I remember an episode from my early career. I got hired as an independent consultant to run a project for a Canadian software company that was doing a project for a much larger US organization. Right at the very beginning of the project we did a high-level estimate with the help of our sales team and came up with a budget of $1.5 million. The customer rejected the number and claimed that they would be able to pay only $750,000. Our company's management agreed (don't ask me why) with the new "forecast", contracts were signed and the work commenced.
Several month later, once we had the detailed requirements document on our hands, we went through the estimation exercise again, this time the bottom-up version. The number we came up with? The same $1.5 million. We felt it would be the right thing to do to go back to the presidents of both organizations and let them know about the results of our findings ...
The reaction from the client's side has been very interesting to say the least. "We feel that Jamal is overly pessimistic in his approach, and we want him to be replaced with a more confident project manager!"
We Still Suck at Estimating
We all know about the famous examples of projects being grossly over budget and late. These include:
- The Denver airport baggage handling system that required an additional 50% of the original
budget - nearly $200m.
- Eurotunnel - an actual cost of £10bn, over double its original estimate of £4.9bn to build
- Virtual Case File (FBI) – scrapped after $170 million while delivering only 10% of the promised scope
What are the explanations for such colossal failures? Currently there are at least three different schools of thought on this topic:
- The Standard Economic Theory
- The "Mass Delusion" Theory and
- The "Machiavelli Factor" Theory
The Standard Economic Theory Explanation
The classical economic theory states that our high failure rates on projects are very simple to explain. If companies take rational risks in order to earn abnormal incomes, these poor outcomes are inevitable. One of the key laws of the financial theory states that in a perfect market, the higher the expected return of an asset, the higher is the inherent risk associated with it.
Furthermore, the management of any given company is willing to accept these risks because in the long run the rewards are going to outweigh the losses. It is somewhat similar to a casino, that knows that the odds of winning are ever so slightly stacked in the favor of the house rather than a random gambler. An occasional big win by their client is considered "business as usual" and definitely not a serious cause for concern.
The "Mass Delusion" Explanation
Having said that, the key experts in what is called "behavioral economics", Dan Lovallo and 2002 Nobel Prize winner Daniel Kahneman strongly disagree with the argument above in their "Delusions of Success: How Optimism Undermines Executives’ Decisions" article. In a nutshell their proposition can be summed up in the following points:
- What happens in today's business world has very little to do with calculated business risks
- Modern business decision making is seriously flawed because of the delusional optimism (optimism bias) that forces people to overestimate the benefits and underestimate the costs of future projects
- Business executives tend to exaggerate the degree of control they have over events, discounting the role of luck.
- For example, a multi-industry study of start-ups found that more than 80% failed to achieve their market-share target.
- Business leaders routinely exaggerate their personal abilities, particularly for ambiguous, hard-to-measure traits like managerial skill.
- Another factor called anchoring also prevents us from producing accurate estimates. Simply put, when the executives propose the new project, they tend to accentuate the positives in order to make the case for their proposal. As a result, all future estimates are skewed towards overoptimism. This phenomenon is the result of anchoring, one of the strongest and most prevalent of cognitive biases.
- For example, one Rand Corporation study of 44 chemical-processing plants owned by major companies like 3M, DuPont, and Texaco found that, on average, the factories’ actual construction costs were more than double the initial estimates. Furthermore, even a year after start-up, about half the plants produced at less than 75% of their design capacity, with a quarter producing at less than 50%.
Conclusion that Lovallo and Kahneman come to as a result of these findings: companies must employ external experts to generate accurate and unbiased estimates for their projects.
The Machiavelli Factor Explanation
Professor Bent Flyvbjerg who dedicated his career to the study of ambitious megaprojects disagrees both with the "economic theory" and the "mass delusion" theory explanations. In his article titled "Delusions of Success: Comment on Dan Lovallo and Daniel Kahneman." he mentions the following counterarguments:
- In the course of his studies him and his colleagues frequently encountered the deliberate cooking of the books in order to make the project proposal look more attractive. He calls it the "Machiavelli Factor".
- His analysis of capital transportation projects revealed that the executives were rewarded with heavy incentives for rosy forecasts and faced very minor penalties when their predictions proved to be wrong
- Moreover, professor Flyvbjerg contends that during the course of 70 years covered by his study, the relative size of the estimation errors remained suspiciously constant
- For example urban rail investments were on average 45% over budget, while the actual ridership has been 50% lower than predicted.
- Finally, he argues that since humans are - as a rule - very capable of learning from their mistakes, it is unlikely that they would continue to make the same blunders decade after decade.
Scientific studies conducted by Bent Flyvbjerg show that political pressure is the top influencer, hence the C-level would be unwilling to accept external fair estimates.
About the Author
Jamal Moustafaev, MBA, PMP – president and founder of Thinktank Consulting is an internationally acclaimed expert and speaker in the areas of project/portfolio management, scope definition, process improvement and corporate training. Jamal Moustafaev has done work for private-sector companies and government organizations in Canada, US, Asia, Europe and Middle East. Read Jamal’s Blog @ www.thinktankconsulting.ca