Underestimation of costs — how to avoid it?
Exceedance of the planned investment costs, or underestimation of investment, is a frequent mistake which entrepreneurs from various industries struggle with. There is no golden means, the panacea, which will allow to perfectly estimate the project cost. However, there are several methods and actions which can help or significantly limit differences between the planned and actually incurred expenses. Underestimated projects may lead to huge losses and even collapse of the enterprise. How to save ourselves from such situations then?
History repeats itself
Bent Flyvbjerg, Danish economist and Oxford University professor, has been dealing with the problem of investment cost underestimation for years. The first scientific publications tackling this matter began to appear at the beginning of 1970s and regarded selected undertakings. However, it was not always possible to analyse all the data, so Bent knew the problem existed but was unable to say on what scale. His studies focused primarily on building projects implemented worldwide. Why did they focus on such projects? He did so as the problem of underestimation occurs most frequently in the building industry, investments in infrastructure and technological projects, including IT projects.
Many years of his studies show that:
- investment implementation costs were exceeded in 9 out of 10 investigated investments and the probability to exceed planned costs was 86%;
- the average exceedance of planned costs was 28%;
- interestingly, no significant differences were noticed in investment underestimation due to the period in which the projects were being performed. Undertakings implemented 10, 30 or 70 years ago showed similar data.
At Statista.com you can find comparison of some of the most well-known buildings in the world concerning the percentage of budget exceedance.
Other interesting data can be found on the Mavenlink blog. They come from different reports and regard various industries, not only the construction one. 4PM states that 70% of projects fail. On the other hand, hbr.org shows that because of unfinished, often underestimated projects, the American IT market loses from 50 to 150 million dollars per year. According to IBM, only 40% of that type of undertakings fit within their budget, quality level and implementation time.
As you can see, statistics are rather cruel and show that project management and good project estimation is a problem occurring on a larger scale and concerns all enterprises — both the small and large ones.
How to protect ourselves against underestimation?
There are several schools which advise how to reduce the probability of cost underestimation and even how to prevent them in some cases. But before we even get to the implementation of the project we have to prepare for work well. The planning stage is vital for the entire project. First and foremost, we have to determine what budget we have and adjust our actions to it. The situation gets worse when we are not entirely sure what our financial capabilities are and what resources or supplies we have. It is then more difficult, or sometimes even virtually impossible, to estimate the undertaking costs.
If we decide to calculate the project price, we have to follow three main indicators:
- time — how much time we have to devote to create a project or perform a service;
- quality — how good a product we want to release;
- price — how much we will earn after the product is sold.
These three indicators have a peculiarity about them: usually, if two are met, the remaining one is not. In other words, we cannot make something cheaply and at the same time well and fast, well and at the same time fast and cheaply or fast and at the same time cheaply and well. Therefore, at this stage already it is worth thinking about proper protection of the budget in order to avoid problems at a later stage. What to do, however, when a project is already in implementation and we have to avoid cost exceedance?
First of all, we have to use an appropriate methodology for project management. Agile is said to be one of the most easily adaptable ways to control tasks. This is so as the flexibility of this methodology allows to easily introduce changes during implementation. It could be said that it is a sequence-based way of managing tasks based on communication, people, cooperation and response to change. You can read about the Scrum methodology, which is a part of Agile, in our post.
Another thing to do is to prepare small task teams and determine short working and reporting periods. Let it be one-week sprints. Each team has to perform its tasks in that time. Why can short periods protect us against cost exceedance? First of all, these small samples reflect the entire process to some degree. If one of the links fails, we can have an additional team in reserve who will help our personnel. We also need to have a small crisis group at standby, one able to deliver several emergency solutions if a difficult situation arises. For such a group it is worth preparing a few “test sprints” focusing on “putting out fires” in situations where our project will start to dramatically come close to its financial threshold. This group will allow us to respond quickly because it will already have some alternative solutions prepared, ones tested “at a laboratory site.”
Communication among the people related to a project is also important. Bad flow of information and correspondence noise can lead to large delays, which often translates into increased total investment cost. This is why it is being more and more frequently recommended to use tools assisting in project management. What is the purpose of this? First and foremost, all people related to an undertaking have access to necessary documents, correspondence and, most importantly, they see at which implementation stage each of the project handling units work. Thanks to this, it is easier to pinpoint bottlenecks and respond to them.
What software to choose? There are many solutions on the market, both paid and free, which allow to integrate the team and create the optimal environment for project-related work. Choice of tools primarily depends on our requirements and budget set for software.
What to do if we still make mistakes in our calculations?
If a situation occurs where we start to come close to the budgetary threshold, we should inform the management or clients as soon as possible in the case of external projects. Thanks to this, people who have a direct influence on the budget and the available funds are involved in the further decision-making process. It also allows to stop the project if the estimated additional costs increase significantly.
Thus, sometimes it seems reasonable to add a tolerance to the assumed costs of 20%, for instance, so that if the assumed costs are exceeded, you will be able to continue working. If these tolerance funds are ultimately saved, we can return them to the client or redirect to other activities.
