Will YOUR Project Overrun?

Do a Cost Risk Analysis

Presented by

David T. Hulett, Ph.D.

Hulett & Associates, LLC
Los Angeles, CA 90049 (310) 476-7699 / info@projectrisk.com

2002 Hulett & Associates, LLC

Cost Overrun Risk

Estimate at Completion (EAC)
Sources of Overrun Risk Steps in Cost Risk Analysis Collecting Risk Analysis Data

2002 Hulett & Associates, LLC

Estimate at Completion (EAC)

Basis of estimates -- at the cost element level
Historical data Engineering estimates Bids from contractors and suppliers Labor productivity rates Pricing Experience Parametric Industry database

Each of these produces a single-point estimate for the cost elements

2002 Hulett & Associates, LLC

Traditional Project Estimate At Completion (EAC) Methodology

We usually:
Estimate the cost by cost breakdown element Add up the elements costs Present the total as the total project cost Cross our fingers

But, is this what the project will cost?

Only if everything goes according to plan

2002 Hulett & Associates, LLC

Real Projects
Do projects usually go according to plan? NO!

Do projects sometimes overrun their budgets? YES!

Do we always have the right contingency? NO!

2002 Hulett & Associates, LLC

Is the Traditional EAC Accurate?

The traditional single-point EAC is precise
It can be audited for summation accuracy

But it may be wrong

Cost estimates are often overrun

Traditional cost estimates are precisely wrong

2002 Hulett & Associates, LLC

Why Conduct a Cost Risk Analysis?

We do not know what the estimate means -- e.g.
How much risk is there of overrun? What is the overrun exposure? How does it relate to ultimate cost at completion?

Cost Risk Analysis answers these questions

2002 Hulett & Associates, LLC

Cost Risk Analysis -- A New Opportunity

Opportunity to improve the accuracy of the estimate
We can determine the contingency needed to reduce the risk to an acceptable level Opportunity to improve our risk management

We can determine where the risk is in a complex project

2002 Hulett & Associates, LLC

Steps in a Cost Risk Analysis

Develop cost analysis model (e.g. WBS) Identify risky cost elements Determine the two dimensions of risk by element
Likelihood of occurring and impact if it does

Explore correlation between elements of cost Insert model and data into simulation software Simulate the model Calculate risk of overrun, contingencies Prioritize risky cost elements for risk management
2002 Hulett & Associates, LLC

Example -- Risk Analysis Model of Project Cost

Project Cost Risk Analysis
Cost Category Project Design Equipm ent Foundat ion, St ruct ure Piping, Elect . HVAC Labor Indirect s Total Project Cost Value for EAC ($ 000) 1,500 5,000 7,000 1,000 8,700 6,000 29,200

What is the likelihood this project will cost $29,200,000?

2002 Hulett & Associates, LLC

Interview to Quantify Cost Risk by Element

Identify experts in the project area
Probably area or team leaders May have estimated the cost and have considered risk

Sometimes experts are biased

Project Manager who is committed Subcontractor looking for relief

Interview them for risk information

Optimistic extreme scenario Pessimistic extreme possible costs Most likely possible cost
2002 Hulett & Associates, LLC

Pessimistic Scenario -- High Range

Worst -case scenario -- the 99% case
What happens if everything goes wrong? Include failure and need to do it over if possible Can several things go wrong simultaneously?

Criterion -- at least a 1% chance of occurring

Has it ever happened? At least once? Are you uncomfortable with this specification? Not yet unbelievable never-never land

2002 Hulett & Associates, LLC

Optimistic Scenario -- Low Range

Lower costs than included in the estimate
Estimates usually include contingency for some things going wrong most likely

Optimistic scenario -- the 1% case

Even expected problems do not materialize Murphy takes a holiday Equipment works fine Labor productivity is uncommonly high Material, equipment comes in as advertised

2002 Hulett & Associates, LLC

Most Likely Scenario

Sometimes the EAC is not the most likely cost Too Low to:
Get the contract (contractor) or please the boss Keep the bankers and other stakeholders happy

Too High to:

Provide cushion Include contingency in estimate -- not bare bones

Explore this possibility before ending the interview

2002 Hulett & Associates, LLC

Triangular Probability Distribution

Relative Opportunities Likelihood of Occurring

Threats

Low

Most Likely

High

Possible Element by the Relative likelihood determined Costs height of the triangle Impact determined by X-Axis Easy to use, commonly used

2002 Hulett & Associates, LLC

Some Analysis Using the Triangular Distribution

Relative Likelihood of Occurring

Expected Cost = 116.7

70

100 Possible Element Costs

180

Average (expected) cost = (low + most likely + high) / 3 (70 + 100 + 180) / 3 = 350 / 3 = 116.7
2002 Hulett & Associates, LLC

Uniform Probability Distributions

Uniform distribution, little information early in project, cannot determine most likely cost
Relative Likelihood of Occurring

Expected cost (high + low)/2

Possible Element Costs

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Beta Distribution
Beta distribution
Flexible, hard to use (shape parameters) Expected cost approximated as (H - L) / 6
Beta Beta

0.00

24.17

48.33

72.50

96.67

0.00

8.67

17.33

26.00

34.67

2002 Hulett & Associates, LLC

Normal Distribution
Normal distribution
Symmetrical Many automatically think of the Normal distribution
Normal

70.00

85.00

100.00

115.00

130.00

2002 Hulett & Associates, LLC

Construction Project Interview and Display Low and High Ranges

Project Cost Risk Analysis
Cost Category Project Design Equipm ent Foundat ion, St ruct ure Piping, Elect . HVAC Labor Indirect s Total Project Cost Value for EAC ($ 000) 1,500 5,000 7,000 1,000 8,700 6,000 29,200 Low 1,200 4,500 6,200 800 4,500 5,000 Most Likely ($ 000) 1,500 5,000 7,200 1,000 5,000 6,000 High 2,000 6,000 8,600 1,600 5,900 6,700

2002 Hulett & Associates, LLC

Assumptions and Results Highlighted

Assumptions -- Input Distributions
Project Cost Risk Analysis
Cost Category Project Design Equipm ent Foundat ion, St ruct ure Piping, Elect . HVAC Labor Indirect s Total Project Cost Value for EAC 1,500 5,000 7,000 1,000 8,700 6,000 29,200 Low ($ 000) 1,200 4,500 6,200 800 7,500 5,400 High 2,000 6,000 8,600 1,600 12,500 6,700

Result Distribution
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The EAC is Not the Average Cost. It is Not Even the Most Likely Cost!
Forecast: Total Project Cost 5,000 Trials
.030

Frequency Chart

0 Outliers
151

.023

EAC = $29,200

Average Cost is Not 113.2 the EAC

75.5

.015

.008 Mean = 30,733 .000 27,000 29,250 31,500 33,750 36,000

37.75

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Cumulative Distribution
Forecast: Total Project Cost 5,000 Trials
1.000

Cum ulative Chart

0 Outliers
5000

.750

.500

.250 Mean = 30,733 .000 27,000 29,250 31,500 33,750 36,000 0

Certainty is 10.24% from -Infinity to 29,200

$29,200 is only 10% likely

2002 Hulett & Associates, LLC

Cumulative Distribution Table

Forecast:Total Project Cost Percent ile Value 0% 27,296 10% 29,172 20% 29,620 30% 29,989 40% 30,305 50% 30,633 60% 31,010 70% 31,377 80% 31,815 90% 32,461 100% 35,143

EAC of $29,200 is just over 10%

Need a contingency of $2,615 for 80% likelihood

2002 Hulett & Associates, LLC

Contingency Percentages on Baseline Project Cost Estimate

Forecast: Total Project Cost
Percent ile 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Value 27,296 29,172 29,620 29,989 30,305 30,633 31,010 31,377 31,815 32,461 35,143
2002 Hulett & Associates, LLC

Cont ingency -7% 0% 1% 3% 4% 5% 6% 7% 9% 11% 20%

How do You Identify the Most Risky Cost Elements?

Which cost elements contribute most to overrun risk? One measure of total project risk
Difference between the EAC and the average cost from the simulation

The Method of Moments (MOM) rule is that: The average total project cost is the sum of the average cost from the elements distributions For the triangular distribution (only) remember: Average = (low + most likely + high) / 3

2002 Hulett & Associates, LLC

Which Elements Contribute Most to the Difference?

Forecast: Total Proj ect Cost 5,000 Trials
.026

Frequency Chart

0 Outliers
132

Explain the Contingency at the Mean

.020 .013 .007

99

66

33

Mean = 30,733 .000 24,000 27,500 31,000 34,500 38,000 0

2002 Hulett & Associates, LLC

Compute the Average Project EAC Assuming Triangular Distribution

Project Cost Risk Analysis
Cost Category Project Design Equipm ent Foundat ion, St ruct ure Piping, Elect . HVAC Labor Indirect s Total Project Cost Value for EAC 1,500 5,000 7,000 1,000 8,700 6,000 29,200 Low 1,200 4,500 6,200 800 7,500 5,400 High 2,000 6,000 8,600 1,600 12,500 6,700 Average 1,567 5,167 7,267 1,133 9,567 6,033 30,733

2002 Hulett & Associates, LLC

Calculate the (Average - EAC) and Sort on It to Help Focus Risk Management
Identifying High-Risk Elements Using Method of Moments Cost Category Labor Foundat ion, St ruct ure Equipm ent Piping, Elect . HVAC Project Design Indirect s Total Project Cost Value for EAC 8,700 7,000 5,000 1,000 1,500 6,000 29,200 Average 9,567 7,267 5,167 1,133 1,567 6,033 30,733 Average - EAC 867 267 167 133 67 33 1,533

2002 Hulett & Associates, LLC

Will YOUR Project Overrun? Do a Cost Risk Analysis -- Summary

The EAC is not even the most likely cost A cost risk analysis can improve the accuracy of the estimate, provide a contingency amount, and identify the high-risk elements Correlation is important in developing cost risk estimates Data collection is the main part of the risk analysis
There are several steps that have proved effective It is important to recognize several important biases

2002 Hulett & Associates, LLC