the typical initial estimate for the most complex and large capital investments is less than half the final cost—as managers further underestimate the cost of completing construction at every subsequent stage of the process—even though project champions almost always see their initial plan as the best or most likely case.
Misplaced Incentives Encourage Strategic Manipulation
Whereas delusion is psychological, deception and strategic manipulation—when they occur—come out of the diverging preferences and incentives of the actors in the system, otherwise known as the principal-agent problem. In this case, the problem arises when the biases of project champions are strong enough or their incentives misdirected enough that they act, deliberately and strategically, to bring about financial or political outcomes different from those preferred by the people they represent or work for.
Transparency and Incentives Reduce Delusion and Deception
Delusion and deception are complementary rather than alternative explanations of why large infrastructure projects fail as a result of cost underestimation and benefit overestimation. In practice, it is often difficult to disentangle them—though both can be surmounted with a combination of learning to overcome biases and providing incentives to promote transparency. Together, learning and incentives suggest a number of steps that project champions and executives can take.