e 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 before but continue to see companies making strategic decisions
BETTER
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 before 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 strategic manipulation
of information or processes on the other. As we’ll explore, the former is often the result of underlying psychological biases
and the latter of misplaced incentives and poor governance. Fortunately, corrective procedures to increase transparency
and improve incentive systems can help ensure better forecasts.
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 future progress, and extrapolating current 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 taskcompletion 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.
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.
To ensure responsibility, companies should also place the financial risk of delay and cost overruns with the contractors who
bid on portions of the project. This mitigates the likelihood of the winning bidder turning out to be the one who most
underestimates the true costs, with the expectation that the initial low price will be compensated for through overpricing as
the scope increases. When compensation is not possible, there is less chance that the bidding price is artificially low. If
bidders instead bear financial penalties for cost overruns or for being late, then they have incentive to disclose information
that they wouldn’t otherwise have shared. In our experience, even these minimal incentives are often not in place.
Extracted from: https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/betterforecasting-for-large-capital-projects
Question
In light of the case study provided, critically discuss why project planners, on average, fail to
forecast costs of complex projects? Your response should make use of relevant examples.
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