A New Approach of Project Cost Overrun and Contingency Management

Said Boukendour, Ph.D. Universit du Qubec en Outaouais

OCRI Partnership Conferences Series Process and Project Management Ottawa March 22, 2005

Presentation Agenda
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Measuring cost overrun Risk and contingency analysis A project as a short selling Contingency as an option premium The value of estimation accuracy Compensation of estimation accuracy

Measuring Cost Overrun

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Usually the media and the public opinion focus on the huge cost overruns experienced by the mega projects such as
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Canadian Firearms Program n Planned cost: $119 m Final cost: $1bn International Space Station : n Planned cost: $8bn Final cost: $26bn Channel Tunnel n Planned cost: 4.9bn Final cost: 10bn Concorde n Planned cost: 90m Final cost:1.1bn In addition, it has never made profit during its 40 years of operation Etc.

The mega projects are only the visible pick of the iceberg

Measuring Cost Overrun

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A large number of studies and surveys evidenced the fact that cost overrun affects all kinds of projects in all industries, and in all countries either in the public or in the private sector Cost Overrun = Actual Cost Estimated Cost The problem is that several cost estimates are usually produced during the project life cycle, but there is no standard rule to determine which one must be considered for computing the cost overrun In consequence, the results could be significantly different from one survey to another depending on which estimate is considered

Measuring Cost Overrun

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A survey based on 258 infrastructure projects in 20 different countries indicates that

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9 times of 10, the actual costs are on average 28% higher than the estimated costs at the time of decision to build Underestimate today is in the same order of magnitude as it was 10, 30, and 70 years ago Of 617 infrastructure projects, only 149 are faced with cost overruns amounting to 22.2% with respect to the latest approved estimates The cost overrun has come down from 62% in March, 1991 to 20.7% in September, 2004

Another survey in India finds that

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Measuring Cost Overrun

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The Standish Group (www.standishgroup.com) has surveyed over 50,000 completed IT projects in its biennial CHAOS research since 1994. The results are summarized below
Years
Average cost overrun

1994 189%

1996 142%

1998 69%

2000 45%

2002 43%

2004 43%

Like most commercial companies, the Standish Group do not reveal their research method and measurement information, which are treated as a trade secret.

Measuring Cost Overrun

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Asked for the chief reasons project success rates have improved, Standish Chairman Jim Johnson says, The primary reason is the projects have gotten a lot smaller. Doing projects with iterative processing as opposed to the waterfall method, which called for all project requirements to be defined up front, is a major step forward. For some academics, the strong decrease of cost overrun from 142% to 69% in two years is a reason to doubt the research method itself since all surveys of cost estimation accuracy related to this period suggest average cost overrun in the range of about 30%

Risk and Contingency Analysis

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The objective of contingency allocation is to prevent a project from experiencing cost overrun Contingency is an amount added to an estimate to allow for additional costs that experience shows will likely be required. This may be derived either through statistical analysis of past project costs, or by applying experience gained on similar projects (AACE 1998) Contingency covers the costs that may result from incomplete design, unforeseen and unpredictable conditions, or uncertainties within the defined project scope (DOE 1994) Contingency usually does not include changes in scope or schedule or unforeseeable major events such as strikes or earthquakes

Risk and Contingency Analysis

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Contingency vs Management reserve q Contingency is an element of a projects cost which is included to allow for the unknowns and to ensure project completion within the budget q Management reserve is an amount of the total allocated budget withheld for management control purposes in order to enhance performance As a part of a projects cost estimate, contingency under estimation or over estimation can lead q To approve a project that should be rejected q To reject a project that should be accepted q To misallocate resources during the project implementation

Risk and Contingency Analysis

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Recommended practices and standards can readily be applied

Risk and Contingency Analysis

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Specific risk analysis methods include qualitative analysis and probabilistic analysis Qualitative analysis relates projects characteristics directly to a percentage figure on the base estimated costs
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The percentages may be developed from checklists or by matching project characteristics to the characteristics of previously completed projects stored in the database The cost engineer makes a judgement should more or less contingency be added to this situation

Risk and Contingency Analysis

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Probabilistic analysis determines the risk of the total project by: q Assigning a low, medium, and a high estimate to each project WBS element, and computing the expected cost and variance of each element and of the total project q Combining risks from various sources and events using a simulation technique In this way, the contingency is determined with respect to a certain level of confidence that the actual cost will not exceed a given cost estimate

Risk and Contingency Analysis

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Limits of the traditional approach

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Contingency is arbitrarily determined or dependent on someones risk aversion There is no compensation for cost estimation accuracy

Our new approach attempts to address these problems

A Project as A Short Selling

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Unlike a long seller who already owns the asset he or she sells, a short seller sells the asset without owning it At the delivery date, the short seller must close his or her position by buying back and delivering the asset By analogy, a contractor or a project manager committed to achieve a project sells something without owning it At the starting date, the product to be developed does not yet exist and nobody exactly knows how much it will cost when it will be completed

A Project as A Short Selling

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Depending on whether the price will raise or fall down, the short seller will gain or lose the difference To prevent the possible loss without losing the opportunity of a potential gain, the short seller can buy a call option on the same asset maturing at the delivery date The call option gives to its buyer the right but not the obligation to buy the underlying asset for the pre-determined price In consequence, le short seller will exercise the option only if the asset price raises beyond the agreed fixed price whereas the options seller is obliged to abide by the decision whatever the price rise This unilateral price change risk thus assumed by the options seller has value, which is the option premium

A Project as A Short Selling

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What is the risk premium that would be required by the market if the project was a traded security or a commodity? Lets assume that there exists a twin security that is perfectly correlated with the project cost such as if the project cost increases, the stock price increases in the same range, and similarly if it decreases. Lets also assume for simplification that all the actual cost incurs at the project completion date Consider that we buy a call option that gives us the right to purchase the security at a fixed price at the project completion date The option will relate to a total amount of stocks that equals the project budget amount whereas the options seller is obliged to abide by the decision whatever the price rise

A Project as A Short Selling

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If the cost goes up, we will exercise the option and we will get the stocks for the agreed fixed price. Then, we will sell them for the spot price and we will earn the difference, which will equal the budget overrun for, the perfect correlation stated here above In contrary, if the cost goes down, we will abandon the option and we will benefit from the budget under run Finally, the call option limits our total expenditure to a ceiling amount made up of the budget amount plus the option premium, and without losing the opportunity of a potential gain that may result from cost decreases By this way, we reach the same position than the short seller who buys a call option.

A Project as A Short Selling

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However, there is a difference between the two situations q The short seller deals with options that are really traded on the market and that allow to virtually transfer the risk to the option seller q In the case of the project, the option does not exist and nothing is guaranteed by a third-person
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The analogy is only made for a valuation purpose.

Contingency as an Option Premium

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At the maturation date of the option, two situations may happen: q The option is abandoned and expires worthless q The option is exercised and it is worth its payoff that is the difference between the spot price of the asset and the exercise price of the option. This is called the intrinsic value of the option But, how is worth the option at the start date of the contract? The value of an option at the start date can be calculated by constructing a portfolio of traded securities which has the same payoffs as the option In virtue of no-arbitrage condition, the value of the option must dynamically equals the value of the portfolio as the stock price evolves.

Contingency as an Option Premium

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Consider this very simple example: q 0 : starting date of the project q 1: completion date in one year q $500,000 : estimated cost at date 0. At date 1, there will be only two possibilities: the cost will either go up by 30% or go down by 20% q 5%: one year interest rate q $500,000 : exercise price of the option that matures at date 1 Suppose there exists a stock that perfectly mimics the project cost movements. At date 1, the total amount of stocks will either go up to $650,000 or go down to $400,000, and consequently the option value will equal $150,000 or $0, respectively.

Contingency as an Option Premium

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To determine the option value at date 0, we construct a portfolio consisting of a combination of the stocks and the bonds that exactly replicates the call option payoffs Let A and B be respectively the proportion of the stocks and the bonds, we state: 650A+1.05B=150 400A+1.05B=0 The linear system equation solves to give A = 0.6 and B = -228.571. Thus investing 60% of the project budget in the stocks and borrowing $228,571 at 5% for one year will give payoffs of $150,000 if the stock price goes up and $0 otherwise.

Contingency as an Option Premium

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From the non-arbitrage condition, which states that two assets or sets of assets that have the same payoffs must have the same market price, the call option at date 0 is worth:
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$500,000*0.6$228,571= $71,429, say 14%.

That is the risk premium that would be required by the market for assuring the project against cost overrun given its cost range estimate. As a result, the total budget will be: $500,000+$71,429=$571,429

The Value of Accuracy

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As a project matures through the design process, many decisions are made, and many uncertainties are resolved. As a result, the estimate becomes more and more accurate Every one-point move in the estimate accuracy must be translated into the change of the contingency provision.

The Value of Accuracy

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The hedge ratio measures this change Financially speaking, it measures how much the calls value changes if the underlying asset price volatility changes by a small amount From the above example, we get : (150-0)/(650-400)=0.6 The result is nothing else than A, which is the share of stocks to invest in the portfolio to replicate the calls value.

60 50 40 30 26,19 20 14,28 10 0 100% 75% 50% 25% 50

38,09

Contingency vs cost estimate accuracy

Compensation of Estimation Accuracy

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In the earlier stages of any project, nobody exactly knows how it will actually cost when it will be completed. Thus, estimating is always risky. Nonetheless, due to their expertise and their experience, the cost estimators can give a more reliable estimate than can do those who decide for funding the project. The issue is then how to reward them as a function of their cost estimate accuracy.

Compensation of Estimation Accuracy

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In the earlier stages of any project, nobody exactly knows how it will actually cost when it will be completed. Thus, estimating is always risky. Nonetheless, due to their expertise and their experience, the cost estimators can give a more reliable estimate than can do those who decide for funding the project. The issue is then how to reward them as a function of their cost estimate accuracy Some would suggest that cost estimators and project appraisers should be accountable for their estimates, and they should totally or partially assume cost overrun. However, any rewarding system which creates high uncertainty in their income will translate into a higher risk premium and consequently in a higher cost estimate

Compensation of Estimation Accuracy

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Virtually, the risk of cost overrun is not transferable because it will ineluctably lead the estimators to bankruptcy Instead, a rewarding system with an acceptable risk can be suggested using an analogy with butterfly strategy The butterfly strategy is used in the security market by investors who want to bet that the underlying asset price will end up very close to its current price. The strategy is built on four trades at one expiration date and three different strike prices.

Compensation of Estimation Accuracy

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Consider we are expecting a stock price currently at $60 to remain at that level at expiration date, say in 6 months. Assume that the premiums of calls maturing in 6 months are traded as follows: Strike price $55 $60 $66 Call price $10 $7 $5 We wish to take advantage of our reasonably established beliefs that the stock price will remain at $60 at the expiration date

Compensation of Estimation Accuracy

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We can build a long butterfly spread which consists in buying one $55 call at $10, one $65 call at $5, and selling two $60 calls at $7. The net expense will be $1, i.e.: q Buying 1 $55 Call at $10..= -$10 q Selling 2 $60 Calls at $7x2...=+$14 q Buying 1 $65 Call at $5.= -$5 q Net debit -$1

Compensation of Estimation Accuracy

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At expiration, if the stock price is at $70, the two $60 calls are exercised against us and we loss $20=2($60-$70), but we exercise our $55 and $65 call, and we gain $20=($70x2-$55-$65) so the net difference would be zero. In that case, we only lose our $1 premium. If the stock price is at $50, all four options would not be exercised, and again our only loss is the $1 premium. If the stock price is at $60, we would exercise our $55 call, and sell the stock at $60 and gain the $5 difference. By subtracting the premium of $1, we have a $4 profit.

Compensation of Estimation Accuracy

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The first break-even value is calculated by adding the net debit to the lowest strike price, i.e.: $56 The second break-even value is calculated by subtracting the the net debit from the highest strike price, i.e.: $64 The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices, i.e.: $60-$55-$1=$4. The maximum risk is limited to the net debit paid for the position

Conclusion
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We pointed out the need to estimate the cost contingency regardless the individual preference or risk aversion For this we considered a project alike a short selling of a security, the contingency provision was viewed as a call option premium. But, the analogy was only made for valuation purpose This allowed us to estimate cost contingency as a risk premium that would be required by the market if the project was a traded security We also suggested an original rewarding system that encourages the cost estimators to produce accurate estimates without having to bear unreasonable risks